Successfully reported this slideshow.
We use your LinkedIn profile and activity data to personalize ads and to show you more relevant ads. You can change your ad preferences anytime.

5

Share

Download to read offline

LEASE & ITS TYPES

Download to read offline

Lease

Related Books

Free with a 30 day trial from Scribd

See all

LEASE & ITS TYPES

  1. 1. University Of Central Punjab F13 Financial Management P age 1 Lease Executive Summary Leasing is a contract between the owner(lesser) and the lessee for the hiring of a specific assets. Leasing can apply to any fixed assets and quite commonly used for plant and machinery, office equipment and motors vehicles. Instead of acquiring these assets for itself, the company enters into an agreement with a leasing company whereby the latter purchase the assets in question and then lease them ( rent or hire them) on a long-term basis to the former. No initial funds are required but there is instead a regular charge for lease payments to be charged in the profit and loss account. The lessee obtains possession and use of the asset in exchange for the rentals, while the lessor retains legal ownership. Leases are of two types: a) operating Leases, and b) finance leases Operating lease is one where an asset leased or hired for a period of time substantially less than that of its useful life. A finance lease is one which last for the whole of an asset's useful life and where the lessee effectively takes all the risks and benefits associated with ownership. Leasing an asset from the lessor or purchase of asset by borrowing the full purchase price of asset should be compared as financing alternatives that are dependent on the investment decision. As such, such investment have been evaluated as part of a company's capital budgeting process and mostly use the NPV method by analysis using the after tax cost of debt as the discount rate for decision making. It means a firm should evaluate whether to purchase an asset or acquire by leasing. Lease rental payments are similar to the payments of interest on debt so leasing may be an good alternative to borrowing for the firm. Thus, lease financing is made using NPV method using the after-tax cost of debt as the discount rate.
  2. 2. University Of Central Punjab F13 Financial Management P age 2 Lease Definition: “A legal document outlining the terms under which one party agrees to rent property from another party. A lease guarantees the lessee (the renter) use of an asset and guarantees the lessor (the property owner) regular payments from the lessee for a specified number of months or years. Both the lessee and the lessor must uphold the terms of the contract for the lease to remain valid.” “Leases are the contracts that lay out the details of rental agreements in the real estate market. For example, if you want to rent an apartment, the lease will describe how much the monthly rent is, when it is due, what will happen if you don't pay, how much of a security deposit is required, the duration of the lease, whether you are allowed to have pets, how many occupants may live in the unit and any other essential information. The landlord will require you to sign the lease before you can occupy the property as a tenant”. Leasing Company (Lessor) Buys / Owns the Asset and the Lessee (Borrower) Controls, Operates, and Uses it. Lessor receives a regular and fixed Lease Rental. Lifespan of lease is limited (few months to several years). It is just like a Collateralized Loan (where the leased asset is the collateral). Lease Contract is just as serious as a loan agreement. Failure to pay lease rental is just like failure to pay interest. Can bankrupt the Lessee (Borrower). Lessor (Lender or Leasing Company) can seize the leased asset and, if the claim is larger demand up to 1 year lease rental. The two parties of lease agreement are:  Lessor (Leasing Company)  Lessee ( Renter Company) Ownership vs. Control:  Ownership of the asset is with leasing company  ·Control is with lessee In most of the countries 10-30% of fixed assets owned by Companies are leased i.e. Warehouses, offices, equipment, machinery, computers, cars, furniture, airplanes Common Lease Types EFSI draws from multiple funding sources, giving the company the flexibility to structure leasing transactions based on many transaction variables, including credit rating, size of transaction, asset type, industry, and location. EFSI offers many types of leases to choose from. We will help you select the type of lease that matches your equipment needs, business goals and cash flow requirements. The most common types of leases are operating leases and finance leases. OperatingLease(or Service Lease) An operating lease is particularly attractive to companies that continually update or replace equipment and want to use equipment without ownership, but also want to return equipment at lease-end and avoid technological obsolescence. An operating lease usually results in the
