Leasing & Hire Purchase

Leasing

A Lease is a contract between owner of the asset and beneficiary. Owner of the asset is called lessor and the beneficiary is called lessee. The lessee has the right to posses and to use the asset on payment of the specified rentals over a predetermined period of time.

Meaning of leasing Leasing is a process by which a firm can obtain the use of a certain fixed assets for which it must pay a series of contractual, periodic, tax deductible payments. The lessee is the receiver of the services or the assets under the lease contract and the lessor is the owner of the assets. The relationship between the tenant and the landlord is called a tenancy, and can be for a fixed or an indefinite period of time (called the term of the lease). The consideration for the lease is called rent.

The essential elements of leasing are the following:

1. Parties to the Contract : There are essentially two parties to a contract of lease financing, viz, the owner and the user, respectively called the lessor and the lessee Lessors as well as lessees may be individuals, partnerships, joint stock companies. Merchant banking divisions of certain foreign banks in India, subsidiaries of some Indian banks and even some private merchant bankers are acting as lease brokers. They charge certain percentage of fees for their services, ranging between 0.50 to I per cent.

2. Asset: The asset, property or equipment to be leased is the subject matter of a contract of lease financing. The asset may be an automobile, plant and machinery, equipment, land and building, factory, a running business, aircraft, etc. The asset must, however, be of the lessee's choice suitable for his business needs.

3. Ownership Separated from user: The essence of a lease financing contract is that during the lease tenure, ownership of the asset vests with the lessor and its use is allowed to the lessee. On the expiry of the lease tenure, the asset reverts to the lessor.

4. Term of Lease: The term of lease is the period for which the agreement of lease remains in operation. Every lease should have a definite period; otherwise it will be legally inoperative. The lease period may sometimes stretch over the entire economic life of the asset (i.e., financial lease) or a period shorter than the useful life of the asset (i.e, operating lease). The lease may be perpetual, i.e., with an option at the end of the lease period to renew the lease for a further specific period.

5. Lease Rentals: The consideration which the lessee pays to the lessor for the lease

transaction is the lease rental. The lease rentals are so structured as to compensate the

lessor for the investment made in the asset (in the form of depreciation), the interest on

the investment, repairs, etc. if any borne by the 1essor and servicing charges over the

lease period.

6. Modes of Terminating Lease: At the end of the lease period, the lease is terminated

and various courses are possible, viz.,

(a) The lease is renewed on a perpetual basis or for a definite period,

(b) The asset reverts to the lessor,

(c) The asset reverts to the lessor and the lessor sells it to a third party,

(d) The lessor sells the asset to the lessee.

The parties may mutually agree to and choose any of the aforesaid alternatives at the

beginning of the lease nature.

ADVANTAGE OF LEASING :

To the Lessee : Lease financing has the following advantages to the lessee:

·         Financing of Capital goods :- Lease financing enables the lessee to have finance for huge investments in land, building, plant, machinery, heavy equipments, etc., up to 100 per cent, without requiring any immediate down payment. Thus, the lessee is able to commence his business virtually without making any initial investment (of course, he may have to invest the minimal sum of working capital needs).

·         Additional Source of Finance :- Leasing facilitates the acquisition of equipment, plant and machinery, without the necessary capital outlay, and, thus, has a competitive advantage of mobilizing the scarce financial resources of the business enterprise. It enhances the working capital position and makes available the internal accruals for business operations.

•     Less Costly :- Leasing as a method of financing is less costly than other alternatives available.

•         Off-Balance Sheet Financing :- Neither the leased asset is depicted on the balance sheet, nor the lease liability is shown, except that the fact of lease arrangement is mentioned by way of a footnote. Lease financing, therefore, does not affect the debt raising capacity of the enterprise, the lessor's security being also confirmed to the leased asset

·         Ownership Preserved: - Leasing provides finance without diluting the ownership or control of the promoters. Against it, other modes of long-term finance, viz,equity or debentures, normally dilute the ownership of the promoters .

