Basics of Leasing By Vinod Kothari

Equipment leasing World-over has developed as one of the most potent alternatives to funding an equipment. This is intended to be a primer to understanding the business of equipment leasing. The basic features of this write-up are:

It is authentic - written by one of the most respected leasing commentators in the World. It is independent - since the author does not have any interest in leasing business other than as trainer-author-consultant, you may expect a completely unbiased treatise. It is very simple and to-the-point. It tries to make full use of the navigational and graphical possibilities offered by the Web for cross-references, details and illustrations. It is excellent value for the time you spend reading, if you have any interest in leasing as lessor, lessee, consultant, academician or accountant.

Leasing: Alternative to funding or alternative to acquisition?: Is leasing merely an alternative to funding, or is it an alternative way of acquiring the equipment? If it were a pure financial alternative, the user should stay in the position of a virtual borrower. In other words, the user can look at leasing as a mode of financing - just as loan, bond or other borrowing option. If it were an alternative mode of acquiring an asset, such as an asset-renting option, it becomes a distinctive way of getting to use an asset without owning, or almost-owning it. In this case, the user would be looking at leasing as an alternative mode of acquiring the equipment, significantly different from a plain financing alternative. If a lease plan is a funding alternative, it is called a financial lease. If it is not a financial alternative alone, it is an operating lease. Most lessors are financial intermediaries, and therefore, are obviously comfortable with financial leases. Most leasing in the World is still financial leasing. However, operating lease plans are also available for many equipments now. Operating leasing is certainly a faster growing segment of leasing business.

Financial leases:
Here, though the device used is leasing, the purpose and effect is virtually financing financing by the device of leasing, or leasing for the purpose of financing. However, the generic differences noted above still remain. In other words, the lessor will provide an asset and not the money needed to buy it, the payments by the lessee will be in form of lease rentals, etc. Financial leases are "loan look-alike": However, financial leases, though being leases by structure, are financings by contrivance. To achieve the financing purpose, the leasing structure here tries to eliminate the substantive differences between leasing and plain financings. Let us have a look at the differences between leasing and plain financing, and see how are these sought to be eliminated in financial leases:

If you are the lessee

These are the differences between leasing and This is how they are tackled borrowing The leased asset belongs to the lessor, not to you As long as you are able to milk the cow, how does as in case of loan. it matter who owns the cow! Ownership, after all, is primarily use-value. If it is a leased asset, it is available only for the The lease period is made sufficiently long to allow period of lease; assets acquired with a loan are you to exhaust most of the asset value - financial your own assets. leases carry a renewal clause also. In a loan, I would buy exactly the asset I need; Yes, the lessor as a matter of fact purchases assets would the lessor be able to provide me exactly selected by you, from a supplier identified by you, what I want? purely at your behest. In a loan, I repay the loan and pay some interest on Mostly, the lease rentals are calculated to fully the loan. How different is the charge in case of return the lessor's investment, and some return on lease? thereon. Except that they are not worded as such, you can look at the rentals as being composite interest and principal. In the loan case, all the risks and costs on the asset are mine - maintenance, obsolescence, repairs, etc. If I take the asset on lease, does it mean all these costs and risks will be taken by the lessor? The lessor would not take any risk in the asset at all : all costs on account of the asset will be borne by you, and all risks on the asset will be yours. The lease document will contain elaborate clauses to this effect.

Having bought the asset with a loan, I am saddled The lease will be non-cancellable till the lessor with the asset for long; can I return the leased asset fully recovers his investment. So you can't do in a as I feel like? lease what you can't do in a loan.

I can prepay a loan; can I prepay a lease?

Unless there are technical difficulties in doing so, prepayment of a lease is allowed; in such case, the lessor will sell the asset at the prepayment value to you.

If you are the lessor

In a loan, I get the interest and the principal. What In a lease, you get the lease rentals. Leave apart the do I get in a lease? name, you can take lease rentals as bundled repayment of principal and interest. In a loan, I am concerned with the asset only as a The risk of obsolescence, nay, all risks on the asset matter of security; if the leased asset is mine, does are absorbed by the lessee. The lease is nonit mean I carry the entire obsolescence risk in it? cancellable, till all your investment is recovered. What if the asset does not work? I am not You are not concerned in case of a lease also. The concerned in case of a loan. rentals are payable unconditionally - meaning without reference to the state or value of the asset. What if the asset appreciates in value? Do I stand Nope, the lessee has a right of renewal. He would to any benefit? I don't get any such benefit in a continue using the asset till it becomes an economic loan. junk. What if the lessee doesn't pay? In a loan, I can You would do the same in a lease, perhaps a little confiscate the asset. more easy in case of a lease, as the asset belongs to you. (This would, however, be subject to local laws.)

