LEASING BUSINESS IN PAKISTAN 0

Hi Friends,

Now i am here with AN OVERVIEW OF LEASING BUSINESS IN PAKISTAN

A HUSAIN A BASRAI, FCA

ARTICLE (June 22): In Pakistan, leasing business started to develop as an organised sector in the middle of eighties as the first leasing company was established in the year 1985.

Thereafter, the sector showed continued progress and development for a decade as in the first six years i.e. up to 1991, 6 leasing companies were established and from 1991 to 1997 the sector showed tremendous growth as during the period as many as 27 new leasing companies were established.

The leasing sector has now become an important sector of the country playing an important role towards capital formation and assisting the other sectors in balancing, modernising and replacement.

According to the Leasing Companies (Establishment and Regulation) Rules, 1996:

“Leasing Company” means a company engaged wholly in the business or which invests in such business of leasing at any one time an amount equivalent to at least seventy percent of the aggregate of its paid-up share capital and free reserves.

According to the Draft Leasing Companies (Establishment and Regulation) Rules, 2000:

“Leasing company” means a company engaged wholly in the business of leasing or which invests in such business at any one time an amount equivalent to at least seventy percent of its assets:

Provided that cash and bank balances and investment in government securities shall be excluded to calculate investment in leasing business for purposes of this definition.

At present there are 33 leasing companies quoted on the Karachi Stock Exchange with a listed capital of Rs 4.66 billion. Out of these 33, only 5 have attained a balance sheet size of over Rs 2 billion. The market capitalisation has hovered around Rs 3.45 billion to Rs 3.9 billion during the month of January 2000, being around 0.8% of the total market capitalisation of the listed companies on the Karachi Stock Exchange.