·         Avoid Conditionalities:- Lease finance is considered preferable to institutional finance, as in the former case, there are no conditionalities. Lease financing is beneficial since it is free from restrictive covenants and conditionalities, such as, representations on the board, conversion of debt into equity, payment of dividend, etc, which usually accompany institutional finance and term loans from banks.

•          Flexibility in Structuring of Rentals:- The lease rentals can be structured to accommodate the cash flow situation of the lessee, making the payment of rentals convenient to him. The lease rentals are so tailor-made that the lessee is able to pay the rentals from the funds generated from operations. The lease period is also chosen so as to suit the lessee’s capacity to pay rentals and considering the operating life-span of the asset.

•     Simplicity:- A lease finance arrangement is simple to negotiate and free from cumbersome procedures with faster and simple documentation. As against it, institutional finance and term loans require compliance of covenants and formalities and bulk of documentation, causing procedural delays.

•     Tax Benefits:- By suitable structuring of lease rentals, a lot of tax advantages can be derived. If the lessee is in a tax paying position, the rental may be increased to lower his taxable income. The cost of asset is thus amortized more rapidly than in a case where the asset is owned by the lessee, since depreciation is allowable at the prescribed rates. If the lessor is in tax paying position, the rentals may be lowered to pass on a part of the tax benefit to the lessee. Thus, the rentals can be adjusted suitably for postponement of taxes.

• Obsolescence Risk is Averted :- In a lease arrangement the lessor being the owner bears the risk of obsolescence and the lessee is always free to replace the asset with the latest technology.

To the Lessor :- A lessor has the following advantages

·      Full Security :- The lessor's interest is fully secured since he is always the owner of the leased asset and can take repossession of the asset if the lessee defaults. As against it, realising an asset secured against a loan is more difficult and cumbersome.

•     Tax Benefit :- The greatest advantage for the lessor is the tax relief by way of depreciation. If the lessor is in high tax bracket, he can lease out assets with high depreciation rates, and thus, reduce his tax liability substantially. Besides, the rentals can be suitably structured to pass on some tax benefit to the lessees.

• High Profitability :- The leasing business is highly profitable since the rate of return is more than what the lessor pays on his borrowings. Also, the rate of return is more than in case of lending finance directly.

• Trading on Equity :- Lessors usually carry out their operations with greater financial leverage, That is, they have a very low equity capital and use a substantial amount of borrowed funds and deposits. Thus, the ultimate return on equity is very high.

• High Growth Potential :- The leasing industry has a high growth potential. Leasing financing enables the lessees to acquire equipment and machinery even during a period of depression, since they do not have to invest any capital. Leasing, thus, maintains the economic growth even during recessionary period.

LIMITATIONS OF LEASING:

Lease financing suffers from certain limitations too :

• Restrictions on Use of Equipment:- A lease arrangement may impose certain restrictions on use or the equipment, or require compulsory insurance, etc. Besides, the lessee is not free to make additions or alterations to the leased asset to suit his requirements.
• Limitations of Financial Lease:- A financial lease may entail higher payout obligations, if the equipment is found not useful and the lessee opts for premature termination of the lease agreement. Besides, the lessee is not entitled to the protection of express or implied warranties since he is not the owner of the asset.
• Loss of Residual Value:- The lessee never becomes the owner of the leased asset. Thus, he is deprived of the residual value of the asset and is not even entitled to any improvements done by the lessor or caused by inflation or otherwise, such as appreciation in value of leasehold land.
• Consequences of Default:- If the lessee defaults in complying with any terms and conditions of the lease contract, the lessor may terminate the lease and take over the possession of the leased asset. In case of finance lease, the lessee may be required to pay for damages and accelerated rental payments.
• Understatement of Lessee's Asset: - Since the leased assets do not form part of lessee's assets, there is an effective understatement of his assets, which may sometimes lead to gross under-estimation of the lessee. However, there is now an accounting practice to disclose the leased assets by way or footnote to the balance sheet.
• Double Sales Tax:- With the amendment of sale-tax law in various states, a lease financing transaction may be charged to sales tax twice-once when the lessor purchases the equipment and again when it is leased to the lessee.

