Lease Finance – AHSEC Class 12 Finance Chapter 14

Here is a comprehensive study note for the AHSEC Class 12 Finance textbook, focusing on Chapter 14: Lease.

Chapter 14: Lease Finance

Summary Note

This chapter explains the concept of lease finance, a method of acquiring the use of an asset without owning it. It details the meaning of a lease, its types, features, advantages, and disadvantages.

• Meaning of Lease:
  • A lease is a contract between two parties: the lessor (the owner of the asset) and the lessee (the user of the asset).
  • In this contract, the lessor gives the lessee the exclusive right to use an asset for an agreed period in return for a series of payments, known as lease rentals.
  • Essentially, it separates the ownership of an asset from its use.
• Types of Lease: There are two main types of leases:
  1. Finance Lease (or Capital Lease):
     • Meaning: A long-term, non-cancellable lease where the lessor transfers substantially all the risks and rewards of ownership to the lessee. The total lease payments usually exceed the asset’s purchase price.
     • Features:
       • The lease term covers the major part of the asset’s economic life.
       • The lessee often has the option to purchase the asset at a lower price at the end of the lease term.
       • The lessee is responsible for the maintenance and insurance of the asset.
       • It is suitable for heavy and costly assets like aircraft, heavy machinery, and land.
  2. Operating Lease (or Service Lease):
     • Meaning: A short-term, cancellable lease where the lessor retains most of the risks and rewards of ownership.
     • Features:
       • The lease period is much shorter than the asset’s economic life.
       • The lessor is responsible for the maintenance of the asset.
       • The lessee can usually terminate the lease by giving due notice.
       • Lease rentals are generally higher.
       • It is suitable for assets that are sensitive to technological obsolescence, like computers, office equipment, and vehicles.
• Differences between Finance Lease and Operating Lease:

• Advantages and Disadvantages of Lease Finance:
  • Advantages to the Lessor (Owner):
    • Assured Return: Receives fixed lease rentals.
    • Tax Benefit: Can claim tax benefits on depreciation.
    • High Profitability: Can earn a high quantum of profit.
    • Right to Repossess: Can take back the asset in case of default by the lessee.
  • Advantages to the Lessee (User):
    • Use without Ownership: Can use a costly asset without making a large initial investment.
    • Maintains Debt-Equity Ratio: Since it’s not a loan, it doesn’t affect the lessee’s borrowing capacity.
    • Benefit of Latest Technology: In an operating lease, the lessee can easily replace outdated assets with new ones.
    • Tax Deductible: Lease rentals are treated as an expense and are fully tax-deductible.
  • Disadvantages:
    • For Lessor: Risk of loss on repossession if the asset’s value has fallen, and responsibility for maintenance in an operating lease.
    • For Lessee: Cannot claim depreciation benefits, may have restrictions on using the asset, and in a finance lease, is obligated to pay rentals even if the asset is not in use.

Complete Textual Question Answers

Here are the answers to all the questions given at the end of Chapter 14.

A. Very Short Answer Questions (1 Mark each)

1. Is finance lease a cancellable lease?
   Ans: No, a finance lease is a non-cancellable lease.
2. Is operating lease a short-term lease?
   Ans: Yes, an operating lease is a short-term lease.

