UNIT 2

Financial Services

2.1 Financial Services: Meaning and Definition, Role of Financial Services in a financial system.

The Indian financial services industry has undergone a metamorphosis since1990. Before its emergence the commercial banks and other financial institutions dominated the field and they met the financial needs of the Indian industry. It was only after the economic liberalisation that the financial service sector gained some prominence. Now this sector has developed into an industry. In fact, one of the world’s largest industries today is the financial services industry. Financial service is an essential segment of financial system. Financial services are the foundation of a modern economy. The financial service sector is indispensable for the prosperity of a nation.

Meaning and definition

In general, all types of activities which are of financial nature may be regarded as financial services. In a broad sense, the term financial services means mobilisation and allocation of savings. Thus, it includes all activities involved in the transformation of savings into investment. Financial services refer to services provided by the finance industry. The finance industry consists of a broad range of organisations that deal with the management of money.

These organisations include banks, credit card companies, insurance companies, consumer finance companies, stock brokers, investment funds and some government sponsored enterprises. Financial services may be defined as the products and services offered by financial institutions for the facilitation of various financial transactions and other related activities.

As per section 65(10) of the Finance Act, 1994, “banking and financial services” means the following services provided by a banking company or a financial institution including a non banking financial company, namely;

(i) financial leasing services including equipment leasing and hire-purchase by a body corporate;

(ii) credit card services;

(iii) merchant banking services;

(iv) securities and foreign exchange (forex) broking;

(v) asset management including portfolio management, all forms of fund management, pension fund management,   custodial depository and trust services, but does not include cash management;

(vi) advisory and other auxiliary financial services including investment and portfolio research and advice, advice on mergers and acquisition and advice on corporate restructuring and strategy; and

Vii) provision and transfer of information and data processing.

Financial services cover a wide range of activities. They can be broadly classified into two :

(i) Traditional activities

(ii) Modern activities.

Traditional activities can be further classified as:

(i) Fund based activities/services

(ii) Fee based activities /services

Fund based activities / services are those where funds of financial institutions are involved such as:

• Underwriting of investments in shares, debentures.
• Advancing different types of loans (short term, medium term, long term) and in the form of clean loan, pledge, hypothecation, housing, education, consumption loan etc.
• Investing / participating in money market instruments like CPs, CDs bill discounting, treasury bills etc.
• Providing finance like leasing, hire purchase, venture capital, seed capital etc.

Non-Fund based activities/services are those where funds are not involved and financial institution gets income in the form of fee such as:

• Commission on demand draft.
• Guarantee/Letter of credit
• Managing capital issue (pre-issue & post issue management services)
• Advisory/Consultancy services
• Project preparation/appraisal/arranging finance through projects from
• Financial institutions
• Assisting in the process of getting clearances from Govt/Govt bodies.

Modern activities/services provided by financial institutions are like advisory role in corporate restructuring, acting as trustees for debentures, rehabilitation and restructuring sick units, portfolio management of large corporate risk management services, hedging of risks, guiding management in cost minimization efforts, safe custody of securities etc.

Role in financial system:

i. Financial Services are fundamental to economic growth and Development;

Ii. Banking, savings and investment, and debt and equity financing, all help us to save our money, guard against uncertainty, and build credit, while enabling our businesses to start up, expand, -increase efficiency, - and compete in local and international markets;

Iii. They provide the payment services;

Iv. Matching savers and investors;

v. Generating and distributing of crucial information,

Vi. Allocation of credits efficiently;

Vii. Pricing, pooling and trading risks;

Viii. Increasing of asset liquidity.

Ix. Accelerate the rate of economic development

x. Allocation of resources to different investment channels.

Xi. Catalyst for economic development

Xii. Lowers risk and helps in diversification.

Xiii. Expert Knowledge and professional guidance

Xiv. Fosters industrial development

Xv. Revival of sick units

Xvi. Investor’s education

Key takeaways –

1. Financial services  involves all activities involved in the transformation of savings into investment. It can also be called financial intermediation which is a process by which funds are mobilized by large number of sectors and make them available to all those who are in need particularly corporate customers.