 Types of Leasing:

An equipment lease transaction can differ on the basis of

(1) the extent to which the risks and rewards of ownership are transferred,

(ii) number of parties to the transaction,

(iii) domiciles of the equipment manufacturer, the lessor and the lessee, etc.

On the basis of these variations, leasing can be classified into the following types:

(a) Finance lease and operating lease

(b) Sales and lease back, and direct lease

(c) Single investor lease and leveraged lease

(d) Domestic lease and International lease

(a) Finance Lease and Operating Lease

Finance Lease :  A lease is defined as a finance lease if it transfers a substantial part of the  risks and rewards associated with the ownership from  the lessor to the lessee. Under this lease the lessor recovers 90% of the fair value of the asset as lease rentals and the lease period is 75% of the economic life of the asset. The lease agreement is irrevocable. Practically all the risks incidental to the asset ownership and all the benefits arising there from are transferred to the lessee who bears the cost of maintenance, insurance and repairs. Only title deeds remain with the lessor. Financial lease is also known as 'capital lease‘. In India, financial leases are very popular with high-cost and high technology equipment.

The IAS-17 stipulates that a substantial part of the ownership related risks and rewards in leasing are transferred when:

(i) The ownership of the equipment is transferred to the lease by the end of the lease term or

(ii) The lease has the option to purchase the asset at a price which is expected to be sufficiently lower than the fair market value at the date the option becomes exercisable and at the stipulation of the lease it is reasonable certain that the option will be exercised, or

(iii) The lease term is for a major part of the useful life of the asset. The title may not eventually be transferred.

(iv) The present value of the minimum lease payment is greater than, or substantially equal to, the fair market value of the asset at the inception of the lease (cost or equipment). The title may or may not be eventually transferred.

2) Operational lease

The International Accounting Standard Committee defines as operating lease as, “Any lease other than a Finance Lease”.

An operating lease stands in contrast to the financial lease in almost all aspects. This lease agreement gives to the lessee only a limited right to use the asset. The lessor is responsible for the upkeep and maintenance of the asset. The lessee is not given any uplift to purchase the asset at the end of the lease period. Normally the lease is for a short period and even otherwise is revocable at a short notice. Mines, Computers hardware, trucks and automobiles are found suitable for operating lease because the rate of obsolescence is very high in this kind of assets.

Features:

       I.            The lease term is significantly less than the economic life of the equipment

    II.            The lessee enjoys the right to terminate the lease at short notice without v any penalty.

 III.            The lessor usually provides the technical know-how and maintain the equipment.

3) Sale and lease back

It is a sub-part of finance lease. Under this, the owner of an asset sells the asset to a party (the buyer), who in turn leases back the same asset to the owner in consideration of lease rentals. However, under this arrangement, the assets are not physically exchanged but it all happens in records only. This is nothing but a paper transaction. Sale and lease back transaction is suitable for those assets, which are not subjected depreciation but appreciation, say land. The advantage of t his method is that the lessee can satisfy himself completely regarding the quality of the asset and after possession of the asset convert the sale into a lease arrangement.

4) Leveraged leasing

Under leveraged leasing arrangement, a third party is involved beside lessor and lessee. The lessor borrows a part of the purchase cost (say 80%) of the asset from the third party i.e., lender and the asset so purchased is held as security against the loan. The lender is paid off from the lease rentals directly by the lessee and the surplus after meeting the claims of the lender goes to the lessor. The lessor, the owner of the asset is entitled to depreciation allowance associated with the asset.

