Leasing Introduction, Meaning, Types, Advantages, Disadvantages #adessonews
1. Introduction to Leasing
Leasing is a unique form of intermediate term financing. Given the globalization context, companies have to go global. For this they have to diversify, expand and modernize their business. This would require a huge amount of investment. Entrepreneurs now do not wish to block their investment in plants and machinery.
Instead, they look for alternative means of financing the projects. In addition to debt and equity financing, leasing has emerged as a third important source of intermediate and long-term financing of corporate enterprises recently.
2. Meaning of Leasing
Lease finance can be said to be a “contract between lessor and lessee whereby the former acquires the equipment/goods/plant as required and specified by the lessee and passes on the goods to the lessee for use for a specific place and in consideration promises to pay the lessor a specified sum in a specified mode at specific interval and at a specified place”.
World over leasing has emerged as an innovative technique of financing industrial equipment. In India leasing has been developed as an important supplementary source of finance and is gaining acceptance from the industries.
A number of non-banking financial companies have shot up and many leading banks started wholly-owned subsidiaries to transact leasing business. Leading financial institutions have also entered into the business of equipment leasing and financing. The importance of leasing can hardly be overemphasized. The technique of leasing gives the facility to possess and operate the asset without owning the asset.
It is a method of financing where huge capital outlays are substituted by periodical rental payments. Under a typical leasing transaction, a lessor acquires the title to the equipment to be leased by paying 100 per cent value for the asset identified by the lessee and then leases it out to the lessee under a lease agreement for a period normally less than the depreciable life of the asset.
Under the lease financing, an asset can be acquired without incurring the initial purchase cost by just making payment of lease rentals over a specified period of the lease contract. It is more or less an off-balance sheet financing, where neither the acquisition of assets nor the loan is to be shown in the financial position statement.
The periodical lease rentals paid will be shown in the financial position statement as business expenditure. It is basically a contract whereby the owner of the asset (the lessor) grants to another party (the lessee) an exclusive right to use the asset for an agreed period of time, for an agreed amount payable on periodical basis (lease rentals) over the specified lease period.
The lease transaction may be broadly equated to an installment credit being extended to the person using the asset by the owner of the asset, but without transferring the title of ownership.
A lease is a contract between a lessor (owner of the asset) and a lessee (user of the asset) in which the owner gives the right to the user for the use of an asset over an agreed period of time for consideration called the lease rental. The lessee pays the rental to the lessor at regular intervals over a period of time.
3. Definition of Leasing
A lease can be defined as a contractual agreement where the owner (lessor) of an equipment transfers the right to use the equipment to the user (lessee) for an agreed period of time for rental. At the end of the lease period the assets reverts to the lessor unless there is a provision for transfer of ownership to the lessee. The lessee usually bears the costs of insuring and maintaining the asset.
In the Indian context the fundamental difference between a lease transaction and other asset financing plans like hire purchase is that a lease contract cannot provide for a transfer of ownership from the lessor to the lessee whereas the other asset based financing plans carry this feature. Consequently the tax and accounting aspects of lease transactions are different from that of other financing plans.
4. Types of Lease
The classification is based on the extent to which the risk and rewards incidental to the ownership of the leased asset lie with the lessor or the lessee.
1. Finance and Operating Lease:
Under the financial lease a substantial part of the risks and rewards associated with the ownership of the asset are transferred from the lessor to the lessee. A finance lease is non-cancellable for a specified period and the lessee is responsible for the maintenance of the assets and its insurance. Therefore a financial lease transfers a major portion of risks and rewards associated with the ownership of the asset to the lessee.
Consequently from the stand-point of the lessee a financial lease is not much different from financing the acquisition of the asset with debt because both the lease payment and the payment of principal and interest on debt are similar in that they are fixed obligations which must be met and inability to meet these obligations will result in financial embarrassment.
Under the operating lease the lessor himself selects and purchases the equipment and leases it out. The lease is for a shorter period as compared to finance lease. During the tenure of the lease the lessor is responsible for insurance and maintenance of the asset. The lessor bears the risk of economic and functional obsolescence of the asset and has continued interest in the leased equipment.
