1 LEASING FINANCE CAIAPHAS HABASONDA MA, BA, LLB.
2 DEFINITION Contract between two parties where one party (the Lessor) provides an asset for usage to another party for a specified period of time, in return for specific payments
3 Indicative tabulation of terms and conditions TermsTERM SHEET Indicative tabulation of terms and conditions Terms Amount Interest Rate Fees Repayment-tenor, method Collateral Pre-conditions Conditions Non-binding
4 ELEMENTS OF A LEASING TRANSACTIONThe Transaction-Asset Renting Parties to a Lease- Lessor Lessee Tripartite Two-Three Party Leasing Leased Asset-non consumable Lease Period Lease Rentals-Consideration for trxn Customer needs it plans to serve
5 Elements of Leasing TransactionResidual Value Market value at the end of the lease Amortized Value Values may differ significantly End- of-Term Options Buyout Option-nominal value Option to Buy at Fair Market Value Option to renew the lease at nominal rentals –bargain renewal option Option to renew the lease at nominal rentals or substantial rentals Option to Return Equipment
6 Upfront Payments Initial Lease rental or down paymentAdvance Lease Rental Payment Security Deposit Initial Fees
7 Financial Lease International financial Reporting Standards (IFRS), a lease is a financial lease, if……it contains at least one of the following features: Lease transfers ownership to the Lessee by the end of the lease term The Lessee has any option to to purchase the assets at a price that is expected to be sufficiently lower than the fair market value at the date the option becomes exercisable, and at inception, it is reasonably certain that the option will be exercised The lease period covers most of the useful life of the asset and where the title to ownership may or may not eventually be transferred. The Present Value of the minimum lease payments at the inception of the lease is greater or equal to the fair value of the leased asset; The leased assets are of such a specialized nature that only the lessee can use them without modification
8 DIFFERENCE BETWEEN LOAN AND LEASEAsset belongs to the Borrower Asset belongs to the Lessor
9 LEASE VERSUS LOAN Similarities SimilaritiesBoth Borrower and Lessee have choice over acquisition of asset and subject to terms being met both can retain asset once payments complete Over the tenor of the lease and the loan, interest & capital are repaid At default both Lender and Lessee have legal rights to reclaim/repossess assets Risks and costs of ownership, including obsolescence, remain the Borrower or Lessee If the asset appreciates, neither the lender nor the lessor benefits; Agreements are non-cancellable until either lender or the lessor has recovered its outlay Both can prepay the loan or lease
10 LEASING DIFFERENT FROM BANKINGFACTOR FACTOR Lessors have knowledge of the asset (often, the industry) Lending, is to some extent, asset based Asset contributes to cash flow either to the lessee or the lessor in case of sale/liquidation Leasing Companies are more sales and service oriented, using their specialized knowledge to bridge the gap between suppliers and purchasers Leasing Companies may have advantage in disposing of repossessed leased assets Leasing Companies specialize in finance, credit and equipment acquisition
11 LESSOR Rights ObligationsAs owner, right to receive scheduled payments; Right to assign its rights to third parties Delivery, at the outset, assets that are “fit for purpose”
12 LESSEE Rights ObligationsRight to Use the Fixed Asset Make scheduled payments; Insure the Asset; Pay applicable taxes Use equipment responsibly and in accordance with the local law and regulations Maintain asset in good working order Liability with respect to operation of the asset or equipment
13 ACCOUNTING & TAX TREATMENT OF LEASESFramework IFRS, IAS-17
14 DETERMINING A FINANCE LEASEOwnership transferred to Lessee Yes NO Bargain Option Yes Term Major Part of Asset’s Useful Life Yes PV of MLP > or substantially equal to Asset Fair Value Yes OPERATING LEASE FINANCE LEASE