5) Direct leasing

Under direct leasing, a firm acquires the right to use an asset from the manufacture directly. The

ownership of the asset leased out remains with the manufacturer itself. The major types of direct

lessor include manufacturers, finance companies, independent lease companies, special purpose leasing companies etc

A direct lease can be of two types : Bipartite and Tripartite Lease.

Bipartite Lease : There are two parties in the lease transaction, namely,

(i) equipment supplier-cum-lessor

(ii) lessee. Such a type of lease is typically structured as an operating lease with inbuilt facilities, like up gradation of the equipment (Upgrade Lease), addition to the original equipment configuration and so on. The lessor maintains the asset and, if necessary, replaces it with a similar equipment in working conditions (Swap Lease).

Tripartite Lease : Such type of lease involves three different parties in the lease agreement : equipment supplier, lessor and lessee. An innovative variant of tripartite lease is the sales-aid lease under which the equipment supplier arranges for lease finance in various company.

Difference between Operating & Finance Lease

Points of Diffence	Operating Lease	Financial Lease
Definition	A lease in which all risks and rewards related to asset ownership remain with the lessor for the leased asset is called operating lease. In this lease, the asset is returned by the lessee after using it for lease term agreed upon.	In financial lease (Also known as capital lease), the risks and rewards related to ownership of asset leased are transferred to the lessee.
Ownership	Ownership of the asset remains with the lessor for the entire lease period.	Ownership transfer option at the end of the lease period is there with the lessee. Title might or might not be transferred eventually.
Accounting Effect	Operating lease is treated generally like renting. That means, the lease payments are treated as operating expenses and the asset does not show on the balance sheet.	Financial lease is treated like loan generally. Here, the asset ownership is considered of the lessee and so asset appears on the balance sheet.
Purchase Option	In operating lease, the lessee does not have any option to buy the asset during the lease period.	Financial lease allows the lessee to have a purchase option at less than the fair market value of the asset.
Lease Term	Lease term extends to less than 75% of the projected useful life of the leased asset.	Lease term is generally more than or equal to estimated economic life of the asset leased.
Expenses Borne	Lessee pays only the monthly lease payment in operating lease.	In financial lease, lessee bears insurance, maintenance and taxes.
Tax Benefit	Since operating lease is as good as renting, lease payment is considered as expense. No depreciation can be claimed.	Lessee can claim interest and depreciation both as financial lease is treated like a loan.
Running Cost	In operating lease, no running or administration costs are to be borne for example: registration, repairs etc. since it gives only right to use the asset.	In a financial lease, running cost and administration expenses are higher.
Example	Normally, A Projector, Computers, Laptops, Coffee Dispensers etc	Normally, Plant and Machinery, Land, Office Building etc

Regulatory frame work for Leasing in India

As there is no separate statue for leasing in India, the provisions relating to bailment in the Indian

Contract Act governs equipment leasing agreements as well section 148 of the Indian Contract Act defines bailment as:

“The delivery of goods by one person to another, for some purpose, upon a contract that they shall, when the purpose is accomplished, be returned or otherwise disposed off according to the directions of the person delivering them. The person delivering the goods is called the ‘bailor’ and the person to whom they are delivered is called the ‘bailee’.

Since an equipment lease transaction is regarded as a contract of bailment, the obligations of the

lessor and the lessee are similar to those of the bailor and the bailee (other than those expressly

specified in the least contract) as defined by the provisions of sections 150 and 168 of the Indian

Contract Act. Essentially these provisions have the following implications for the lessor and the

lessee.

1. The lessor has the duty to deliver the asset to the lessee, to legally authorise the lessee to use

the asset, and to leave the asset in peaceful possession of the lessee during the currency of the agreement.

2. The lessor has the obligation to pay the lease rentals as specified in the lease agreement, to protect the lessor’s title, to take reasonable care of the asset, and to return the leased asset on the expiry of the lease period.

