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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 borrowing	This is how they are tackled
The leased asset belongs to the lessor, not to you as in case of loan.	As long as you are able to milk the cow, how does 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 period of lease; assets acquired with a loan are your own assets.	The lease period is made sufficiently long to allow you to exhaust most of the asset value - financial leases carry a renewal clause also.
In a loan, I would buy exactly the asset I need; would the lessor be able to provide me exactly what I want?	Yes, the lessor as a matter of fact purchases assets selected by you, from a supplier identified by you, purely at your behest.
In a loan, I repay the loan and pay some interest on the loan. How different is the charge in case of lease?	Mostly, the lease rentals are calculated to fully return the lessor's investment, and some return on 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 with the asset for long; can I return the leased asset as I feel like?	The lease will be non-cancellable till the lessor fully recovers his investment. So you can't do in a 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 do I get in a lease?	In a lease, you get the lease rentals. Leave apart the 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 matter of security; if the leased asset is mine, does it mean I carry the entire obsolescence risk in it?	The risk of obsolescence, nay, all risks on the asset are absorbed by the lessee. The lease is non-cancellable, till all your investment is recovered.
What if the asset does not work? I am not concerned in case of a loan.	You are not concerned in case of a lease also. The 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 to any benefit? I don't get any such benefit in a loan.	Nope, the lessee has a right of renewal. He would continue using the asset till it becomes an economic junk.
What if the lessee doesn't pay? In a loan, I can confiscate the asset.	You would do the same in a lease, perhaps a little 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 and secondary lease period

The first 5 years are called the primary lease period and the extended period is called the secondary 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.

Full payout lease

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.

The IRR

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.

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 hire-purchase transaction.

Hire-purchase and financial leases compared

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 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.

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.

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Primer on Leasing by Vinod Kothari