  3. 3. University Of Central Punjab F13 Financial Management P age 3 lowest payment of any financing alternative and is an excellent strategy for bypassing capital budgeting restraints. It typically qualifies for off-balance sheet treatment and can result in improved Return on Asset (ROA) due to a lower asset base. It can also result in higher reported earnings in the early years of the lease. Operating Lease offers Financing AND MAINTENANCE: often the Lessor is the Supplier / Vendor of the Asset i.e. IBM Operating Lease is NOT FULLY AMORTIZED AND IS CANCELLABLE Example of Operating Lease: Car rental company (Lessor) charges you Rs.1000 per day for renting out a new Honda Civic with driver. You can lease the car for 2 days. You will pay the Lessor Rs.2000. BUT the value of the car might be Rs.1 million. Lessor does NOT expect you to pay that entire amount for using the car for just2 days. The car rental company will service and maintain the car in good condition so it can rent it out to other people. This way, they can recover the value of the car from 1000 days of lease rent (= value / daily rental = 1,000,000/ 1000)! This is the Payback Period (without taking their maintenance costs and profit margin). You can Cancel the lease and return the car after 1 day. Now you just have to pay Rs.1000. Other Examples of Operating Lease: IBM for Computer Hardware, Boeing for Airplanes. By not fully amortizing operating lease means, the leasing company does not expect to recover the whole amount or value of asset from you. Financial Lease Popular form of Leasing in Pakistan Financial Lease is fully amortized: Lessor recovers both the full Value of Asset (Principal amount) and the Profit (in form of interest or mark-up). Both are built into the Lease Rental amount collected by the Lessor over the lifespan of the Lease. Recall amortization table for Bank Loan where Principal and Interest are recovered in equal regular installments. Fully Amortized Lease means the lessor recovers the principal amount plus interest amount. Financial Lease is nor cancelable: If Lessee must cancel or Terminate the Lease Prematurely then pays heavy penalty to Lessor. Example of Financial Lease: You need to buy a Pentium IV computer hardware system complete with peripherals but you don't have enough money. You go to computer hardware store and negotiate the price for the system at Rs.50000. You then contact a leasing company to buy the computer system and lease it to you in return for a monthly rental of say, Rs.5000 per month. After one year, if you have paid all the lease rentals on time, the Leasing Company will transfer the Ownership to you. Advantage of Financial Lease for Lessee:  If factory needs to buy new machine urgently and does not have enough finances. Leased Assets (and lease liabilities) can sometimes be treated “off the balance sheet items”. Accounting Standards (i.e. FASB USA) in some countries restrict this so generally speaking, Lease does affect debit ratio & Capital Structure in similar way as Loan on Balance Sheet.
  4. 4. University Of Central Punjab F13 Financial Management P age 4  If Company can not justify an increase in Assets on the Balance Sheet based on historical earnings. Capital expenditure in Leased Asset can be "Expensed" out gradually.  Lease Rental is a “tax deductable expenses” just like interest payments.  As long as IRR from leased equipment is higher than cost of lease financing. Capital Lease Type of lease classified and accounted for by a lessee as a purchase and by the lessor as a sale or financing, if it meets any one of the following criteria:  The lessor transfers ownership to the lessee at the end of the lease term  The lease contains an option to purchase the asset at a bargain price  The lease term is equal to 75 percent or more of the estimated economic life of the property (exceptions for used property leased toward the end of its useful life  The present value of minimum lease rental payments is equal to 90 percent or more of the fair market value of the leased asset less related investment tax credits retained by the lessor. Direct Financing Lease (Direct Lease) A non-leveraged lease by a lessor (not a manufacturer or dealer) in which the lease meets any of the definitional criteria of a capital lease, plus certain additional criteria. 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. If the purchase option is not exercised, then the lease is automatically renewed for a fixed term (typically 12 or 24 months) at a fixed rental intended to approximate fair rental value, which will further reduce the lessor's end-of-term residual position. The lessee is not permitted to return the equipment on the option exercise date. If the lease is automatically renewed, then at the expiration of that initial renewal term, the lessee typically has the right either to return the equipment without penalty or to renew or purchase at fair market value. 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. Guideline Lease A lease written under criteria established by the IRS to determine the availability of tax benefits to the lessor.
  5. 5. University Of Central Punjab F13 Financial Management P age 5 Leveraged Lease In this type of lease, the lessor provides an equity portion (usually 20 to 40 percent) of the equipment cost and lenders provide the balance on a nonrecourse debt basis. The lessor receives the tax benefits of ownership. Net Lease A lease wherein payments to the lessor do not include insurance and maintenance, which are paid separately by the lessee. 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. 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. Synthetic Lease A synthetic lease is a financing structured to be treated as a lease for accounting purposes, but as a loan for tax purposes. 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 use the structure. 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. Trace Lease A tax-oriented lease of motor vehicles or trailers that contains a terminal rental adjustment clause and otherwise complies with the requirements of the tax laws. 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. Sale & Lease-Back Sale & Lease-Back is the Most Interesting Leasing Scheme ¬ creative extension of Financial Lease where the Seller of the asset is the User-lessee. User sells his asset to Leasing Company in return for lump sum cash and then repays the Leasing Company in form of Lease Rentals over a period to buy-back the asset. It is considered a creative way of mobilizing your asset to raise debt. Example of Sale & Lease-Back: You need Rs.300000 to start a business and all you own is a car. What can you do? Go to Leasing Company. Ask them to buy your car for Rs.300000 and then lease it back to you for 1 year! This way, the Leasing Company will take ownership of the car and give you Rs.300000 cash to start your business. Company has bought the car and you can start business from the