2.2 Leasing: Meaning and features. Introduction to equipment leasing: Types of Leases, Evolution of Indian Leasing Industry. Legal Aspects of Leasing: present Legislative Framework.

Leasing: Meaning and features

Leasing is a process by which a firm can obtain the use of a certain fixed assets for which it must pay a series of contractual, periodic, tax deductible payments.

A lease transaction is a commercial arrangement whereby an equipment owner or Manufacturer conveys to the equipment user the right to use the equipment in return for a rental. In other words, lease is a contract between the owner of an asset (the lessor) and its user (the lessee) for the right to use the asset during a specified period in return for a mutually agreed periodic payment (the lease rentals). The important feature of a lease contract is separation of the ownership of the asset from its usage.

The lessee is the receiver of the services or the assets under the lease contract and the lessor is the owner of the assets. The relationship between the tenant and the landlord is called a tenancy, and can be for a fixed or an indefinite period of time (called the term of the lease). The consideration for the lease is called rent.

Features

Here are some features and benefits for the landlord/seller:

1. Top sales price, even if demand is low: You attract more buyers who are willing to pay a premium because of the exclusive financing terms and value you're offering.
2. Higher than usual rent: Since you are flexible on your financing terms and are offering a tremendous value, you can demand a higher than usual rent.
3. Positive cash flow: Since you can demand a higher than usual rent, your positive cash flow will increase.
4. Non-refundable option money: When a tenant/buyer executes (signs) a Lease 2 Purchase contract, you receive an non-refundable option deposit that is yours to keep should they default or decide not to buy.
5. Save thousands in fees: Since you are selling your home by owner, you will avoid paying a 5-10% realtor commission which quickly adds up to thousands of dollars. You will also save on advertising costs because your home will be sold a lot faster.
6. Highest quality tenants, minimum risk: Because you are renting to tenants who have a vested interest in your home, they think like homeowners and tend to take good care of it.
7. No maintenance, no landlording headaches: Tenants who have a vested interest and believe they are a homeowner may feel a "pride of ownership" that encourages them to pay on time, perform routine maintenance and make improvements to your home.
8. Tax shelter is held intact: Because you remain on the deed until the option is exercised, you maintain all of the tax benefits of ownership.
9. Largest market of buyers: You are marketing your home not only to traditional buyers, but also to renters and investors. These three groups make up over 95% of people whom buy real estate.
10. No vacancies: When you advertise your home as a Lease 2 Purchase your phone will literally ring off the hook. Typical turnover time is days or weeks instead of months or even years.
11. Peace of mind: It is safer than conventional rentals because of the quality of the tenants and their vested interest in your home. It also means that someone is living on-site who will watch and guard your home against fire, theft, vandalism, etc.

Here are some features and benefits for the tenant/buyer:

1. Faster equity growth: Equity accumulates much faster (five times or more!) than with conventional financing through a bank or lender.
2. Rent money is working towards purchase: Every month a portion of your rental payment (typically $100-$500) is credited towards your down payment or off of the sales price.
3. Option money is credited towards purchase: When you sign a Lease 2 Purchase contract, you will pay the seller an option deposit. This money is your vested interest in the home and will be fully (100%) credited to you when you buy the home.
4. Minimum cash out of pocket: When you purchase a home the conventional way, you must pay at least 5% down plus closing costs and prepaid fees. When you buy with a Lease 2 Purchase, you only pay first month's rent and a small option deposit. This will save you between 25% and 85% every time you buy a home.
5. Frequently no down payment at close: Since you have given the seller an option deposit and you have been receiving monthly rent credits, there will frequently be very little or nothing left to pay for a down payment at closing.
6. Profits from appreciation: Since the sales price is locked in before closing (as specified in your agreement), any increase in property value will mean that your equity (what you owe minus what it's worth) is increasing in the home.
7. Possible sale for a profit: If you are allowed to sell (assign) your option (it will be in your agreement), you may sell it to a third party for a profit.
8. Increased buying power: When you buy a Lease 2 Purchase home, you can put down as little as first month's rent and a $1 option deposit. Compare that to a typical bank or lender who requires 5-30% down plus closing costs and prepaids.
9. Credit problems okay: Qualification restrictions simply do not exist. You will be approved at the sole discretion of the landlord/seller.
10. No lengthy escrows or mortgage approvals: Your approval will be based solely at the discretion of the landlord/seller instead of a lender who can take up to a month (or longer) to render a decision.
11. Control of the home: You will be put in full legal control of the home for a specified period of time without actually having to own it.
12. No taxes, less liability: Since you do not own the home (yet), you will not have to pay property taxes and your liability exposure will be dramatically reduced.
13. Quick move in time: You can typically take possession of the home in a week or less, instead of conventional move in times of one to three months, after your offer was accepted.
14. Maximum leverage: You are spending very little (or zero) money to control a potentially very expensive, and very profitable, piece of real estate.
15. Time: Before you actually buy the home, you will have 3-24 months (depending on your agreement) to repair your credit, find the best interest rates, investigate the home and research the neighborhood and/or schools.
16. Minimal maintenance: Large maintenance problems or any maintenance problems that exceed a certain amount of money can be delegated to the landlord/seller.
17. Privacy: Your name will not be on the deed or in the public records until you exercise your option to buy.
18. Peace of mind: You will have full control of the home and can maintain or improve it however you wish.

Introduction to equipment leasing

Equipment leasing is basically a loan in which the lender buys and owns equipment and then "rents" it to a business at a flat monthly rate for a specified number of months. At the end of the lease, the business may purchase the equipment for its fair market value (or a fixed or predetermined amount), continue leasing, lease new equipment or return it.

There are many different avenues through which you can secure an equipment lease:

• Banks and bank-affiliated firms that will finance an equipment lease may be difficult to locate, but once found, banks may offer some distinct advantages, including lower costs and better customer service. Find out whether the bank will keep and service the lease transaction after it's set up
• Equipment dealers and distributors can help you arrange financing using an independent leasing company.
• Independent leasing companies can vary in size and scope, offering many financing options
• Captive leasing companies are subsidiaries of equipment manufacturers or other firms.
• Broker/packagers represent a small percentage of the leasing market. Much like mortgage or real estate brokers, these people charge a fee to act as an intermediary between lessors and lessees.

Types of leases

1)  Financial lease  - Long-term, non-cancellable lease contracts are known as financial leases. The essential point of financial lease agreement is that it contains a condition whereby the lessor agrees to transfer the title for the asset at the end of the lease period at a nominal cost. At lease it must give an option to the lessee to purchase the asset he has used at the expiry of the lease. Under this lease the lessor recovers 90% of the fair value of the asset as lease rentals and the lease period is 75% of the economic life of the asset. The lease agreement is irrevocable. Practically all the risks incidental to the asset ownership and all the benefits arising there from are transferred to the lessee who bears the cost of maintenance, insurance and repairs. Only title deeds remain with the lessor. Financial lease is also known as 'capital lease‘. In India, financial leases are very popular with high-cost and high technology equipment

2)  Operational lease - An operating lease stands in contrast to the financial lease in almost all aspects. This lease agreement gives to the lessee only a limited right to use the asset. The lessor is responsible for the upkeep and maintenance of the asset. The lessee is not given any uplift to purchase the asset at the end of the lease period. Normally the lease is for a short period and even otherwise is revocable at a short notice. Mines, Computers hardware, trucks and automobiles are found suitable for operating lease because the rate of obsolescence is very high in this kind of assets.

3)  Sale and lease back - It is a sub-part of finance lease. Under this, the owner of an asset sells the asset to a party (the buyer), who in turn leases back the same asset to the owner in consideration of lease rentals. However, under this arrangement, the assets are not physically exchanged but it all happens in records only. This is nothing but a paper transaction. Sale and lease back transaction is suitable for those assets, which are not subjected depreciation but appreciation, say land. The advantage of this method is that the lessee can satisfy himself completely regarding the quality of the asset and after possession of the asset convert the sale into a lease arrangement.

