Leasing of Plant & Machinery

(2 marks)

Rajkumar Sarda
B.E., MBA
RV-P&M & Insolvency Professional
rajsarda@gmail.com
50 Hour MEP – P&M dated 27th May 2020
Topics
•  Definition of lease
•  Leasing, Hiring and Renting
•  Obligations of supplier of asset & user of asset
•  hire purchase company/lessor in cases of loan
•  supplier’s credit
•  hire purchase and leasing
•  Leasing as an instance of bailment
•  nature of the bailment agreement
•  features & contracts law on bailment
•  Leasing rules
•  Types of leases and their characteristics
•  Structure and steps of a lease agreement/contract
•  Leasing from point of view of lessor/lessee
•  Limitations of Leasing
•  Accounting treatment of leasing as per Ind AS
•  Assessment of Lease related risks, Risk & return trade-off
•  Valuation of leased P & M
Definitions – Lease, Leasing, Hiring & Renting
•  Leasing is a type of contract between a lessor (the owner of the equipment) and a lessee (the one
who uses the equipment).
•  The right to use an asset is transferred from lessor to lessee for a ‘consideration’ (rentals).
•  It is a form of financing using asset- renting.
•  The word 'lease' is mostly used for long-term hiring contract
•  The Indian Accounting Standard (Ind. AS-116) defines lease as an agreement whereby the lessor
conveys to the lessee in return for a payment or series of payments the right to use an asset for an
agreed period of time.
•  Every contract of asset-renting is a contract of lease.
•  The law of Bailment-defined in general terms-in the Indian Contract Act, 1872 is followed as the
law of leases in India
•  The word 'lease' is mostly associated with immovable property
•  In a lawyer's terminology, "hiring agreement" or "rental" or "contract hire" is known as equipment
leasing.
•  Leasing, hiring and renting, mostly describes the same transaction in law

Leasing as an instance of bailment
Nature of Bailment Agreement: (Agreement: offer, acceptance,
legal, competent persons etc.

Section 148 of ICA, 1872 defines bailment as follows:
“the delivery of goods by one person to another for some
purpose, upon a contract that they shall, when the purpose is
accomplished, be returned or otherwise disposed off according
to the directions of the person delivering them.”

In a bailment, there is a transfer of a ‘thing’ to a bailee. That
‘thing’ referred to here is a movable property (i.e plant and
machinery)
Key Features of bailments
§  A delivery, actual or constructive, of goods
§  Delivery made by the owner called the bailor
§  Delivery made to another person called the bailee
§  Delivery made for a specific purpose
§  Existence of a condition that the goods shall be returned in specie
either in their original or in an altered form to be disposed off in
accordance of the direction of the bailor
Contracts law on bailments
Sections 148 to 171 of ICA, 1872 govern general bailment contracts

General Duties of Bailee

§  To take care of the goods bailed to him as an ordinarily prudent man in his
place would have taken under the similar situation
§  Not to make any unauthorized use of goods bailed
§  Not to mix or part with his own goods
§  To return goods at the specific decided time or when the purpose is
accomplished
§  Not to set up an adverse title to the goods

Contracts law on bailments
General Duties of Bailor
§  To disclose faults of goods to be bailed
§  To repay Bailee’s expenses
§  To indemnify the Bailee
§  To compensate Bailee for breach of warranty
§  To claim back the goods



General Rules of Leasing
PARTIES TO A LEASE
Two parties: Owner and the user. Joint lessors and Joint lessees where the amount
involved is sizeable
In order to be a lessor, one has to have the right to use the asset. It is NOT necessary for
the lessor to be the owner

THE ASSET
Only tangible assets can be leased. (machines, vehicles, aircrafts, land etc)
Intangible assets cannot be leased.
Lease of moveable properties becomes effective by mere DELIVERY.
Lease of immovable property becomes effective by way of written instrument
Property must have the capability to be redelivered
Property must be durable, at least during the lease period, identifiable and servable
A lease does not exist, if there are no leasable goods or property
Lease of movable propert commences when delivered to lessee & terminated when
redelivered to the lessor
General Rules of Leasing
TERM OF LEASE: LEASE PERIOD
This is the period for which the agreement of lease is proposed to be in operation
(Typically, equal to the economic useful life of the asset)
(a)  Lease period should be certain
Perpetual lease: Lease for indefinite period of time is recognized in India
(b) Redelivery of the asset on termination of lease
Generally, lease provides for the return of asset to the lessor on expiry of the lease
period. However, lessor & lessee are free to enter into mutual agreed terms.
(c ) Primary & secondary Lease period in financial leases
Primary lease period - Lessor wants to see his investment paid back with interest in a
reasonable period of time (say 5 years where life of asset could be 8 years)
Secondary lease period is for the balance of the life of the asset, when only nominal
rentals are charged just to keep the lease agreement operative.
Lease period can be as short as the parties prefer. There is no limit at all.

