LEASE FINANCING

Meaning
A lease is a contract whereby the owner of
an asset (the lessor) grants to another
person (the lessee) exclusive right to use the
asset for an agreed period of time, in return
for the payment of a rent (called lease rental)

Asset
Lessor Lessee
(owner of the asset) (user of the asset)
Rentals
 Examples
Capital assets like land, buildings,
equipments, machinery, vehicles
are the usual assets which are
generally acquired on lease basis.
The lessor remains the owner of the
asset, but the possession and
economic use of the asset is vested
in the lessee.
 Leasing as a source of Finance
Leasing companies finance for:
• Modernization of business
• Balancing equipment
• Items entitled to 100% or 50%
depreciation
• Assets which are not being financed
by banks/institutions
• Vehicles and other durables
 Steps in leasing Transaction
• Select asset, supplier, design specifications,
price, warranties, terms of delivery, etc.
• Agreement between lessee and lessor. It
contains following terms and conditions:
 Lease period
 Timing and amount of rental payments
 Option to renew or purchase
 Payment of cost of maintenance, repairs, taxes
and insurance and other expenses
• Lessor contacts manufacturer, makes payment
after it has been accepted by lessee
The essential features of a leasing

• A Valid Contract of Leasing: legal and

written
• Delivery of Goods: goods are used in
physical form
• Purpose:
• Consideration:
• Return of the Goods: due to
obsolescence and misuse
• Ownership: remains with lessor
• Methodology:
 Types of Lease
The lease agreement can be classified
broadly into four categories:
(i)Financial Lease
(ii)Operating Lease
(iii)Leverage Lease
(iv)Sale and Lease Back
 Financial Lease
• A financial Lease is also known as Capital Lease, Net
lease and close lease. Long-term, non-cancellable
lease contracts are known as financial leases.

• In FL lessor agrees to transfer the title for the asset at

the end of the lease period at a nominal cost. At lease it
must give an option to the lessee to purchase the
asset he has used at the expiry of the lease. 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.
 Operating Lease

In case of operating lease, the lessor not only leases the

asset of which he remains the owner throughout, but
also undertakes to provide services attached to such
assets.

Example: maintenance, repairs, technical advice, etc.

Such lease is also called service lease.

Computers, office equipments, automobiles and trucks

are the typical capital assets which are leased under
operating lease arrangement.
 Features of an operating lease are as
follows :
• The lease contract is generally for a period
which is considerably shorter than the useful life
of the leased asset.

• The lessor does not, therefore, recover the full

cost of the asset from one lessee only. The
leased asset is returned back to the lessor at the
end of the lease period and is, thereafter, leased
again to another lessee for another lease period.
• Operating lease generally contains a cancellation
clause also, wherein the lessee retains the right to
cancel the lease any time before the lease period
is over. Such clause is beneficial to the lessee as
he may terminate the lease, if the asset becomes
obsolete or his need for the asset is over.

• The lease agreement contains a maintenance

clause whereby the lessor is required to maintain
the leased assets.

• The lease rental includes: (a) a part of the cost

of the equipment (b) cost of the maintenance
services provided (c) profit of the lessor
 Leveraged Lease

• In case of an ordinary lease, the lessor purchases the

asset with an appropriate mix of debt and equity.
In case the lessor defaults in making repayment of the
debt, the creditor cannot claim the same from the lessee.
He will have recourse to the lessor only.

• Leveraged lease is just opposite to the above. In such

case, the creditor remains entitled to have recourse to
the lessee, i.e., he can recover his claims from the
lessee also. The lease rental is assigned to the creditor.
The lessee is required to pay the lease rental directly to
creditor
 Sale and Lease Back

Type of lease arrangement wherein the lessee who

already owns the assets, sells the same to the lessor,
and thereafter takes the same asset from him on lease
basis. This is called 'Sale and Lease Back arrangement'.

Under this arrangement, the lessee immediately

recovers the value of his already owned assets from the
lessor. Thereafter, the lessee makes payment of the
lease rentals periodically as usual.
Such a lease arrangement enhances the
liquid resources of the lessee immediately,
which can be utilized otherwise to meet his
working capital requirements or to purchase
another asset on cash payment basis.
 LEGAL ASPECTS OF LEASING

According to Section 146 of the Indian Contract

Act, 1872

Bailment is "the delivery of goods by one person

to another person 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 the bailor and the person to
whom they are delivered is called the bailee`
 Since an equipment lease transaction falls in the
category of a bailment contract, the obligations of
the lessor and the lessee are similar to those of the
bailor and the bailee (unless expressly specified
otherwise in the lease agreement) as given in the
Indian Contract Act. Briefly, these may be stated as
follows :

(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 lease period.
(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.
 MAIN CLAUSES IN THE LEASE
AGREEMENT
(1) Nature of the Lease : This clause specifies the nature of the lease
(i.e., operating lease, financial lease or a leveraged lease) and the
names of the parties to the Agreement.

(2) Description of the Asset : This clause gives the description of the
equipment to be leased, its make, model, size, specification etc.

(3) Duration of Lease Period : This clause specifies the period for
which the asset is leased, which is called the primary period. The
clause generally also gives an option to the lessee to renew the
agreement for a further period.

(4) Lease Rentals

(5) Delivery and Re-delivery : This clause mentions when and how
the leased equipment would be delivered to the lessee and how it
will be delivered back to the lessor on the completion of the lease
period.