4)  Leveraged leasing-  Under leveraged leasing arrangement, a third party is involved beside lessor and lessee. The lessor borrows a part of the purchase cost (say 80%) of the asset from the third party i.e., lender and the asset so purchased is held as security against the loan. The lender is paid off from the lease rentals directly by the lessee and the surplus after meeting the claims of the lender goes to the lessor. The lessor, the owner of the asset is entitled to depreciation allowance associated with the asset.

5)  Direct leasing - Under direct leasing, a firm acquires the right to use an asset from the manufacture directly. The ownership of the asset leased out remains with the manufacturer itself. The major types of direct lessor include manufacturers, finance companies, independent lease companies, special purpose leasing companies etc.

Other types of leasing:

1)  First Amendment Lease: The first amendment lease gives the lessee a purchase option at one or more defined points with a requirement that the lessee renew or continue the lease if the purchase option is not exercised. The option price is usually either a fixed price intended to approximate fair market value or is defined as fair market value determined by lessee appraisal and subject to a floor to insure that the lessor's residual position will be covered if the purchase option is exercised.

2)  Full Payout Lease: A lease in which the lessor recovers, through the lease payments, all costs incurred in the lease plus an acceptable rate of return, without any reliance upon the leased equipment's future residual value.

3)  Guideline Lease: A lease written under criteria established by the IRS to determine the availability of tax benefits to the lessor.

4)  4) Net Lease: A lease wherein payments to the lessor do not include insurance and maintenance, which are paid separately by the lessee.

5)  Open-end Lease: A conditional sale lease in which the lessee guarantees that the lessor will realize a minimum value from the sale of the asset at the end of the lease.

6)  Sales-type Lease: A lease by a lessor who is the manufacturer or dealer, in which the lease meets the definitional criteria of a capital lease or direct financing lease.

7)  Synthetic Lease: A synthetic lease is basically a financing structured to be treated as a lease for accounting purposes, but as a loan for tax purposes. The structure is used by corporations that are seeking off-balance sheet reporting of their asset based financing, and that can efficiently use the tax benefits of owning the financed asset.

8)  Tax Lease: A lease wherein the lessor recognizes the tax incentives provided by the tax laws for investment and ownership of equipment. Generally, the lease rate factor on tax leases is reduced to reflect the lessor's recognition of this tax incentive.

9)  True Lease: A type of transaction that qualifies as a lease under the Internal Revenue Code. It allows the lessor to claim ownership and the lessee to claim rental payments as tax deductions.

Evolution of Indian Leasing Industry:

Leasing activity was initiated in India in 1973. The first leasing company of India, named First Leasing Company of India Ltd. Was set up in that year by Farouk Irani, with industrialist A C Muthia. For several years, this company remained the only company in the country until 20th Century Finance Corporation was set up - this was around 1980.

By 1981, the trickle started and Shetty Investment and Finance, Jaybharat Credit and Investment, Motor and General Finance, and Sundaram Finance etc. joined the leasing game. The last three names, already involved with hire-purchase of commercial vehicles, were looking for a tax break and leasing seemed to be the ideal choice.

The industry entered the third stage in the growth phase in late 1982, when numerous financial institutions and commercial banks either started leasing or announced plans to do so. ICICI, prominent among financial institutions, entered the industry in 1983 giving a boost to the concept of leasing. Thereafter, the trickle soon developed into flood, and leasing became the new gold mine. This was also the time when the profitperformance of the two doyen companies, First Leasing and 20th Century had been made public, which contained all the fascination for many more companies to join the industry. In the meantime, International Finance Corporation announced its decision to open four leasing joint ventures in India. To add to the leasing boom, the Finance Ministry announced strict measures for enlistment of investment companies on stock-exchanges, which made many investment companies to turn overnight into leasing companies.

As per RBI's records by 31st March, 1986, there were 339 equipment leasing companies in India whose assets leased totaled Rs. 2395.5 million. One can notice the surge in number - from merely 2 in 1980 to 339 in 6 years.