Contents of a lease agreement: The lease agreement specifies the legal rights and obligations of

the lessor and the lessee. It typically contains terms relating to the following:

1. Description of the lessor, the lessee, and the equipment.

2. Amount, time and place of lease rentals payments.

3. Time and place of equipment delivery.

4. Lessee’s responsibility for taking delivery and possession of the leased equipment.

5. Lessee’s responsibility for maintenance, repairs, registration, etc. and the lessor’s right in case of default by the lessee.

6. Lessee’s right to enjoy the benefits of the warranties provided by the equipment manufacturer/supplier.

7. Insurance to be taken by the lessee on behalf of the lessor.

8. Variation in lease rentals if there is a change in certain external factors like bank interest rates, depreciation rates, and fiscal incentives.

9. Options of lease renewal for the lessee.

10. Return of equipment on expiry of the lease period.

11. Arbitration procedure in the event of dispute.

Problems of leasing in India

Leasing has great potential in India. However, leasing in India faces serious handicaps which may bar its growth in future. The following are the some of the problems.

1. Unhealthy competition–There is over supply of lessor in India. The stiff competition between

these lessors are force them to reduce their profit margin to bare minimum level.

More over subsidiaries of banks and financial institution have competitive edge over private sector lessor due their cheap source of finance.

2. Lack of qualified personnel- leasing requires qualified and experienced personnel at the helm of its affairs. In India, leasing is of recent one and hence it is difficult to get right man to deal with leasing business.

3. Tax Consideration- In reality, the lessee’s tax shelter is lessors’ burden. The lease becomes economically viable if lessors effective tax rate is low. more over taxes like sales tax, wealth tax, additional tax , surcharge etc, add to the cost of leasing. It makes leasing relatively more  expensive.

4. Stamp Duty- States treats the leasing transaction as a sale for the purpose of making them eligible to sales tax. On the contrary, for stamp duty, the transaction is treated as pure lease transactions. Accordingly heavy stamp duty imposed on lease document.

5. Delayed payment and bad debts- The problem of delayed payment of rents and bad debts add to the cost of lease. This problem would disturb prospects of leasing business.

Evolution of Leasing

Leasing activity was initiated in India in 1973. The first leasing company of India, named First Leasing Company of India Ltd. was set up in that year by Farouk Irani, with industrialist A C Muthia. For several years, this company remained the only company in the country until 20^th Century Finance Corporation was set up – this was around 1980.

By 1981, the trickle started and Shetty Investment and Finance, Jaybharat Credit and Investment, Motor and General Finance, and Sundaram Finance etc. joined the leasing game. The last three names, already involved with hire-purchase of commercial vehicles, were looking for a tax break and leasing seemed to be the ideal choice.

The industry entered the third stage in the growth phase in late 1982, when numerous financial institutions and commercial banks either started leasing or announced plans to do so. ICICI, prominent among financial institutions, entered the industry in 1983 giving a boost to the concept of leasing. Thereafter, the trickle soon developed into flood, and leasing became the new gold mine. This was also the time when the profit-performance of the two doyen companies, First Leasing and 20th Century had been made public, which contained all the fascination for many more companies to join the industry. In the meantime, International Finance Corporation  announced its decision to open four leasing joint ventures in India. To add to the leasing boom, the Finance Ministry announced strict measures for enlistment of investment companies on stock-exchanges, which made many investment companies to turn overnight into leasing companies.

As per RBI’s records by 31st March, 1986, there were 339 equipment leasing companies in India whose assets leased totaled Rs. 2395.5 million. One can notice the surge in number – from merely 2 in 1980 to 339 in 6 years.

Subsequent swings in the leasing cycle have always been associated with the capital market – whenever the capital markets were more permissive, leasing companies have flocked the market. There has been appreciable entry of first generation entrepreneurs into leasing, and in retrospect it is possible to say that specialised leasing firms have done better than diversified industrial groups opening a leasing division.

