Management of Financial Ser

vices
Module 2

Leasing
After debt and equity, leasing has beco
me an important source for long term fi
nancing.
Lease is defined as a contract transferri
ng the use of land, space, structure or e
quipment, in consideration of a paymen
t , usually in the form of rent
Widely used in western countries
In India it is a recent development whic
h started in 1973 only

Leasing- Concepts
Leasing is an arrangement that provides a fir
m with use and control over assets without b
uying and owning the same.
It is a form of renting assets
Contract between the owner of the asset(less
or) and user of the asset(Lessee)
Lessor gives the right to use the asset to the
Lessee over an agreed period of time for a co
nsideration called lease rental
Regulated by the terms and conditions of the
agreement

Leasing- Concepts
Lessee pays the rent periodically as regular fi
xed payments over a period of time
The rentals may be payable at the beginning
or end of the month, quarter, half yearly or ye
ar.
Lease rentals can be paid out of profits earne
d by the use of the equipment and rent is cen
t percent tax deductible
At the expiry of the lease period , the asset re
verts back to the lessor.

Essential Elements of Leasing

No. of parties to contract(Two, Lessor and Le
ssee)
Asset(Subject matter is an asset)
Consideration(Lease Rental)
Lease period(No. of years or economic life of
the asset)
Use Vs. Ownership(ownership with lessor and
possession with the lessee)
Termination of Contract(contract may be rene
wed or Lessee may buy the asset or the asset
reverts back to the lessor)

Types of Leasing

1. Operating or Service Lease

2. Financial Lease

Operating or Service Lease

Gives the lessee only a limited right to use the
asset
Lessor is responsible for the upkeep and maint
enance of the asset.
The lessor is not given any option to purchase t
he asset after the expiry of the period
Lease is for a short period and it may be recove
red at a short notice.(e.g: computers , vehicles
etc)

Financial Lease
Also known as Capital lease
Agreement may contain conditions that the les
sor agrees to transfer the title of the asset at t
he end of the lease period at a nominal cost
Usually for a longer period and non cancellable
Lessee is responsible for maintenance(e.g: Lan
d , Building , Machinery)

Types of Financial Lease

1. Sale and Lease Back: Sale of an asset already
owned by a firm (vendor) and leasing the same
asset back to the vendor from the buyer
2. Direct leasing: may be arranged through a finan
cial institution or manufacturer. They are acqui
ring the property for their clients and entering i
nto lease contract under usual terms and condi
tions
3. Leveraged Lease: Lessor borrows funds from a
third party (bank or finance company) for the p
urchase of assets and entered into lease agree
ment

Types of Financial Lease

4. Straight Lease and Modified Lease: Straight lea
se is where lessee fulfills the conditions withou
t any modifications. But in modified lease , less
ee has different options like purchasing of asse
ts or retaining the same.
5. Primary and Secondary Leasing: also known as
front ended and back ended lease. The rentals
charged in the primary period are much more t
han that of the secondary period.

Types of Financial Lease-Contd

Floating rental rate lease: in this type lea
sing rates are increased or decreased acc
ording to the borrowing rates by the lesso
r. It permits the lessor to undertake the ri
sk and enjoy the benefit of interest rate v
ariations.
Domestic Lease and International Lease: I
f all parties are residents of the same cou
ntry, it is called domestic lease . If the co
ntracting parties are residents of differen
t countries it is called international lease.

Types of Financial Lease-Contd

International lease is of two types:
1. Import lease: both the lessor and les
see are in one country but the equipme
nt supplier belong to different country
2. Cross Border Lease: Lessor leases a
n equipment to a lessee who is not falli
ng in the jurisdiction of lessors countr
y. The domicile of the supplier is imma
terial.

Types of Financial Lease-Contd

Sale Aid Leasing: a manufacturer direc
tly extends facility of leasing either by
one of his own subsidiaries or through
a third party.
Foreign to foreign lease: Three parties:
a. The manufacturer(in one country)- e
g: China
b. Lessor (another country)- India
c. Lessee (third country)- Australia

Advantages of leasing to the Les

see
Avoidance of initial cash outlay: can use
asset without capital investment
Easy source of finance: immediate long
term financing without mortgage
Minimum delay: less time processing by
leasing companies
Shifting risk of obsolescence: Due to rap
id change in technology firm has to bear
the risk of obsolescence if purchasing t
he asset