15 ADDITIONAL INDICATORS OF A FINANCIAL LEASEIf lessee can cancel lease and losses associated with cancellation are borne by the Lessee Gains and losses from fluctuations in fair market value or residual value accrue to Lessee Lessee has ability to continue into secondary period at a rent which is substantially lower than market value
16 Principles Record as Asset Liability Valuation method-lower fair value or present value of minimum lease payments Finance Lease payment apportioned between finance charge and reduction of outstanding liability Depreciation Policy- consistent with that applied to owned assets
17 Principles Not certain, depreciate lease over the shorter of the lease term and the life of the asset Under IAS, economic substance precedes legal form. Lessee considered as buying the asset rather than paying cash for use of asset; Lessee treated as obtaining a loan from Lessor to purchase asset Hence: Asset is recorded in the books of the lessee Asset is depreciated according to Lessee’s policy Payable is recorded Interest Expense Reecognised Interest is expensed to income and calculated on the outstanding amount of the liability at end of period
18 CONCEPT OF MINIMUM LEASE PAYMENTSMLP comprises of amounts the Lessee is obliged to pay to the Lessor over the life of the Lease, viz: Annual or monthly repayment Any required purchase price or bargain purchase options included in the lease Any amount of Residual Value that is guaranteed by the Lessee or by a party related to the Lessee Excluded costs: tax, maintenance, taxes on leasing item not included in the calculation of PV of MLP
19 Journal Entries Cash Paid Interest Expensed Lease Liability RepaidAnnual Lease Payment less Interest Expense (beginning value of lease x rate of interest)=Reduction of Lease Liability for the Period
20 Recording the Lease in Lessee’s BooksUsing the selling price of the asset (as this the amount Lessee is deemed to have paid) Debt (DR) Fixed Assets Account Credit (CR) –Leased Liability Account
21 The Finance Lease TransactionAsset transferrable to the books of the Lessee Lessee Accounts for the lease as if its loan Two Parts Acquisition of a fixed asset Obtaining and Repayment of Loan Payments in two parts Capital Interest
22 Calculating Value of Leased AssetDetermine amount at which Asset will be recorded (selling Price of asset as if Lessee had paid cash instead of financing the purchase) Amount to be capitalized as Fixed Asset of Lessee’s Balance Sheet =PV of MLP discounted at the lowest rate of interest (for higher PV). The rate is derived from Implicit rate in the lease Market rate-incremental borrowing rate
23 Value of Leased Asset: ExceptionIf fair market value of leased asset is lower than the PV of MLP, asset will be recorded at fair market value; Any eventual gain over book value usually recorded upon disposal of assets
24 Treatment of DepreciationAsset is on the Lessee’s books Hence, depreciate like any other asset Determine the depreciable amount which is = to the cost of the asset (paid by the lessee) less salvage or Residual Value Determine the useful life of the Asset Depreciation Expense for each accounting period Depreciation policy should be consistent with that applied to owned assets
25 Reducing the Lease LiabilityLease Liability Recorded at Commencement Must be reduced over life of the lease Amount of Liability is less the cash value of all lease payments to be made over the life of the lease Last payment should result in Lease Liability being at Zero If there is a bargain purchase option, Lease Liability will be equal to the amount of the bargain purchase after the last payment
26 Interest Expense Interest Expense = Balance of lease liability at the beginning of the period x interest rate used to calculate the NPV of MLP. Interest Expense =Interest Rate x Outstanding balance
27 The Current Liability in the Balance SheetThe Current Liability is the amount by which the lease liability will be reduced in the upcoming year, that is, the portion falling due in each accounting period.
