Leasing and Hire Purchase

Unit II

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Introduction to Asset Finance Modes of financing assets Leasing as a source of financing Accounting Treatment for Leasing

Introduction to Asset Finance .

Modes of financing assets 1. bank loan or overdraft Leasing Finance Hire/Contract purchase Finance . 2. 3. Purchase outright with cash.

or debt finance. which adds to the cost  A small company will have limited bargaining power and knowledge with regards to the potential discounts available  The cost cannot be spread to coincide with money coming in to the business  Maintenance and servicing of the asset  Banks can withdraw overdrafts and loans at short notice and demand early repayment  Unable to take advantage of the tax benefits of deducting the cost of rental from your taxable income  The owner has to take all the risk  .PURCHASE OUTRIGHT  Advantages of purchase  Can own the asset  The owner of the asset from a tax perspective can claim capital allowances  The owner is not tied into potentially inflexible medium or longlongterm agreements which may be difficult to terminate Disadvantages of purchase  The purchases hasto pay the full cost of the asset up front out of working capital.

The business customer chooses the equipment it requires and the finance company buys it on behalf of the business. in return for regular payments.Leasing and hire purchase Finance   Leasing and hire purchase are financial facilities which allow a business to use an asset over a fixed period. .

Equipments for leasing and Hire purchase Modernization of Business Plant and machinery Business cars Commercial vehicles Agricultural equipment Hotel equipment Medical and dental equipment Computers. including software packages Office equipment .

Leasing as Source of Finance .

 Lessor is a person who conveys to another person (lessee) the right to use an asset in consideration of a payment of periodical rental. the right to use an asset for an agreed period of time. in return for rent. agreement.  Lessee is a person who obtains from the lessor. time. the right to use the asset for a periodical rental payment for an agreed period of time  Leasing finance company is a company which buys the equipment on behalf of the lessee .Leasing as Source of Finance   A financial arrangement that provides a firm with the advantage of using an asset without owning it. may be termed as Leasing Institute of Charted Accountants of India ³ A lease is an agreement where by the lessor conveys to the lessee. under a lease agreement.

The business customer can generally deduct the full cost of lease rentals from taxable income. as a trading expense.    Ownership never passes to the business customer Instead. the leasing company claims the capital allowances and passes some of the benefit on to the business customer i. The business customer will normally be responsible for maintenance of the equipment. by way of reduced rental charges.e lessee. .

A financial lease is non cancelable in nature. prethe lessee has the option to buy the equipment / asset at a pre-determined value. Financial  lease: also called capital lease or lease:    Financial lease with the purchase option. prevalue. lessee. nature. where at the end of pre-determined period. Finance lease which is long term and where the asset is hired to only one lessee. The Lessee is responsible for the maintenance of the asset leased .

depreciation tax shields etc. are offered to the lessor. value.. . Full Payout lease The Lessor recovers the full value of the leased asset with in the period of the lease by way of lease rentals and residual value. such as investment tax credit.  True Lease The Typical tax-related taxbenefits.

The lease is terminable by giving stipulated notice as per the agreement.  Net lease:   . Lessor is not concerned with the repairs and maintenance of the leased asset. The risk of obsolescence is enforced on the lessor who will also bear the cost of maintenance and other relevant expenses. A variant type of operating lease. Operating Lease    Operating lease which is short-term and where the shortasset may be hired to several lessees.

5. Operating lease May be used commonly by a number of users Lessor bears the ownership risk Lessor bears the risk of obsolescence Lease period is generally small Cost of repairs & maintenance are borne by the lessors Lease can be cancelled . 2.Financial Lease vs Operating Lease ‡ ‡ 1. 5. 2. 3. 3. 6. 4. 4. Financial lease The asset leased out is use specific for the lessee Lessee bears the ownership risk Lessee bears the risk of obsolescence Lease period coincides with the life of the asset Cost of repairs & maintenance are borne by the lessee The lease can not be cancelled by either of the parties ‡ 1.

 Sale and Lease back: the owner of an back: asset sells it to the lessor. agreement. high during the mid years and low during the end of the lease. and gets the asset back under the lease agreement. lease. Leveraged lease: part or whole of the lease: financial requirement involved in a lease are arranged with the help of a financier.  Consumer leasing: leasing of consumer leasing: durables such as TV.  Balloon lease : Lease rentals are low at the inception.. Refrigerators etc. financier. etc. .