A typical financial lease: Take the following as an illustrative prototype of a financial lease:

Company A wants to acquire a boiler of a particular specification. It would cost $ 100,000. Company B is prepared to give it on lease on lease rentals of $ 22.50 per month payable monthly in advance, for 60 months. Let us suppose the deal is to be put through. A will be allowed to negotiate all commercial terms with the supplier including the technical specifications. B would walk in after everything is finalised: B would place its orders in the terms A instructs, and acquire the asset. The asset would be put on lease for 60 months; if the asset is expected to last for more than 5 years, the lessee will be given a convenient renewal option, for, say, next 5 years at a nominal rental. [Alternatively, depending on the regulations prevailing, the lessee could be given an option to buy the asset as a token value.]

As you might notice, in the above example, the lessee has been put virtually in the position of an asset owner - he has the right to use the asset for 5 years, with a power to extend the lease period for another 5 years. The primary The first 5 years are called the primary lease period and the and secondary extended period is called the secondary lease period. lease period The lease is non-cancellable during the primary lease period - that is, the lessee cannot return the asset and not pay balance of the lessor's rentals. For the secondary period, the lessee will have no incentive of returning the asset, as what the lessee has to pay is nominal, whereas the asset might still carry substantial value. Thus, the asset will be enjoyed by the lessee virtually for the whole of its economic life. payout The lessor too has no significant risk/reward other than that of a virtual money-lender: he would continue getting the lease rentals for the primary period which will fully-payout the lessor's investment in the lease as also give him his desired return on investment, irrespective of the state, value or utility of the asset. If the lessee performs as per agreement, the lessor would get no more, and no less, than such pre-fixed return on investment. Full lease Incidentally, in the present example, the lessor gets a return of 12.98% - this is equivalent to the rate of interest in case of loans. As this rate is not explicit, but implicit in the rate of rentals, the rate is implicit rate of return or IRR. The IRR Features of financial leases: The above discussion leads to the following features of financial leases: Financial leases allow the asset to be virtually exhausted by the same lessee. Financial leases put the lessee in the position of a virtual owner. The lessor takes no asset-based risks or asset-based rewards. He only takes financial risks and financial rewards, and that is why the name financial leases. The lease is non-cancellable, meaning the lessee cannot return the asset and not pay the whole of the lessor's investment. In this sense, they are full-payout, meaning the full repayment of the lessor's investment is assured. As the lessor generally would not take any position other than that of a financier, he would not provide any services relating to the asset. As such, the lease is net lease.

The risk the lessor takes is not asset-based risk but lessee-based risk. The value of the asset is important only from the viewpoint of security of the lessor's investment. In financial leases, the lessor's payback period, viz., primary lease period is followed by an extended period to allow exhaustion of asset value by the lessee, called secondary lease period. As the renewal is at a token rental, this option is called bargain renewal option. Alternatively, if the regulations permit, the lessee may be given a purchase option at a nominal price, called bargain buyout or purchase option. In financial leases, the lessor's rate of return is fixed: it is not dependant upon the asset-value, performance, or any other extraneous costs. The fixed lease rentals give rise to an ascertainable rate of return on investment, called implicit rate of return. Financial leases are technically different but substantively similar to secured loans. Financial leases and Hire-purchase : In some countries, distinction is made between lease and hire-purchase transactions. A hire-purchase transaction is usually defined as one where the hirer (user) has, at the end of the fixed term of hire, an option to buy the asset at a token value. In other words, financial leases with a bargain buyout option at the end of the term can be called a hirepurchase transaction. Hire-purchase is decisively a financial lease transaction, but in some cases, it is necessary to provide the cancellation option in hire-purchase transactions by statute: that is, the hirer has to be provided with the option of returning the asset and walking out from the deal. If such an option is embedded, hire-purchase becomes significantly different from a financial lease: the risk of obsolescence gets shifted to the hire-vendor. If the asset were to become obsolete during the pendency of the hire term, the hirer may off-hire the asset and close the contract, leaving the owner with less than a full-payout. Hire-purchase and financial leases compared Hire-purchase is of British origin - the device originated much before leases became popular, and spread to countries which were then British dominions. The device is still popular in Britain, Australia, New Zealand, India, Pakistan, etc. Most of these countries have enacted, in line with United Kingdom, specific laws dealing with hire-purchase transactions. Substance of financial lease:

If financial leases are substantively so close to secured financing transactions, the categorical issue is: why should they be treated as a lease at all? Why should they not be regulated, taxed and accounted for as plain loan transactions? This question may be significant from viewpoint of :

Regulation of financial leasing activity. Asset rights of the lessor. Taxation of the lessor/lessee. Accounting for the lease transaction.

