Lease-Accounting

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LEASING:

LEASING

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MEANING A lease may be defined as : a contractual arrangement / transaction in which a party owning an asset / equipment (lessor) provides the asset for use to another / 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 payment (rental) at the end of the period of contract (lease period) ,the asset /equipment reverts back to the lessor unless there is a provision for the renewal of the contract.

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ESSENTIAL ELEMENTS 1. Parties to the contract Essentially there are two parties to the contract , namely , the owner (lessor) and the user (lessee) . Lessor as well as lessee may be individuals ,partnership , joint stock companies, financial institutions. There may be joint lessors There may be lease broker ,who acts as an intermediary in arranging the lease deal. Private merchant bankers are also acting as lease brokers. They charge fee ranging from 0.5% to 1% for their services. A lease contract may involve a lease financier, who refinances the lessor, either by providing term loans or by subscribing to equity .

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2. Assets The asset under a lease contract includes : Automobile Plant and Machinery Equipment Land and Building Factory A Running Business Aircraft , Ship etc

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3. 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 tenure the asset reverts to the lessor.

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4. Term of lease It is the period for which the agreement of lease financing remains in operation. Every lease should have a definite period otherwise it will be legally inoperative . The lease period may sometimes spread stretch over the entire economic life of the asset or a period shorter than the useful life of the asset. The lease may be perpetual , that is, with an option at the end of lease period to renew the lease for the further specific period

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5. Lease rental The consideration which the lessee pays to the lessor for the lease transaction is the lease rental. It is so structured as to compensate the lessor for the : investment made in the asset , the interest on investment , repairs borne by the lessor ,and servicing charges over the lease period.

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6. Mode of terminating lease The lease is terminated at the end of the lease period and various courses are possible , namely : lease is renewed on perpetual basis or for a definite period the asset reverts to the lessor the asset reverts to the lessor and the lessor sells it to the other party the lessor sells the asset to the lessee The parties may mutually agree to , and choose , any of the aforesaid alternatives at the beginning of the lease term.

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CLASSIFICATION An equipment lease transaction can differ on the basis of : The extent to which the risks and rewards of ownership are transferred. Number of parties to the transaction. Domiciles of the equipment manufacturer , the lessor and the lessee .

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1. Finance Lease According to the International Accounting Standard (IAS-17) in a finance lease the lessor transfers to the lessee, substantially all the risks and rewards incidental to the ownership of the asset whether or not the title is eventually transferred . It involves payment of rental over an obligatory non – cancelable lease period , sufficient in total to amortize the capital outlay of the lessor and leave some profit . In such leases , the lessor is only a financier and is usually not interested in the assets. Such leases are also called as Full Payout Leases as they enable a lessor to recover his investment in the lease and derive a profit.

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Types of assets included under such lease are : Ships Aircrafts Railway Wagons Land Building Heavy Machinery Diesel Generating Sets etc

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The IAS-17 stipulates that a substantial part of the ownership related risks and rewards in leasing are transferred when : The ownership of the equipment is transferred to the lessee by the end of the lease term , or The lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than the fair market value at the date option becomes exercisable and at the inception of the lease it is reasonably certain that the option will be exercised , or The lease term is for a major part of the useful life of the asset.

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Features of Finance Lease The lessee selects the equipment according to his requirements , from its manufacturers or distributors The lessee negotiates and settles with the manufacturer or distributor , the price , the delivery schedule , installation , terms of warranties , maintenance and payment and so on. The lessor purchases the equipment either directly from the manufacturer or distributor (under straight forward leasing) or from the lessee after the equipment is delivered (under sale and lease back). The lessor then leases out the equipment to the lessee.

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A finance lease may provide a right or option , to the lessee , to purchase the equipment at a future date. The lease period spreads over the expected economic life of the asset. The lessee is entitled to exclusive and peaceful use of the equipment during the entire lease period provided he pays the rental and complies with the terms and conditions. As the equipment is chosen by the lessee , * the responsibility of its suitability , * the risk of obsolescence and * the liability for repairs , * maintenance and * insurance of the equipment rests with the lessee.

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Operating Lease According to the IAS-17 in operating lease also known as Service Lease , the lessor does not transfer all the 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 lessor provides services ( other than the financing of the purchase price ) attached to the leased asset , such as maintenance , repairs and technical advice. The lease rental in an operating lease includes : a cost for the services provided and the lessor does not depend on a single lessee for recovery of his cost.

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Operating lease is generally given for : Computers Office equip Automobiles Trucks Other equip Telephones etc

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Features of Operating Lease An operating lease is generally for a period significantly shorter than the economic life of the leased asset . In some cases it may be even on hourly , daily ,weekly or monthly basis . The lease is cancelable by either party during the lease period . Since the lease periods are shorter than the expected life of the asset , the lease rentals are not sufficient to totally amortize the cost of the assets.