B. Short Answer Questions (2 Marks each)

1. What is lease?
   Ans: A lease is a contract between two parties, the lessor (owner) and the lessee (user), where the lessor gives the lessee the right to use an asset for an agreed period of time in return for a series of payments called lease rentals.
2. Who are the parties involved in a contract of lease?
   Ans: The two parties involved in a contract of lease are (i) the lessor (the owner of the asset) and (ii) the lessee (the user of the asset).
3. What is finance lease?
   Ans: A finance lease is a long-term, non-cancellable lease agreement where the lessor transfers substantially all the risks and rewards associated with the ownership of an asset to the lessee.
4. State two features of finance lease.
   Ans: Two features of a finance lease are:
   i. It is non-cancellable prior to its expiry date.
   ii. The lease term covers the major part of the economic life of the asset.
5. What is operating lease?
   Ans: An operating lease is a short-term, cancellable lease agreement where the lessor does not transfer all the risks and rewards of ownership to the lessee. The lessor is typically responsible for the asset’s maintenance.
6. State two features of operating lease.
   Ans: Two features of an operating lease are:
   i. It is a cancellable lease, meaning the lessee can terminate it with due notice.
   ii. The lessor bears the responsibility for the maintenance of the asset.
7. State two differences between finance lease and operating lease.
   Ans: Two differences are:
   i. A finance lease is long-term and non-cancellable, while an operating lease is short-term and cancellable.
   ii. In a finance lease, the lessee bears the cost of maintenance, whereas in an operating lease, the lessor bears the cost of maintenance.
8. Write two advantages of lease finance to the lessor.
   Ans: Two advantages to the lessor are:
   i. Additional financial product: Leasing provides an additional source of business and income for finance companies and banks.
   ii. Tax benefit: The lessor, as the owner, can claim tax benefits on the depreciation of the leased asset.
9. Write two advantages of lease finance to the lessee.
   Ans: Two advantages to the lessee are:
   i. Additional source of finance: It enables a lessee to acquire and use a costly asset without making a large initial investment or borrowing money.
   ii. Maintenance of debt-equity ratio: Since leasing is not a loan, it does not appear as debt on the lessee’s balance sheet, thus keeping their borrowing capacity intact.
10. Write two disadvantages of lease finance to the lessor.
    Ans: Two disadvantages to the lessor are:
    i. Loss on repossession: If the lessee defaults and the asset is repossessed, the lessor may suffer a loss if the asset’s residual value is very low.
    ii. Responsibility of maintenance: In an operating lease, the lessor has to bear the cost and risk of maintenance and obsolescence.
11. Write two disadvantages of lease finance to the lessee.
    Ans: Two disadvantages to the lessee are:
    i. No benefit for depreciation: The lessee cannot claim tax benefits for depreciation on the leased asset, as they are not the owner.
    ii. Limited scope: Leasing facilities are generally not available for project finance, which requires a gestation period before revenues are generated.

C. Long Answer Questions (Type-I) (5 Marks each)

1. Write five features of finance lease.
   Ans: (Refer to the “Features” of Finance Lease in the summary and explain five points, such as Transfer of ownership, Option to purchase, Lease term covers economic life, Non-cancellable, and Lessee bears maintenance).
2. Write five features of operating lease.
   Ans: (Refer to the “Features” of Operating Lease in the summary and explain five points, such as Short period of lease, Cancellable lease, Lessor maintains the asset, Lessor bears risk of obsolescence, and High lease rental).
3. State five advantages of lease finance to the lessor.
   Ans: (Refer to the “Advantages to the Lessor” in the summary and explain five points, such as Additional financial product, Increases profitability, Increase in sales, No gestation periods, and Tax benefit).
4. State five advantages of lease finance to the lessee.
   Ans: (Refer to the “Advantages to the Lessee” in the summary and explain five points, such as Additional source of finance, Maintenance of debt-equity ratio, Acquisition of assets by easy instalments, Avoidance of risk, and Benefit of latest technology).
5. Write the disadvantages of lease finance to the lessor and the lessee.
   Ans: (Combine the answers from B.10 and B.11, elaborating on each point to provide a comprehensive view of the disadvantages for both parties).
6. Write five differences between finance lease and operating lease.
   Ans: (Refer to the table in the summary and explain five points of difference in detail, covering Lease Period, Cancellability, Responsibility of Maintenance, Risk of obsolescence, and Nature of contract).