In each case, treating the lease as a lease or, based on substance, a financing transaction, may lead to completely different implications.
o o o From viewpoint of general regulation of financial leasing activity, if it is taken as financing by another name, it should form a part of overall financial markets regulation most countries' central banks maintain some control on financial intermediaries. The asset-rights of the lessor would also be similar to those of a secured lender, while in a plain lease contract, the lessor is the sole owner of the asset and the lessee is merely its bailee. If the lease is treated as a financing transaction, the lessor should not be allowed to claim any asset-related benefit, such as depreciation. His income should be the implicit part of rentals going towards return on investment. Likewise, the lessee, apparently a mere user of the asset, should be treated as a virtual owner and should be allowed all asset-based benefits. From accounting viewpoint, if the lease is a mere financing arrangement, the asset should feature on the Balance Sheet of the lessee rather than the lessor, along with a corresponding liability to pay fixed rentals to the lessor.

Ideally, any system should be able to differentiate or integrate transactions based on their substance, and not nomenclature. So, if financial leasing is so close to lending, it should have been treated as such for every purpose, and the lessor should have been treated as a lender. However, such ideal is never achieved. There are two reasons to this - one, to an extent, laws, regulators and taxmen are conditioned by the legal fabric of a transaction. And two, lessors would emphasize upon on one or more structural differences between a lease and a loan, and be able to create a situation by which the substance rule fails. Therefore, financial leasing all over the World continues to live with, or rather thrive on, differing approaches to its character - it being treated at par with loans for some purposes, and distinguished from loans in for some others. Besides, the lease/loan treatment also depends upon the maturity of a country's regulatory system to appreciate the substance of a deal by exploding its form - understandably, doing so is not easy because it would mean going beyond the apparent form of a contract. Based on the 4 major areas listed above (general regulation, asset rights, taxation and accounting), there might be numerous combinations treating financial leases as loans on

security for some purpose and true lease for some other purposes. Accountings standards are the first (perhaps because they are least dependent on a statute) to realize the indifference between leases and loans. Taxation, particularly, income-tax, moves close to accounting standards. General property laws are the last to do so, because often, for enforcement of a contract, the way the parties create their mutual rights apparently is more important than what could have been their intent behind such creation

Operating leases:
Any lease other than a financial lease is an operating lease. Operating lease does not mean the lessor operates the asset - any lease other than a financial lease is operating lease. In a financial lease, the lessor does not operate the asset he leases, he merely finances it. Does the name "operating" lease mean the it is the lessor who operates the leased asset? Well, that might have been the meaning years ago, but today, the word "operating lease" is applied with no indication to the lessor operating the asset, but only a contra-distinction to financial leases.

Therefore, any lease where lessor takes a risk other than a plain financial risk is an operating lease. This would include a variety of lease plans with differing add-ons or leave-outs by different lessors but broadly falling into two categories:

Short term rentals Long term cancellable leases

The first category includes hiring of utility assets for short periods - say, hiring of a car for a day, or furniture for a function at home, etc. These hirings are done by agencies specialized in this respective hiring, and since these assets are hired for a very short-term need, these are not included in the caption "lease" at all. Understandably, such rentals are highly commodity-specific, and including these all as a part of the "operating lease" category would bring into fold an extremely variegated, mutually unrelated asset-rental activity. So what is included in the "operating leasing" industry is such asset renting where the user needs the asset for long term, but he does not commit himself to any permanent usage or a very long term. In other words, the lease is long term, but is cancellable. Within this long-term but cancellable lease variety, it is possible to have:

Full service leases Net, but cancellable leases

A full service lease will imply the lessor will run and maintain the asset. Such leases are common in case of cars, earth-moving equipments, etc. It makes good sense for the lessor to run and maintain the asset, because thereby the lessor can control his asset-based risks. In some cases, a lessor would take the risk of obsolescence by providing the cancellation option, but would not operational or maintenance responsibilities. This is almost a financial lease by structure, and might be non-cancellable for a substantial part of the asset life to allow the lessor to recover a major part of his investment; thereafter, the lease is cancellable at the lessee's option. This is more common in case of plant and machinery. Such leases are not operating leases in the strict sense as they are non-cancellable in part; they are also not financial leases as the lessor does carry a risk, albeit limited risk, on the asset value. Such leases can be called hybrid operating leases or hybrid financial leases. Hybrid operating lease are virtually financial leases, but with an element of asset risk with the lessor - the lease period is partly cancellable, and the lease is not full payout. A prototype operating lease: Whereas financial leases are more or less similar, operating leases take innumerable forms - based on the risks the lessor takes or avoids, and the involvement of the lessor in operation of the asset. Besides, operating leases are still in emerging form, and there are no standard operating lease plans. The following is, however, one possible operating lease example. This is a re-statement of prototype financial lease example taken earlier.

