A Brief Introduction About the Finance Lease Agreement
A finance lease is a long-term lease contract between a lessor and a lessee. The lessor is usually a financial institution but may also be an individual or other legal entity. As per the terms of such an agreement, the asset is owned by the lessor for the duration of the lease, and the borrower or the lessee has both operational control and economic interest in the underlying value of the asset. The lease allows:
- The lessee selects the asset to be leased
- The lessor purchases the chosen asset
- The lessee can use the asset for the period of the lease in exchange for the installments or fees to be paid to the lessor
- During this period, the lessor recovers the cost and earns a profit from the installments
- The lessee is given the option to acquire ownership of the asset
A finance lease is also called a capital lease.
Finance Lease vs Operating Lease
The differences between a capital lease and an operating lease include:
- Finance and operating leases use different accounting methods
- Financial leases create assets that can be accounted for in the balance sheet as an asset. Operational leases, on the other hand, do not create assets and can be thought of as renting, rather than paying installments and therefore, cannot be quantified as an asset in the balance sheet.
- A capital lease is more like a loan, while operational contracts are like rentals in the way that they do not create an asset.
- The ownership of the underlying leased asset might be transferred to the lessee in the case of a capital lease, but not with operational contracts.
- Capital leases contain bargain purchase options to purchase the asset at less than the market price, but operating leases don’t.
Who Takes the Finance Lease Agreement? – People Involved
You would need to enter into a finance lease if:
- You are an individual or company looking to avail the purchase an asset, but do not have immediate capital to do so.
- You are a financial institution, company, or an individual looking to finance the purchase of an asset for the lessee in the interest of earning a profit from the interest on the installments paid by the lessee.
The contracting parties here are the lessor and the lessee.
Purpose of the Finance Lease Agreement – Why Do You Need It?
The purpose of a financial lease is to:
- To familiarize the parties with all the terms and conditions of the transaction in a single comprehensive document.
- Establish a lessor-lessee relationship between the parties.
- Detail essential terms and conditions. Such as those regarding the term, rental, and ownership.
- Allow legal forums to be used for dispute resolution.
Contents of the Finance Lease Agreement – Inclusions
An effectively drafted financial lease contract must be detailed and include the following terms:
- Effective Date: This specifies the date on which the terms of the contract come into force and take effect. This is a standard yet important inclusion in all contracts.
- Parties: This clause identifies the parties that intend to contract. In this case, they are the lessor and the lessee. It is critical to ensure that the names and addresses of the parties are spelled correctly. A simple typographical error may cause the contract to be rendered void and unenforceable.
- Term: This term specifies the term of the lease.
- Rental: This term specifies the amount that the lessee is liable to pay the lessor as a regular installment for the term of the lease. The frequency of the payments must also be included.
- Ownership: This term spells out the ownership rights over the assets and how it can be transferred to the lessee from the lessor. The entire premise of a capital lease is to acquire the leased asset by paying installments or by purchasing it at a discounted price at the end of the term of the contract. The lessor may include conditions for the use of the asset, including prescribing that the equipment must stay within and be used only on the address as agreed upon in the lease. Further, this term is critical to its nature of being a capital lease. Care must be exercised to ensure that the method of acquisition of the asset is well-defined. This term also makes provisions for the bargain purchase option.
- Inspection: This term allows the lessor and lessee to inspect the equipment to make sure that no damage or harm has been caused to it and that it is working as it is intended to.
- Maintenance: This term prescribes that the lessee handles the equipment with care and to ensure its upkeep and maintenance.
- Sublease: This clause determines the rights of the lessee to sublease or assign the equipment to anyone else. In most cases, this term is used to prevent such use of the equipment, but it can also be used to authorize the lessee to do the same.
- Loss, Damage, and Replacement: This term specifies the liabilities of the parties in the event of loss or damage of equipment.
- Insurance and Liabilities: Most financial institutions that offer capital leases will often use this clause to require you to ensure the asset for the duration of the leasehold to prevent losses to the lessor.
- Termination: Termination clause specifies the circumstances under which the agreement may be terminated. Include any warranties, defects, disclaimers, indemnifications, and limitations under this term.
- Governing Jurisdiction: This clause mentions the jurisdiction that will regulate.
- State-specific Laws: You can include any term that may be required for compliance with state-specific laws and legislations.
How to Draft the Finance Lease Agreement?
The procedure to draft a finance lease:
- Mention the date on which the contract will come into force and take effect that is the effective date.
- Identify the contracting parties with their names and addresses.
- Establish the relationship between the parties.
- Specify the term of the lease and the rentals to be paid to the lessor, including the rate of interest, frequency of payments, mode of payment, and other relevant details.
- Detail the terms and conditions on ownership using a relevant clause for the same. This will include provisions for the bargain purchase option.
- The lessor and lessee must be allowed to inspect the asset to ensure that it is being maintained well and hasn’t been harmed or damaged in any way. Use an Inspection Rights clause to enforce this.
- A Maintenance clause will ensure that the lessee takes appropriate care of the asset and does not abuse it.
- Including a sublease, the clause can prevent or authorize the lessee from subletting the asset to another third party.
- Include a term that specifies how loss, damage, and replacement will be handled.
- Most financial institutions require the asset to be insured to minimize the chances of damage.
- The agreement must state the name of the jurisdiction that will govern the document and any disputes that arise from it.
- The parties need the signed contract to signify the acceptance of terms.
You can include a list of all the equipment that is to be purchased including the prices and the installments that are owed for each item, calculated using a finance lease calculator.
It is critical to make sure that the interests of all the parties are recognized and taken into consideration while framing the terms of the lease. The terms must not be framed such that it is unduly and unfairly enriches one or more parties at the expense of the others. The terms must be framed such that the transaction is carried out with the most smoothness. Further, ensure that the terms of the contract are clear, concise, and free of ambiguity. This will allow the parties to have a sound understanding of the terms and conditions of the contract and reduce the chances of a dispute caused by disagreement.
Benefits & Drawbacks of the Finance Lease Agreement
The benefits of having a finance lease:
- Provides the parties with a clear overview of the terms and conditions involved in the transaction, thereby avoiding ambiguity and miscommunication.
- Safeguards the interests of the parties.
- Ensures that the parties fulfill their respective obligations to each other.
- Allows disputes to be resolved systematically, as per the established laws that are applicable.
- Gives legal transaction validity.
- Payment schedules are more flexible than in loans.
- A capital lease creates an asset, not a liability.
The drawbacks of having a finance lease:
- Legal costs of framing the agreement.
- Negotiations can be time-consuming.
What Happens in Case of Violation?
Contracts are legally binding documents that ensure that the parties to the contract perform their obligations towards each other. The violation of the terms of a capital lease, like any other contract, allows the aggrieved parties to approach the court and seek resolution of their disputes using the traditional legal method of going to court. Approaching the court should be considered a last resort. Using alternative dispute resolution methods allow quicker disposition of justice and save the resources of the courts. Ideally, a dispute should be resolved amicably and internally among the parties(1).
A finance lease is used when the lessee wishes to acquire the ownership of the asset but does not have the capital to purchase it in one go. Therefore, the lessee pays installments along with interest as per the agreed rate of interest over the term of the leasehold. At the end of the leasehold, the lessee is given the option to acquire ownership of the asset by purchasing it at a discounted price. The most critical terms in a capital lease are the Term, Rental, and Ownership clauses.