The equipment cost is not fully amortised over the lease period of course the lessor can release the equipment or may dispose it off at a profit (selling price – Book value at the end of the lease period). The lessee has the option to terminate the lease contract by notice. It involves higher payment of rentals for lessor obligations are not confined to mere financing but span over maintenance repair and technical advice.
2. Sale and Lease Back and Direct Lease:
In a sale and lease back transaction the owner of an equipment sells it back to the erstwhile owner. The ‘lease-back’ arrangement in this transaction can be in the form of a ‘finance lease’ or an ‘operating lease’. In general the ‘Sale and lease back arrangement’ is a readily available source of funds for financing the expansion and diversification programmes of a firm.
In cases where capital investment in the past has been funded by high-cost short term debt the sale and lease back transactions provide an opportunity to substitute the short-term debt by medium term finance.
A direct lease can be defined as any lease transaction which is not a ‘sale and leaseback transaction’. In other words in a direct lease the lessee and the owner are two different entities.
3. Single Investor Lease and Leveraged Lease:
In a single investor lease transaction, there are only 2 parties to the transaction the lessor and the lessee in contrast to a leveraged lease transaction where there are 3 parties to the transaction the lessor the lender and the lessee.
5. Leasing in India
Leasing industry in India is of recent origin. It was pioneered in 1973 when for the first time ‘Leasing Company of India’ was set up in Madras. For almost seven years in the country, this company was the sole leasing company.
In 1980 another leasing company known as “20th Century Leasing” came into existence. Both these leasing companies were promoted by management — qualified professionals from the City bank.
Thereafter, a virtual explosion in the leasing industry was noticeable. In 1981 four organisations, viz., Shetty Investment and Finance, ‘Jaybharat Credit and Investment’, ‘Motor and General Finance’ and ‘Sundaram Finance’ joined the leasing business essentially for taking tax advantage.
The leasing industry entered the third stage in the growth phase in late 1982 when numerous financial institutions and commercial banks either started leasing or announced plans to do so. ICICI embraced leasing activity in 1983 where after the trickle soon developed into flood and leasing became the new gold mine.
This was also the time when the profit performance of the first two dozen companies had been made public which was so fascinating as to attract many more companies in leasing business.
In the meantime, International Finance Corporation announced its decision to open four leasing joint ventures in India. To add to the leasing boom, the Finance Ministry announced strict measures for enlistment of investment companies on stock exchanges, which made many investment companies turn overnight into leasing companies. Foreign banks in India particularly Grindlays, did commendable work in marketing the leasing idea.
At present, there are about 300 leasing companies in the country. Apart from these, many companies engaged in other businesses are also leasing out mainly to employ their investible surplus in tax-benefits.
Over the period 1980-88 gross leased assets of these companies expanded by Rs.700 crores indicating the extent to which leasing companies have played a significant role in asset formation.
This is a basic fact that requires recognition and encouragement by the government. It is most intriguing to note that the leasing industry is being singled out for discriminatory practices.
Leasing is coming of age in India as is evidenced by phenomenal growth of the leasing industry by over 100 percent in recent few years. Against only Rs. 3,000 crore of lease deals done during 1993-94, the buzz in the leasing industry puts leasing volume in 1994-95 at close to Rs. 7,000 crores.
A large part of this unprecedented growth was contributed by the Public Sector Units (PSUs). For instance, the IDBI single handedly did a Rs. 50 crore lease deal for the Shipping Corporation of India for financing the acquisition of a single ship.
SBI capital markets syndicated a Rs. 240 crore lease deal for Mangalore Refinery and Petrochemical Ltd. Similarly, Infrastructural Leasing and Financial Services Ltd., syndicated a Rs. 200 crore lease deal for Maharashtra State Electricity Board (MSEB).
KDTK Mahindra Finance Ltd., has structured Rs. 300 crore transmission and distribution equipment lease deal for MSEB.
IDBI Sanctioned Lease finance to the tune of Rs.1,007 crore in 1997-98 which was more than what was provided during 1994-95. The institution is looking at financing leasing of small aircraft for spraying pesticides and ferrying executives and larger allocations for shipping, telecom and the power sector.
