PRESENTED BY: RAJESH KUMAR MBA(FINANCE), ACS, A I I I

LEASING AND HIRE PURCHASE

LEASE ?

• Lease is a contract under which a lessor, the owner of the assets, gives right to use the asset to a lessee, the user of the assets, for an agreed period of time for a consideration called the lease rentals.

ADVANTAGES OF LEASING

• Saving of capital• Flexibility and convenience• Planning cash flow• Improvement in liquidity

DISADVANTAGES OF LEASING

• Commitment to contract entire validity period• Higher fixed cost per month• More expenses and purchase• Loss tax benefits• Leasing can be an expensive way of financing

TERMINOLOGY IN LEASING

• In up-fronted leases, more rentals are charged in the initial years and less in the later years of the contract. The opposite happens in back ended leases.• Primary lease provides for the recovery of the

cost of the assets and profit through lease rentals during a period of about 4 or 5 years. It may be followed by a perpetual, secondary lease on nominal lease rentals.

•Cross-border leasing is

a leasing arrangement where lessor and lessee are situated in different countries. This presents significant additional issues related to tax avoidance and tax shelters.

• Cross-border leasing has been widely used in some European countries, to arbitrage the difference in the tax laws of different jurisdictions, usually between a European country and the United States. Typically, this rests on the fact that, for tax purposes, some jurisdictions assign ownership and the attendant depreciation allowances to the entity that has legal title to an asset, while others (like the U.S.) assign it to the entity that has the most indicia of tax ownership (legal title being only one of several factors taken into account). In these cases, with sufficiently long leases (often 99 years), an asset can end up with two effective owners, one in each jurisdiction; this is often referred to as a double-dip lease.

• Often the original owner of an asset is not subject to taxation in any jurisdiction, and therefore not able to claim depreciation. The transaction often involves a city selling an asset (such as a sewerage system or power plant) to an investor (who can claim depreciation), and long-term leasing it right back (often referred to as a sale leaseback). However, since 2004 cross border leasing has been effectively eliminated by the passage of the JOBS ACT of 2004, which made the vast majority of cross border leases unprofitable.

• Net net net lease : in the triple net (net net net) lease, the lessee is obliged to take care of maintenance, taxes and insurance of the equipment.• Update lease : It is to protect the lessee against

the risk of obsolescence. The lessor agrees to replace obsolete asset with new one at specified rent.

• Wet and dry lease: In the aircraft industry, when the lease involves financing as well as servicing and fuel, it is called wet lease. Dry lease provides only for financing.• Percentage Lease : Provides for a fixed rent plus

some percent of the previous year’s gross revenue to be paid to the lessor. This ensures protection against inflation.

LEASING IN INDIA HISTORY

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 1973 by Farouk Irani, with industrialist A C Muthia. 

The Company's object is Leasing of movable and immovable properties and financing.

For several years, this company remained the only company in the country until 20th 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.

As per RBI's records , there were only 2 leasing companies in India in 1980. While by 31st March, 1986, there were 339 equipment leasing companies in India whose assets leased totaled Rs. 2395.5 million.

Banks were allowed themselves to offer leasing facilities in 1994.

IMPACT OF ECONOMIC FACTOR ON LEASING COMPANY IN INDIA

IMPACT OF INTEREST, DEPRECIATION, AND TAX ON FIRST LEASING COMPANY IN INDIA.

The graph visually shows how the net profit of the company stand reduced due to the impact of Interest, Depreciation, and Tax.

HIRE PURCHASE

• Hire purchase is the legal term for a contract, in which a purchaser agrees to pay for goods in parts or a percentage over a number of months.• In Canada and the United States, a hire purchase

is termed an installment plan although these may differ slightly as in a hire purchase agreement the ownership of the good remains with the seller until the last payment is made.

