A lease is defined as finance lease if it transfers a substantial part of the risks and rewards associated with ownership from the lessor to the lessee. According to the International Accounting Standards Committee (IASC), there is a transfer of a substantial part of the ownership-related risks and rewards if:
i. The lease transfers ownership of the asset to the lessee by the end of the lease term; (or)
ii. The lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than the fair market value at the date the option becomes exercisable and, at the inception of the lease, it is reasonably certain that the option will be exercised; (or)
iii. The lease term is for a major part of the useful life of the asset. The title may or may not eventually be transferred; (or)
iv. The present value of the minimum lease payments (See Glossary) is greater than or substantially equal to the fair market value of the asset at the inception of the lease. The title may or may not eventually be transferred.
The aforesaid criteria are largely based on the criteria evolved by the Financial Accounting Standards Board (FASS) of USA. The FASS has in fact defined certain cut-off points for criteria (iii) and (iv). According to the FASS definition of a finance lease, if the lease term exceeds 75 percent of the useful life of the asset or if the present value of the minimum lease payments exceeds 90 percent of the fair market value of the asset at the inception of the lease, the lease will be classified as a ‘finance lease’
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-cancelable, 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.
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.
For the purpose of determining the present value, the discount rate to be used by the lessor will be the rate of interest implicit in the lease and the discount rate to be used by the lessee will be its incremental borrowing rate.
Therefore, a lease is to be classified as a finance lease if one of the conditions (iii) or (IV) is satisfied.
In a finance lease, the lessee is responsible for repair, maintenance and insurance of the asset. The lessee also undertakes a “hell or high water” obligation to pay rental regardless of the condition or the suitability of the asset. A finance lease which operates over the entire economic life of the equipment is called a “full pay out lease”.