LEASE & ITS TYPES

University Of Central Punjab F 13

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.



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.

Operating Lease (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



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.



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.



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



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


Depreciation expense XXX

Accumulated depreciation

XXX

To record a rental payment split between principal and interest


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


Rental expense XXX

Cash

XXX



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.

Subsequent Accounting 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



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



Subsequent accounting: depreciation


($14,275/4 years) 3,568

Cr Accumulated depreciation 3,568

Subsequent accounting: 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


and Shrub retains the right to use this asset for four years in accordance with the lease



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





($28,000/4 years) 7,000




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


Depreciation 7,000

Finance costs 2,000


Non-current assets


(28,000 – 7,000)

21,000



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?



Solution


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




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


($35,000/4 years x 6/12) 4,375


1 April 2009 – 31 March 2010


($35,000/4 years) 8,750



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).


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



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


(35,000 – 4,375 (first 6 months depreciation) –

8,750 (current year charge))

21,875



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:



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


Lease expense 2,500


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:


Rental

($144,000/5 years) 28,800


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.



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



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.



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.



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.



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 (outf low) 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



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.



* 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.



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 ccoosstt llyy alternative is the tteerrmm llooaann. Basket Wonders should proceed with the

term loan rather than the lease.

OOtthheerr ccoonnssiiddeerraatt iioonnss: The ttaaxx rraattee ooff tthhee ppootteenntt iiaall 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/

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_lease-back_lease_analyses_calculations_financial_management&b=44&c=42

http://www.zeepedia.com/read.php?lease_financing_and_types_of_lease_financing_sale_lease-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/

http://www.yourarticlelibrary.com/financial-management/lease-finance-type-advantage-and-disadvantage-of-leasing/27973/

LEASE & ITS TYPES

Business

Transcript of LEASE & ITS TYPES