  6. 6. University Of Central Punjab F13 Financial Management P age 6 cash you received. Suppose you expect to earn Rs.50000 per month from your business. Then you can easily pay Rs.30000 per month as lease rental and get your car back in 1 year. Remember company bought car from you for Rs.300000 but you will pay suppose Rs.360000 back to company at the end of period to have your car back. Rs.60000 is the profit, interest, or mark-up Company is charging above the principal amount of Rs.300000. ACCOUNTING TREATMENT FOR LEASE Typical Finance Lease Accounting Journal Entries To record a fixed asset funded by lease finance and a cash deposit Account Debit Credit Fixed assets XXX Lease liability XXX Cash XXX Journal entry to record depreciation Account Debit Credit Depreciation expense XXX Accumulated depreciation XXX To record a rental payment split between principal and interest Account Debit Credit Lease Liability XXX Interest XXX Cash XXX A note on Operating Leases The other form of lease is an operating lease; in this case, the rental payments are simply recorded on a straight-line basis as operating expenses. Operating lease rental payment Account Debit Credit Rental expense XXX Cash XXX
  7. 7. University Of Central Punjab F13 Financial Management P age 7 Finance Lease Accounting Initial Accounting The initial accounting is that the lessee should capitalize the finance-leased asset and set up a lease liability for the value of the asset recognized. The accounting for this will be: Dr Non-current assets Cr Finance lease liability (This should be done by using the lower of the fair value of the asset or the present value of the minimum lease payments*.) *Note: The present value of the minimum lease payments is essentially the lease payments over the life of the lease discounted to present value – you will either be given this figure in the Paper F7 exam or, if not, use the fair value of the asset. You will not be expected to calculate the minimum lease payments. SubsequentAccounting Depreciation Following the initial capitalization of the leased asset, depreciation should be charged on the asset over the shorter of the lease term or the useful economic life of the asset. The accounting for this will be: Dr Depreciation expense Cr Accumulated depreciation Lease rental/interest When you look at a lease agreement it should be relatively easy to see that there is a finance cost tied up within the transaction. For example, a company could buy an asset with a useful economic life of four years for $10,000 or lease it for four years paying a rental of $3,000 per annum. If the leasing option is chosen, over a four-year period the company will have paid $12,000 in total for use of the asset ($3,000 pa x 4 years) – i.e. the finance charge in this example totals $2,000 (the difference between the total lease cost ($12,000) and the purchase price of the asset ($10,000)). When a company pays a rental, in effect it is making a capital repayment (i.e. against the lease obligation) and an interest payment. The impact of this will need to be shown within the financial statements in the form of a finance cost in the statement of profit or loss and a reduction of the outstanding liability in the statement of financial position. In reality there are several ways that this can be done, but the Paper F7 examiner has stated that he will examine the actuarial method only. The actuarial method of accounting for a finance lease allocates the interest to the period it actually relates to, i.e. the finance cost is higher when the capital outstanding is greatest, but as the capital gets repaid, interest payments become lower (similar to a repayment mortgage that you may have on your property). To allocate the interest to a specific period you will require the interest rate implicit within the lease agreement – again, this will be provided in the exam and you are not required to calculate it. One of the easiest ways to apply the actuarial method in the exam is to use a leasing table. Please take note of when the rental payment is actually due, is it in advance (i.e. rental made
  8. 8. University Of Central Punjab F13 Financial Management P age 8 at beginning of the lease year) or is it in arrears (i.e. rental made at the end of the lease year)? This will affect the completion of the lease table as highlighted below: Rental payments in advance Year B/fwd Rental Capital o/s Interest (rate given) C/fwd X X (X) X X X To statement of profit or loss (finance costs) To statement of financial position (liability) Rental payments in arrears Year B/fwd Interest (rate given) Rental C/fwd X X X (X) X To income statement (finance costs) To statement of financial position (liability) Tip: to be technically accurate the lease liability should be split between a non-current liability and a current liability.
 Example 1 – Rentals in arrears treatment On 1 April 2009, Bush Co entered into an agreement to lease a machine that had an estimated life of four years. The lease period is also four years, at which point the asset will be returned to the leasing company. Annual rentals of $5,000 are payable in arrears from 31 March 2010. The machine is expected to have a nil residual value at the end of its life. The machine had a fair value of $14,275 at the inception of the lease. The lessor includes a finance cost of 15% per annum when calculating annual rentals. How should the lease be accounted for in the financial statements of Bush for the year-end 31 March 2010? 