Subsequent swings in the leasing cycle have always been associated with the capital market - whenever the capital markets were more permissive, leasing companies have flocked the market. There has been appreciable entry of first generation entrepreneurs into leasing, and in retrospect it is possible to say that specialised leasing firms have done better than diversified industrial groups opening a leasing division.

Another significant phase in the development of Indian leasing was the Dahotre Committee's recommendations based on which the RBI formed guidelines on commercial bank funding to leasing companies. The growth of leasing in India has distinctively been assisted by funding from banks and financial institutions.

Banks themselves were allowed to offer leasing facilities much later - in 1994. However, even to date, commercial banking machinery has not been able to gear up to make any remarkable difference to the leasing scenario.

The post-liberalisation era has been witnessing the slow but sure increase in foreign investment into Indian leasing. Starting with GE Capital's entry, an increasing number of foreign-owned financial firms and banks are currently engaged or interested in leasing in India.

Legal Aspects of Leasing: present Legislative Framework.

As there is no separate statue for leasing in India, the provisions relating to bailment in the Indian Contract Act govern equipment leasing agreements as well section 148 of the Indian Contract Act defines bailment as:

“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. The person delivering the goods is called the ‘bailor’ and the person to whom they are delivered is called the ‘bailee’.

Since an equipment lease transaction is regarded as a contract of bailment, the obligations of the lessor and the lessee are similar to those of the bailor and the bailee (other than those expressly specified in the least contract) as defined by the provisions of sections 150 and 168 of the Indian Contract Act. Essentially these provisions have the following implications for the lessor and the lessee.

1. The lessor has the duty to deliver the asset to the lessee, to legally authorise the lessee to use the asset, and to leave the asset in peaceful possession of the lessee during the currency of the agreement.
2. The lessor has the obligation to pay the lease rentals as specified in the lease agreement, to protect the lessor’s title, to take reasonable care of the asset, and to return the leased asset on the expiry of the lease period.

Contents of lease agreement

The lease agreement specifies the legal rights and obligations of the lessor and the lessee. It typically contains terms relating to the following:

1. Description of the lessor, the lessee, and the equipment.

2. Amount, time and place of lease rentals payments.

3. Time and place of equipment delivery.

4. Lessee’s responsibility for taking delivery and possession of the leased equipment.

5. Lessee’s responsibility for maintenance, repairs, registration, etc. and the lessor’s right in case of default by the lessee.

6. Lessee’s right to enjoy the benefits of the warranties provided by the equipment manufacturer/supplier.

7. Insurance to be taken by the lessee on behalf of the lessor.

8. Variation in lease rentals if there is a change in certain external factors like bank interest rates, depreciation rates, and fiscal incentives.

9. Options of lease renewal for the lessee.

10. Return of equipment on expiry of the lease period.

11. Arbitration procedure in the event of dispute.

There is no legislation which is exclusively meant for leasing transactions. However, various provisions of a number of laws/ Acts / directions are applicable to lease. In the following paragraphs, we will the main provisions of different Acts/ laws which are very common.

Indian Contract Act, 1872

The provisions relating to bailment in the Indian Contract Act cover equipment leasing agreement. Since an equipment lease transaction is regarded as a contract of bailment, the obligation of the lessor and the lessee are similar to those of the bailor and the bailee as defined by the provisions of the Indian Contract Act. The special provisions of Indian Contract Act relating to leasing are:

• The lessor is required to deliver the asset to the lessee with all legal documents enabling him to use the asset.
• The lessor must ensure the peaceful possession of the lessee during the tenure of the agreement.
• The lessor must disclose to the lessee about the faults, defects and risks (if any) of the assets leased failing which the lessor has to compensate the loss arising out of that.
• The lessor (Bailor) must ensure that the asset leased is fit and usefull for the lesee(bailee).
• The lessee has the obligation to pay the lease rentals as specified in the lease agreement, to project the lessor’s title,
• Take reasonable care of the asset, and the lesse must not use the asset for unauthorized purpose.
• The lessee has to return the leased asset on the expiry of the lease, or when the agreement is terminated.