Advantages of leasing to the Les

see
Enhanced Liquidity: Sale and lease ba
ck arrangement helps a firm to improv
e its liquidity position by realising cas
h from the sale of fixed assets and ret
aining the economic use of the same
Conserving Borrowing capacity: It doe
s not affect the debt equity ratio and i
t does not reduce the borrowing capa
city of lessee

Advantages of leasing to the Les

see
Tax Advantage: As lease rentals are
considered as a revenue expenditur
e while determining taxable profits
Higher returns on capital employed :
lease does not appear on the asset
side of balance sheet higher earni
ngs against capital employed and hi
gher rate of return on capital

Advantages of leasing to the Les

see
Convenience and Flexibility: in case of o
perating or service leases lessee has th
e right to terminate the lease if it does n
ot require the use of asset.
No floatation costs: cost of issue of shar
es and debentures can be avoided
No disposal problem: ends with the leas
e contract
Lesser administrative and Maintanence
cost

Limitations of leasing for the less

ee
Higher cost: Lease rental include a margin f
or the lessor as the cost of risk of obsolesc
ence
Loss of moratorium period: lease rentals do
not take care of the gestation period
Risk of being deprived of the use of the ass
et: due to the deterioration of the financial p
osition of the lessor or winding up of the lea
sing company
No alteration or change in asset: as lessee i
s not the owner

Limitations of leasing for the less

ee
Loss of ownership incentives: not entitl
ed to depreciation and investment allo
wance
Penalties on termination of lease : nee
d to pay penalties if lease is terminated
before the expiry period
Loss of salvage value of the asset: As h
e is not the owner he does not get the s
alvage value at the expiry of useful life.

Advantages of leasing to the less

or
Higher profits: Cost of capital+ risk invo
lved
Tax benefits: can claim various cash be
nefits like depreciation, investment allo
wance etc
Quick returns: receives quick returns in
the form of rent when compared to othe
r investments
Increased sales: Lease financing throug
h third parties help manufacturers

Disadvantages of leasing to the l

essor
High risk of obsolescence
Competitive market: unable to obtain suff
icient rentals
Price level changes: fixed rentals are onl
y received. Inflation is not taken into con
sideration
Management of cash flows is difficult
Increased cost due to loss of user benefi
ts
Long term investments

Legal Aspects of Leasing

No separate statute for equipment leasing in I
ndia
Governs the provisions of Bailment in the India
n Contract Act 1872
Sec 148, Bailment as the delivery of goods b
y one person to another, for some purpose, upo
n a contract that they shall, when the purpose
is accomplished, be returned or otherwise disp
osed off according to the directions of the per
son delivering them.The person delivering the
goods is called the bailor and person to whom
they are delivered is called the bailee

Legal Aspects of Leasing

The lessor has the duty to deliver t
he asset to the lessor, authorise to
use the asset legally, and returned
the asset according to the agreem
ent.
The lessee has the obligation to pa
y lease rental, to protect the lesso
rs title, take reasonable care of th
e asset

Documentation

1.
2.
3.

Various steps involved in lease transaction are:

Decide the asset required/leased
Select the supplier /description of lessor/lessee
Enter into a lease agreement and it must contai
n
a. amount , time and place of lease rental paym
ent
b. time and place of equipment delivery
c. lessees responsibility for taking delivery and
posession of the leased equipment
d. responsibility for maintenance, repairs, regist
ration etc

Documentation continued
Rights in the case of default
f. Right to enjoy the benefits of the
warranties provided by the manuf
acturer or the supplier
g. Insurance provisions
h. Variation in lease rental due to c
ertain external factors like bank i
nterest rate,depreciation rates et
c

Documentation Contd
i. Option of lease renewal
j. Return of equipment on expiry
k. Arbitration procedure in the event of di
spute
4. After the lease agreement is signed, th
e lessor contacts to the manufacturer
opr the supplier to supply the asset to
lessee. The lessor makes the payment
and asset has been delivered and acc
epted by the lessee

Financial Evaluation
An alternative method for financing investme
nts
Compares leasing with buying
Lease rentals are equal to debt financing
Compares the cost of leasing with cost of bo
rrowing
Financial decision depends on the compariso
n of cost of debt financing and lease financin
g
Lessee can claim lease rentals as income ta
x deductible expense