 Solution
 The lease should be classified as a finance lease as the estimated life of the asset is four years and Bush retains the right to use this asset for four years in accordance with the lease agreement therefore enjoying the rewards of the asset.

 Initial accounting: recognize the asset and the lease liability. Dr Property, plant and equipment 14,275 Cr Finance lease obligations 14,275
  9. 9. University Of Central Punjab F13 Financial Management P age 9 Subsequent accounting: depreciation
 Dr Depreciation expense ($14,275/4 years) 3,568 Cr Accumulated depreciation 3,568 Subsequentaccounting:lease rental/interest Tip: use the lease table and complete next year as well to help you complete the split between non-current and current liabilities. Year B/fwd Interest (15%) Rental C/fwd 1 14,275 2,141 (5,000) 11,416 2 11,416 1,712 (5,000) 8,128* * NCL Statement of profit or loss extract Depreciation 3,568 Finance costs 2,141 Statement of financial position extract Non-current assets Carrying value machine (14,275 – 3,568) 10,707 Non-current liabilities Lease obligation 8,128 Current liabilities Lease obligation Capital (11,416 – 8,128) 3,288 Example 2 – Rentals in advance treatment On 1 April 2009, Shrub Co entered into an agreement to lease a machine that had an estimated life of four years. The lease period is also four years at which point the asset will be returned to the leasing company. Shrub is required to pay for all maintenance and insurance costs relating to the asset. Annual rentals of $8,000 are payable in advance from 1 April 2009. The machine is expected to have a nil residual value at the end of its life. The machine had a fair value of $28,000 at the inception of the lease. The lessor includes a finance cost of 10% per annum when calculating annual rentals. How should the lease be accounted for in the financial statements of Shrub for the year-end 31 March 2010? Solution The lease should be classified as a finance lease as the estimated life of the asset is four years and Shrub retains the right to use this asset for four years in accordance with the lease
  10. 10. University Of Central Punjab F13 Financial Management P age 10 agreement therefore enjoying the rewards of the asset. In addition to this Shrub is required to maintain and insure the asset, therefore retaining the risks of asset ownership. Initial accounting: recognize the asset and the lease liability Dr Property, plant and equipment 28,000 Cr Finance lease obligations 28,000 Subsequent accounting: depreciation Dr Depreciation expense ($28,000/4 years) 7,000 Cr Accumulated depreciation 7,000 Subsequent accounting: lease rental/interest Year B/fwd Rental Capital o/s Interest (10%) C/fwd 1 28,000 (8,000) 20,000 2,000 22,000 2 22,000 (8,000) 14,000* * NCL Statement of profit or loss extract Depreciation 7,000 Finance costs 2,000 Statement of financial position extract Non-current assets Carrying value machine (28,000 – 7,000) 21,000 Non-current liabilities Lease obligation 14,000 Current liabilities Lease obligation Accrued interest 2,000 Capital (22,000 – 14,000) – 2,000) 6,000 Example 3 – Split lease year treatment On 1 October 2008, Number Co entered into an agreement to lease a machine that had an estimated life of four years. The lease period is also four years with annual rentals of $10,000 payable in advance from 1 October 2008. The machine is expected to have a nil residual value at the end of its life. The machine had a fair value of $35,000 at the inception of the lease. The lessor includes a finance cost of 10% per annum when calculating annual rentals. How should the lease be accounted for in the financial statements of Number for the year-end 31 March 2010?
  11. 11. University Of Central Punjab F13 Financial Management P age 11 Solution The lease should be classified as a finance lease as the estimated life of the asset is four years and Number retains the right to use this asset for four years in accordance with the lease agreement therefore enjoying the rewards of the asset. Initial accounting: recognize the asset and the lease liability Dr Property, plant and equipment 35,000 Cr Finance lease obligations 35,000 Subsequentaccounting:depreciation Tip: the depreciation for the year ended 31 March 2010 is a straightforward annual charge, but you will also have to take into account the depreciation for the first six months of the lease that was attributable to the year ended 31 March 2009 as this will be required to find the closing carrying value in the statement of financial position. 