Competition Act The lease contract also comes under the purview of Restrictive Trade Practices Act, now Competition Act. According to this Act, the following practices considered to be restrictive

• Use of leased assets in certain purposes
• Binds the lessee to use a certain types of machinery manufactured by the Lessor
• Binds the lessee to buy the accessories and spare parts from the lessor only.

Foreign Exchange Management Act - Certain provisions pertaining to holding of assets in India by NRIs, restriction of payment on imported assets, restrictions in sending assets to outside on lease or hire purchase etc are appended in the FEMA which cover lease transactions involving foreign party or currency.

Motor Vehicle Act- Under Motor Vehicle Act the lessor of a lease contract is considered as the dealer and the lessee is considered as the owner for the purpose of registration, even if the legal ownership remains with the lessor.In this the lessor is treated as financier of the assets.

Indian Stamp Act - The leasing contracts are subject to the provisions of Indian Stamp Act for the payment of stamp duty creating a right or liability in monetary terms.

Income Tax Act, 1961

Income Tax Act 1961 provides for implications and offers tax benefits both to the lessor and the lessee the provisions are:-

• Lessor can deduct the amount of depreciation of the leased assets from his taxable income.
• Where leasing constitutes the business or main activity of the assessee (lessor), income from the lease is taxable under the head Profits and Gains from business and profession. In other cases, the income from lease is taxed as income from other sources.
• While computing the income of lessor from leasing, certain expenses are allowed as deductible expenses to determine the taxable income.

These include-

• Depreciation
• Rent, taxes, repairs and insurance
• Preliminary expenses
• Interest on borrowed capital
• Bad debts
• Expenses incurred in the furtherance of trade/business
• Entertainment expenses
• Travel expenses

Sales Tax Act

Leased transactions are also covered by certain provisions of Sales Tax Act. These provisions are following.

–      While purchasing equipment by the lessor, the normal sales tax is applicable.

–      Sale tax is payable on the annual taxable turnover (aggregate lease rentals) of the lessor.

–      Lessor with an annual taxable turnover beyond the specified limits must seek registration as ‘dealer’ under the local sales tax law.

–      Surcharge, additional surcharge, additional sales tax is levied on turnover exceeding a specified limit or turnover.

Key takeaways –

1. Leasing is a process by which a firm can obtain the use of a certain fixed assets for which it must pay a series of contractual, periodic, tax deductible payments.

2.3 Hire purchase: concept and characteristics of Hire purchase. Difference between hire purchase and leasing

Hire purchase is a type of installment credit under which the hire purchaser, called the hirer, agrees to take the goods on hire at a stated rental, which is inclusive of the repayment of principal as well as interest, with an option to purchase. Under this transaction, the hire purchaser acquires the property (goods) immediately on signing the hire purchase agreement but the ownership or title of the same is transferred only when the last installment is paid. The hire purchase system is regulated by the Hire Purchase Act 1972. This Act defines a hire purchase as “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 and includes an agreement under which:

1) The owner delivers possession of goods thereof to a person on condition that such person pays the agreed amount in periodic installments.

2) The property in the goods is to pass to such person on the payment of the last of such installments, and

3) Such person has a right to terminate the agreement at any time before the property so passes”.

Features

1. Immediate possession-under HP, the buyer takes immediate possession of goods by paying only a portion of its price.

2. Hire Charges- under HP, each instalment is treated as hire charges.

3. Property in goods - ownership is–passed to the hirer only after paying last or specified number of instalments

4. Down payment- hirer has to pay 20 to 25% of asset price to the vendor as down payment.

5. Repossession- Hire vendor, if default in payment of instalment made by hirer, can reposes the goods and he can resell the goods.

6. Return of goods- hirer is free to return the goods without being required to pay further instalment falling due after the return.

7. Depreciation- depreciation and investment allowances can be claimed by the hirer even though he is not an exact owner.

