Chapter 10 LEASING “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Learning Goals: Explain the concept of leasing and contrast it with other forms of financing Study the different types of lease contracts Evaluate the benefits of leasing Explain the lease evaluation process from lessee’s and lessor’s point of view Present an overview of leasing industry “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Leasing : An Introduction Source of medium-term finance for business Facilitates firms to acquire assets or avail the use of assets Supplements traditional sources of finance Through asset building, contributes to capital formation in an economy Convenient and flexible source of financing Used as a marketing tool by the manufacturers “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Concept of Leasing Leasing means obtaining the services of an asset on rent or on hire A lease is a contract by which the legal owner of an asset (lessor) gives the right to use the asset to another person (lessee) for a specified period in return for the payment of rent implying the parting of possession of an asset for a temporary period. Contd… “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

The International Accounting Standards (IAS) No The International Accounting Standards (IAS) No. 17 defines lease as an agreement whereby the lessor conveys to the lessee, in return for a payment or a series of payments, the right to use an asset for an agreed period of time. “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Elements of Lease Transaction 1. Lease is a contract. 2. Contract between lessor and lessee. 3. Legal ownership of the asset separated from use of the asset. 4. The use of asset by the lessee is the subject matter of a lease contract. 5. Lease contract is for a specific period. 6. Legal owner of the asset is the lessor. Contd… “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

7. Lessee is the person in possession of the asset and user of the asset. 8. Lessee pays lease rent to the lessor for using the asset. “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Elements of a Lease Contract Lease is a bail transaction Two parties involved – lessor (owner), lessee (user) The asset must exist at the inception of lease as well as at the end of the lease period. lease period-operation of contract of lease Upfront charges are collected from the lessee towards lease management fees, security deposit etc Contd… “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Residual value of leased asset Lessee pays lease rent to the lessor for using the asset recovering investment and also returns Residual value of leased asset At the end of lease period, lessee may buy the asset or renew lease contract “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Lease vs. Loan Finance Lease Loan finance Lessee is beneficiary Lessor is finance provider Asset involved Ownership with lessor Medium term finance Off balance sheet Tax benefits to lease payments Loan finance Borrower is beneficiary Lender is finance provider Money involved Lien over the asset Long term finance On the balance sheet of borrower Tax benefits on interest and depreciation “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Lease vs. Hire Purchase Hire purchase Lease Ownership with hire purchase financier Hirer -depreciation in accounting books Hirer -depreciation claim for income tax Only financial charges are deductible Hirer has buying option at end of term Lease Ownership with lessor Lessee-depreciation in accounting books Lessor-depreciation claim for income tax Lease rent deductible in full No buying option at end of term “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Finance Lease According to International Accounting Standard No. 17, a finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. The lessee selects the equipment, negotiates the price and terms of sale, and fixes a lease financing company to buy the asset. Lessee takes the equipment on lease by entering into a non-cancellable agreement with the lease financing company Contd… “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Lessee uses the equipment, and takes care of insurance and maintenance of the asset. Lessee bears the risk of obsolescence or risk of loss or damage of the asset risk of loss or damage to the asset is borne by the lessee. Lease period finance lease is split into primary period and secondary period During the primary period, full recovery of investment is made through the lease rents “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Operating Lease Also known as service lease or maintenance lease An operating lease is a contract between the lessor and lessee such that the cost of the asset is not fully recovered from a single lessee. Short duration lease periods and multiple lessees for the asset Contd… “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Risk of obsolescence with the lessor Involves technological skills, ability to maintain and manage fleets of equipment and training of personnel on the part of the lessor “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Finance Lease Vs. Operating Lease Financial lease Lessor provides finance risk and reward to the lessee 5 to 7 years of lease period non-cancellable contracts Operating lease lessor provides assets risk and reward to the lessor 1 to 3 years of lease period cancellable contracts Contd… “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Maintenance and repairs, risk of obsolescence is with the lessee. Investment recovered from a single lessee Maintenance and repairs, risk of obsolescence is with the lessor. Investment recovered from multiple lessees “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Other Types of Lease Full pay out lease – a finance lease for the economic life of the equipment. Leveraged lease (Japanese Leveraged Lease) – big-ticket leases involving huge capital outlays and equity component in the lease structure ‘Wet lease’ and ‘Dry lease’ – In a ‘wet lease’, the lessor is responsible for control and maintenance of the assets and in dry lease by the lessee. Contd… “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Domestic lease vs. International lease – In domestic lease the lessor and lessee are from same country. On the other hand, if the lessor and lessee are domiciled in different countries, it is a international lease. Sale and Lease Back – adopted by Cash- strapped firms i.e. sale of assets to the lease finance company and getting the same assets on lease basis from the leasing company. Contd… “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Vendor leasing – a market promotion tool for vendors by offering Lease finance at the point of sale. “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Benefits of Leasing 100 per cent financing i.e. margin free financing Flexible according to requirements of the lessee Restrictive provisions absent Quick finance Cost economical when compared to term loans Off-balance sheet financing Contd… “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Risk management in cases of residual risk Access to Capital Risk management in cases of residual risk “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Rights and Obligations of lessor Right of ownership of the asset Right to claim depreciation on the leased assets Right to ensures proper utilization of asset Right to receive the lease rental and other payments Right to terminate the contract in case of misuse of leased assets Contd… “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Right to file a suit against the lessee for conversion of assets . “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Rights and Obligations of lessee Right to use the asset during the lease period based on leased contract Regularly pay the lease rents Protect the asset by taking insurance policy Return the leased asset to the lessor at the end of the lease period or on early termination of leased contract “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Lease Evaluation: Lessee’s Point of View A decision has to be made whether to lease the asset or to buy the assets. The steps involved in the process are as follows: 1. The NPV of the lease alternative has to be computed. 2. The NPV of the buy alternative is computed. 3. Compare the NPV of the lease alternative and the buy alternative. Contd… “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