1 October 2008 – 31 March 2009 Dr Depreciation expense ($35,000/4 years x 6/12) 4,375 Cr Accumulated depreciation 4,375 1 April 2009 – 31 March 2010 Dr Depreciation expense ($35,000/4 years) 8,750 Cr Accumulated depreciation 8,750 Subsequent accounting: lease rental/interest Tip: you are looking for the outstanding value of the lease 18 months after the lease agreement began. It is advisable that you extend your lease table so that you have two separate ‘c/fwd’ balances – the balance at the end of the accounting year (31 March) and the balance at the end of the lease year (30 September). Year B/fwd Rental Capital o/s Interest (10%) (6 months) C/fwd (31 Mar) Interest (10%) (6 months) C/fwd (30 Sep) 1 35,000 (10,000) 25,000 1,250 26,250 1,250 27,500 2 27,500 (10,000) 17,500 875 18,375 875 19,250 3 19,250 (10,000) 9,250* * NCL
  12. 12. University Of Central Punjab F13 Financial Management P age 12 Statement of profit or loss extract 31 March 2010 Depreciation 8,750 Finance costs (1,250 + 875) 2,125 Statement of financial position extract 31 March 2010 Non-current assets Carrying value machine (35,000 – 4,375 (first 6 months depreciation) – 8,750 (current year charge)) 21,875 Non-current liabilities Lease obligation 9,250 Current liabilities Lease obligation Interest 875 Capital (18,375 – 9,250) – 875) 8,250 OPERATING LEASE ACCOUNTING As the risks and rewards of ownership of an asset are not transferred in the case of an operating lease, an asset is not recognized in the statement of financial position. Instead, rentals under operating leases are charged to the statement of profit or loss on a straight-line basis over the term of the lease, any difference between amounts charged and amounts paid will be prepayments or accruals. Example 4 – Operating lease treatment On 1 October 2009, Alpine Ltd entered into an agreement to lease a machine that had an estimated life of 10 years. The lease period is for four years with annual rentals of $5,000 payable in advance from 1 October 2009. The machine is expected to have a nil residual value at the end of its life. The machine had a fair value of $50,000 at the inception of the lease. How should the lease be accounted for in the financial statements of Alpine for the year-end 31 March 2010? Solution In the absence of any further information, this transaction would be classified as an operating lease as Alpine does not get to use the asset for most of/all of the assets useful economic life and therefore it can be argued that they do not enjoy all the rewards from this asset In addition to this, the present value of the minimum lease payments, if calculated (you are not required to do this in the exam, only use if the examiner gives to you) would be substantially less than the fair value of the asset. The accounting for this lease should therefore be relatively straightforward and is shown below:
  13. 13. University Of Central Punjab F13 Financial Management P age 13 Rental of $5,000 paid on 1 October: Dr Lease expense (statement of profit or loss) 5,000 Cr Bank 5,000 This rental however spans the lease period 1 October 2009 to 30 September 2010 and therefore $2,500 (the last six-month’ rental) has been prepaid at the year-end 31 March 2010. Dr Prepayments 2,500 Cr Lease expense 2,500 Statement of profit or loss extract Lease expense 2,500 Statement of financial position extract Current assets Prepayments 2,500 Example 5 – Initial rent-free incentive A Co entered into an agreement to lease office space on 1 April 2009 for a fixed period of five years. As an incentive to encourage the office space to be occupied, a first year rent-free period was included in the agreement after which A Co is required to pay an annual rental of $36,000. How should the lease be accounted for in the year ended 31 March 2010? Solution The total cost of leasing the office space is $144,000 ($36,000 4 years). Despite there being a ‘rent-free’ period, the total cost of the lease should be matched to the period in which it relates. Therefore, in year 1: Statement of profit or loss extract Rental ($144,000/5 years) 28,800 Statement of financial position extract Current liabilities Accruals 28,800 In summary, the accounting topic of leases is an important accounting area and is highly examinable. To master this topic, ensure that you know the definitions of both types of lease; the recognition criteria for finance lease and practice plenty of examples of accounting for finance leases.