Difference between Leasing and Hire Purchase:

Lease finance and hire purchase are the options of financing the assets. These options vary from each other in many aspects viz. Ownership of the asset, depreciation, rental payments, duration, tax impact, repairs and maintenance of the asset and the extent of finance.

Starting any business involves a lot of financial planning for acquisition of fixed assets like land, plant and machinery etc. Most entrepreneurs are scared of capital intensive projects due to huge financial commitments. When large capital is involved in the business, an entrepreneur wishes to spread his cost of acquisition of fixed assets over a longer period. Longer period would reduce per year commitment towards the cost of asset. The intention is to match the commitment with the revenue generated per year so that the payments are easily manageable without any cash flow mismatch.

Lease and Hire purchase is an exact solution to that kind of financial arrangement where the cash commitment is spread over the life of the asset and on the top, lease financing does not even require any initial capital outflow also. Hence under lease, the entrepreneur can use his capital for other working capital requirements.

Meaning: In simple words, Lease is a financial contract between the business customer (user) and the equipment supplier (normally owner) for using a particular asset/equipment over a period of time against the periodic payments called “Lease rentals”. Lease generally involves two parties i.e. the lessor (owner) and the lessee (user). Under this arrangement, the lessor transfers the right to use to the lessee in return of the lease rentals agreed upon. Lease agreement can be made flexible enough to meet the financial requirements of both the parties.

Hire Purchase is a kind of installment purchase where the businessman (hirer) agrees to pay the cost of the equipment in different installments over a period of time. This installment covers the principal amount and the interest cost towards the purchase of an asset for the period the asset is utilized. The hirer gets the possession of the asset as soon as the hire purchase agreement is signed. The hirer becomes the owner of the equipment after the last payment is made. The hirer has the right to terminate the agreement anytime before taking the title or the ownership of the asset.

Ownership of the Asset: In lease, ownership lies with the lessor. The lessee has the right to use the equipment and does not have an option to purchase. Whereas in hire purchase, the hirer has the option to purchase. The hirer becomes the owner of the asset/equipment immediately after the last installment is paid.

Depreciation: In lease financing, the depreciation is claimed as an expense in the books of lessor. On the other hand, the depreciation claim is allowed to the hirer in case of hire purchase transaction.

Rental Payments: The lease rentals cover the cost of using an asset. Normally, it is derived with the cost of an asset over the asset life. In case of hire purchase, installment is inclusive of the principal amount and the interest for the time period the asset is utilized.

Duration: Generally lease agreements are done for longer duration and for bigger assets like land, property etc. Hire Purchase agreements are done mostly for shorter duration and cheaper assets like hiring a car, machinery etc.

Tax Impact: In lease agreement, the total lease rentals are shown as expenditure by the lessee. In hire purchase, the hirer claims the depreciation of asset as an expense.

Repairs and Maintenance: Repairs and maintenance of the asset in financial lease is the responsibility of the lessee but in operating lease, it is the responsibility of the lessor. In hire purchase, the responsibility lies with the hirer.

Extent of Finance: Lease financing can be called the complete financing option in which no down payments are required but in case of hire purchase, the normally 20 to 25 % margin money is required to be paid upfront by the hirer. Therefore, we call it a partial finance like loans etc.

Key takeaways –

1. The hiree (counterpart of lessor) purchases the asset and after agreement gives it on hire to the hirer (counterpart of lessee).
2. At the time of hire purchase agreement, the hirer pays an agreed amount to the hiree and the balance in the form of hire purchase installments over the specified period of time.
3. The hire purchase installments cover interest as well as principal payments. When the hirer pays the last installment, the title of the asset is transferred from the hiree to the hirer.

Sources

1. M.Y.Khan, Financial Services, Tata McGraw-Hill, 11th Edition, 2008

2. Gopal C.R – Management Financial Service – S.Chand

3. NaliniPravaTripathy, Financial Services, PHI Learning, 2008

4. Machiraju, Indian Financial System, Vikas Publishing House, 2nd Edition, 2002.

5. J.C.Verma, A Manual of Merchant Banking, Bharath Publishing House, New Delhi.