Equipment Leasing | Lease Financing | PAPER III – ACCOUNTING & FINANCIAL MANAGEMENT FOR BANKERS | MODULE C: FINANCIAL MANAGEMENT

Equipment Leasing / Lease Financing

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Meaning of a Lease

A lease is a contractual agreement whereby the owner of an asset (lessor) permits another party (lessee) to use the asset for a specified period in return for periodic payments (lease rentals).

Features of a Lease

• Involves two parties – lessor and lessee
• Asset ownership remains with the lessor
• Lessee pays lease rentals for using the asset
• Can be short-term or long-term
• Termination conditions are pre-agreed

Types of Leases

• Finance Lease: Long-term, non-cancellable lease transferring most risks and rewards of ownership.
• Operating Lease: Short-term, cancellable lease where the lessor bears the risk and reward of ownership.
• Sale and Leaseback: Seller sells the asset and leases it back from the buyer.
• Leveraged Lease: Involves third-party funding, usually used for high-cost equipment.

Rationale for Leasing

• Preserves working capital
• Provides 100% financing
• Off-balance-sheet financing (in operating lease)
• Tax benefits for both lessor and lessee
• Flexibility in asset acquisition

Contents of a Lease Agreement

• Parties involved
• Description of leased asset
• Lease term and rental payments
• Maintenance responsibilities
• Termination and renewal clauses
• Ownership transfer clause (if any)

Legal Aspects of Leasing

Lease agreements must comply with the Indian Contract Act, Transfer of Property Act, and relevant tax laws. The lessor retains ownership unless specified otherwise.

Accounting of Lease Transactions

In the books of Lessee

• Finance Lease: Asset and liability recorded in books; depreciation and interest charged to P&L.
• Operating Lease: Lease rentals charged as expense without asset recognition.

In the books of Lessor

• Finance Lease: Lease receivable recorded; interest income recognized.
• Operating Lease: Asset remains in books; rental income recognized periodically.

Leasing as a Financing Decision

Leasing is an alternative to borrowing or outright purchase. A lease-vs-buy analysis helps decide the cheaper and more tax-efficient option, especially for capital-intensive assets.

Mathematical Examples (Medium-Hard)

1. If lease rental is ₹2,00,000 annually for 5 years and discount rate is 10%, calculate Present Value (PV) of lease payments.
   PV = ₹2,00,000 × [(1 - (1+0.10)^-5) / 0.10] ≈ ₹7,58,000
2. Asset cost = ₹10,00,000; lease term = 5 years; interest rate = 8%; annual lease rental?
   Use annuity formula: PMT = PV × [r(1+r)ⁿ]/[(1+r)ⁿ-1] ⇒ PMT ≈ ₹2,50,457
3. Depreciation under finance lease: Asset cost ₹5,00,000; useful life = 5 years; straight-line method.
   Annual depreciation = ₹1,00,000
4. Interest for first year if liability is ₹7,00,000 and interest rate = 9%: ₹63,000
5. Operating lease expense over 4 years with ₹1,50,000 annual rental: Total = ₹6,00,000
6. Calculate IRR of lease cash flows: Outflows = ₹0; Inflows = ₹2,00,000/year for 5 years; PV = ₹7,58,000 → IRR ≈ 10%
7. If tax shield on depreciation (₹1,00,000/year) @ 30%: Tax saving = ₹30,000/year
8. NPV comparison: Buy (NPV = -₹1,20,000), Lease (NPV = -₹1,10,000) → Prefer Lease
9. Lease liability amortization: Year 1 interest = ₹72,000; lease rental = ₹2,00,000; principal repaid = ₹1,28,000
10. Asset resale value at end = ₹1,00,000; affects finance lease classification if risk transferred to lessee

Multiple Choice Questions (MCQs)

1. Which of the following is a characteristic of a finance lease?
   a) Short-term duration
   b) Lessor bears risks
   c) Transfer of risk and rewards to lessee
   d) No asset recognition in books
2. Operating lease is typically:
   a) Capital intensive
   b) Cancelable and short-term
   c) Non-taxable
   d) Long-term with ownership transfer
3. In a lease, ownership of the asset remains with:
   a) Lessee
   b) Lessor
   c) Bank
   d) Vendor
4. Lease rental payments in finance lease are:
   a) Treated as expense
   b) Split into interest and principal
   c) Ignored in books
   d) Capitalized fully
5. Which lease type offers tax benefits to the lessee?
   a) Operating lease
   b) Finance lease
   c) Leveraged lease
   d) None of the above
6. Which is not a part of lease agreement?
   a) Asset description
   b) Company audit details
   c) Term and rental
   d) Termination clause
7. Accounting for a finance lease in lessor’s books involves:
   a) Asset depreciation
   b) Lease receivable and interest income
   c) Charging rent expense
   d) Ignoring cash inflows
8. Lease vs. Buy decision is based on:
   a) Income of the owner
   b) Preferences of vendor
   c) NPV and cash flows comparison
   d) Brand of equipment
9. In leveraged lease, funding comes from:
   a) Only lessor
   b) Third-party financier
   c) Lessee only
   d) Government grants
10. Which of these is an example of lease financing?
    a) Term loan
    b) Overdraft
    c) Equipment lease
    d) Fixed deposit