Financial services- Leasing and purchasing

1. Leasing and hire purchasing
Module 6

2. Leasing: lease is the form of contract for the use or
occupancy of land, space, structure or equipment
in consideration of a payment, usually in the form
of a rent. 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.

3. Lessor: is a person who conveys to other person
(Lessee) the right to use of the asset in
consideration of payment periodically under lease
agreement. Lessor is the nominal owner of the
asset as the possession and economic use of the
equipment vests the lessee.
Lessee: lessee is a person who obtains from the
lessor to use of the asset in periodically under
lease agreement.
It is a conceptual agreement between the 2 parties
where one who owns the asset (lessor) has
agreed to provide his asset for use to the user
(lessee) with the benefit of periodical payment
(rental) for certain periods.

4. Essential elements of lease
 Parties to the contract (lessor, lessee and
merchant banker): There are essentially two
parties to a contract of lease financing, viz. the
owner and the user, respectively called the lessor
and the lessee. Lessor as well as lessees may be
individuals, partnerships, joint stock companies,
corporations or financial institutions. Sometimes,
there may be joint lessor or joint lessees,
particularly where the properties or the amount of
finance involved is enormous

5.  Assets: 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, and so on.
The asset must, however, be of the lessee's
choice suitable for his business needs.
 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.
 Term of lease (every lease should have definite
period if not it will be legally in operated)
 Lease rentals.

6. Steps involved in leasing transaction
 It is summarized as follows:
1. First the lessee, has to decide the asset required and
select the supplier. He has to decide about the design
specifications, the price, warranties, terms of delivery,
servicing.
2. The lessee, then enters into a lease agreement with the
lessor . The lease agreement contains the terms and
conditions of the lease such as:
 The basic lease period during which the lease is
irrecoverable
 The timing and amount of periodical rental payments
during the lease period.
 Details of any option to renew the lease or to purchase
the asset at the end of the period.
 Details regarding payment of cost of maintenance and
repairs , taxes, insurance and other expenses

7. 3. After the lease agreement is signed , the lessor
contacts the manufacturer and requests him to
supply the asset to the lessee. The lessor
makes payment to the manufacturer after the
asset has been delivered and accepted by the
lessee.

8.  Types of lease financing
 Finance lease.
 Operating lease.
 Sale and lease back lease.
 Direct lease.
 Leveraged lease.
 Single investor lease.
 Domestic lease.
 International lease.

9.  Finance lease
 It is also known as capital lease or long term
lease. It is a lease where owner or lessor is
eventually transfers his assets with risk and return
to user or lessee even it may include the title of
ownership. The cost of insurance, maintenance
and other related expenses are debited to the
account of the lessee. The lessee has the option
of purchasing the asset at a price which is
expected to be sufficiently lower than fair market
value at the date.

10.  Operating lease
 It is a short term lease where the contractual period
between the lessor and the lessee is lesser than the
expected economic life of the equipment. In this
lessor is not transfer substantially all risk & return or
reward to user or lessee.
 The lessor depends on many different lessees for
recovering his cost. Ownership along with its risks
and rewards lies with the lessor. Here, lessor is not
only acting as a financier but he also provides
additional services required in the course of using the
asset or equipment. Example of an operating lease is
music system leased on rent with the respective
technicians. The lessor also does the services like
handling warranty claims, paying taxes, scheduling
and performing maintenance and keeping complete
records lease in suitable for computers, material
handling equipments, and vehicles etc. which become
obsolete soon. The term of lease is very small

11.  Sale and lease back lease.
 It is indirect form of lease where the owner of the
asset or equipment will sell it to leasing company
and gets it back on lease. The asset is sold at its
market value. Most of the lease back agreements
are on a net basis which means that the lessee
pays all maintenance expenses, property taxes
and insurance. Retail stores, office building,
multipurpose industrial building and shopping
centers are financed under this method.
 In other words sale and lease back the lessee
sells his asset or equipment to the lessor
(financier) with an advanced agreement of
leasing back to the lessee for a fixed lease rental
per period. It is exercised by the entrepreneur
when he wants to free his money, invested in the
equipment or asset, to utilize it at whatsoever
place for any reason.