Financial Evaluation
Rentals received by the lessor are t
axable
Lessor is not entitled to concession
al rate of Central Sales Tax because
asset purchased is meant neither fo
r resale or for use.
Lease come under the head of sale
and central or state government can
levy sales tax on lease transactions

Financial Evaluation
According to the provisions of Schedule
VI of Companies Act ; Accounting treat
ment in the books of lessor should be :a. To disclose the asset in the balance sh
eet
b. Lease rental shown in the P&L account
as Gross Income
c. Lease rental should be shown on actu
al basis and not on accrual basis

Financial Evaluation
d) Minimum statutory depreciation can be charge
d
e) A fair value of the leased asset to be recovered
every year is ascertained and is called annual
lease charge
f) When the actual lease charge is more than the
statutory depreciation, the difference is called
lease equalisation charge and is charged in th
e income statement
g) For Adjusting the annual lease charge, a lease
equalisation account and a lease adjustment a
ccount will be opened as follows:

Financial Evaluation
i) If the annual lease charge is more
Lease Equalisation Account Dr
To Lease Adjustment Account
j) If it is less,
Lease Adjustment Account Dr
To Lease Equalisation Account
Balance in the lease adjustment account
will appear in balance sheet whereas the
equalisation account will go into the inco
me statement

Financial Evaluation
Profit & Loss Account
To Statutory
Depreciation

xxxxxxxxxxxx
xx

By Gross
income- Lease rental
-Add Lease
Equalisation
-Or
-Less Lease
Equalisation

xxxxxxxxxxxx

xxxxxxxxxxxxx
x

Financial Evaluation
Balance Sheet
Assets
-Fixed Assets
--Lease hold assets
xxxx
--less accumulated
depreciation
xxxx
--less lease
adjustment xxx

Amount

xxxxxxxxxxxx

Financial Evaluation
But for the financial lease no special treatment is requi
red in the books of lessee. But the following treatment
can be made : The assets taken as lease should be shown as a footag
e in the B/S
Lease rental paid should be shown in the income state
ment
Lease rental should be shown on accrual basis (adjust
ment of outstanding and prepaid)
It is also desirable to disclose the future obligations as
per agreement of the lease by way of footnote

Structure of Leasing Industry

In India it consists of :
1. Private Sector Leasing
2. Public Sector Leasing
Private Sector consists of
a. Pure Leasing Companies
b. Hire Purchase and Finance Compa
nies
c. Subsidiaries of Manufacturing comp
anies

Structure of Leasing Industry

The public sector consists of :
a. Leasing divisions of financial
instituitions
b. Subsidiaries of Public Sector
banks
c. Other public sector leasing o
rganisations

Leasing Industry
Pure Leasing Companies: works in
dependently-no link with others-eg
: The Groves leasing ltd, twentieth
century finance corporation ltd .
Hire purchase and finance compan
ies: Started before 1980 and added
vehicle leasing during 80s . Sunda
ram finance ltd; Motor and general
finance ltd are examples.

Leasing Industry
Subsidiaries of Manufacturing gro
up companies: Two categories:
a. Vendor leasing(to promote pa
rent companies product)
b. In house leasing (to meet fun
d requirements or to avoid tax liab
ilities of the group company)

Leasing Industry
Public Sector:
1. Financial Instituitions: set up their leasing div
isions or subsidiaries to do leasing business.
IFCI, ICICI are examples
2. Subsidiaries of Banks: Sec 19(1) of banking re
gulation Act allows commercial banks to set
up subsidiaries for leasing business. SBI was
the first bank to do so inn 1986.
3. Other public sector organisations: Bharat Elec
tronics ltd, Electronics cor[oration of India ltd
have started to sell products through leasing

Buy or Lease Decision

Takes financial decision at the appropria
te time
Buy an asset or take on lease
Financial viability of both have to be eval
uated
Generally NPV technique is used
The present values of net cash outflows
after tax from these options should be c
ompared and option with lower present v
alue should be selected

Decision Making Process

1. Calculate Depreciation:
Depreciation= Cost of asset-Sal
vage value
No. of years of life
2.

Ascertain savings in tax on depreciation:

Saving = Depreciation* Tax Rate

Decision Making Process

3. Find out savings in tax on interest paid w
ith the help of the tax rate for the given p
eriod.
4. Calculate PV of after tax cash outflows u
nder purchase option with the help of th
e appropriate discount rate (minimum ra
te of return required)