  14. 14. University Of Central Punjab F13 Financial Management P age 14 TAXATION TREATMENT OF FINANCE LEASES - IT 52 Explanation Many traders finance their fixed asset requirements through finance leasing. The trader leases the asset for a fixed period (the primary period) with an option to lease for a further period. At the end of the lease, the finance company sells the asset at market value and refunds this amount (less any amounts still owing on the lease) to the lessee, i.e. the person who leases the asset. The trader may receive the rebate by direct payment, may use it to purchase the asset that had been leased or may use it as an up-front payment against a further leased asset. This leaflet outlines the tax treatment of finance leases for lessees. Lease Payments The lessee is allowed a deduction for lease payments in calculating profits for tax purposes. Payments under a lease can be either:  Ordinary recurring payments - usually payable monthly, or  Initial leasing payments, i.e., an up-front payment by the lessee, followed by recurring payments. The up-front payment may be:  A lump sum payment in cash at the beginning of the lease, or  A trade-in of an asset already owned by the trader, or  A rebate of lease rentals on an asset, which was previously leased by the trader. Primary Period Most finance leases operate for a primary period during which the taxpayer effectively pays for the asset. At the end of the primary period, the lessee has the option to extend the lease for a further period. For tax purposes, all lease payments, including up-front payments, are spread evenly over the expected period of the lease (i.e. the period during which it is expected that the asset will be leased). Revenue will generally accept that payments may be spread over the primary period of the lease, where the primary period is standard for the type of asset in question and it is not clear at the start of the lease that the asset will be leased for a longer period. In practice, the primary period should not be less than three years. For example, where there is a primary period of, say, four years (which is standard for the type of asset), and the lessee does not plan to opt to lease the asset beyond that time, lease payments should be spread over four years. Advance Payments Many finance companies require lessees to pay a number of installments of lease payments in advance. Spreading of such advance payments could unnecessarily complicate the preparation of tax returns, where the amounts are not material. Where such a payment in
  15. 15. University Of Central Punjab F13 Financial Management P age 15 advance does not exceed three months lease payments and all other payments under the lease are spread evenly over the period of the lease, however, it will not be necessary to spread the advance payment. Seasonal Trades In seasonal trades, to comply with the principle of matching income with associated costs, lease payments may be spread on a seasonal basis. Where the expected period of a lease corresponds effectively to the seasons during which the asset will be used, lease payments may be spread evenly over the tax years corresponding to those seasons. Example 1 An agricultural contractor, who prepares accounts to 31 December annually, takes out a three year lease on a combine harvester in August 2004. Under the lease, one annual lease payment is to be made in August of each year of the lease (to correspond with the harvesting season). A deduction for the August 2004 lease payment may be taken in the accounts year ended 31 December 2004, which forms the basis for the income tax year 2004. Lease Termination At the termination of a lease:  The asset is returned to the leasing company, or  The lessee purchases the leased asset, or  The lessee trades-in the asset, i.e., uses the rebate of rentals as an up-front payment against another leased asset. Asset returned to the leasing company Where the asset is returned to the leasing company, the leasing company gives a rebate of rentals to the lessee. The rebate is approximately the market value of the asset. The rebate of rentals must be