LEASING OF ASSETS

1. LEASING OF ASSETS • Tax advantages • Commercial advantages

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

3. 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

4. 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

5. 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

6. 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

7. 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

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

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

10. FINANCE LEASEBALANCE 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)

11. FINANCE LEASEPROFIT 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

12. 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

13. 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

14. FINANCE LEASE EXAMPLE Discount factor at 10% Time Cash flow PV 1.000 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 10,425 NPV

15. 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

16. 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

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

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

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

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

21. 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 Nil

22. 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

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

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