The SBI group is forming a consortium for lease financing. A syndicate of leasing companies provided Rs. 250 crore lease finance to the Rajasthan State Electricity Board.
6. Contents of Lease Agreement
The Lease Agreement contains the following contents:
(i) (Description) of the lessor lessee and the asset
(ii) The amount of the lease rent along with other conditions of payment like time, mode etc.
(iii) The terms and conditions regarding the payment of repairs and maintenance of the asset and the lessee’s responsibility of the payment of such charges.
(iv) Restrictions, if any put by the lessor on the use of the leased asset by the lessee.
(v) Provisions regarding renewal cancellation of lease or regarding return of equipment on expiry of lease period.
(vi) Variations in lease rentals in specific conditions like variations in bank rates depreciation etc. The lessor and lessee prepares an agreement as above and sign it.
7. Advantages of Leasing
Leasing offers following advantages:
(i) Regular income
Lessor gets assured rental income during the period of lease without transferring the ownership of the asset to the lessee.
(ii) High profitability
Leasing is highly profitable since the rate of return is the lease rental which is higher than the interest payable on financing the asset.
(iii) Growth and expansion
An entrepreneur will not have to spend a lot of money acquiring the asset. He can utilize the funds for further growth of the business.
(iv) Tax benefit
Lease rental is deductible from the taxable income of the lessee. The lessor has the benefit of depreciation in respect of leased assets.
Leasing as a source of financing is cheaper than many other sources of finance. The lessee can use the asset and earn profits without investing money in the asset.
8. Disadvantages of Leasing
Some of the disadvantages of leasing are as follows:
1. Deprivation of Equipment:
The apparent disadvantage of lease to the lessee is that he does not become the owner of the leased property unless the lease contract contains any purchase option.
2. Consequences of Default:
The lessee in the case of default of installment payment may have to terminate the lease. The lessor may take over the property at his own will. In case of finance leases, the lessor may in addition require the lessee to pay for damages and accelerated rental payments.
3. Inadequate Protection against Loss:
In the case of finance lease, the lessee is not entitled to the same protection of express or implied warranties that would be available to the purchaser. As the lessor is the purchaser for the property he is entitled to all such protection. In operating lease this disadvantage is minimized with lessor’s responsibilities towards maintenance and upkeep of the property.
4. Fixed Commitment:
The lessee in a finance lease is normally required to make an absolute and unconditional commitment to pay rent to the lessor despite loss, destruction or defects in the leased property. The purchaser might be entitled to offset his payment obligation in the event of supplier’s breach. The lessee is generally required to make his rent payments in all circumstances.
5. Loss of Terminal Value:
Lessee remains at a loss of terminal values after the end of lease. Appreciation of land and increases in values caused by inflation and improvements done by the lessee will not provide him any benefit at the end.
6. Lack of Freedom to Make Changes:
The lessee has no freedom to make changes and additions to the leased property and has to do so with the formal approval of the lessor.
7. High Interest Cost:
The cost of leasing is generally higher than the cost of debt. The lessor charges, not only for debt, but for inventory costs, overhead costs, and a passing on the risk of obsolescence back to the lessee.
8. Not Suitable for Project Finance:
Leasing is not a suitable mode of project finance as the rentals are payable soon after entering into the lease agreement. However, in new projects cash generations may start only after a fairly long gestation period. Borrowing allows a long gestation period for repayment and by that time the project starts generating cash flows in the firm.
9. No Special Consideration:
Debt finance is available on concessional rate of interest and other relaxations for setting up projects in selected backward areas, but these concessions are not available on leased equipment.
10. Heavy Penalties:
The lessee, particularly in the cases of finance lease, cannot terminate the contract at his will except by paying heavy penalties. This may prove to be a handicap for those lessee firms who discontinue a particular type of manufacturing or business.
11. Tax Benefits Challengeable:
The tax benefits will be challenged when the lessee is given an option to purchase at other than interest value at the time of purchase. Some leases have been constructed as sales or have been ignored for tax purposes if they were held to be mere devices for charging off undue amounts against taxable income for depreciation under the guise of rentals.
Besides, the lessee is put to disadvantage for paying sales tax twice on the leased assets once the asset is purchased and again when it is leased out.
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