HIRE PURCHASE–CONDITIONS

The owner of the asset (the Hiree or the manufacturer) gives the possession of the asset to the Hirer with an understanding that the Hirer will pay agreed instalments over a specified period of time. • The ownership of the asset will transfer to the

hirer on the payment of all instalments.• The Hirer will have the option of terminating the

agreement any time before the transfer of ownership of assets. ( Cancellable Lease)

The hire purchase agreement was developed in the United Kingdom in the 19th century to allow customers with a cash shortage to make an expensive purchase.

For example in cases where a buyer cannot afford to pay the asked price for an item of property as a lump sum but can afford to pay a percentage as a deposit, a hire-purchase contract allows the buyer to hire the goods for a monthly rent.

There are two types of hire purchases that include an installment plan and deferred payment plan.

1. An installment payment plan requires a set monthly payment to be paid on a certain day each month for a specified length of time. After the last payment, the property then belongs to the buyer.

2. A deferred payment plan allows the property to immediately belong to the buyer as soon as payments begin.

HIRE PURCHASE FINANCING VS LEASING FINANCING

Both hire purchase financing and lease financing are a form of secured loan.

Both involves fixed payments.The hirer becomes the owner of the asset sas

soon as he pays the last installment.In case of lease, the asset reverts backs to the lessor at end of the lease period.

DIFFERENCE BETWEEN LEASING AND HIRE PURCHASE FINANCING

Hire Purchase financing

• Option is provided to the

hirer (user) for purchasing the good.

Lease financing

• No option is provided to the lessee (user) to purchase the goods.

CASE STUDY-1

• A company is considering whether it should buy or lease equipment that cost Rs 80 lac.A finance company has offered to lease the equipment for 5 years at annual lease payments Rs 20lac at the beginning of each year. The owner of the equipment can claim depreciation on written down basis at 25 % each year.The company tax rate is 35% and the cost of borrowing is 14% and the cost of capital is 16%.

• Should company buy the assets or lease.• What will be your answer if we assume that the equipment

has a salvage value of Rs 10 lakh.and the lessor will maintain the equipment which would cost Rs 1 lakh each year.

• Instead of lease the company goes for hire purchase.how much max hire purchase installment should it be prepaid to pay each year.

CASE STUDY-2

• A firm proposes to lease an asset of Rs 800 lacs.The annual end of the year lease rental will be 160 lakh for 8 year.The firm is not in position to pay tax for next five year.The depreciation is of straight line method.The lessor marginal tax rate is 35% .calculate the net present value of lease to the lessee and the lessor.what are the break even rental to the lessee and the lessor.how can both benefit from leasing.Assume the lessee pre tax borrowing rate is 14%.

ACCOUNTING FOR LEASING AS-19

LEASE AND ITS TYPES

• Lease is an agreement by which the lessor gives the right to use as assets for given period of time to the lessee on rent.

• Type of lease • 1. Operating lease 2. Finance Lease • Operating Lease: • It is a lease which does not transfer substantially all the risk and reward

incidental to ownership. • • Finance Lease: • It is a lease, which transfers substantially all the risks and rewards incidental

to ownership of an asset to the lessee by the lessor but not the legal ownership.

• The lease term is for the major part of the economic life of the asset even if title is not transferred;

• At the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset;

APPLICABILITY: THIS AS IS NOT APPLICABLE TO FOLLOWING TYPE OF LEASE:

• 1. Lease agreement to explore natural resources oil ,gases,timber,metal• 2. Lease agreement for motion picture film, video,

plays and other rights. • 3. Lease agreement to use land.

ACCOUNTING FOR OPERATING LEASE:

• In the books of lessor: • 1. Record lease out asset as the fixed assets in

the balance sheet. • 2. Charge depreciation as per AS 6 • 3. Recognise lease income in P & L account using

straightline method. • 4. Other cost of operating lease should be

recognized as expenses in the year in which they are incurred. • 5. Initial direct cost of lease may be expensed out

immediately or deferred as per lease term.

IN THE BOOKS OF LESSEE:

• Lease payments should be recognized as an expense in the P & L account on a straightline • basis over the lease term.

ACCOUNTING FOR FINANCE LEASE: IN THE BOOKS OF LESSOR:

• Recognize asset given under finance lease as receivable at an amount equal to net investment in the lease and corresponding credit to sale of assets.