Another significant phase in the development of Indian leasing was the Dahotre Committee’s recommendations based on which the RBI formed guidelines on commercial bank funding to leasing companies. The growth of leasing in India has distinctively been assisted by funding from banks and financial institutions.

Banks themselves were allowed to offer leasing facilities much later – in 1994. However, even to date, commercial banking machinery has not been able to gear up to make any remarkable difference to the leasing scenario.

The post-liberalisation era has been witnessing the slow but sure increase in foreign investment into Indian leasing. Starting with GE Capital’s entry, an increasing number of foreign-owned financial firms and banks are currently engaged or interested in leasing in India.

HIRE PURCHASE

Hire purchase is a method of selling goods. In a hire purchase transaction the goods are let out on hire by a finance company (creditor) to the hire purchase customer (hirer). The buyer is required to pay an agreed amount in periodical installments during a given period. The ownership of the property remains with creditor and passes on to hirer on the payment of last installment.

The hire purchase system is regulated by the Hire Purchase Act 1972. This Act defines a hire purchase as

“An agreement under which goods are let on hire and under which the hirer has an option to purchase them in accordance with the terms of the agreement…..

Features of Hire Purchase

1. Immediate possession-under HP, the buyer takes immediate possession of goods by paying only a portion of its price.

2. Hire Charges- under HP, each instalment is treated as hire charges.

3. Property in goods - ownership is–passed to the hirer only after paying last or specified number of instalments.

4. Down payment- hirer has to pay 20 to 25% of asset price to the vendor as down payment.

5. Repossession- Hire vendor, if default in payment of instalment made by hirer, can reposes the goods and he can resell the goods.

6. Return of goods- hirer is free to return the goods without being required to pay further instalment falling due after the return.

7. Depreciation- depreciation and investment allowances can be claimed by the hirer even though he is not an exact owner.

Hire Purchase and Leasing

Hire Purchase is also different from leasing on following grounds :

1. Ownership In a contract of lease, the ownership rests with the lessor throughout and the

lessee (hirer) has no option purchase the goods.

2. Method of Financing Leasing is a method of financing business assets whereas hire purchase

is a method of financing both business assets and consumers articles.

3. Depreciation

In leasing depreciation and investment allowance can not be claimed by the leasee. In hire

purchase, deprecation and investment allowance can be claimed by the hirer.

4. Tax Benefits The entire lease rental is tax deductible expense. Only the interest component of

the hire purchase installment is tax deductible.

5. Salvage Value  The lessee, not being the owner of the asset, does not enjoy the salvage value

of the asset. The hirer, in purchase, being the owner of the asset, enjoys salvage value of the

asset.

6. Deposit Lessee is not required to make any deposit whereas 20% deposit is required in hire

purchase.

7. Rent-Purchase  With lease, we rent and with hire purchase we buy the goods.

8. Extent of Finance Lease Financing is invariably 100 per cent financing. It requires no

immediate down payment or margin money by the lessee. In hire purchase, a margin equal to 20

25 per cent of the cost of the asset is to be paid by the hirer.

9. Maintenance The cost of maintenance of the hired asset is to be borne by the hirer himself. In

case of finance lease only, the maintenance of leased asset is the responsibility of the lessee.

10. Reporting  The asset on hire purchase is shown in the balance sheet of the hirer. The leased

assets are shown by way of foot note only.

References:

 cde.annauniv.edu/mbaqp/pdf/Elective/DBA1751/MBA%201751.pdf

 https://www.scribd.com/doc/20950164/Presentation-on-Hire-Purchase-and-Leasing 

 https://www.slideshare.net/herekarsuneet/hire-purchase-leasing

  techshristi.com/wp-content/uploads/author/66be7_Lesson_15.pdf

 www.academia.edu/.../Hire-Purchase_and_Leasing_Chapter_13_Hire-Purchase_and_...

 www.lpude.in/academics/online_study_material_for_management.php 

 www.pondiuni.edu.in/.../Merchant%20Banking%20and%20Financial%20servicest200

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