Introduction

Among the various methods of customer credit, lease financing is one of the

very important methods. In developing economies it provides a safe mode of

financing, where customer gets the equipment he requires, and the financer has

the safety through ownership of the equipment. Now let us discuss in detail

various aspects of leasing.

Meaning: Lease is a contractual arrangement/ transaction in which a party

(lessor) owning an asset/equipment provides the asset for use to another party/

transfer the right to use the equipment to the user (lessee) over a certain/for an

agreed period of time for consideration in form of / in return for periodic

payments / rental with or without a further payment (premium). At the end of

the contract period (lease period) the asset/equipment is returned to the lessor.

It is a method of financing the cost of an asset. It is a contract in which a

specific equipment required by the lessee is purchased by the lessor (financier)

from a manufacturer / vendor selected by the lessee. The lessee has the

possession and use of an asset on payment of the specified rental over a pre-

determined time. Lease financing is, thus a device of financing/money lending.

The real function of lessor is not renting of asset but lending of funds or

financing or extending credit to the borrower.

Or

Main characteristics of lease financing can be explained as following:

Parties to Contract: There are essentially two parties to the

contract of leasing i.e. financer (or owner - Lessor) and user

(lessee). Also, there could be lease-broker who works as an

intermediary in arranging lease finance deals, in case of exposure

to large funds. Apart from above three there are some times

lease-financers also, who refinances to the lessor (owner).

Ownership Separated from User: The essence of a lease

finance deal is that during the lease-period, the ownership of

assets 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.

Lease Rentals: The consideration which the lessee pays to the

lessor for the lease transaction is the lease rental. The lease

rentals are so structure as to compensate the lessor the investment

made in the asset (in the form of depreciation), the

interest on the investment, repairs and so forth, borne by the

lessor, and servicing chares over the lease period.

Term of lease: The term of lease is the period for which the

agreement of lease remains in operations. Every lease should

have a definite period otherwise it will be legally inoperative.

The lease can be renewed after expiry of the term.

Classification of Lease: A lease contract can be classified on various

characteristics in following categories:

A. Finance Lease and Operating Lease

B. Sales & Lease back and Direct Lease

C. Single investor and Leveraged lease

D. Domestic and International lease

A. Finance Lease and Operating Lease

Finance Lease: A Finance lease is mainly an agreement for just

financing the equipment/asset, through a lease agreement. The

owner /lessor transfers to lessee substantially all the risks and

rewards incidental to the ownership of the assets (except for the

title of the asset). In such leases, the lessor is only a financier

and is usually not interested in the assets. These leases are also

called “Full Payout Lease” as they enable a lessor to recover his

investment in the lease and derive a profit. Finance lease are

mainly done for such equipment/assets where its full useful/

economic life is normally utilized by one user – i.e. Ships,

aircrafts, wagons etc.

Generally a finance lease agreement comes with an option to

transfer of ownership to lessee at the end of the lease period.

Normally lease period is the major part of economic life of the

asset.

Operating Lease: An operating lease is one in which the lessor

does not transfer all risks and rewards incidental to the ownership

of the asset and the cost of the asset is not fully amortized

during the primary lease period. The operating lease is normally

for such assets which can be used by different users without

major modification to it. The lessor provides all the services

associated with the assets, and the rental includes charges for

these services. The lessor is interested in ownership of asset/

equipment as it can be lent to various users, during its economic

life. Examples of such lease are Earth moving equipments,

mobile cranes, computers, automobiles etc.

B. Sales & Lease back and Direct Lease

Sale and Lease Back: In this type of lease, the owner of an equipment/asset

sells it to a leasing company (lessor) which leases it back to the owner (lessee).

Direct Lease: In direct lease, the lessee and the owner of the equipment are two

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

lease.

Bipartite lease: There are only two parties in this lease transaction, namely (i)

Equipment supplier-cum-financer (lessor) and (ii) lessee. The lessor maintains

the assets and if necessary, replace it with a similar equipment in working

condition.

Tripartite lease: In such lease there are three different parties (i) Equipment

supplier (ii) Lessor (financier) and (iii) Lessee. In such leases sometimes the

supplier ties up with financiers to provide financing to lessee, as he himself is

not in position to do so.

C. Single investor and Leveraged lease

Single investor lease: This is a bipartite lease in which the

lessor is solely responsible for financing part. The funds

arranged by the lessor (financier) have no recourse to the lessee.

Leveraged lease: This is a different kind of tripartite lease in

which the lessor arranges funds from another party linking the

lease rentals with the arrangement of funds. In such lease, the

equipment is part financed by a third party (normally through

debt) and a part of lease rental is directly transferred to such

lender towards the payment of interest and installment of

principal.