It is a combination of investment and financing decision Lease evaluation comprises of financial evaluation and non-financial evaluation It is a combination of investment and financing decision “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Lease Evaluation: Lessor’s Point of View The lessor are the financial institutions, banks, NBFCs and specialised leasing companies or sometimes manufacturers. For the lessor, leasing business is an investment of funds and a fair return on the funds invested are expected The major concerns of lessors are: fixing the break-even lease rental lease assessing the extent of lease-related risks such as default risk, residual value risk, interest rate Contd… “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Lessor’s analysis includes the determination of: 1. The net cash outlay (net of lease payments made in advance) required for investment. 2. The net cash inflows (i.e. lease rents received minus the maintenance expenses met by the lessor and income tax). 3. The residual value of the leased asset. 4. Finally, the NPV of the lease proposal. “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Lease Accounting As per the Accounting Standard-AS 19 issued by the ICAI, finance lease has to be capitalized in the books of the lessee At commencement of the lease period, finance lease is recorded as an ‘asset’ and the obligations of the lessee to pay the lease rentals in future are shown as ‘liabilities’ in the balance sheet of the lessee . Contd… “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Lessee will claim depreciation for the leased assets as per Income Tax Act while computing his taxable income. The lessor neither capitalises the asset in his balance sheet nor claims depreciation in his books of account “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Leasing Industry: A Review Leasing industry in UK, USA and other European nations is well developed compared to other developing countries In late 1850’s, UK wagon leasing companies initiated leasing business In 1950s, vendor leasing prominent in USA in 1960s operations started in the UK, Germany and Japan Contd… “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

During 1970s due to aggressive marketing developed in South Korea, Brazil, the Philippines and Sri Lanka “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Leasing Industry in India Incorporation of First Leasing Company of India Limited (FLCI) in September1973 in Chennai introduced Lease finance. In 1980’s, Twentieth Century leasing Limited, Industrial Reconstruction Bank of India, ICICI also entered the leasing sector In 1984 when 65 leasing companies were floated and it increased to 400 in late 1990’s Leasing companies today in India is around 10 Contd… “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Many companies failed due bogus transactions and RBI’s measures to control them “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

Conclusion Hiring an asset for use in the business for lease rental Finance lease and operating lease are two types of popular lease contracts Cheaper funding option and not a device for tax shelter Contd… “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.

In India, the lease contracts are largely finance leases in areas like aircraft leasing business, car leasing business and Infrastructure projects “Financial Services” by R Shanmugham Copyright  2009 Wiley India Pvt. Ltd. All rights reserved.