• Net Investment : Gross investment – unearned finance income

• Gross Investment : Minimum lease payment from lessor point of view + Unguaranteed residual value

• Unearned Finance Income : Gross investment – PV of gross investment

Recognition of Finance Income: On the basis of constant periodic return on the net investment outstanding in respect of finance lease.

IN THE BOOKS OF LESSEE:

• Lease assets as well as liability for lease should be recognized at the lower of:

• a. Fair value of the leased assets at the in caption of lease, or • b. PV of minimum lease payment from the lease point of view. • 2. Apportionment of lease payment: • a. Principal Amount: is reduced from the outstanding liability. • b. Finance charges: is allocated over lease term in such a

manner that it would produce a constant rate of return on the remaining principal balance.

• 3. Charge depreciation on finance lease assets as per AS 6. • 4. Initial direct cost for financial lease is included in assets

under lease.

ACCOUNTING TREATMENT IN CASE OF FINANCE LEASE

This can be explained with the help of an illustration- Fair value of the machinery `2,35,500 Lease Term 3 years Lease Rent `1,00,000 Guaranteed Residual Value by lessee ` 17000 Implicit Rate of Interest 16% p.a. Method of Depreciation SLM

The amount of depreciation charged is equal to ` 72,833(2,35,500-17,000/3)

IN THE BOOKS OF LESSOR-

THE ASSET GIVEN UNDER A FINANCE LEASE IS RECOGNIZED AS A RECEIVABLE AT AN

AMOUNT EQUAL TO THE NET INVESTMENT IN THE LEASE.

Year Lease receivable

Installment Finance Income (Lease receivable x 16%)

Principal Closing Balance

1 2,35,500 1,00,000 37,680 62,320 1,73,180

2 1,73,180 1,00,000 27,710 72,290 1,00,890

3 1,00,890 1,00,000 16,140 83,860 17,030

Profit & Loss Account Balance Sheet

Year 1 By Finance income 37,680 Asset (Year 1) Year 2 By Finance income 27,710 Lease Rent Receivable 2,35,500 Year 3 By Finance income 16,140 (-)Lease rent received 62,320 1,73,180

Amount in `

IN THE BOOKS OF LESSEE-THE ASSET TAKEN ON LEASE IS RECOGNIZED AT AN AMOUNT WHICH WOULD

BE LOWER OF FAIR VALUE OR P.V. OF MLP FROM STANDPOINT OF LESSEE.

Year Lease Rental payable

Installment Finance charges(Lease rental payable x 16%)

Repayment of liability

Closing balance

1 2,35,500 1,00,000 37,680 62,320 1,73,180

2 1,73,180 1,00,000 27,710 72,290 1,00,890

3 1,00,890 1,00,000 16,140 83,860 17,030

Charge in Profit and Loss (Amount in `)

Year Finance Charges

Depreciation Total

1 37,680 72,833 1,10,513

2 27,710 72,833 1,00,543

3 16,140 72,834 88,974

GRAND TOTAL 3,00,030

(Amount in `)

Liability Asset1st year O/s Liability 2,35,500 Machinery 2,35,500

(-) Repayment of Liab. 62,320 1,73,180 (-)Depreciation 72,833

1,62,667

2nd year O/s Liability 1,73,180 Machinery 1,62,667

(-) Repayment of Liab. 72,290 1,00,890 (-)Depreciation 72,833 89,834

3rd year O/s Liability 1,00,890 Machinery 89,834 (-) Repayment of Liab. 83,860 17,030 (-)Depreciation 72,834

17,000

Balance Sheet

MYTHS ABOUT LEASINGLeasing Provides 100% Financing: One misconception about leasing is that it provides 100%

financing for the asset, as the lessee can avoid payment for acquiring the asset.

The lessee, it is assumed, can preserve his liquid resources for other purposes.

When a firm borrows to buy an asset, cash flow increases with borrowing and decreases by the same amount, with the purchase of the asset.