D. Long Answer Questions (Type-2) (8 Marks each)

1. What is finance lease and operating lease? Write the differences between finance lease and operating lease.
   Ans: (First, define Finance Lease and Operating Lease clearly as in B.3 and B.5. Then, provide a detailed comparison by explaining the differences based on various points like lease term, cancellation, maintenance, risk, purchase option, and nature of the contract, as covered in the summary table).
2. What is finance lease? State the features of finance lease.
   Ans: (Combine the answers from B.3 and C.1. Start with a clear definition of a finance lease. Then, discuss its various features in detail, such as the long-term and non-cancellable nature, transfer of risks and rewards, purchase option, and the lessee’s responsibility for maintenance).
3. State the advantages of lease finance to the lessor and lessee.
   Ans: (Combine the answers from C.3 and C.4. First, explain the advantages for the lessor, such as assured returns, tax benefits, and increased sales. Then, explain the advantages for the lessee, such as acquiring assets without a large investment, tax-deductible rentals, and avoiding the risk of obsolescence in an operating lease).

Previous Year AHSEC Question Answers (2015-2025)

Short Questions (1-2 Marks)

• What is a Lease? (AHSEC 2015, 2019)
  Ans: A lease is a contract where the owner of an asset (lessor) gives another party (lessee) the right to use the asset for an agreed period in return for periodic payments called lease rentals.
• What is a Finance Lease? (AHSEC 2016, 2020)
  Ans: A finance lease is a long-term, non-cancellable lease where substantially all the risks and rewards of ownership of an asset are transferred from the lessor to the lessee.
• Mention two advantages of leasing to the lessee. (AHSEC 2017)
  Ans: Two advantages of leasing to the lessee are: (i) It allows the use of an asset without making a large initial investment, and (ii) Lease rentals are fully tax-deductible as a business expense.
• What is an Operating Lease? (AHSEC 2018, 2022)
  Ans: An operating lease is a short-term, cancellable lease where the lessor retains the risks and rewards of ownership and is responsible for the maintenance of the asset.

Long Questions (5-8 Marks)

• Distinguish between Finance Lease and Operating Lease. (AHSEC 2017, 2021)
  Ans: (This answer is the same as the textual Long Answer Question C.6. Please refer to that answer above, using a table for clarity).
• Explain the advantages of lease financing from the point of view of the lessee. (AHSEC 2018)
  Ans: (This answer is the same as the textual Long Answer Question C.4. Please refer to that answer above).

10 Most Important Questions

1. Who are the two parties in a lease agreement?
   Ans: The two parties are the lessor (the owner of the asset) and the lessee (the user of the asset).
2. What is the main difference between a finance lease and an operating lease in terms of risk?
   Ans: In a finance lease, the risk of obsolescence and maintenance is borne by the lessee. In an operating lease, these risks are borne by the lessor.
3. Why is a finance lease often called a ‘Capital Lease’?
   Ans: It is called a capital lease because it is used to finance long-term capital assets, and the transaction is similar in substance to purchasing the asset with borrowed funds.
4. Which type of lease is suitable for assets like computers and why?
   Ans: An operating lease is suitable for assets like computers because they become technologically obsolete quickly. An operating lease allows the lessee to easily replace the old equipment with new models without being stuck with an outdated asset.
5. What is the primary tax advantage for the lessee in a lease agreement?
   Ans: The primary tax advantage for the lessee is that the entire lease rental payment is treated as an operating expense and is fully deductible from their taxable income.
6. What is the primary tax advantage for the lessor in a lease agreement?
   Ans: The primary tax advantage for the lessor is that, as the legal owner of the asset, they can claim tax deductions for depreciation on the asset.
7. Can a finance lease be cancelled by the lessee?
   Ans: No, a finance lease is generally non-cancellable by the lessee before its expiry date.
8. What does it mean that leasing helps a lessee “maintain their debt-equity ratio”?
   Ans: It means that since a lease is not considered a loan, it does not appear as debt on the lessee’s balance sheet. This allows the company to acquire assets without increasing its debt level, thus keeping its borrowing capacity intact for other needs.
9. What are ‘lease rentals’?
   Ans: Lease rentals are the series of periodic payments made by the lessee to the lessor in consideration for the right to use the asset.
10. In which type of lease does the lessee usually have an option to buy the asset at the end?
    Ans: The lessee usually has an option to buy the asset at the end of the term in a finance lease.