Leasing is, in essence, an agreement between two parties
for the rental of property (land or asset). It allows one
party, the Lessee, to use an asset or property owned by another
party, the Lessor. In this regard, leasing is equivalent to
an Ijara, an Islamic mode of acquiring property. The
lessee makes the economic use of the lessor’s assets
and pays in the form of a rental for this privilege.
Basic rules governing Leasing under Islamic Law
- Lease is a contract whereby the owner of an asset transfers
its benefits to another person for an agreed period, at
an agreed consideration.
- The object being leased must have a valuable use.
- It is necessary for a valid lease contract that the leased
asset remains in the ownership of the seller, and only its
usage is transferred to the lessee. A lease cannot be effected
in respect of consumables, fuel, ammunition, etc. because
their use is not possible unless they are consumed.
- As the leased property remains in the ownership of the
lessor, all the liabilities emerging from the ownership
shall be borne by the lessor, but the liabilities arising
from the use of the property shall be borne by the lessee.
- The period of lease must be defined.
- The lessee cannot use the leased asset for any purpose
other than the purpose specified in the lease agreement.
- The lessee is liable to compensate the lessor for any
damage to the leased asset caused by any misuse or negligence
on the part of the lessee.
- Any harm or loss incurred during the lease period and
caused by factors beyond the control of the lessee shall
be borne by the lessor.
- A property jointly owned by two or more persons can be
leased out, and the rental shall be distributed between
all the joint owners according to the proportion of their
respective shares in the property.
- It is necessary for a valid lease that the leased asset
is fully identified by the parties.
Basic Principles of Leasing
Types of Leases
Leases can be conducted in several different
ways by varying the terms and conditions of the contract.
However, these can be divided in two broad categories - Finance
Leases and Operating Leases.
Operating Lease
An Operating Lease is a pure rental agreement
with three distinctive features: (i) the cost of the asset
is not fully amortized over the lease period, (ii) the lessor
provides maintenance of the asset, and (iii) the asset is
usually returned to the lessor. Therefore, the lessee has
the advantage of procuring an asset, utilizing it for its
benefit and returning the same when it has served its purpose.
Finance Lease
A Finance Lease is in essence similar to
a loan because substantially all risks and rewards related
to the leased assets pass on to the lessee. It is mainly characterized
by (i) the asset being fully amortized over the lease period,
(ii) the lessee is responsible for maintenance costs, and
(iii) the ownership is usually transferred to the lessee at
the end of the lease. In this respect, the involvement of
the lessor is restricted to financier.
Components of a Lease
These components are essential to a lease
contract. By varying these, the type of the lease is determined.
In order to analyze any lease, the following elements should
be carefully studied:
Adjusted Lease Amount or Adjusted Capitalized
Cost
Security Deposit / Down Payment
Lease Term
Rental
Residual Value
Termination
These elements are explored in detail below.
Adjusted Lease Amount Or Adjusted Capitalized
Cost
The starting point in the calculation of
any lease payment is the capitalized cost. This cost is equivalent
to the "purchase price" of the asset and generally
known as the lease amount. It is reduced by the amount of
any security deposit /down payment, and miscellaneous charges.
These adjustments are called capitalized cost reductions.
After all adjustments are made, the final amount is referred
to as the adjusted lease amount or adjusted capitalized cost.
This is the amount of financing provided by the lessor to
the lessee.
Security Deposit /Down Payment
The security deposit, often termed as a Down
Payment or Equity Contribution, is the amount most Lessors
obtain at the onset of a lease. This amount serves as a security
for the lessor (apart from the asset itself) and is refunded
to the lessee at the end of the lease provided the terms and
conditions of the lease contract have been met. For the lessee,
a higher amount yields a lower adjusted lease amount resulting
in reduced rentals. Therefore, the lessee has to make a trade-off
between a higher security deposit and higher rentals.
Lease Term
The lease term can vary considerably from
lease to lease. However, in Pakistan, it is usually between
three to five years. The length of the lease term has a vital
role in determining the payments. In a fully amortized lease,
a longer lease period can reduce the payments while a shorter
period has the opposite effect.
Rental
The rental represents periodic payments of
agreed rent over the lease term. It represents a charge for
the depreciating asset as well as a rent charge. The rent
charge includes the cost of funds, overheads and services
being provided by the lessor. It is the compensation that
a lessor claims for providing the lessee the economic use
of the asset.
Residual Value
The residual value is the amount the asset
is considered to be worth at the end of the lease. It is generally
expressed as a percentage of the lease amount. In cases where
the ownership is transferred to the lessee, the residual value
forms the sale price. Like the security deposit, a higher
residual value can lower the rental payments.
Termination
Most leases cannot be terminated before the
end of the lease by design. Terminations are possible if the
lessee wants to payoff the lessors or when a forced termination
is undertaken in the event that the underlying assets are
destroyed, i.e. stolen or made unproductive. If one terminates
the lease early, he has to pay for the privilege. For the
lessor, an early termination results in generating an unexpected
cash inflow. The lessor looses the expected income from the
lease until the terminated amount is redeployed in another
investment. Generally, lessors charge a penalty for early
termination to avoid this loss of income.
Benefits of Leasing
Leasing offers many substantial benefits
both for the lessee and the lessor. The following are some
of the benefits that a lessee can derive from a lease.
- Leasing is acceptable within the Islamic modes of finance
as fixed rental payments are made and interest is not involved.
- Large lease payments are fully tax deductible at the time
of payment, therefore an incentive may exist to load payments
into a particular tax year.
- Lower present value of after-tax leasing costs compared
to purchase costs.
- Leasing provides long-term lending at fixed rentals.
- Leasing assures maximum conservation of capital as it
makes large investments in fixed assets unnecessary. The
lessee can use this for other purposes such as working capital,
trade debts, and seasonal expenditures.
- Leasing permits conservation of existing lines of credit
that can be used for other purposes.
- Leasing guards against technological obsolescence.
- The terms and conditions are flexible and can be customized
for the lessee.
- Lease rentals can be structured in accordance with the
Lessee’s cashflow requirements.
- Leasing being long-term provides a hedge against inflation.
- Facilitates capital budgeting as rental payments are fixed.
- Off balance sheet financing may enhance ability to borrow
by improving apparent liquidity and enhancing return on
investment.
Lease vs. Buy
The primary difference between Leasing and Buying is the
ownership of the asset. A straight purchase gives a person
an immediate ownership of the asset. However, in a lease,
the ownership of the asset vests with lessor. The lessee benefits
from the economic use of an asset that does not belong to
him. A closer look reveals that it is the usage of the asset
that is important rather than its ownership. The economic
benefit of the asset lies with a person whether he leases
or buys the asset. For personal usage, it is the pleasure
of say, driving a new car. For business purposes, it’s
the usage that translates into profits.
Another difference is the initial cash outlay requirement.
When buying, a person pays the cost of the asset as a lump-sum
amount at the onset. However, leasing enables a person to
pay only a part of the cost (down payment) and begin utilization
of the asset before repaying the full amount. The remaining
amount is repaid with fixed payments over a period of time. |