The firm has the asset to use but a liability to repay the loan and interest. In practice, therefore, leasing like – borrowing, commits the company for a stream of payments, in future.

Leasing Provides Off-the-Balance-Sheet Financing:As the lessee may not be obliged to disclose his lease

liability on the balance sheet, it is believed that leasing does not affect the debt-equity ratio, while borrowing increases his debt-equity ratio.

The myth goes, therefore, that leasing provides off-the-balance-sheet financing, leaving the firm’s debt raising ability intact or unbroken. This is a misleading argument.

Leasing can certainly help companies which have enough debt servicing ability but cannot borrow from the banks or financial institutions, on account of institutional norms on debt-equity or regulations. Under no circumstances can a lease enhance the firm’s debt capacity.

Leasing Improves Performance: Another myth is that the return on investment will

increase, since a lease does not appear as an investment on the books or the balance sheet.

Besides, back-ended leases enable showing higher profits in the initial years of the lease. Such performance ratios are illusory.

A firm’s value is affected by the value of it’s assets and liabilities rather than book profits created through accounting adjustments.

A lease will create value to the firm only if the benefits from it are more than its costs.

Leasing Avoids Control of Capital Spending:Another misconception is that leasing does not need

capital expenditure screening as no investments are involved.

Since a long-term lease involves long-term financial commitment, it ought to be screened accordingly, in any good capital expenditure planning and control system.

If leasing is not screened and is used to circumvent capital expenditure screening and approval, it may add to the firm’s risk, make it vulnerable to business fluctuations, and endanger its survival.

EVALUATING A TRUE TAX LEASE

• In summary, when evaluating a true-tax lease, compare the leasing to a purchase that is financed with equivalent leverage.

• First, compute the incremental cash flows for leasing versus buying, including the depreciation tax shield (if buying) and the tax deductibility of the lease payments if leasing.

• Then compute the NPV of leasing versus buying using equivalent leverage by discounting the incremental cash flows at the after-tax borrowing rate.

….CONTINUE

• If the NPV is negative, then leasing is unattractive compared to traditional debt financing.

• If the NPV is positive, then leasing does provide an advantage over traditional debt financing and should be considered.

EVALUATING A NON-TAX LEASE

• Evaluating a non-tax lease is much more straightforward than evaluating a true tax lease.

• The lessee still receives the depreciation deductions, however, only the interest portion of the lease payment is deductible.

….CONTINUE

• In terms of cash flows, a non-tax lease is directly comparable to a traditional loan and is attractive only if it offers a better interest rate than would be available with a loan.

• To determine whether it offers a better rate, discount the lease payments at the firm’s pretax borrowing rate and compare it to the purchase price of the asset.

…..CONTINUE

• If there is a residual value, differences in the maintenance arrangements with a lease versus a purchase, or any cancellation or other lease options, they should also be included when comparing leasing versus a debt-financed purchase.

REGULATORY FRAMEWORK OF LEASING

• A lease is a legal contract, and thus enforceable by all parties under the contract law of the applicable jurisdiction. • Common elements of a lease include:Names of the parties of the agreement.The starting date and duration of the agreement.Identifies the specific object (by street address, VIN, or

make/model, serial number) being leased.Provides conditions for renewal or non-renewal.Has a specific consideration (a lump sum or periodic

payments) for granting the use of this object.

….CONTINUE

Has provisions for a security deposit and terms for its return.May have a specific list of conditions which are therein

described as Default Conditions and specific Remedies.May have other specific conditions placed upon the parties

such as:• Need to provide insurance for loss.• Restrictive use.• Which party is responsible for maintenance?

TYPES OF TENANCIES

• Fixed-term tenancy or tenancy for years : A fixed-term tenancy or tenancy for years lasts for some fixed

period of time. It has a definite beginning date and a definite ending date. At common law the duration did not need to be certain, but could be conditioned upon the happening of some event, (e.g., "until the crops are ready for harvest" or "until the war is over"). In many jurisdictions that possibility has been partially or totally abolished.