D. Domestic and International lease

Domestic Lease: A lease transaction is classified as domestic if

all the parties to such agreement are domiciled in the same

country.

International Lease: If the parties to a lease agreement domiciled in different

countries, it is known as international lease.

This lease can be further classified as (i) Import lease and (ii) cross border lease.

Import lease: In an import lease, the lessor and the lessee are

domiciled in the same country, but the equipment supplier is

located in a different country. The lessor imports the assets and

leases it to the lessee.

Cross border lease: When the lessor and lessee are domiciled in

different countries, it is known as cross border lease. The domicile of asset

supplier is immaterial.

Advantages of Leasing

Leasing offers advantages to all the parties associated with the agreement.

These advantages can be grouped as

(i) Advantages to Lessee (ii) Advantages to lessor.

Advantages to the Lessee: The lease financing offers 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 etc., up to 100%, without requiring any

immediate down payment.

Additional Sources of Funds: Leasing facilitates the acquisition

of equipments/ assets without 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 a less costly

method than other alternatives available.

Ownership preserved: Leasing provides finance without

diluting the ownership or control of the promoters. As against

it, other modes of long-term finance, e.g. equity or debentures,

normally dilute the ownership of the promoters.

Avoids conditionality: Lease finance is considered preferable to

institutional finance, as in the former case, there are no strings

attached. Lease financing is beneficial since it is free from

restrictive covenants and conditionality, such as representation

on board etc.

Flexibility in structuring rental: 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 bale to pays the

rentals from the funds generated from operations.

Simplicity: A lease finance arrangement is simple to negotiate

and free from cumbersome procedures with faster and simple

documentation.

Tax Benefit: By suitable structuring of lease rentals a lot of tax

advantages can be derived. If the lessee is in tax paying position,

the rental may be increased to lower his taxable income. The

cost of asset is thus amortized faster to than in a case where it is

owned by the lessee, since depreciation is allowable at the

prescribed rates.

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 latest technology.

Advantage to the Lessor: A lease agreement offers various

advantages to lessor as well. Let us discuss those advantages

one by one.

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 in case of default by the lessee.

Tax benefit: The greatest advantage to the lessor is the tax

relief by way of depreciation.

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: The lessor usually carry out their business

with high financial leverage, depending more on debt fund

rather equity.

High growth potential: The leasing industry has a high

growth potential. Lease financing enables the lessee to acquire

equipment and machinery even during a period of depression,

since they do not have to invest any capital.

Limitations of Leasing

On one hand leasing offers various advantages to both lessor

and lessee, but on the other hand it also has some limitations.

Now let us try to visualize these limitations.

Restrictions on use of limitations: Under a lease agreement,

sometimes restrictions are imposed related to uses, alteration

and additions to asset even though it may be essential for the

lessee.

Limitations of Financial Lease: A financial lease may entail a

higher payout obligations, if the equipment is found not useful

and the lessee opts for premature termination of the lease.

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 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 assets: Since the leased asset do

not form part of 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.

Double sales tax: With the amendment of sales tax law 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.

HIRE PURCHASE

Introduction

Hire purchase is a mode of financing the price of the goods to

be sold on a future date. In a hire purchase transaction, the

goods are let on hire, the purchase price is to be paid in

installments and hirer is allowed an option to purchase the

goods by paying all the installments. 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 the last installment.

A hire purchase agreement is defined in the Hire Purchase Act,

1972 as peculiar kind of transaction in which the goods are let

on hire with an option to the hirer to purchase them, with the

following stipulations:

a. Payments to be made in installments over a specified

period.

b. The possession is delivered to the hirer at the time of

entering into the contract.

c. The property in goods passes to the hirer on payment of

the last installment.

d. Each installment is treated as hire charges so that if default

is made in payment of any installment, the seller becomes

entitled to take away the goods, and

e. The hirer/ purchase is free to return the goods without

being required to pay any further installments falling due

after the return.

Features of Hire Purchase Agreement

· Under hire purchase system, the buyer takes possession of

goods immediately and agrees to pay the total hire purchase

price in installments.

· Each installment is treated as hire charges.

· The ownership of the goods passes from the seller to the

buyer on the payment of the last installment.

· In case the buyer makes any default in the payment of any

installment the seller has right to repossess the goods from

the buyer and forfeit the amount already received treating it

as hire charges.

· The hirer has the right to terminate the agreement any time

before the property passes. That is, he has the option to

return the goods in which case he need not pay installments

falling due thereafter. However, he cannot recover the sums

already paid as such sums legally represent hire charges on

the goods in question