included in the profits of the period in which it is received and is taxed accordingly. Lessee purchases the leased asset Where a trader purchases the leased asset at the end of the lease, the leasing company sets the rebate of rentals against the cost of the asset to the lessee (market value). This is instead of giving the rebate to the lessee as a cash payment. Again, the rebate of rentals is taxable in the period in which it is received. The trader can claim Capital Allowances on the cost of the asset, i.e., market value at the date the lease ends, from the time the asset is purchased. Example 2 At the termination of a lease in the basis period for 2004, the market value of the leased asset is €15,000. The lessee opts to purchase the asset. The finance company refunds the market value €15,000 to the lessee (less a small transaction cost) by way of credit against the cost of the asset. The lessee is chargeable on the €15,000 for 2004 and may claim Capital Allowances on the asset for that and subsequent years. The lessee trades-in the asset The rebate of rentals on the old leased asset is set against the cost of the new leased asset. In other words, it is used as an up-front payment for the new asset.
  16. 16. University Of Central Punjab F13 Financial Management P age 16  The amount of the rebate is taxable in the period in which it is received.  The up-front payment, i.e., the rebate, is spread evenly over the expected period of the new lease (see paragraph headed “Lease Payments”). Example 3 Assume the asset in Example 2 is used as a trade-in against a further leased asset with an expected lease period of four years. The rebate of €15,000 is taxable in 2004 and the up-front payment is spread over four years, i.e., the lessee claims €3,750 per annum for 2004 to 2007 inclusive. Motor Vehicles There is a restriction on the amount of lease payments allowable for tax purposes on private motor vehicles. Where the retail price of the vehicle at the time of manufacture exceeds the relevant Capital Limit* the allowable lease payments are restricted to: Lease Payments x Relevant Capital Limit / Retail Price of Vehicle Where a rebate of rentals arises and the lease rentals have been restricted, the lessee is taxed only on the proportion of the rebate that has been allowed for tax purposes. Any deferred charges are similarly restricted. *The current amount of the relevant Capital Limit can be obtained from any Revenue office (see note headed Further Information below). Corporation Tax While the examples in this leaflet refer only to Income Tax, the same principles will be applied in relation to Corporation Tax. ECONOMIC RATIONAL FOR LEASES Operational advantages to the lessee: Leasing ready-to-use equipment may be more attractive if the asset requires lengthy preparation and set-up. Leasing avoids having to own the asset that will be required only seasonally, temporarily or sporadically. Leasing for short periods provides protection against obsolescence. Financial advantages to the lessee: Lease payments can be tailored to suit the lessee's cash flows (up to 100% financing, instead of the 80% limit by banks). Properly structured leases may be “off-balance sheet”, avoiding debt-covenant restrictions. Leasing provides tax advantages from accelerated depreciation and interest expense. Disadvantages to Leasing Disadvantages to the lessee:  Leased ready-to-use equipment may be of lower quality than custom built, resulting in lower quality products and lower sales.  Seasonal leasing may affect equipment availability and pricing.  Premium must be paid for the protection against obsolescence. 
  17. 17. University Of Central Punjab F13 Financial Management P age 17 Disadvantages to financial statement users: Off-balance sheet financing hides the true leverage of the firm. ANALYSIS “Should Company Lease or Should Company Buy?” Analyze cash flows and determine which alternative has the lowest (present value) cost to the firm. Example:  Basket Wonders (BW) is deciding between leasing a new machine or purchasing the machine outright.  The equipment, which manufactures Easter baskets, costs $74,000 and can be leased over seven years with payments being made at the beginning of each year.  The lessor calculates the lease payments based on an expected return of 11% over the seven years. (Ignore possible residual value of equipment to lessor.)  