LEASE

Nature, Types Accounting Evaluation

Nature of lease


A lease is an agreement conveying the right to use property, plant or equipment usually for a stated period of time, in exchange for periodic cash payments. The owner of the property is referred to as the lessor, and the renter is the lessee.

Economic Rationale for a Lease

Operational advantage to the lessee


Leasing ready to use equipment can be more attractive if the asset requires lengthy preparation and set-up Leasing avoids having to own the asset that will not be required only seasonally, temporarily or sporadically ( leasing contracts can be tailored)


Lessor may be in a position to lease the equipment again But lease payments are accordingly higher

Leasing for short periods protects against obsolesce



Economic Rationale for a Lease

Financial advantage to the lessee


Lease payments can be tailored to suit the lessee s cash flows (up to 100% financing, instead of the 80% limit by banks) Properly structured leases may be offbalance sheet , avoiding debt-covenant restrictions. Leasing can be tax advantageous when the lessee is unable to take the depreciation tax advantage of owning

Disadvantages of a Lease
Disadvantages to Lessee  Leased ready to use equipment may be of lower quality than custom built (resulting in lower quality products and lower sales)  High quality eq. might be unavailable for leasing  Seasonal leasing may affect equipment availability and pricing  Premium must be paid for protection against obsolescence

Disadvantages of a Lease
Disadvantage to financial statement users


Off-balance sheet financing can hide the true leverage of the firm

Economic substance of Lease

Operating lease
 

Lessee rents the property Lessee accrues rent expense Lessee economically owns the property Lessee records the leased asset in the balance sheet (ie. capitalizes the asset) and reflects the corresponding lease obligation

Capital lease
 

Risk Vs Reward in Lease



Risk includes possibility of losses from idle capacity or technological obsolescence and variations in return due to changing economic conditions Rewards may be represented by the expectation of profitable operation over the economic life of the asset and of gain from appreciation in value of realization of residual value

Financial lease-definition


If a lease plan is a funding alternative, it is called a financial lease the lessor will provide an asset and not the money needed to buy it, the payments by the lessee will be in form of lease rentals, etc Financial leases are "loan look-alike

A typical financial lease



 

Company A wants to acquire a boiler of a particular specification. It would cost $ 100,000. Company B is prepared to give it on lease on lease rentals of $ 22.50 per month per thousand payable monthly in advance, for 60 months. Let us suppose the deal is to be put through. A will be allowed to negotiate all commercial terms with the supplier including the technical specifications. B would walk in after everything is finalised: B would place its orders in the terms A instructs, and acquire the asset.

The asset would be put on lease for 60 months; if the asset is expected to last for more than 5 years, the lessee will be given a convenient renewal option, for, say, next 5 years at a nominal rental. [Alternatively, depending on the regulations prevailing, the lessee could be given an option to buy the asset as a token value.]

Characteristics of financial leases

allow the asset to be virtually exhausted by the same lessee put the lessee in the position of a virtual owner.

Characteristics of financial leases

Risk of the Lessor


The lessor takes no asset-based risks or asset-based rewards. He only takes financial risks and financial reward The risk the lessor takes is not asset-based risk but lessee-based risk. The value of the asset is important only from the viewpoint of security of the lessor's investment

Contd..


The lease is non-cancellable, meaning the lessee cannot return the asset and not pay the whole of the lessor's investment. they are full-payout, meaning the full repayment of the lessor's investment is assured.

Bargain Renewal/ Buyout



The payback period, viz., primary lease period is followed by an extended period to allow exhaustion of asset value by the lessee, called secondary lease period. As the renewal is at a token rental, this option is called bargain renewal option. Alternatively, if the regulations permit, the lessee may be given a purchase option at a nominal price, called bargain buyout or purchase option.

In financial leases, the lessor's rate of return is fixed Financial leases are technically different but substantively similar to secured loans

Operating lease
Any lease other than finance lease

Characteristics  The lease term is significantly less than the economic life of the equipment.  The lessee enjoys the right to terminate the lease at short notice without any significant penalty.

Operating lease


An operating lease does not shift the equipment-related, business and technological risks from the lessor to the lessee. The lessor structuring an operating lease transaction has to depend upon multiple leases or on the realization of substantial resale value (on the expiry of the first lease), to recover the investment cost plus reasonable rate of return thereon.

