What is Direct Lease?
Direct lease refers to a contractual arrangement between a lessor and a lessee where the lessor leases out some property (generally equipment) to the lessee.
There are two types of contract that come under direct lease. The first is the bipartite agreement where the lessor already owns the property and directly leases it out to the lessee. The second is a tripartite agreement where the lessor, usually a bank or a lending institution, purchases the property from a third-party (usually the manufacturer) and then leases it out to the lessee.
How Direct Leasing Works
Under direct leasing, the lessor recognizes the gross investment in the lease and the related amount of unearned income. The gross investment in the lease is calculated as:
sum of lease payments – executory cost + unguaranteed residual value benefiting lessor
The unearned income is the difference between the gross investment and the carrying amount (book value of the asset in the balance sheet) of the lease. Unearned income is recognized in earnings over the term of the lease. The lessor can use the interest method to realize the unearned income.
The accounting principle behind direct leasing recognizes losses but does not recognize gains. At least once a year, the lessor will review the estimated value of the leased property. If the residual value has declined and the decline seems irreversible, the lessor will account for the decline as a loss in the current period. If the residual value has increased, on the other hand, the gain is not recognized.
A direct financing lease is usually offered by banks and other lending institutions, such as equipment leasing companies.
Direct Lease vs Sale and Lease Back
A sale and lease-back agreement generally occurs in a situation where the lessee has already acquired a property but needs to free up capital in order to maintain operational cash flows. In such a case, the lessee sells their property to the lessor and then leases it back from the lessor and makes monthly payments. This allows the lessee to free up cash to make other investments or use the money to manage day-to-day operational expenses. The sale and lease-back agreement has some disadvantages because it may be hard to estimate the depreciation on certain kinds of equipment and there may not always be a viable secondary market for the sale of such assets.
Direct sale, on the other hand, refers to the situation where the lessor directly leases the property to the lessee. The lessor either owns the property already or buys it from the manufacturer.
Types of Direct Lease Financing
True Tax Financing
In this type of direct lease, the lessor legally owns all the equipment that is leased and can avail tax benefits through depreciation and interest expense. The lessee makes monthly payments that are set off as a cost of doing business. Once the lease expires, the lessee has the option to purchase the equipment for its fair market value, renew the lease at a fair market value rental rate, or return the equipment without any further financial obligation. This is also known as capital lease financing.
Operating Lease Financing
In this type of lease, the term of the lease is less than the total life of the asset during which it is economically useful. To qualify as an operating lease, the net present value of the rental payments over the time period of the lease should be less than 90% of the total cost of the equipment. The lessor claims depreciation on the asset and the lessee sets of monthly payments as a cost of doing business.
Master Lease Financing
This type of lease has an upfront agreement which has certain clauses that allow the lessee to put down funds for equipment purchase at different points. It usually involves a pre-decided line of credit and is negotiated upfront.
Who Provides a Direct Lease?
Direct leases are mostly provided by equipment leasing companies. An equipment leasing company is usually an NBFC (Non-Banking Financial Company) that is primarily engaged in leasing equipment or financing such a lease.
Any non-banking finance company can obtain a license to start equipment leasing, subject to certain conditions. Equipment leasing companies cannot trade, hold, and deal in real estate business and the lease period cannot be fixed for less than three years in the case of any finance lease agreement. The only exception to this is in the case of IT and computer accessories.