Sem1 Leasing

8/4/2019 Sem1 Leasing

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Leasing

- Managerial Accounts


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Introduction Contract between two parties

Lessor Lessee

(owner of the asset) (user of theasset)

Owner right to use the assetfor a fixed period of time

In return foraconsideration- lease rentals

payable, at the beginning or at theend of a month, quarter, half-yearor year.


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Important Terms

Lessor

Lessee

Lease Rental


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Procedure ofa Lease

Selection of equipment by lessee as per his agreement.

After the selection procedure, the lessee approaches the lessor either directly orthrough a lease broker.

The lease agreement is broadly negotiated & finalised.

The lessor has to place an order with the manufacturer for the equipmentselected by the lessee.

The lessor purchases the equip. either directly from the manf. ( straight fwd.leasing) or purch. back from the lessee (sale & lease back arrangement)

Lessee gives his acceptance to the equipment.

During the lease period, lessee makes the lease payment.

At the end of the contract, equipment reverts back to the lessor.


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Types ofleasing/ Forms

1. Finance Lease / FullPayout Lease

Def.: According to International Accounting Standards 17,(IAS 17), in a finance lease, the lessor transfers to the lessee,substantially all the risks and rewards incidental to theownership of the asset whether or not the title is eventuallytransferred.

All risks and rewards incidental to the transfer of ownershipof the asset are transferred to the lessee i.e lessee has to bearall the costs (cost of maintenance, insurance and repairs.)

Rewards may be represented by the expectations ofprofitable operation over the economic life of the asset andof gains in the form of appreciation in value of realisation ofresidual value.


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Lease term should exceed 75% of the useful life of the asset.

It involves payment of rental over an obligatory non-cancellable lease period, sufficient to amortise the capitaloutlay of the lessor and leave some profit.

The lessor is usually a financer and is usually not interested inthe asset.

Assets included: ships, aircrafts, railways, land, building,heavy machinery etc.

The lessee has the option to purchase the asset at a veryreasonable price. i.e. price lower than the market value of theasset.

If the lessee cancels the lease, the lessors losses associatedwith cancellation are borne by the lessee.


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There are 2lease periods:

primary lease period secondary lease period

(lease period during which the (lease period during which

lessee is not allowed rentals are very low)

to cancel the lease)

Lease can be renewed after the primary lease period is over.

Lessee can enjoy the use of the equipment during the lease

period provided he pays the rentals.

As the equipment is chosen by the lessee, the responsibility ofits suitability, risk of obsolescence & the liability for repair,maintenance & insurance of equipment rests with the lessee.


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B. Operating Lease/ Service Lease

Def: according to IAS-17, an operating lease is one which isnot a finance lease.

- Preferred in the following circumstances:

a) Where there is a possibility ofrapid obsolescence of the asset.

b) Where the lessee is interested in tiding over acontemporaryproblem.

Features:

Involves no transferof all risks & rewards incidental to the

transfer of ownership of services from the lessor to the lessee.

This lease agreement gives to the lessee only a limited right touse the asset. Leased period is usually shorter than theeconomic life of the leased asset & is revocable at a shortnotice.


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The lessee is not given any uplift to purchase the asset at the

end of the lease period.

Lease rentals include servicing costs, & the lessor recoversthe cost of the asset from different lessees.

The lessoris responsible for the upkeep and maintenance ofthe asset & bears the risk of obsolescence.

Mines, Computers hardware, trucks and automobiles are foundsuitable for operating lease because the rate of obsolescence is

very high in this kind of assets.

Known as

Dry Lease / Service Lease Wet Lease

(if asset based services are (if lessor does not provide

provided by the lessor) any asset based services)


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3. Sale & Lease Back It is a sub-part of finance lease.

The owner of the asset sells it to a leasingcompany (lessor) which leases it back to theowner(lessee)

under this arrangement, the assets are not

physically exchanged but it all happens inrecords only.

This is nothing but a paper transaction.

suitable for those assets, which are not

subjected depreciation but appreciation, sayland.

The advantage of this method is that the lesseecan satisfy himself completely regarding thequality of the asset and after possession of theasset convert the sale into a lease arrangement.


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4. Leveraged Leasing

3 parties involved: lessor, lessee &

Lender.

The lessor borrows a part of thepurchase cost (say 80%) of the assetfrom the third party i.e., lender andthe asset so purchased is held assecurity against the loan.

The lender is paid off from the leaserentals directly by the lessee and thesurplus after meeting the claims of thelender goes to the lessor(owner of theasset).

Lessor is entitled to depreciationallowance associated with the asset.


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5. Direct Lease

Bipartite Lease Tripartite Lease

2 parties 3 parties

2seperate entities 3sepearte entities

Equip. supplier cum lessor Equip. su pplier, Lessor & & LesseeLessee

6. Domestic Lease

Lessor Lessee Equip. Supplier

domicile

Same country


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7. International Lease:

If parties to the lease are domiciled in different countries.