Company A wants to acquire a boiler of a particular specification. It would cost $ 100,000. Company B is prepared to give it on operating lease on lease rentals of $ 22.50 per month payable monthly in advance, for a non-cancellable period of 4 years, and thereafter, cancellable at the lessee's option. Let us suppose the deal is to be put through. A will be allowed to negotiate all commercial terms with the supplier including the technical specifications. B would walk in after everything is finalised: B would place its orders in the terms A instructs, and acquire the asset. The asset would be put on lease for 48 months non-cancellable period; thereafter, the lessee has the option to renew the lease at the same rental or to return the asset and close the lease. All operation and maintenance will be the responsibility of the lessee.

Returns operating leases residualdependent

in This model has been drawn on the basis of the financial lease example above, but there are significant differences. Most are significantly, the non-cancellable lease period is only 4 years, during which the rental charge does not fully payout the lessor. In other words, the lease is non-full payout : after paying off the

lessor over 4 years, the lessee may decide to go for an alternative equipment. As the lessor would not have recovered the whole of his investment over the fixed period, he depends on the value of the asset at the end of the lease period, viz., residual value for recovery of the balance. He might make a profit or a loss in the deal depending upon the actual residual value of the asset - therefore, the lessor's returns in an operating lease carry a residual dependence. As a matter of fact, an operating lease is an investment in the value of an asset, and therefore, it is never possible to pre-estimate the returns from the operating lease. Note one striking feature: though hypothetically, but we presumed that the rentals in the above example are the same as in case of financial lease. Is that possible? Is it possible that the lessor charges the same as in the financial lease example, and yet significant risk on the value of the asset? Yes, it is quite possible that the operating lease rentals may be the same, or in fact, lower than those of a financial lease. This is based on the lessor's estimation of the residual value of the asset - in a financial lease, this value has no significance since all the lessor would get is the pre-fixed rental. In the example above, the lessor may continue to get the same rental for the 5th, the 6th and the 7th year, if the asset has substantial value. Or, he may make a profit by sale of the asset at the end of 4th year. Features of an operating lease: Once again, as an operating lease itself fails a standard definition, there are no standard features of operating leases. However, the basic features that differentiate it from a financial lease are as follows. Once again, the following is a re-statement of the features of financial leases noted earlier: Operating leases may not allow the asset to be virtually exhausted by the same lessee: a rental transaction, for example, allows an asset to be used by a series of users. Operating leases do not put the lessee in the position of a virtual owner: in full service rentals, the lessee is merely using the asset. Even in case of hybrid leases, the lessee does not have the same commitment to the asset he has in case of owned assets. The lessor does take asset-based risks and asset-based rewards: the extent of such risks and rewards differs based on the nature of the lease. In a full-service operating lease, the lessor is directly affected by the state and efficiency of the asset. In a hybrid lease, the lessor carries a residuary asset-based risk. Hence, the lessor takes both financial risks and asset-based risks. The lease is either fully cancellable or partly non-cancellable and partly cancellable, meaning the lessee can return the asset and not pay the whole of the lessor's investment.

In this sense, operating leases are non-full-payout, meaning the full repayment of the lessor's investment is not assured by the lessee. In an operating lease, the lessor may provide any services relating to the asset, such as maintenance, or operations. In such case, the lease is wet lease. The risk the lessor takes is asset-based risk; of course, there is always a dependence on the lessee's commitment to pay, and hence a lessee-based risk. The value of the asset is important not only from the viewpoint of security of the lessor's investment, but the value itself determines the lessor's returns. In operating leases, the lessor's rate of return is dependant 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 in an operating lease is always a matter of probabilities and is uncertain. Financial leases are technically as well as substantively different from secured loans. The move towards operating leases: It was noted earlier that there has been a growing awareness among regulators, taxmen, and accountants that a plain financial lease is no different from a secured lending. Hence, there has been a strong tendency towards equating the two. Operating lease, a developing part of the leasing industry, has been propelled both by market forces (basically the need to distinguish the lease product from other financial products) as also by such regulatory tendency. Accounting standards in many countries have long recognized the substance of financial leases and put leased assets and liabilities on the lessee's balance sheets. Tax laws also over years have moved from granting asset-based tax allowances to every lease to only such leases which qualify as true leases and that term would exclude a strict financial lease. The move towards operating leases, particular the hybrid leases, has been helped largely by such regulatory developments, and the trend would understandably continue. Move towards operating leases is partly for tax and accounting motivations Source: http://www.india-financing.com/Basics1.html