12.  Direct lease
 Direct lease is a simple lease where the asset is
either owned by the lessor or he acquires it. In
the former case, the lessor and equipment
supplier are one and the same person and this
case is called ‘bipartite lease’. In bipartite lease,
there are two parties. Whereas, in the latter case,
there are three different parties viz. equipment
supplier, lessor, and lessee and it is called
tripartite lease. Here, equipment supplier and
lessor are two different parties

13.  A direct lease can be two types’ namely
 Bipartite lease
 Tripartite lease.
 Bipartite lease: is one where there are two
parties to the transaction i.e. equipment supplier
cum lessor and the lessee. It functions like
operating lease with built in facilities like up
gradation of the equipments in the original
equipment configuration.
 Tripartite lease: is one that involves three
different parties i.e. the equipment supplier, the
lessor, and the lessee. Most of the equipment
lease transactions fall under this category.

14.  Leveraged lease
 A leveraged lease is used for financing those
assets which require huge capital outlay. It
involves three parties namely the lessee, the
lessor and the lender. Equity is arranged by the
lessor and debt is financed by the lender or
financier. The lessor acquires the asset as per the
terms of the lease agreement but finances only a
part of the total investment say 20% to 50%.
Here, there is a direct connection of the lender
with the lessee and in case of default by the
lessor; the lender is also entitled to receive
money from lessee. Such transactions are
generally routed through a trustee. The leveraged
lease includes railway lines, electricity generating
plants, pipelines, ships etc…….

15.  International lease
 A type of lease where the lessor in one country
leases out assets to another country is known as
international lease.
 It can be classified into 2 types
 Importer lease.
 Cross border lease.
 Importer lease: When lessor and lessee reside
in same country and equipment supplier stays in
different country, the lease arrangement is called
import lease.
 Cross border lease: When the lessor and lessee
are residing in two different countries and no
matter where the equipment supplier stays, the
lease is called cross border lease.

16.  Domestic lease.
 When all the parties of the lease agreement
reside in the same country, it is called domestic
lease, i.e. Lessor and lessee are belongs to a
similar country than the lease become domestic
lease.
 Single investor lease.
 In single investor lease, there are two parties -
lessor and lessee. The lessor arranges the
money to finance the asset or equipment by way
of equity or debt. The lender is entitled to recover
money from the lessor only and not from the
lessee in case of default by lessor. Lessee is
entitled to pay the lease rentals only to the lessor.

17.  Significance / Advantages of lease
 Advantages to lessor
 Stable business: provides continues and stable
manufacturing business.
 Wider distribution: leasing allows for capturing a
wider distribution network.
 Sale of supplies: the lessor has to ensure the supply
of spare parts and components required for the
maintenance of the asset leased.
 Second hand market.
 Tax benefit.
 Absorbing obsolescence risks.
 Easy finance.
 High growth potential.
 High return.

18.  Advantages to lessee
 Efficient use of funds: the use of assets without
having to own it.
 Cheaper source.
 Flexible source.
 Enhanced borrowing capacity.
 Off-balance sheet financing.
 Tax benefits.
 Favorable terms.
 Guards against obsolescence.
 Avoidance of initial cash outlay.
 Better liquidity.

19.  Disadvantage of leasing
 Restrictions on Use of Equipment A lease
arrangement may impose certain restrictions on use
of the equipment, or require compulsory insurance,
and so on. Besides, the lessee is not free to make
additions or alterations to the leased asset to suit his
requirement.
 Limitations of Finance Lease A finance 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 lessee or caused by
inflation or otherwise, such as appreciation in value of

20.  Double Sales Tax With die amendment of sale tax
laws of 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
 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 the lessee's assets, there is
an effective understatement of his assets, which may
sometimes lead to gross underestimation of the
lessee. However, there is now an accounting practice
to disclose the leased assets by way of footnote to the
balance sheet.
 Unfavorable gearing

21.  No ownership.
 Risk of default.
 No working capital.
 Indiscriminate finance.
 Long term venture.

22.  Income tax provisions relating to leasing
 The lease rentals income is taxable under income
from business and profession while in case of
other it is taxed as income from other sources as
per the income tax act, 1961.
 The lessee can claim lease rentals as tax
deductible expenses.
 The lease rentals received by the lessor are
taxable under the head profit from business.
 The lessor can claim investment allowance and
depreciation on investment on leased asset.

23. Legal frameworks relating to leasing
As there is no separate statute for equipment
leasing in India, the provisions relating to
bailment in the Indian contract act govern
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 of according to the
directions of the person delivering them.
The person delivering the goods is called bailor and
the person to whom they are delivered is called
the bailee.

