Leasing – Regulatory framework

A lease is an arrangement vide which the owner of an asset/equipment (lessor) provides the asset for use to the user (lessee) for an agreed period of time in return for periodic payment of rental.

Essential elements of leasing –Parties to the contract

• Two parties are participating to a contract of lease transaction/agreement.

• These parties are owner and user.• Both these parties are known as lessor (owner) and lessee

(User).• Who may by lessor and lessee. For example:• An individuals, partnerships, companies, corporations or

financial institutions.

Lessor and Lessee

• Lessor is the owner of the asset that is being leased.• Lessee is the receiver of the services of the asset under a

lease contract.• In some of the lease contract, a lease financier is also involved

and provides refinances the lessor, by extending term loans or subscribing to equity or under a specific refinance scheme.

Asset, Property or Equipment

• The asset, property or equipment to be leased is the subject-matter of a contract of lease financing.

• Generally the asset be of the lessee’s choice suitable for his business needs.

• The asset may be plant and machinery, land & building, factory, automobile (2/4 wheeler), equipment, aircraft and others.

Ownership Separated from User

• During the contract period of the lease, the ownership of the leased asset(s) remains under the control of the lessor and its use is allowed to the lessee.

• On the expiry of the lease contract – tenure, the leased asset(s) reverts to the lessor.

Term of Lease

• The term of lease is the period for which the agreement of lease remains in operation.

• Every lease should have a definite period and in its absence it will be legally not operative.

• The lease tenure to be the expected entire economic life of the asset (i.e. financial lease)

• Whenever lease period is shorter than the useful life of the asset (i.e. operating lease)

Lease Rentals

The consideration which the lessee pays to the lessor for the the lease transaction is the lease rental.

The lease rentals are worked out/ structured as to compensate the lessor for the investment made in the asset which comprises of the interest on the investment, depreciation, repairs, serving charges and other expense is to be incurred by the lessor during the lease period.

Modes of Terminating Lease

• Usually the lease is terminated at the end of the lease period. However, the parties may mutually agree to and choose any of the alternatives at the time of preparation of lease agreement: The lease is renewed on its expiry

• The asset reverts to the lessor, or • The assets reverts to the lessor and the lessor sells it to a third

party, or • The lessor sells the asset to the lessee.

Kinds of Lease

• Finance Lease is for terms that approach the economic life of the asset; the total payments over the term of the lease are in total more than the lessor’s initial cost of the leased asset.

• It involves payments of rentals over an obligatory non-cancellable lease period, which is enough in total to amortize the capital outlay of the lessor and leave some profit.

• In such leases, the lessor is only a financier and is usually not interested in the assets. Therefore, such leases are also called as ‘full payout leases’ as they enable a lessor to recover his investment in the lease and derive a profit. Types of assets under such lease, are railway wagons, ships, aircrafts, lands, buildings, generating sets, heavy machinery and others.

Situations lead to a lease being classified as a finance lease are:

• The lease transfers ownership of the asset to the lessee by the end of the lease tenure;

• The lease term is for a major part of the economic life of the asset.

• At the inception of the lease, the present value of the minimum lease payments amounts to at-least substantially all of the fair value of the leased asset;

• The leased asset is of a specialized natures such that lessee can use it without major modifications being made.

Operating Lease

• Operating lease is for a term shorter than the economic life of the asset; generally the payment over the term of the lease is less than the lessor’s initial cost of the leased asset. In an operating lease, the lessor does not transfer all the risks and rewards incidental to the ownership of the asset and the cost of the asset is not fully amortized during the primary lease period