LEASE & ITS TYPES

Lease

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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.

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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

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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.

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 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.

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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

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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

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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

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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

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Subsequent accounting: depreciation

Dr Depreciation expense
($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
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

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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?

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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

Subsequent accounting: 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

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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:

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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.

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TAXATION TREATMENT O F 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

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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.

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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.


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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.

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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

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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.

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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.

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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/