Lease Classification

The classification of lease is based on the extent to which risks and rewards incidental to ownership of a leased asset lie with the lessor or the lessee. Risks include the possibilities of losses from idle capacity or technological obsolescence and of variations in return because of changing economic conditions. Rewards may be represented by the expectation of profitable operation over the asset’s economic life and of gain from appreciation in value or realisation of a residual value.


There are basically two types of lease:

1. Finance/Capital and

2. Operating lease

All other variations belong to either of these two types. Lessees can choose from several of these lease plans to suit their peculiar circumstances. The distinctions between Finance from Operating lease lie basically on the rights and obligations of the parties to the lease, the risks and benefits accruing to the parties to the lease, differences in accounting treatment, and differences in tax treatment. In order words the difference between a finance lease and an operating lease can be defined from four different perspectives: – the industry, legal, accounting and tax. The distinguishing factors from these perspectives have been telescoped into the features of the two types of leases.

The FINANCE LEASE, also called the CAPITAL or FULL PAY-OUT LEASE, is a contract in which the lessee is obligated to pay agreed lease rentals periodically to the lessor over the tenor of the lease in return for the possession and use of the asset under lease. It is “a contract involving payment over a period of time (known as the primary or basic period), of specified sums sufficient in total to amortise the capital outlay of the lessor and provide for the lessor’s cost of funds plus a desired return” (Ugboaja 1989).

A finance lease is a lease involving rental payment over an obligatory period sufficient in total to amortise the capital outlay of the lessor and also give the lessor some benefits” (Equipment Leasing Act s.44)

In a finance lease, the lessee is generally responsible for the maintenance and servicing of the asset and may have the opportunity of either buying the asset at the end of the primary lease term or extending the lease for a secondary period beyond the initial (primary) tenor. Ownership and title to the leased asset is retained by and vested in the lessor, but all the risks associated with and benefits accruing from the ownership of the asset are substantially transferred to the lessee during the tenor of the lease.

Features of Finance Lease

(a) Fixed Obligation: – The lessee and lessor are obligated to the lease and cannot cancel it except by mutual consent before the expiration of its tenor.

(b) Long Term: – Finance lease usually last for a longer period of time. It is drawn in such a way as to cover substantially the economic life of the asset during which the lessee must fulfill the obligations of the lease.

(c) Lease Rental Payments: – Total lease rentals in a finance lease are usually higher than the original value of the leased asset. This is to cover all attendant costs and expenses and the lessor’s return on investment during the tenor of the lease. The salvage of the asset is extra profit to the lessor.

(d) Risks and Rewards of Ownership: – The lessor takes no asset-based risks or asset based rewards. It only takes financial risks and financial reward despite, retaining ownership of the leased asset.

(e) Maintenance: – Generally, the lessee is responsible for the maintenance of the asset.

(f) Ownership Option: – In practice, the intention of the parties is for the lessee to own the asset at the end of the lease term.

OPERATING LEASE: is a lease agreement in which the cost of the asset is not fully amortised during the primary lease period and the lessor does not necessarily depend on the lease rentals during the primary lease period for his total returns but expects to recover the balance of its cost plus profit from the secondary lease or sale of the returned asset at the end of the lease period. In other words, the operating lease is usually for a period shorter than the economic life of the asset after which it can then be re-leased to the same lessee or some one else at a new rental rate or even sold. It can be cancelled before the end of its tenor by either party and the lessor retains ownership, risks and benefits accruing to it. In determining the rentals on an operating lease, the lessor also charges for such additional services as asset maintenance, insurance and technical support staff that are provided for in the lease by the lessor.

The lessor in an operating lease may not expect to recover the full cost of the asset and total expected return on the investment from a single lease tenor. Hence, there are multiple tandem lease terms while the lessor continues to retain ownership of the asset. On the other hand, in a finance lease, the lessor expects to recoup the capital cost of the asset, including associated expenses and interest charges from the lease rentals payable during the non-cancellable lease term.

An operating lease is a lease involving rental payment over an obligatory period but the equipment is not wholly amortised during the non-cancellable period if any, of the lease, and the lessor does not rely for his profit on the rentals in the cancellable period”. (Equipment Leasing Act s.44)

Features of Operating Lease

(a) Equipment service included in cost: Ordinarily, the lessor bears the responsibility for servicing and maintaining the asset and these expenses are built into the cost of the lease. It allows for the lessor to maintain a pool of skilled maintenance crew for servicing a large number of assets economically.

(b) Equipment cost not fully amortised: the total lease rentals for the tenor of the lease is lower than the equipment cost.

(c) Lease is cancellable: The lessee can cancel the lease before the expiration of the primary lease period.

(d) Bundled services: Apart from the provision of the asset, the lessor may provide extra services relating to the asset such as insurance, product warranties, swaps (replacing the leased asset with another pending major repair on the asset) and other technical and operational support.

(e) Asset based risks and rewards: In a full-service operating lease, the lessor is directly affected by the state and efficiency of the asset. The lessor therefore has a great interest in ensuring the asset is kept in good condition.

(f) The Uncertain IRR: the lessor’s rate of return is dependent upon the asset value, performance, or costs relating to the asset. The fixed lease rentals cannot give rise to an ascertainable rate of return on investment. Therefore, the implicit rate of return is always a matter of probabilities.

It is important to clearly distinguish between a finance lease and an operating lease for two major reasons.

i. The type of lease determines how it is recorded in the accounting books of the lessor and the lessee.

ii. The type of lease determines who (the lessor or the lessee) gets the capital allowance from the tax authorities.