Further divided into:

a) Import lease: the lesser & lessee domiciled in the same

country but equip. supplier is from a diff. country.

lessor imports the asset and leases it to the lessee.

b) Cross borderlease: the lessor and lessee domiciled in different

countries. The domicile of the equip. supplier is immaterial.


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Advantages - To the Lessee

SAVING OF CAPITAL: Leasing covers the full cost of theequipment used in the business by providing 100% finance. Thelessee is not to provide or pay any margin money as there is nodown payment. In this way the saving in capital or financialresources can be used for other productive purposes e.g. purchase

of inventories.

(2) FLEXIBILITYAND CONVENIENCE: The lease agreementcan be tailor- made in respect of leaseperiodand lease rentalsaccording to the convenience and requirements of all lessees.

(3)PLANNING CASH FLOWS: Leasing enables the lessee to planits cash flows properly. The rentals can be paid out of the cashcoming into the business from the use of the same assets.


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- to the Lessee

(4) IMPROVEMENT IN LIQUIDITY: Leasing enables thelessee to improve their liquidity position by adopting the saleand lease back technique.

(5) LESS COSTLY: leasing as a method of financing is lesscostly than other alternatives.

(6)TAX BENEFITS: if lessee is in tax paying position, therental may be increased to lower his taxable income.


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Advantages- To the lessor

1. OWNERSHIPPRESERVED: leasing provides financewithout diluting the ownership or control of promoters.

2. FULL SECURITY: since ownership is preserved, lessor

can take repossession of the assets if the lessee defaults.

3. TAX BENEFIT: if the lessor is in high tax bracket, he

can lease out assets with high depreciation rates, to reduce

his tax liability.

4. HIGH PROFITABILITY: as the rate of return is more

than what the lessor pays on his borrowings.


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Limitations of Leasing

Restrictions on use of equipment: certain restrictionsare imposed on use of equipments, such as compulsoryinsurance. Lessee is not free to make additions oralterations to the leased asset to suit his requirement.

Limitations of finance lease: lessee has to bear costsincidental to transfer of ownership, lessee cannotterminate the agreement during primary period, & if hedoes so, he has to bear huge expenditure.

Loss ofResidualValue: lessee never becomes owner ofthe asset, & is deprived of the residual value of the asset.


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4. Consequences ofDefault: incase of default, the lessormay terminate the agreement & take over the possessionof the goods. In finance lease, the lessee may be asked

to pay for the damages due to default of rental payment.

5. Loss of obsolescence: has to be borne by the lessorincase of operating lease.

6. No benefits of latest technology: lessee cannot reap thebenefits of latest technologies in the market incase of afinance lease.


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Leasing in India

Leasing activity was initiated in India in 1973. 1st leasing company of India, named First Leasing Company

of India Ltd. was set up in 1973 by Farouk Irani.

This company remained the only company in the country until20th Century Finance Corporation was set up in 1980.

The industry entered the growth phase in late 1982, whennumerous financial institutions and commercial banks eitherstarted leasing or announced plans to do so

ICICI, entered the industry in 1983 giving a boost to theconcept of leasing, followed by SBI, Canara Bank, Bank of

Baroda, etc. As per RBI's records by 31st March, 1986, there were 339equipment leasing companies in India.


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Factors that contributed to growth of Indian

leasing: Factors that contributed to growth of

Indian leasing:1. No entry barriers - any one could float a leasing entity, and

even an existing company not in leasing business could write alease purely for tax shelters.

2. Growth in capital expenditure by companies - The post -liberalization era saw increasing number of new ventures andfresh investments by existing ventures. New ventures reliedupon leasing as a source of additional funding.

3. Fast growth in car market:Needless to state with facts, thegrowth in car leasing volume has been the highest over theseyears - the spurt in car sales with the entry of several newmodels was funded largely by leasing plans.


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4. Tax motivations: India had an unclear distinction between alease that will qualify for tax purposes, and one which wouldnot.

5. Optimistic capital markets: Data would establish a clearconnection between bullish stock markets and the growth inboth number of leasing entities and lease volumes. A newentrant in business, could price itself on unexplainable

premium and walk out with pride.

6. Access to public deposits: Most leasing companies in Indiahave relied heavily on retail public funds in the form ofdeposits. Most of these deposits were raised for a 1 yeartenure, and on promise of high rates of interest, at times evenmore than the regulated rate


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Conclusion:

Leasing has grown by leaps and bounds in the eighties but it is

estimated that hardly 1% of the industrial investment in India iscovered by the lease finance, as against 40% in USA and 30% inUK and 10% in Japan.

The prospects of leasing in India are good due to growing

investment needs and scarcity of funds with public financialinstitutions.

This type of lease finances is particularly suitable in India where alarge number of small companies have emerged more recently.

Leasing in the sphere of land and building has been in existence inIndia for a long time, while equipment leasing has become verycommon in the recent times.


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