General Rules of Leasing
THE LEASE RENTALS
The lease rentals represent the consideration for the lease agreement. The consideration
may be for the following:
•  Interest on the lessor's investment
•  If the lessor is bearing any repairs, insurance, maintenance or operation costs, then
charges for such cost (A)
•  Depreciation
•  Servicing charges, packaging charges
In a finance leasing (A) is absent, since lessor does not bear any of these expenses

In addition, there could be several other payments under a lease, both for financial &
otherwise such as :
•  An upfront payment as a security deposits
•  An upfront non-refundable fee for processing / marketing
•  An upfront fee, called the lease management fee is customary
Types of Leases
Fundamentally, there are 2 types: Financial Lease (most popular in India) & Operating
Lease.
FINANCE LEASE OPERATING LEASE
It is an alternative for borrowing & is a mode of finance. It is a series of short-term hiring contracts wherein the
It has a long lease period and typically a single user/ asset is hired out to a number of persons (lessees) in
lessee sequence. A good example is Car rentals
The asset purchased is use specific and is selected to suit The asset has common use & utility
the requirements of the lessee.
Transfer of all major risks & rewards of ownership to the The lessee is allowed to use the asset for a speicifc
lessee period of time. Risks incidental to ownership is borne by
the lessor
Risk of obsolescence is borne by the lessee Risk of obsolescence is borne by the lessor
Lessor is primarily intereste in rent received rather thn Since the lessor can lease the same asset to other
the asset. The intention is that the lessor gets his lessees, the lease can be cancelled by the lessee, though
principal back with interest, hence it is NON- it may be non-cancelable for a certain short period.
CANCELABLE by either parties
Types of Leases
Fundamentally, there are 2 types: Financial Lease (most popular in India) & Operating
Lease.
FINANCE LEASE OPERATING LEASE
The lease period & economic life ends during the same The lease periods are shorter (1 day to 3 years) and
period, largely. Lease period may be broken into primary lessor intends to lease the same asset repeatedly to
& secondary lease periods. more than one user
The role of lessor is just as a financier. All costs of The lessor generally bears the costs of operation.
operation (repairs & maintenance, insurance etc) are
borne by lessee.
The lessor cannot render any specialized service in The lessor provides specialixed services in handling and
connection with the asset as he is typically a financier operating the identified asset
Generally, these leases are in the form of FULL_PAYOUT These leases are in the form of non-payout leases, since
leases. Cost of the asset together with interest is repaid the lessor leases the same asset repeatedly to more than
by the single lease one user.
Since the lessor can lease the same asset to other
lessees, the lease can be cancelled by the lessee, though
it may be non-cancelable for a certain short period.
Other Types of Leases and their characteristics
Sales & 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) .

Leveraged & non-leveraged lease

• When a lessor obtains finance from outside financiers, for a large part of the useful life
of the property, such a lease is known as leveraged lease
• Normally leveraged lease has at least three parties:
• The lessee
• The long term creditor who plays role of financier for major part
• The lessor who plays role of the equity participants

Specialized service lease

• Lesser is a specialist in the asset which he is leasing
• He also provides his specialized personal services
Other Types of Leases and their characteristics
Cross border lease
•  When the lessor and the lessee are domiciled in different countries.
•  The domicile of the supplier is immaterial.

Net leases, net & net

•  In a net lease, the lessor is not concerned about repairs & maintenance part of
the asset
•  In Net-Net lease, residual value is guaranteed by the lessee. Thus, the uncertainty
over the estimation of the residual value is avoided. Hence double-net

Full- payout & non-payout leases

•  Finance-lease is full-payout and operating leases are non-payout leases
Steps in the formation of a lease contract

Ø  The lessee identifies the nature and type of equipment that he proposes to purchase.

Ø  The lessee then contacts the manufacturers or suppliers of required equipment and
negotiates with them.

Ø  The lessee simultaneously, contacts a lessor stating his intention to enter into a lease
agreement. The lessee may contact more than one lessor. In each case lessee carries
out negotiations with a lessor, and chooses a lessor who offers the most convenient
terms

Ø  The lessee completes negotiations with the supplier or suppliers, as the case may be,
and the purchase agreement is shared with the lessor

Steps in the formation of a lease contract
The lessee is expected to furnish such details to the lessor as; the specifications of the
equipment, the price, the terms of payment, terms of warranties, delivery period,
installation costs, transportation costs and other costs pertaining to bring the equipment
into operation.

The negotiations between the lessor and the lessee are finalized with respect to the
length of the lease period, the distribution of rentals over the period, the amount of
rentals to be collected and the mechanism of collecting rentals. This results in a lease
agreement.

The lessee, if a corporate entity, would be required to submit in writing a confirmation:
(a) that it has the corporate power to enter into the agreement
(b) that the agreement will not violate any provision of the company's memorandum or
articles of association, or any other contract to which the lessee is subject to;
(c) that all necessary licenses and consents in connection with the execution, performance
and validity of the agreement have been obtained and are in full force.
Steps in the formation of a lease contract

The lessee is then allowed to take possession of the asset, for which the necessary
ownership papers are processed in favour of the lessor. The lessor undertakes to pay the
supplier on the terms agreed to between the supplier and the lessee. The lessee in turn
undertakes to take full responsibility for the performance of the equipment. To this end
the lessee is expected to provide a certificate to the lessor, (before the lessor makes any
payment), that the lessee has inspected the equipment and that it is as per the
specifications asked for. The lessee is further expected to certify that the equipment is in
good working condition and that it can be used for the purpose for which it was obtained.


