Theoretical and Regulatory Framework of Leasing
Concept
Conceptually, a lease is a contractual arrangement/transaction in which the owner of an asset/ equipment (lessor) provides the asset for use to another/transfers the right to use the asset to the user (lessee) for an agreed period of time in return for periodic payment (rental).
At the end of the lease period the asset reverts back to the owner. Leasing essentially involves the divorce of ownership from the economic use of an equipment/asset.
Classification
Leasing can be classified into four categories:
Finance and operating lease,
Direct lease and sale and lease back lease,
Single investor and leveraged lease
Domestic lease and international lease
Of these, the classification of lease into finance and operating is of fundamental importance. The distinction between the two types of leases is based on the extent to which the risks and rewards of ownership are transferred from the lessor to the lessee.
Risk means the possibility of loss arising out of under- utilisation or technological obsolescence of the leased asset, while reward refers to the incremental net cash flows generated by the usage of the equipment over its economic life and the realisation of the anticipated residual value on the expiry of the economic life.
If a lease transfers a substantial part of the risks and rewards, it is called finance lease;
Otherwise, it is operating lease.
The cut-off criterion in India is that if the lease term exceeds 75 per cent of the useful life of the asset or if the present value of the minimum lease rentals exceeds 90 per cent of the fair market value of the equipment at the inception of the lease, the lease is classified as finance lease.
Profile/Structure of Leasing in India
The major players in leasing in India are independent leasing companies, other finance and investment companies, manufacturer-lessors, development finance institutions, in-house lessors and banks.
Product Profile
As far as the product profile of leasing in India is concerned, by and large leases, are of finance type and operating leases are not very popular.
The lease rentals are payable generally in equated monthly instalments at the beginning of every month.
The rental structures are related to the requirements of the lessee and projected cash flow pattern.
They are structured so as to recover the entire investment during the primary period.
Further, most of the transactions are direct lease; sale and lease back type are rare. Equipment leasing covers a wide range of assets and equipment but project leasing and cross-border leasing are not popular.
Significance/Advantaes and Limitations
The significance of lease financing is based on several advantages both to the lessors and the lessees such as:
flexibility,
user-orientation,
tax-based benefits,
convenience, expeditious disbursements of funds, hundred per cent financing and better utilisation of own funds and so on.
REGULATORY FRAMEWORK
There is no law/legislation/act/direction which exclusively applies to equipment leasing. Such transactions are governed by the relevant provisions of number of acts/laws/directions and so on.
Some of these are quite intricate involving fine points of law.
The main elements of the framework are: Indian Contract Act, RBI NBFCs Directions and Lease Documentation and Agreement.
Obligations of Lessor and Lessee
Since the features of an equipment lease transaction closely resemble the features of bailment, the provision of Contract Act in general and those relating to contracts of bailment in particular apply to equipment lease transactions.
The implied obligations of the bailor (lessor) and bailee (lessee) are defined by this enactment. However, one implied obligation of lessor, namely, fitness of the bailed goods is inapplicable.
As in a typical equipment lease transaction, the lessor plays the role of a financier, the implied obligation of the lessor (bailor) relating to fitness of the goods/assets is expressly negatived by the lease agreement.
Other Acts/Laws:
Some provisions of Motor Vehicle Act and Stamp Act also apply to equipment leasing.
RBI NBFCs Directions:
With a view to coordinate, regulate and control the functioning of all the NBFCs, RBI has issued directions under the RBI Act. These also apply to leasing companies.
Lease Documentation
The lease documentation process is fairly simple. It starts with the submission of a proposal by the lessee.
On approval, the lessor issues a letter of offer detailing the terms and conditions of the lease.
The letter of offer is accepted by the lessee by passing a Board resolution.
This is followed by the lessor and lessee entering into a formal lease agreement.
Lease Agreement
The lease agreements provide for a number of obligations on the part of the lessee which do not form part of his implied obligations under the Contract Act.
While the exact contents of the lease contract differ from case to case, a typical lease contract provides :
for nature of lease,
description of the equipment,
delivery and re-delivery period,
lease rentals, repairs and maintenance,
alteration, peaceful possession, charges,
indemnity clause, inspection,
prohibition of sub-leasing, defaults and remedies and so on.
Accounting/Reporting Framework and Taxation of Leasing
IAS-17 FRAMEWORK
AS-19: LEASES
TAX ASPECTS OF LEASING
IAS-17 FRAMEWORK
An appropriate method of accounting is necessary for income recognition for the lessor and asset disclosure for the lease.
Recognising the need for a proper accounting system for lease transactions, IAS-17 was issued in 1982.
The ICAI issued a guidance note in 1988 which favoured the adoption of IAS-17 in the long run but recommended for the interim period a set of accounting guidelines in the context of the state of leasing industry in India and the income-tax framework.
However, due to court intervention its recommendatory character was kept in abeyance. After judicial pronouncement, the ICAI Revised Guidances Notes was issued in September 1995.
The Reserve Bank of India constituted a study group on the guidance note and on its recommendations made it compulsory on the leasing companies.
The ICAI issued the AS-1 9: Lease based on IAS-1 7 in January 2001.
Accounting for Leases by a Lessee
According to the IAS-17, in case of operating lease, the lease has to allocate the aggregate lease rental over the lease term on straight line basis or any other systematic basis which better reflects the pattern of the timing of the benefit of the use of the equipment to the lessee (user).
Finance lease should be shown in the balance sheet of lessee as an asset to properly account for the economic resources and as a liability to reflect the level of its obligations.
The asset and liability should be recorded at the inception of the lease at an amount equal to the fair market value of the asset or the present value of the minimum lease payment whichever is lower;
The lease rentals should be apportioned into interest and capital components using the effective rate of interest/actuarial method or any other acceptable approximation (e.g., sum of the year’s digits);
The interest/finance charge should be expensed;
The leased asset should be depreciated in line with the depreciation policy of the firm in respect of owned asset. It must be fully depreciated over the lease term or the useful life whichever is shorter.
The interest/finance charge should be expensed;
The leased asset should be depreciated in line with the depreciation policy of the firm in respect of owned asset. It must be fully depreciated over the lease term or the useful life whichever is shorter.
Accounting for Leases by Lessors
As regards the lessor, the IAS-17 guidelines require that a finance lease should be recorded as a receivable in his books equal to the net investment in lease;
that is, gross investment in lease minus unearned finance income.
The unexpired finance income should be allocated according to effective rate of interest method to the relevant accounting period.
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