Other Types of Lease

    

Sale and lease back Bank Vault Direct lease - 2 Types Bipartite Lease Tripartite Lease Leveraged Lease

Other Types of Lease



Bipartite Lease
 

There are two parties to the transaction equipment supplier-cum-lessor and the lessee. It functions like an operating lease with built in facilities like up-gradation of the equipments (Upgrade Lease) Swap Lease


The lessor undertakes to maintain the equipment and even replaces the equipment that is in need of major repair with similar functioning equipment

Tripartite Lease: It involves three different parities - the equipment supplier, the lessor, and the lessee.


sales


aid

lease

where the equipment supplier arranges for lease finance, where the customer is short on liquidity.

Other Types of Lease

 

Leveraged Lease There are three parties to the transaction: lessor, lender and lessee. The leasing company (equity investor) invests in equipments by borrowing large investments with full recourse to the lessee and without any recourse to it. The lender (loan participant) obtains an assignment of the lease and the rentals to be paid by the lessee and a first mortgage on the leased assets. This transaction is routed through a trustee who looks after the interest of the lender and the lessor.

Lease Accounting Book



Lessee

 

Financial charge ( interest component of the lease payment ) P & L a/c Depreciation P & L a/c Asset = Fair value of leased asset / PV of minimum lease rental WIL ( Discount factor for PV is incremental rate of int) Liability = Lease Rental ( Fin Charge) shown as CL and the rest of the Lease rental amount due shown as O/S secured loan

Lease Accounting Book



Lessors

Recorded as a receivable at an amount equal to the net investment in the lease

Operating Lease - Accounting



Lessee Lease rental shown as an expense.



Excess rental paid shown as prepaid expenses in B/S

Lessor Leased asset as depreciable asset and lease rental as income

Taxation


Income Tax
 

Depreciation Interest Flexible Restructuring of lease rentals Transfer of investment related unabsorbed tax shield

Tax Planning
 

Sales Tax

Financial Evaluation of Lease



NPV(L)/NAL = Investment Cost



(-) PV of lease payments (discount by Kd)



(+) PV of tax shield on lease payment



(henceforth Disc by Kc )

(-) management fee



(+) PV of tax shield on mgt fee

  

(-) PV of depreciation shield (-) PV of interest shield (-) PV of residual or salvage value

HIRE PURCHASE Vs LEASING

   

Ownership Salvage value Depreciation Tax-deductible expense

HIRE PURCHASE Vs LEASING

    

Magnitude Nature of asset Maintenance of asset Down payment Reporting

TATA FINANCE LIMITED (TFL)

 

TFL is a leading Non-Banking Finance Company (NBFC) from the Tata Group. It has a strong branch network of 75 branches across the country. Incorporated in 1984 as a wholly owned subsidiary of Tata Industries Ltd. Objective of undertaking hire purchase, leasing and other finance related activities. Tata Industrial Finance Corporation (TFC) and Telco Dealers Leasing & Finance Company (TDLF) were merged in 1992 and 1995 respectively with TFL. TFL is classified as an "Equipment Leasing and Hire Purchase Company".

 

  

core business - asset financing The merchant banking division has been classified is in to Category-I status by SEBI. Hire purchase finance of commercial vehicles Auto Finance activity Finances construction equipment and lease of plant and machinery. Wide focus on housing finance, credit cards, foreign exchange services, badla financing, etc. During 2002-03 sold its credit card business to ICICI Bank Limited. The sale entitles transfer of 87,672 card members to ICICI Bank limited along with their dues to the company. (to meet its capital adequacy ratio as per the RBI stipulation for non-banking finance companies)

Consumer Finance


Consumer Credit includes all asset based financing plans offered primarily to individuals to acquire durable consumer goods.

Evaluation
  

Flat rate of Interest Effective rate of Interest (ERI) Original amount is repaid over the term of loan in equated installments. The ERI is used to determine the interest component of each installment of the declining balance of principal amount used.

 

ERI is otherwise called Annual percentage rate (APR) ERI Computation depends on a. Whether a down payment is made or b. invest in fixed deposit of the finance company

ERI/APR Computation


 

I = [N/ (N+1) ] X 2F (Payment in arrear) I = [N/ (N-1) ] X 2F (Payment in advance) Where N is Number of Repayments F is Flat Rate of Interest