LEASING OF ASSETS Tax advantages Commercial advantages IAS

LEASING OF ASSETS • Tax advantages • Commercial advantages

IAS 17 ACCOUNTING FOR LEASES The international standard recognises two types of lease: • Finance lease • Operating lease

THE NEED FOR AN IAS • Leasing represented off balance sheet financing • Accounting treatment not uniform • Distortion of financial reports • Effect on gearing and other ratios • True and fair view • Need to reflect commercial reality

FINANCE LEASE • Substantially all the risks and rewards of ownership of an asset transferred to the lessee • Present value of minimum lease payments amounts to at least 90% of the fair value of the assets • Lessee responsible for the upkeep and maintenance of the asset

FINANCE LEASE • Long-term - lessee will have use of the asset for the greater part of its useful life • Primary and secondary lease periods • Full lease payments during the primary period • Peppercorn rental in the secondary period

FINANCE LEASE • During the primary period the lease cannot be cancelled and is legally binding • Lessor earns profits relating to the asset in the primary period

OPERATING LEASE • Lessor retains all risks and rewards of ownership of the asset • IAS 17 defines an operating lease as any lease which is not a finance lease

ACCOUNTING TREATMENT BY THE LEASEE Operating lease • All lease payments charged to income statement as incurred • No recognition in balance sheet

ACCOUNTING TREATMENT BY THE LEASEE Finance lease • capitalise asset and liability in the balance sheet • finance charge and depreciation in the income statement

FINANCE LEASE BALANCE SHEET OF LEASEE • PV of minimum lease payments capitalised as a fixed asset, using the discount rate implicit in the lease, and included as – Fixed assets held under finance lease • PV of minimum lease payments capitalised and included as liability under – Creditors due within one year – Creditors due after more than one year • Rental payments split between – repayment of loan (balance sheet) – finance charge (income statement)

FINANCE LEASE PROFIT AND LOSS ACCOUNT OF LEASEE • Finance charge to be included as a cost and included as – Interest payable and similar charges • Finance charge to be allocated to accounting periods to give a constant periodic rate of charge on the remaining balance of the outstanding obligation using – actuarial method – sum of the digits method – straight line method • Depreciation to be charged over the shorter of – the lease term – the asset’s useful life

FINANCE LEASE EXAMPLE • On 1 January 2000 Paton plc leases an asset from Lloyd plc on a non-cancellable lease contract • Primary term of the lease is 5 years • Rental £ 2, 500 pa payable in advance • Paton plc can extend the lease into a secondary period at a rental of £ 50 pa • Paton plc is responsible for all maintenance and insurance costs

FINANCE LEASE EXAMPLE • The discount rate used by Lloyd plc in calculating the lease payments is 10% (the interest rate implicit in the lease) • The fair value of the asset is £ 11, 000 • Paton plc prepares its accounts to 31 December in each year

FINANCE LEASE EXAMPLE Discount factor at 10% 1. 000 Time Cash flow PV 2, 500 01/01/00 2, 500 01/01/01 2, 500 0. 909 2, 273 01/01/02 2, 500 0. 826 2, 066 01/01/03 2, 500 0. 751 1, 878 01/01/04 2, 500 0. 683 1, 708 NPV 10, 425

FINANCE LEASE EXAMPLE • Fair value of the asset £ 11, 000 • Minimum required PV of the lease payments at 90% of fair value £ 9, 900 • PV of lease payments £ 10, 425 • Finance lease disclosure applicable

FINANCE LEASE EXAMPLE Balance sheet will record • asset under finance lease at cost £ 10, 425 • depreciated value at end of each year, assuming straight line depreciation over 5 years (the term of the lease) • outstanding liability at each balance sheet date

FINANCE LEASE EXAMPLE Income statement will record • annual depreciation charge • finance cost at 10% of outstanding liability

FINANCE LEASE EXAMPLE Fixed asset and depreciation Fixed asset at cost Depreciation 2000 Fixed asset at 31/12/00 Depreciation 2001 Fixed asset at 31/12/01 Depreciation 2002 Fixed asset at 31/12/02 Depreciation 2003 Fixed asset at 31/12/03 Depreciation 2004 Fixed asset at 31/12/04 Balance Sheet 10, 425 (2, 085) 8, 340 (2, 085) 6, 255 (2, 085) 4, 170 (2, 085) 2, 085 (2, 085) Nil Profit and Loss Account (2, 085) (2, 085)

FINANCE LEASE EXAMPLE Outstanding liability and finance charge Liability at 01/01/2000 Cash payment at 01/01/2000 Balance at 01/01/2000 Interest year to 31/12/2000 at 10% Balance at 31/12/2000 Cash payment at 01/01/2001 Balance at 01/01/2001 Interest year to 31/12/2001 at 10% Balance at 31/12/2001 Cash payment at 01/01/2002 Balance at 01/01/2002 10, 425 (2, 500) 7, 925 792 8, 717 (2, 500) 6, 217 622 6, 839 (2, 500) 4, 339

FINANCE LEASE EXAMPLE Outstanding liability and finance charge Balance at 01/01/2002 Interest for year to 31/12/2002 at 10% Balance at 31/12/2002 Cash payment at 01/01/2003 Balance at 01/01/2003 Interest for year to 31/12/2003 at 10% Balance at 31/12/2003 Cash payment at 01/01/2004 Balance at 01/01/2004 4, 339 434 4, 773 (2, 500) 2, 273 227 2, 500 (2, 500) Nil

FINANCE LEASE EXAMPLE Liability and finance charge Balance Sheet at Profit and Loss Account to 31/12/2000 7, 925 792 31/12/2001 6, 217 622 31/12/2002 4, 339 434 31/12/2003 2, 273 227 31/12/2004 Nil

ACCOUNTING BY THE LESSOR • Balance sheet – balance due from the lessee should be reported as a debtor • Income statement – total gross earnings should be allocated to accounting periods to give a constant annual return using either • the actuarial method or • the investment period method

LEASES - THE MAIN ISSUES • • Substance over form Ratio analysis Fair value may be an artificial amount Difficult to classify some leases

LEASES - THE ADVANTAGES • • 100% financing Conserves lines of credit Matches cash receipts with payments Acquisition expenses amortised May be tax efficient Convenient Fixed cost