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• Periodic tenancy : • A periodic tenancy also known as a tenancy from year to year,

month to month, or week to week, is an estate that exists for some period of time determined by the term of the payment of rent.

….CONTINUE

• Tenancy at will: A tenancy at will is a tenancy which either the landlord or the

tenant may terminate at any time by giving reasonable notice. Unlike a periodic tenancy, it isn't associated with a time period. It may last for many years, but it could be ended at any time by either the lessor or the lessee for any reason, or for no reason at all.

….CONTINUE

• A tenancy at will is broken, again by operation of law, if the:Tenant commits waste against the property;Tenant attempts to assign the tenancy;Tenant uses the property to operate a criminal enterprise;Landlord transfers his/her interest in the property;Landlord leases the property to another person;Tenant or landlord dies.The specifics of these rules differ from jurisdiction to

jurisdiction.

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• Tenancy at sufferance: A tenancy at sufferance (sometimes called a holdover

tenancy) exists when a tenant remains in possession of a property after the expiration of a lease, and until the landlord acts to eject the tenant from the property.

FORMAT OF LEASE AGREEMENT

LEGAL FRAMEWORK OF HIRE PURCHASE

• Standard provisions : • To be valid, HP agreements must be in writing and signed by

both [parties]. • They must clearly lay out the following information in a print

that all can read without effort:

….CONTINUE• a clear description of the goods• the cash price for the goods• the HP price, i.e., the total sum that must be paid to hire and then

purchase the goods• the deposit• the monthly instalments (most states require that the applicable

interest rate is disclosed and regulate the rates and charges that can be applied in HP transactions) and• a reasonably comprehensive statement of the parties' rights

(sometimes including the right to cancel the agreement during a "cooling-off" period).• The right of the hirer to terminate the contract when he feels like

doing so with a valid reason.

IMPLIED WARRANTIES AND CONDITIONS TO PROTECT THE HIRER

• The extent to which buyers are protected varies from jurisdiction to jurisdiction, but the following are usually present:

the hirer will be allowed to enjoy quiet possession of the goods, i.e. no-one will interfere with the hirer's possession during the term of this contract

the owner will be able to pass title to, or ownership of, the goods when the contract requires it

that the goods are of merchantable quality and fit for their purpose, save that exclusion clauses may, to a greater or lesser extent, limit the Finance Company's liability

where the goods are let by reference to a description or to a sample, what is actually supplied must correspond with the description and the sample.

THE HIRER'S RIGHTS• The hirer usually has the following rights: To buy the goods at any time by giving notice to the owner and paying the

balance of the HP price less a rebate (each jurisdiction has a different formula for calculating the amount of this rebate)

To return the goods to the owner — this is subject to the payment of a penalty to reflect the owner's loss of profit but subject to a maximum specified in each jurisdiction's law to strike a balance between the need for the buyer to minimize liability and the fact that the owner now has possession of an obsolescent asset of reduced value

With the consent of the owner, to assign both the benefit and the burden of the contract to a third person. The owner cannot unreasonably refuse consent where the nominated third party has good credit rating

Where the owner wrongfully repossesses the goods, either to recover the goods plus damages for loss of quiet possession or to damages representing the value of the goods lost.

THE HIRER'S OBLIGATIONS

• The hirer usually has the following obligations:to pay the hire instalmentsto take reasonable care of the goods (if the hirer damages the

goods by using them in a non-standard way, he or she must continue to pay the instalments and, if appropriate, recompense the owner for any loss in asset value)

to inform the owner where the goods will be kept.A hirer can sell the products if, and only if, he has purchased

the goods finally or else not to any other third party.• it is pretty much similar to instalment but the main difference

is of ownership.

THE OWNER'S RIGHTS

• The owner usually has the right to terminate the agreement where the hirer defaults in paying the instalments or breaches any of the other terms in the agreement. This entitles the owner:

to forfeit the depositto retain the instalments already paid and recover the balance

dueto repossess the goods (which may have to be by application

to a Court depending on the nature of the goods and the percentage of the total price paid)

to claim damages for any loss suffered.

HIRE PURCHASE FORMAT