As the overall economic scenario of the country is grim and depressed since the last couple of years and passing through a phase having multiple uncertainties and threats of further economic sanctions, hence, it also adversely effected the performance and growth of the leasing sector considering the fact that the growth and sustainability of leasing business is directly variable with the performance of other sectors. Presently leasing companies are facing with issues that are not pertaining to the aspects directly governing leasing companies. The intrusion by commercial banks in the leasing sector, lack of volume and uncollectibility of receivables are the factors hampering the performance of leasing companies. Banks and the DFIs find leasing business very attractive and with an edge in resource potential and cost, these institutions poise a real threat to the leasing companies.
The other factors which also played significant role in deterioration of the leasing business and hampered its growth in Pakistan inter alia include:
— Economic sanctions imposed, following the nuclear test:
— Drying up of capital inflows in the country;
— Freezing of foreign currency accounts;
— Deterioration in business growth due to poor economic conditions resulting in desperate and reckless efforts to promote business, thereby overlooking the strict credit risk appraisal; and
— Mandatory requirement to raise paid-up capital to Rs 200 million.
RELEVANT STATUTES AND REGULATORY FRAMEWORK:
Leasing enjoys the privilege of being regarded as an Islamic mode of financing and conforms to Islamic principles.
Accordingly, Modarabas, in particular Leasing Modarabas carry on the business of leasing. Their documentation is reviewed and approved by “The Religious Board” which confirms the compliance of the transactions and the documentation with Islamic principles.
Modarabas generally treat leases as operating lease and their documentation is prepared accordingly. However, most leasing transactions done by leasing companies are in the form of finance lease and the documentation and accounting treatment is accordingly in compliance with IAS-17.
Leasing is carried out either through companies established under the Companies Ordinance, 1984 or by the Modarabas established under The Modaraba Companies and Modaraba (Floatation and Control) Ordinance 1980. Leasing Companies and Modarabas have separate regulatory frameworks, however, they consist of a large number of common ground rules, particularly in respect of the conduct of leasing business. The rules and regulations applicable to leasing companies and their business are enumerated in the following:
— The Companies Ordinance, 1984
— The Income Tax Ordinance, 2001
— The Leasing Companies (Establishment and Regulation) Rules, 1996.
— The Modaraba Companies and Modaraba (Floatation and Control)
Ordinance, 1980.
— The Prudential Regulations applicable to Non-Banking Financial Institutions (NBFIs).
Since the promulgation of the SECP Act, 1997, all the powers vested with the abolished Corporate Law Authority have now been conferred to the SECP which in accordance with the provisions of the Act is responsible for overall maintaining compliance and regulatory affairs of the leasing sector and maintains constant review to provide guidelines from time to time necessitated by the dynamic market conditions.
EXISTING LEASING COMPANIES (ESTABLISHMENT AND REGULATIONS) RULES, 1996
The Controller of Capital Issues had initially issued comprehensive guidelines for establishment of leasing companies through SRO. 520 on 27 May 1992 under the Capital Issues (Continuance of Control) Act, 1947 (now repealed). The leasing companies in addition to complying with other conditions, were required to have a minimum paid-up capital of Rs 100,000,000 (Rupees One Hundred Million) and listed on the Stock Exchange for commencing leasing operations. These rules were later amended vide SRO. No. 776(1)/92 dated 18th August 1992, whereby a proviso was added directing the companies, formed prior to the issue of the SRO 520, to raise their paid-up capital to Rs 100,000,000 within five years from the date of the notification.
After the repeal of Capital Issues (Continuance of Control) Act, 1947, through Finance Act, 1995, the Corporate Law Authority through SRO 345 dated June 4th 1995 issued new rules for leasing companies titled “Leasing Companies (Establishment and Regulation) Rules, 1996,” under the Companies Ordinance, 1984. These Rules provide the basic framework for the establishment and the terms and conditions of operations of leasing companies.
The Leasing Companies (Establishment and Regulations) Rules, 1996 were promulgated on 4th June, 1996 with the objective to regulate and govern leasing companies, their establishments and operations.
The aspects covered by the said Rules are broadly summed up as follows:
(1) Eligibility conditions/criteria for the establishment of a leasing company, for its sponsors, proposed directors and chief executive.
(2) Guiding notes as to the application for seeking permission to form a leasing company, laying a non-refundable processing fee of Rs 100,000.
(3) Conditions for grant of licence to commence leasing business with the significant provisions being highlighted as:
— the company to be incorporated as a public limited company
— minimum paid-up capital requirement of Rs 100 million which was subsequently revised and raised to Rs 200 million by SRO 1133(1)/97 dated 4th November 1997 by the Corporate Law Authority (now the SECP).
— at least 15% of the paid-up capital to be subscribed by the promoters with the condition not to dispose of the same for a minimum period of 3 years without the prior approval of the CLA,
— chief executive restricted from holding similar office in any Bank or NBFI or insurance company,
— senior management level experience in finance for at least 5 years for the Chief Executive and at least for one director,
— restriction on the appointment of more than 25% of directors from the same family,
— minimum qualification and experience criteria for chief accounting officer.
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6) Bar on purchase or sale transaction with the beneficial owners, except with the prior approval of the authority.
7) The eligibility criteria and guidelines for the issuance of Certificate of Investment by leasing companies
The eligibility criteria includes the following:
— the company being engaged in leasing business for a minimum period of two years, with a minimum earning of profit after tax of 15% of the paid-up capital,
— the corporate and fiduciary conduct being satisfactory.
— conditions for the issue of certificate of investment by leasing companies being namely;
— registration in the name of the person to whom issued
— maturity period being that of 3 months or 6 months or 1 to 5 years as mentioned therein and redemption thereof
— obtaining credit rating from a Registered Credit Rating Agency.
— return on Certificate of Investment to be paid out of and to the extent of the profits only.
— publicity of issue of Certificate of Investment to public with prior approval of the authority.
— minimum of 15% of resources raised through certificates of investment to be invested in National Saving Scheme, NIT units, government securities or listed securities.
8) Submission of reports etc. to members, any regulatory authority, stock exchange etc. and the power of the authority to monitor financial health of the leasing companies and if required to order special audit, appoint auditors and inspectors and issue directions in this respect.
I would like to highlight here that the Corporate Law Authority (now SECP) vide its Circular No. 8/2/CF/LES/97 dated 6th February, 1997 directed all the leasing companies, pursuant to rule 10 of the Leasing Companies (Establishment and Regulation) Rules, 1996, to file the returns/information prescribed by the State Bank of Pakistan under the NBFI Regulations, with the Corporate Law Authority as well, within the stipulated time as prescribed by the State Bank of Pakistan.
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9) Rate of mark up and fees to be charged on loans made by the company.
10) Insurance coverage for losses increased on account of employees fraud or gross negligence and on properties financial by the company.
11) Bar on certain transactions, that of:
— Merger, acquisition or take over of any other leasing company, without the authority sanctioning the scheme thereof or
– employment of directors, officers or employees or beneficial owners as a broker.
12) Penalties for non-compliance or contravention of the provisions of the rules with power to authority to cancel licence and refer case to court for winding up order.
I may add that in addition to the leasing rules as elaborated above, the existing leasing companies are also governed by the NBFI Prudential Regulations issued by the SBP and the same have now been included in the proposed Leasing Rules to facilitate the conduct and monitoring of leasing operations under one single regulatory framework. As such instead of covering the applicability of the relevant NBFI Prudential Regulations here separately, I will cover these in my comments on the relevant provision of the new proposed rules for leasing companies.
II. SIGNIFICANT CHANGES IN THE PROPOSED RULES
I shall now proceed with the new proposed rules namely, “The Draft Leasing Companies (Establishment and Regulation) Rules, 2000”, which are already in the pipeline, and in last stage of finalisation. However, in my review of the proposed Rules, I will not reiterate the aspects already covered by the existing rules. Instead, I shall proceed to elaborate under each head the significant additions and amendments having major influence/impact on the leasing business.
The Securities and Exchange Commission of Pakistan is in the process of restructuring the leasing sector, in consultation with the Leasing Association of Pakistan, and is eager to finalise the new set of draft Leasing Companies (Establishment and Regulations) Rules, 2000 issued vide SRO. 71 (1) 2000 dated 17th February 2000 after seeking public opinion and suggestions. The rules being in its final stage of approval from the SECP Policy Board, would be notified in due course. The provisions of the said draft rules would after the finalisation, govern the establishment and operations of leasing companies. The significance of the new rules lies in that:
* the Prudential Regulations applicable on the leasing companies (already in issue by the State Bank of Pakistan) have now been included in the proposed Leasing Rules in order to provide a single regulatory platform;
* acquiring and maintenance of membership of the Leasing Association of Pakistan and following of its code of conduct has been made mandatory to unite the companies in this sector on a single platform to enhance the strength of the leasing sector;
* strong emphasis is laid on credit rating as an integral analytical base;
* allowing of one year lease in case of Computers and Information Technology Equipment, to promote technological development; and
* raising of facility limit for small entrepreneurs.
The significant additions and amendments made in the proposed new rules for leasing companies to facilitate leasing business, others remaining effective and applicable as earlier, are now being elaborated in detail under each head.
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These include:
1) Definitions:
Amendments under this head include the additions of some new definitions and revision of the existing ones, as highlighted below:
“Documents”
to include vouchers, bills, promissory notes, securities for leases, advances and claims by or against the company and other documents supporting entries in the books of the leasing company.
“Equity,”
being defined to include paid up share capital, free reserves, the unappropriated profits and subordinated loans excluding, deferred tax reserves.
“Government Securities”
to include such types of Pakistani rupee obligations of the Federal Government or of a Corporation wholly owned or controlled, by the Federal Government or Provincial Government and guaranteed by the Federal Government as the Federal Government may by notification in the Official Gazette, declare to the extent determined from time to time, to be Government securities.
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“Leasing company,”
being redefined to mean a company engaged wholly in the business of leasing or which invests in such business at any one time an amount equivalent to at least 70% of its assets.
Further, a provision has been added to exclude cash and bank balance and investment in government securities (as defined in the rules) for calculating the investment in leasing business for this definition.
“Lease key money,”
to mean lease security deposit.
“Major shareholder”