24.  Since an equipment lease transactions 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 .
 They 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 authorize 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 lessee 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 return the leased asset on the
expiry of the lease period.

25. Contents of a lease agreement
 The following are the contents of lease agreement
1. Description of the lessor, the lessee and the equipment
2. Amount, time and place of rental payments
3. Time and place of equipment delivery
4. Lessee ‘s responsibility for taking delivery and
possession of the lease equipment
5. Lessee ‘s responsibility for maintenance , repairs
registration 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.

26.  9. option of lease renewal for the lessee.
10. Return of equipment on expiry of the lease
period.
11.Arbitration procedure in the event of dispute.

27. Other factors influencing buy /borrow
or lease decision
 The firm takes certain factors while evaluating the
above finanancial proposal. These factors are:
1. Capital adequacy- if the firm has adequate
shareholder’s equity, it is better to go for buying
the asset rather than taking it out on a lease
basis. In the absence of sufficient capital,
raising new capital or retaining a greater
proportion of earnings should be considered
rather than assuming further debt obligations
through leasing.
2. Liquidity considerations: a firm has to maintain
sufficient liquidity for meeting any sudden
shortfall in cash inflows or for meeting any
capital expenditures. If sufficient liquidity is not

28.  Flexibility considerations- buying an asset involves one
time payment which cannot be flexible. If the asset is
bought through borrowed funds, that will be rigid
repayment schedule. On the other hand , leasing
arrangements may be tailored to the lessee’s needs more
easily and lease rentals can be structured to match the
lessee’s cash flows
 Nature of asset- for those assets which become absolute
at a faster rate, buying that asset is not preferable.
 Availability of finance: in the absence of adequate owned
funds, one has to go for borrowed funds to buy an asset.
 Debt capital: from the lessee’s point of view leasing is off
balance sheet financing and hence it increases the overall
debt capacity of a firm.
Leasing plays a vital role in the firm’s overall financing
strategy to the extent which it enables the firm to increase
its overall debt raising capacity.

29.  Grants and incentives consideration- government
grants, incentive and other benefits are available
for purchased equipment as well as leased
equipment depending upon the government’s
policy . Therefore the method of finance either to
buy or lease should take into account the eligibilty
conditions to avail of such grants and incentives.
 Borrowing restrictions- borrowings for the purpose
of acquiring an asset may not be permitted due to
some restrictive covenants and government
regulations.
 Administrative considerations-

30. Problems in leasing
 The following are some of the problems in leasing
1. Unhealthy competition- the market for leasing
has not grown with the same pace as the
number of lessor. As a result, there is over
supply of lessor leading to the competition.
2. Lack of qualified personnel: leasing requires
qualified and experienced people at the helm of
its affairs. Leasing is a specialized business and
persons constituting its top management should
have expertise in accounting , finance, legal and
decision areas. In India the concept of leasing is
quite new so its difficult to get right person .

31. 3. Tax considerations: most people believe that
lessees prefer leasing because of the tax benefits
it offers.
In reality it only transfers the benefit, i.e. the
lessee’s tax shelter is lessor’s burden.
In india the taxes like sales tax, wealth tax,
additional tax, surcharge add to the cost of
leasing.
4. Stamp duty- the states treat a leasing transaction
as a sale for the purpose of making them eligible
to sales tax. On the contrary for stamp duty is
levied on lease documents, this adds to the
burden of leasing industry.
5. Delayed payment and bad debt-the problem of
delayed payment and bad debt add to the cost of

32. Hire purchasing
 Hire purchase is the legal term for a contract, in
which persons usually agree to pay for goods in
parts or a percentage at a time.
 It was developed in the United Kingdom and can
now be found
in Australia, China, India, Jamaica, Japan, Malays
ia, New Zealand, and South Africa. It is also
called closed-end leasing. 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.