. Close end leasing: the asset leased out is leasing: reverted to the lessor. A rental agreement lessor. maintenance. that puts no obligation on the lessee to purchase the leased asset at the end of the agreement  Open end leasing: A rental agreement that leasing: obliges the lessee to purchase the leased asset at the end of the agreement  Swap leasing: lessee is allowed to exchange leasing: the equipment leased out whenever the original asset has to be sent to the lessor for some repair or maintenance.

retaining a fee  Import leasing: leasing of imported capital leasing: goods  Cross border leasing: lessor in one country leasing: leases out assets to a lessee to another country  International leasing: leasing company leasing: operates in different countries through its branches  Wrap .leasing: lessee further subleases the leasing: asset to the end user.

the 100% tax allowances of lease rental are normally more beneficial than capital allowances for outright purchase options Maintenance and other asset management service items can be written into operating lease or contract hire contracts The risk is carried by the leasing company .Advantages of leasing      Avoid having to pay the full cost of the asset up front and using up working capital or borrowed money The lessee can reduce tax bill by deducting the full cost of lease rentals from taxable income For companies that either do not pay tax or pay at the small company rate.

The cost of financing is higher than debt financing.Disadvantages of Leasing   Lease rentals are payable soon after entering into lease agreement while in new projects cash generation may start after gestation period. .

. The entire lease rental is treated as an income in the books of the lessor and expense in the books of lessee.Accounting Treatment of Lease    The leased asset is shown on the balance sheet of the lessor. Depreciation and other tax shields associated with leased asset are claimed by the lessor.

Debit statutory Depreciation 2. Debit lease rental 2.in the books of lessor  Adjustment in P/L A/C Receipt of lease rentals ‡ Debit cash ‡ Credit lease rentals Recording lease rentals 1.Accounting and reporting for financial lease . Credit leased asset Charging statutory depreciation 1. Debit P/L A/c 2. Credit P/L A/c Provision for Depreciation 1. Credit Statutory Depreciation .

Lease Equalization Account: Temporary account Account: introduced to provide a cushion to offset the differences between annual lease charge and statutory depreciation. Transfer of LEA to Profit & Loss A/c 1.Introducing Lease Equalization Account( LEA) 1. . Debit LEA Credit lease Adjustment account Debit P/L A/c Credit LEA 6. depreciation.in the books of lessor 5. 2. 2.Accounting and reporting for financial lease .

Hire Purchase as a source of financing .

Hire purchase .definition  An agreement under which goods are let on hire and under which the hirer has an option to purchase them in accordance with the terms of the agreement.    Goods are let out on finance by a finance company to the hire purchaser customer Buyer is required to pay an equal amount of periodic installments during a given period Ownership transfers at the payment of the last installment .

Features      Buyer takes immediate possession of the goods and agrees to pay installments Each installments is a hire charge Ownership transfers to the buyer at the last installment In case of any default the seller has the right to reposses goods and forfeit the amount already received The hirer or customer has the option of terminating the agreement anytime but will not get the amount that has been already paid. .

Leasing vs Hire purchase      In leasing the Ownership never passes to the business customer Depreciation & investment allowance cannot be claimed by lessee Entire lease rental is tax deductible by lessee Lessee does not enjoy the salvage value of the asset No deposit is required in leasing The extent of finance is 100% as no down payment required Maintenance cost is borne by the lessor except in finance lease Leased assets are shown by way of foot note only by lessee            Ownership transfers to the buyer at the last installment Depreciation & investment allowance can be claimed by hirer Only the interest is tax component deductible for hirer Hirer enjoys the salvage value of the asset 20% deposit is required in hire purchase The extent of finance is not 100% because of down payment Hirer bears the cost of maintenance Asset is shown in b/s of the hirer .

Accounting Treatment for Hire Purchase The cost of the fixed asset is shown on the balance sheet of Hirer. In the profit and loss account the interest paid during the year is shown. The liability does not include interest. . together with any depreciation. In the balance sheet the liability for future payments is shown. The cost shown excludes any interest paid. The net book value is the cost less any provision for depreciation.

Entries in the books of Hirer  Purchase of an asset on hire purchase   Asset on hire purchase debit Hire purchase vendor a/c credit Hire vendor ac debit Bank A/c Credit Depreciation on asset a/c debit Asset account credit   Payment of an asset purchased on hire purchase    Depreciation of an asset purchased on hire purchase   SECOND ENTRY   P & L a/c debit Depreciation a/c credit .

Entry in the books of vendor on hire purchase sale HIRE PURCHASE SALE   Hire purchaser a/c debit Hire purchase sale a/c credit (with the cash price of goods) Bank a /c debit Hire purchaser a/c credit Hire purchaser debit Interest on hire purchase sale a/c credit WHEN PAYMENT IS RECEIVED   FOR INTEREST .

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