to mean any person holding 5% (instead of 10% in the earlier rules) or more of the paid up share capital, thus broadening the scope of the definition of the shareholders holding beneficial interest.
“NBFI”
means a Non-Bank Financial Institution and includes a DFI, Modaraba, Leasing Company, Housing Finance Company, Investment Bank, Discount House and Venture Capital Company.
“Small Entrepreneurs”
to mean individuals, firms and private limited companies having fixed assets excluding land building of the value of not more than Rs 20 million.
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2) The eligibility conditions for the establishment of leasing company:
These include:
a) the sponsors, proposed directors and chief executive with investment in other companies of as much as 5% (instead of 10% in existing rules) having
(i) Over due loans or instalments outstanding towards Banks and NBFI’s
(ii) defaulted in the payment of taxes are declared ineligible for the purpose; and
(b) the net worth of the sponsors, proposed directors and Chief Executive (except nominee director) is required/raised to be as much as twice of the amount to be subscribed by him personally, instead of existing requirement of having net worth equivalent to his subscription, to serve as an enhanced security element.
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3) Terms and conditions of operations:
Terms and conditions of operations of the leasing companies have been further revised as follows:
— the experience for a chief accounting officer is required to be 7 years instead of 5 years in the existing rules.
— disclosure requirement has been relaxed for facilities exceeding 30% of its paid up capital and free reserves (instead of 20% in existing rules).
— the requirement of creation of Reserve Fund has been added, to which shall be credited:
— minimum of 20% of the after tax profit until reserve fund equals the amount of paid up capital of the company and,
— thereafter minimum of 5% of its after tax profits
Further, in case of issuance of bonus shares, additional amount should be transferred to the reserve fund so that the reserve fund should, in any case, not fall below the enhanced capital of the company
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Further, the leasing companies are required to:
— ensure that total facilities availed by the lessee should not exceed 10 times of the equity of the borrower/lessee;
— ensure while granting any facilities:
— that the prescribed current ratio of the borrower/lessee has been maintained
— that the prescribed debt equity ratio has been maintained
— that the weightage has been given to credit report of the borrower obtained from Credit Information Bureau of the State Bank of Pakistan
— provide at least 5% facilities of its fund base to small entrepreneurs.
— acquire and maintain membership of the Leasing Association of Pakistan.
— follow guidelines issued to protect leasing companies from money laundering.
Further, the conditions on the operations of leasing companies have also been revised so that;
— making exposure to single group has been enhanced from 20% to 30%.
— shorter period of lease in case of computers and other Information Technology instruments has been allowed.
— removal of records of documents of leasing company from Pakistan to outside Pakistan, without prior permission of the SECP, has been prohibited.
— Allowing facilities for speculative purposes has been prohibited.
— investment in unquoted shares, without prior approval of the SECP has been prohibited.
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4) Limits on Exposure:
During the first two years of its operations, the liabilities, excluding contingent liabilities, and the contingent liabilities of a leasing company should not exceed 7 times of its equity and in the subsequent years should not exceed 10 times of its equity.
5) Margins against facilities:
— Minimum margins should be maintained as prescribed.
— For classification of assets and provisioning thereof, every leasing company should comply with the prudential guidelines as prescribed.
6) Overdues and defaults – recovery thereof:
To monitor and regularise effective recovery of loans and facilities and fulfilment of fiduciary obligations by defaulters who have defaulted payment for over 90 days from due date, towards any leasing company in Pakistan, provisions have been inserted in the proposed rules, whereby the leasing companies are directed to furnish the following details to the Commission on specified formats.
— list of defaulters, on quarterly basis
— list of rescheduled and restructured facilities
— quarterly recovery targets set up by the company, on quarterly basis.
— report in respect of achievements on recovery targets, on quarterly basis, with explanation as to deficiencies therein if any and the strategies evolved for pursuing achievements of future targets.
— the list of default cases considered for reference to the Court and Revenue Authorities and any progress of recovery therein, on quarterly basis.
Further, leasing companies are also directed to nominate a recovery officer or Constitute a recovery section for the purpose, depending on the magnitude of defaults.
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7) Insurance Coverage:
By amendment under this head, the leasing companies will also be required to provide full insurance cover for its deposits/COI’s etc. of more than 100,000.
8) Internal audit:
One of the significant provision of the proposed rules is the requirement of Establishing an Internal Audit Department laying reports as well as compliance responsibilities on the head of this department. The head of the department would report directly to the Chief Executive and is also responsible for establishing effective means of testing, checking and compliance with the leasing regulations and policies and procedures of the company.
9) Places of Business:
Another significant provision of the new rule is opening of branches by the leasing companies, both the establishment and disclosure of which is directed to be intimated to the SECP within 15 days thereof, respectively.
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10) Issue of Certificate of Investment:
The amendment made under this head include:
— the requirement of getting the credit rating updated every year during the currency of the issue;
— publication of credit rating within 10 days of obtaining thereof; and
— the enhancement of the period of 7 days to 15 days for the Commission to convey its decision on the application for publication of the advertisement inviting investment in the certificates.