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The lessor does not rely on the single lessee for recovery of his investment. He has the ultimate interest in the residual value of the asset The lessor bears the risk of obsolescence , since the lessee is free to cancel the lease at any time . Operating leases normally include maintenance clause: * requiring the lessor to maintain the leased asset and * provide services such as * insurance , * support staff , * fuel and so on .

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Examples : Providing mobile cranes with operators Chartering of aircrafts and ships , including the provision of crew , fuel and support services Hiring of computers with operators Hiring a taxi for a particular travel , which includes service of driver , provision for maintenance , fuel , immediate repairs , and so on.

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3. Sales and Lease Back It is an indirect form of leasing . The owner of an equipment / asset sells it to a leasing company (lessor) which leases it back to the owner (lessee) .

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Example: The sale and lease back of safe deposits vaults by banks under which banks sell them in their custody to a leasing company at a market price substantially higher than the book value . The leasing company in turn offer these lockers on a long – term basis to the bank . The bank sub- leases the lockers to its customer . The lease back arrangement in sale and lease back type of leasing can be in the form of finance lease or operating

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4. 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 Lease There are two parties in the lease transaction : (i) equipment supplier - cum - lessor and (ii) lessee. Such type of lease is typically structured as an operating lease with in - built facilities like : up gradation of equipment ( Upgrade Lease ) , addition to the original equipment configuration and so on . the lessor maintains the asset and if necessary , replaces it with a similar equipment in working condition ( Swap Lease ).

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Tripartite Lease Such types of lease involves three parties in the lease agreement : * equipment supplier , * lessor and * lessee. An innovative variant of tripartite lease is the Sales-aid Lease under which the equipment supplier arranges for lease finance in various forms by : providing reference about the customer to the leasing company negotiating the terms of the lease with the customer and completing all the formalities on behalf of the leasing company

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writing the lease on his own account and discounting the lease receivables with the designated leasing company . The sales-aid lease is usually with recourse to the supplier : in the event of default by the lessee either in the form of offer from the supplier to buy back the equipment from the lessor or a guarantee on behalf of the lessee.

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5. Single Investor Lease There are only two parties to the lease transaction : the lessor and the lessee. The leasing company (lessor) funds the entire investment by an appropriate mix of debt and equity funds . The debts raised by the leasing company to finance the assets are without recourse to the lessee ,i.e. , in the case of default of servicing the debt by the leasing company , the lender is not entitled to payment from the lessee.

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6. Domestic lease A lease transaction wherein all parties to the agreement namely : equipment supplier , lessor and the lessee , are domiciled in the same country. 7. International lease If the parties to the lease transaction are domiciled in different countries . This type of lease is further sub-classified into :

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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 asset and leases it to the lessee. Cross Border Lease: When the lessor and the lessee are domiciled in different countries. The domicile of the supplier is immaterial.

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MAJOR PLAYERS Independent Leasing Companies A major part of their income is derived from leasing . Some of them have financial / technical collaboration with overseas partners . They offer their services through : * direct advertisement , * personal contracts , * lease brokers including foreign banks and * merchant banks.

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2. Other finance companies A large number of other finance and investment companies also carry on leasing business because of tax advantage. Leasing is not their regular business and They normally opt for lease finance of 100 % depreciation items once in a while so as to defer taxes.

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3. Manufacturer- Lessor A number of manufacturing companies have either set up independent leasing outfits or through separate divisions carry on leasing business to promote the sale of their own product. 4. Financial Institution The development finance institutions , both All-India and State level , provide leasing facility. 5. In-house Lessor Some big business houses have formed captive leasing companies for providing lease finance to group companies. 6. Commercial Banks With effect from 1994-95 , banks have been permitted to directly carry on leasing and hire purchase business.

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ADVANTAGES to the lessee Financing of capital goods Additional source of finance Less costly Ownership preserved Avoids conditionalties Flexibility in structuring of rentals Simplicity Tax benefits Obsolescence risk is averted

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ADVANTAGES to the lessor Full security Tax benefit High profitability Trading on equity High growth potential

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LIMITATIONS Restriction on the use of equipment Limitations of financial lease Loss of residual value Consequences of default

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LIABILITIES OF LESSEE Reasonable care Not to make unauthorized use To return the goods Not to set up an adverse title To pay the lease rental To insure and repair the goods

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LIABILITIES OF LESSOR Delivery of the goods Peaceful possession Fitness of goods To disclose all defects

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