The lease is a net lease.  The firm is in the 40% marginal tax bracket.  If bought, the equipment is expected to have a final salvage value of $7,500.  The purchase of the equipment will result in a depreciation schedule of 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76% for the first six years (5-year property class) based on a $74,000 depreciable base.  Loan payments are based on a 12% loan with payments occurring at the beginning of each period. Determining the PV of Cash Outflows for the Lease This is an annuity due that equals $74,000 today. $74,000.00 = L (PVIFA 11%, 7) (1.11) $66,666.67 = L (4.712) $14,148.27 = L  The lessor will charge BW $14,148.27, beginning today, for seven years until expiration of the lease contract.
  18. 18. University Of Central Punjab F13 Financial Management P age 18 The result indicates that a $74,000 lease that costs 11% annually for 7 years will require $14,147.68* annual payments. B = Tax-shield benefit (Inflow) = $ 5,659.31 L = Lease payment (Outflow) = $ 14,148.27 Net cash outflows at t = 0: $ 14,148.27 Net cash outflows at t = 1 to 6: $ 8,488.96 Net cash outflows at t = 7: $ -5,659.31 Comments  Since the lease payments are prepaid, the company is not able to deduct the expenses until the end of each year.  The lessee, BW, can deduct the entire $14,148.27 as an expense each year. Thus, the net cash outflows are given as the difference between lease payments (outflow) and tax- shield benefits (inflow).  The difference in risk between the lease and the purchase (using debt) is negligible and the appropriate before-tax cost is the same as debt, 12%. Calculating the Present Value of Cash Outflows for the Lease  The after-tax cost of financing the lease should be equivalent to the after-tax cost of debt financing.  After-tax cost = 12% (one - .4) = 77..22%%.  The ddiissccoouunntteedd present value of cash outflows: $14,148.27 x (PVIF 7.2%, 1 ) = $$1133,,119988..0011 $ 8,488.96 x (PVIFA 7.2%, 6 ) = 4400,,221144..3344 $ -5,659.31 x (PVIF 7.2%, 7 ) = --33,,447788..5566 PPrreesseenntt VVaalluuee == $$ 4499,,993333..7799 This annuity due equals $74,000 today $74,000.00 = TL (PVIFA 12%, 7) (1.12) $66,071.43 = TL (4.564) $14,477.42 = TL
  19. 19. University Of Central Punjab F13 Financial Management P age 19 BW will make loan payments of $14,477.42, beginning today, for seven years until full payment of the loan. The result indicates that a $74,000 term loan that costs 12% annually for 7 years will require $14,477.42* annual payments. Loan balance is the principal amount owed at the end of each year.
  20. 20. University Of Central Punjab F13 Financial Management P age 20 * Based on schedule given on Slide 21-25. ** .4 x (annual interest + annual depreciation). *** Tax due to recover salvage value, $7,500 x .4. * Loan payment - tax-shield benefit. ** Present value of the cash outflow discounted at 7.2%. *** Salvage value that is recovered when owned.
  21. 21. University Of Central Punjab F13 Financial Management P age 21
  22. 22. University Of Central Punjab F13 Financial Management P age 22 Conclusion  The present value of costs for the term loan is $$4466,,774411..8888. The present value of the lease program is $$4499,,993333..7799.  The lleeaasstt ccoossttllyy alternative is the tteerrmm llooaann. Basket Wonders should proceed with the term loan rather than the lease.  OOtthheerr ccoonnssiiddeerraattiioonnss: The ttaaxx rraattee ooff tthhee ppootteennttiiaall lleesssseeee,, timing and magnitude of the cash flows, discount rate employed, and uncertainty of the salvage value and their impacts on the analysis. References http://www.cimc.com/res/service_en/finance/201001/t20100106_4211.shtml http://www.investopedia.com/terms/l/lease.asp http://www.zeepedia.com/read.php?lease_financing_and_types_of_lease_financing_sale_lea se-back_lease_analyses_calculations_financial_management&b=44&c=42 http://www.ahli.com/What_is_Financial_Leasing.shtml http://www.yourarticlelibrary.com/financial-management/lease-finance-type-advantage-and- disadvantage-of-leasing/27973/
  • AliKhan1257

    Nov. 27, 2019
  • KoLa3

    May. 28, 2018
  • charusingla5

    May. 11, 2018
  • jawaid533

    Mar. 21, 2017
  • qayyum314

    Oct. 31, 2016

Lease

Views

Total views

4,816

On Slideshare

0

From embeds

0

Number of embeds

9

Actions

Downloads

72

Shares

0

Comments

0

Likes

5

×