11) Submission of Reports etc:
A sub-clause has been added under this head under the new proposed rules, whereby the Commission has been authorised to require from every leasing company to submit any return as the Commission deems fit from time to time.
12) Penalty:
Penalty for non-compliance or wilful default of the provisions of the existing rules as defined therein would under the new rules be regulated by the provisions of sub-section (2) of Section 506 of the Companies Ordinance, 1984.
Hi Friends,
I shall now proceed with the Accounting, Tax and other related issues pertaining to the leasing companies,
III. Accounting Issues
As the issue of distinction of leases between finance and operating has been debated since long, I have elaborated the basis difference between finance and operating leases to facilitate better understanding.
— Focus is on transfer of substantially all risks and rewards of ownership in lease arrangements.
— Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract. Indicators of situations which individually or in a combination could lead to a lease being classified as a finance lease are:
— the lease transfers ownership of the asset to the lessee by the end of the lease term;
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— the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than the fair value at the date the option becomes exercisable such that, at the inception of the lease, it is reasonably certain that the option will be exercised:
— the lease term is for the major part of the economic life of the asset even if title is not transferred;
— at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset.
— the leased assets are of a specialised nature such that only the lessee can use them without major modifications being made.
Other factors which may lead to classification as finance lease:
— if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee.
— gains or losses from fluctuation in the fair value of the residual fall to the lessee.
— the lessee has the authority to continue the lease for a secondary period at a rent which is substantially lower than market rent.
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The revised IAS-17 “Accounting for Leases” replaces the existing IAS-17 and is effective for accounting periods beginning on or after 1st January 1999.
The basic differences between the two, include:
Existing
— Lease an arrangement whereby lessor conveys the right to use an asset in return for “rent”.
— Indicators provided for facilitate classification as a finance lease.
— Term “useful life” used for comparison to the lease term classification period.
— Silent whether contingent rents should be included or excluded in computation of minimum lease payments.
— Silent about accounting treatments of initial direct costs incurred by lessee.
— Provided a free choice to lessors for recognition of income either on net investment outstanding or net cash investment outstanding.
— Did not address the impairment of assets issue.
Next one is described in next post please see it….
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The next one difference is……..
Revised
— The word “rent” substituted with “a payment or series of payments”
— Additional indicators provided to facilitate classification
— Term replaced by “economic life” to take account that an asset might be used by one or more users.
— Contingent rents to be excluded.
— Costs that are directly attributable to activities relating to securing finance lease to be included in the amount of leased asset.
— To be recognised reflecting a constant periodic rate of return on net investment outstanding basis only.
— Require compliance with IAS on impairment of asset.
In addition to above, the revised IAS requires additional disclosures and also gives additional guidelines on sale and lease back transactions.
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G-4+1 position paper – Leases: Implementation of a new approach:
G-4+1 is a working group consisting of board members and senior staff members of the standard-setting bodies of Australia, Canada, New Zealand, the UK, the USA and staff of the International Accounting Standards Committee (IASC).
The objectives of the organisation inter alia include that of:
— providing quality financial reporting standards.
— seeking common solutions to financial reporting issues.
— viewing that financial reporting standards should be based on a conceptual framework.
The position paper developed by G-4+1 on the leasing accountancy and reporting issues, inter alia, include the following:
— It proposes that the present treatment of operating leases and finance leases should be replaced by an approach that applies the same requirements to all leases.
— The position paper explores in more detail the principles that should determine the extent of the assets and liabilities that lessees and lessors would recognise under leases, and how those principles might be applied in new accounting standards to account for many of the complex features (such as options, contingent rentals and residual value guarantees) that are found in lease contracts.
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Lessees
— Lease value to include
— minimum payments required under the lease
— amounts payable in respect of obtaining renewal options
— contingent rentals that represent consideration for the fair value of rights conveyed to the lessee
— fair value of residual guarantees.
— Lessees – Lease value to exclude
— rentals relating to optional renewal periods and contingent rentals relating to optional additional usage
— residual values guaranteed, where transfer of economic benefits in settlement is not probable.
Lessors
— Lessors would report financial assets (representing amounts receivable from the lessee) and residual interests as separate assets, since they are subject to quite different risks.
— The amounts reported as financial assets by lessors would, in general, be the converse of the amounts reported as liabilities by lessees. They would be accounted for in a broadly similar way to finance lease assets at present, although the position paper does not reach a consensus on whether to use the net cash investment method or the net investment method (as required under IAS 17).
— Residual interest assets would be recorded at present value and the discount would be accreted over the lease term.