33.  When a sum equal to the original full price plus
interest has been paid in equal installments, the
buyer may then exercise an option to buy the
goods at a predetermined price (usually a
nominal sum) or return the goods to the owner.
In Canada and the United States, a hire purchase
is termed an installment plan; other analogous
practices are described as closed-end
leasing or rent to own
 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

34.  HP is frequently advantageous to consumers
because it spreads the cost of expensive items
over an extended time period. Business
consumers may find the different balance
sheet and taxation treatment of hire-purchase
goods beneficial to their taxable income. The
need for HP is reduced when consumers have
collateral or other forms of credit readily available.
 A transaction of finance whereby goods are
bought and sold as per the terms and condition
specified below is known as ‘hire purchase
finance’

35.  Payment of periodic installments.
 Immediate possession of goods by the buyer.
 Ownership of goods remaining with the vendor
until the payment of the last installment.
 Vendor’s right to repossess the goods in the
event of default committed by the buyer.
 Treatment of each installment as hire charge till
the payment of the last installment.

36.  According to the hire purchase act 1972, the term
‘hire purchase’ is defined 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, and includes an
agreement under which:
 Possession of goods is delivered by the owner thereof
to a person on the condition that such person pays
the agreed amount in periodic payments.
 The property of the goods is to pass to such a person
on the payment of the last of such installment.
 Such a person has a right to terminate the agreement
any time before the property so passes.”

37. Features of hire financing
 The hirer has an option to purchase the goods when
he has made the payment of a certain sum.
 Possession of goods is delivered by the owner thereof
to a hirer on the condition that such person pays the
agreed amount in periodic payments.
 The property of the goods is to pass to hire on the
payment of the last of such installment.
 Hirer has a right to terminate the agreement any time
before the property so passes.
 Treatment of each installment as hire charge till the
payment of the last installment.

38. Hire purchase agreement
 There is no prescribed form of hire purchase
agreement but it has to be written and signed by
both parties to the agreement
 A hire purchase agreement must contain the
following particulars
1. The description of the goods in a manner
sufficient to identify them.
2. The hire purchase of the goods
3. The date of commencement of the agreement
4. The number of installments in which hire
purchase price is to be paid, the amount, and
due date.

39. Hire purchase and credit sale
Hire purchase transaction is different from credit
sale’
In case of actual sale, the title in the property,.i.e
ownership and possession in transferred to the
purchase simultaneously , in hire purchase the
ownership remains with the seller until the last
installment is paid.

40. Characteristics Lease financing hire purchase financing
Ownership Ownership of property lies with the
finance company, the lessor, and it is
never transferred to the lessee, the user.
Ownership of the property is transferred
to the hirer on the payment of the last
installment.
Depreciation Lessor, and not the lessee, is entitled to
claim depreciation tax shield.
The hirer (owner) is entitled to claim
depreciation tax shield.
Capitalization Capitalization of the asset is done in the
books of the lessee.
Capitalization of the asset is done in the
books of the hirer.
Payments The entire lease payments are eligible
for tax computation in the books of the
lessee.
Only the hirer interest is eligible for tax
computation in the books of the hirer.
Salvage value The lessor, and not the lessee, has the
right to claim the benefit of salvage
value.
The hirer can claim benefit of salvage
value as the prospective owner of the
asset.
Magnitude Leasing is used as a source of finance,
usually for acquiring high cost assets
such as machinery, ships, airplanes,
etc…
Hire purchase is used as a source of
finance, usually for acquiring relatively
low cost assets such as automobiles,
office equipments, etc.

41. Down payment No down payment is required for acquiring
the use of the leased assets.
Down payment is required to be made for
acquiring the asset and there is a margin
maintained to the extent of 20-25%.
Reporting In the books of the lessee, leased assets are
disclosed by way of a note only.
The asset bought on the hire purchase will be
shown as an asset, and the amount of
installments payable to the lessor as a
liability.
Maintenance of assets Whereas the lessee has to maintain the leased
asset in case of financial lease, upkeep is the
responsibility of the lessor in the case of
operating lease.
It is the hirer’s responsibility to ensure the
maintenance of the asset bought.
Suitability It is not suitable for the low-capital
enterprises which desire to show a strong
asset position in their balance sheets.
It is highly suitable for the low-capital
enterprises which need to show a strong asset
position in their balance sheets.
Nature of asset An asset given on lease by a leasing company
is considered as the fixed asset of the lessor.
The hire vendor normally shows the asset let
under HP either as stock in trade, or as
receivables.
Receipts All receipts from the lessee are taken into the
lessor’s profit & loss account.
Only the interest portion is taken into the hire
vendor’s profit & loss account.
Income Lessor’s income decline as the investment
outstanding in the lease declines.
In the case of hire purchase transactions,
finance charges are allocated to the HP period
equally.