(6) Right to Use :

(7) Repairs and Maintenance : Usually this clause states that the
lessee shall maintain and repair the equipment and keep it in good
and working condition. The cost of such maintenance shall be borne
by the lessee.

(8) Alterations/Additions to Equipment : This clause states that the

lessee shall not make any alterations or additions to the equipment
or remove it from the premises without the written consent of the
lessor.

(9) Right to Inspect Equipment : This clause gives the lessor the right
to enter the premises of the lessee and to inspect the equipment as
and when he desires.
(10) Damage to Equipment : It is usual to stipulate that the
lessee will bear all risks, losses, damages, theft or
destruction of the equipment as long as it is in his custody.

(11) Prohibition of Sub-leasing : This clause prohibits the

lessee from sub-leasing the equipment or selling it to any
party.

(12) Insurance : This clause requires the lessee to take out

a fire insurance policy in respect of the equipment in the
joint names of the lessee and the lessor (named therein as
the owner). Lessee shall pay the premium and renew the
policy every year.

(13) Other Charges : This clause shall specify which party

will pay the various expenses and charges in connection
with the purchase and installation of equipment.
(14) Default by Lessee and Remedies : It is usual
to include a clause indicating the specific events
of default by the assesse and the remedies
available to the lessor in such cases. The
remedies may be :

(a) to declare that all unpaid rentals are due and

payable immediately and to sue the lessee for
the recovery of the same,
(b) to terminate the lease agreement, and
(c) to seize the equipment given on lease.
ACCOUNTING TREATMENT OF
LEASE (Lessor)
1. The leased asset is shown on the balance
sheet of the lessor.
2. Depreciation and other tax shields associated
with the leased asset are claimed by the
lessor
3. The entire lease rental is treated as income
in the books of the lessor
4. Lease rentals are shown on actual basis not
on accrual basis
 ACCOUNTING TREATMENT
OF LEASE (Lessee)
1. The assets taken under lease may be
shown as a footnote in balance sheet
2. Lease rentals should be charged to the
income statement
3. The lease rentals should be shown on
accruals basis and adjustments for
outstanding and prepaid should be done
4. Disclose future obligations of the lease by
way of footnote
 Tax Implication on lessor and
lessee

1. The lessee can claim lease rentals as tax-deductible

expenses.

2. The lease rentals received by the lessor are taxable

under the head of 'Profits and Gains of Business or
Profession'.

3. The lessor can claim investment allowance (this may be

doubtful) and deprecation on the investment made in
leased assets.
 Advantages of Leasing
(a) Convenience in case of short-term need : need is
over.

(b) Saving of Capital : Leasing covers the full cost of the

equipment used in the business by providing 100%
finance. The lessee is not to provide or pay any margin
money as there is no down payment. In this way the
saving in capital or financial resources can be used for
other productive purposes e.g. purchase of inventories.

(c) No Risk of Technological Obsolescence

(d) Improvement in Liquidity : Leasing enables the

lessee to improve their liquidity position by adopting the
sale and lease back technique.
(e) Efficient Maintenance Services : Under operating or
full service lease, the lessee avails of the maintenance
and other services provided by the lessor, who is well
equipped, qualified and experienced to provide such
services efficiently. Of course, the lessee pays for such
services in the form of higher rentals.

(f) Administrative ease: Many leasing companies

specialise in leasing a few types of equipments,
machines or vehicles only. They can easily bargain with
the suppliers/manufacturers etc. and acquire the assets
at better prices and can economise in other
administrative expenses also. It is a revenue item do not
need elaborate justifications.

(g) Benefit of Tax Shield

(h) Transaction cost, speed and convenience:
borrowing involves scrutiny by lenders,
documentation, long time in processing,
management attention and follow up but
leasing is time saving
(i)Lessor risk for lessor: ownership with lessor
so in case of any default recover the asset
(j) Flexibility: tailor made to the lessess needs
(k) Good for small firms:
 Limitations

• Not suitable for project finance

• Certain tax benefits/incentives such as subsidy
may not be available
• Cost of financing higher than that of debt
financing
• It is irrevocable
• If lessee is not able to pay rentals regularly, the
lessor would suffer a loss
 Limitations
• If contract is to be discontinued then heavy
penalty is paid but if it is own asset can be
sold
• In lease agreement lessor purchases
asset not the lessee. Hence lessee is not
protected in case of any breach of
warranties related to assets
Evaluation of Leasing(Lessee point of view)
• Decision about investment in asset
• Comparison of cost of leasing and cost of
financing
• Payment of lease rental is similar to
interest borrowings
 Steps
• Calculate present value of net cash flow of buying
option NPV (B)
• Calculate present value of net cash flow of leasing
option NPV (L)
• Decide buy or lease on the basis of following
criterion:
(i)NPV (B) is + and greater than NPV (L) purchase
asset
(ii) NPV (L) is + and greater than NPV (B) lease the
asset
(iii)NPV (B) and (L) are both negative reject proposal
Evaluation of Leasing(Lessor point of view)

Capital budgeting methods can be applied

• Present value method:
(i)Determine cash outflows
(ii)Determine cash inflows
(iii)Calculate present value by applying
discount rate
(iv)If PV of cash inflow is more than PV of
cash outflow asset can be given on lease
 Internal Rate of Return Method
(i) Determine future cash inflows for the
period of the lease
(ii) Determine rate of discount