The lessor makes the payment to the supplier and lessee takes possession of the asset.
The lessee continues thereafter to discharge his obligation under the lease agreement

Structure of a Lease Agreement
A lease agreement provides the terms & conditions mutually acceptable rules, consistent
with law. Key provisions are the following:

The Lease Transaction: Lease rental, terms of payment & period of lease (varies between
5-15 years, generally for Fin leases)

Title, identification and ownership of the asset (Always the lessor)

Costs of maintenance and use (Maintenance & insurance are linked)

Liabilities of lessee: Provisions included relating to insurance, quality of asset, safety,
damage & surrender of asset/purchase option, indemnity against defect in performance
or construction of asset, theft or damage

Structure of a Lease Agreement
Liabilities of lessor: None in Fin Lease but in contract hire/Op lease, lessor is responsible
for maintenance of the asset-sometimes, depending on the asset, maintenance done by
lessee but cost is borne by lessor

Default of lessee (non payment of due money, violation of any covenant/condition, sell/
transfer/encumber without express consent of lessor, procedure for dealing with
contraventions. May also include mutually agreed remedial actions)

Remedies in the event of default (as per ICA, 1872-Rescission, suing for damages,
quantum merit, injunction etc)

Arbitration (In case of dispute, an Arbitration procedure under Arbitration & Conciliation
Act, 2015 – must be in writing in the agreement)

Miscellaneous provisions: Standard provisions such as cost escalation clause, no
capitalization of asset etc OR ANY OTHER-lease deeds are flexible & customized
Limitations of Leasing
•  Financial leasing is only another form of debt financing (Exactly similar to a loan)

•  Higher Cost : In many cases, lessor is a financial intermediary, borrowing from the market
and adds his own profit margin, thus increasing the cost of leasing than borrowing

•  Loss of Tax Benefits: At times, due to the rental structure & depreciation rates may lead
to losing out on tax benefits

•  Loss of residual Value (in cases where the residual value may be more than was provided
for at the commencement of the lease)

•  Leasing does not provide the lessee the pride of ownership

Lessee’s point of view in leasing
•  Lesser Cost compared to other methods of acquiring capital equipment (Especially if
lessor provides lower capital cost due to incremental tax benefits or his own cost is low)
•  Flexible, fast & negotiable (mutually acceptable terms & no hard & fast rules)
•  Freeing of Working capital (margin money requirement not there)
•  Lessee’s borrowing capacity increases (Another source of finance)
•  Off-balance sheet means of finance (Doesn’t impact Debt/Equity ratio & improves return
on investment-RoI)
•  Tax Postponement (If structured in a way that the repayment is faster than depreciation
of that asset or by making larger upfront rentals – purely based on negotiations)
•  Helps in financing of high value of tangible assets with small investments
•  Avoids restrictive covenants (such as restrictions on transfer of shares, appointing
nominee directors etc in large loan agreements)
•  Hedge against the risk of obsolescence (example, IT equipment)

Negative: He has the right of use, only there is no ownership, he cannot make major
changes or alterations to the asset
Lessor’s point of view
•  Advantages to the manufacturer-lessor: Ready market for his goods almost like consumer
goods rather than capital goods and steady income stream

•  Sale of supplies: Typically, lessee undertakes to purchase consumables from lessor and
thus a captive market with additionla assured income stream

•  Control over second-sale market: Can influence second hand market to disallow the
customer/user getting hold of used asset and to that extent, lessening of competition
from used machines

•  Income Tax benefits: Can claim depreciation on own products and investment benefits
•  Absorbing risk of obsolescence: By offering cancelable lease at a charge, can help absorb
risk of obsolescence, thereby minimizing the risk

•  Specialized services: Since he is well versed with the product, can offer specialized service
and open up a new revenue stream.
Assessment of Lease related risks
•  Default Risk: not receiving lease rentals as per the scheduled date

•  Residual Value Risk: Possibility of decline in the estimated residual value of the
equipment

•  Interest rate risk: Adverse Changes in the market rate of interest

•  Purchasing power risk: Risk of reduction in real value of lease rentals due to inflation

•  Risk due to Government policy: Changes in general Govt. policies & fiscal policy, in
particular

•  Currency & cross-border risk: Fluctuation in exchange rate

Risk & return trade-off
In leasing, the benefits derived from asset ownership & use are bifurcated between lessor &
lessee.

Value is “ present worth of future benefits, discounted at an appropriate rate of return”. This
definition is the basis of the Income Approach, used in valuing P&M in lease.

Mathematically, it can be expressed as

Capital Value of P&M = (Net income from the P&M) X (multiplier which depends on the
rate of interest to be yielded by the investment in the leased equipment)

CV = (NI) x YP {known as Years purchase, is the inverse of the capitalization rate=required
rate of return less growth rate}

YP is the multiplier which is the summation of the present worth of series of income
Valuation of Leased Plant & Machinery
THANK YOU