28 Lease Disclosures By the Lessee IAS 17Carrying amount of the Asset Reconciliation between Minimum Lease Payments and its Present Value Amount of Minimum lease payments at balance sheet date and the PV thereof for (a) the next year (b) Years 2-5 © Beyond Contingent Rent recognized as an expense Total Future Minimum Lease Income under none-cancellable subleases General Description of Significant lease arrangements including contingent rent provisions, renewal or purchase options, and restrictions imposed on dividends, borrowings or future leasing
29 Accounting For a Lease as a LessorDetermine nature of lease (operating or finance lease) Accounting for the lease by the lessor is the same as the accounting for the Lessee except the Lessor accounts for rent as revenue and not expense Annual Payment =Fair Value of Leased Asset Present Value Factor Present Value factor being the table factor for annuity for the number of periods at the desired rate of return
30 PRESENT VALUE INTEREST FACTOR TABLEPeriod 1% 2% 3% 4% 5% 6% 7% 8% 9% 1 0.991 0.9804 0.9709 0.9615 0.9434 0.9346 0.9174 2 3 4 5 6 7
31 FUTURE VALUE INTEREST FACTOR TABLEPeriod 1% 2% 3% 4% 5% 6% 7% 8% 9% 1 1.0100 1.0200 1.0300 1.0400 1.0500 1.0600 1.0700 1.0800 2 3 4 5 6 7
32 Accounting For a Lease as a LessorLeased Asset Recorded as a Receivable, not Fixed Asset; Constant Periodic Rate of Return on the Lessor’s investment assumed for prudence Lease recorded as a Receivable at an amount equal to the net investment in the Lease Net Investment in the Lease being the PV of MLP Any guaranteed residual value accruing to the Lessor Net Investment in the lease is analogous, if not identical, to principal outstanding Periodic Rate of return (i.e interest rate) embodies risk and financing costs
33 Accounting For a Lease as a LessorAnalogous to a bank loan and the method banks use for accounting for loans Lessor will: Remove the fixed asset from its books Recognize revenue from the sale of the asset Recognize a gain or loss on sale Record a receivable Record Interest Revenue each time payment is made
34 CRITERIA Threefold criteria for Lessor to account for Lease as a Finance Lease Lease must be accounted for as Finance Lease by the Lessee; There is reasonable assurance that minimum lease payments are collectible and; There are no uncertainties regarding the costs to the Lessor associated with the lease If these criteria not met account for lease as an operating lease- in same manner as the Lessee
35 Journal Entries for Year OneJanuary 1, 2014 Record the (lease) Sale of the Asset Debit Lease Receivable 100,000 Credit Sales Revenue 83,398 Unearned Int. Income 16,602
36 Journal Entries for Year OneJanuary 1, 2014 2. Remove asset from Lessor’s books, Recognize cost of goods sold. Combination of this entry with entry 1 gives us no profit on sale of the asset as revenue and COS amounts are the same Debit Cost of Goods Sold 83,398 Credit Fixed Assets
37 Journal Entries for Year OneJanuary 1, Record the Initial Collection Due at Signing of the Lease Debit Cash 20,000 Credit Lease Receivable
38 Journal Entries for Year OneDecember 31st , Record Accrued interest for the year on outstanding principal Debit Unearned Interest 6,340 Credit Interest Income-Lease
39 Journal Entries for Year OneJanuary 1 , Record the Second Lease Payment, recognizing the payment of the accrued interest as 31st December 2014 Debit Cash 20,000 Credit Lease Receivable
40 Accounting For Cost of the LeaseTwo Types of costs are associated with creation and execution of a lease; Direct Costs Indirect Costs
41 Accounting For Cost of the LeaseDirect costs arise from negotiating/closing the lease, inspection and valuation of collateral and security deposits, preparation of documentation and finder’s fees
42 Accounting For Cost of the LeaseThese costs are capitalized Hence, they are recognized as reducing the interest rate implicit in the lease;
43 Accounting For Cost of the LeaseIndirect Costs arise from Advertising Servicing of an existing lease; Establishing and monitoring credit policies Administrative expenses Indirect costs are expensed (not capitalized)
44 Lease Disclosures of the LessorContingent Rentals recognized as revenue in the current period and included in the income statement on expectation that some event will occur in the future Reconciliation between Gross Investment in the lease and the PV of MLP Gross Invest and PV of MLP receivable for the next year Years 2-5 Combined and beyond 5 years Unearned Finance Income Unguaranteed Residual Values Accumulated Allowance for uncollectable lease payments receivables Contingent Rent Recognized in income General Description of Significant Leasing arrangements
45 TAX TREATMENT OF LEASESGovts taxes financial services to raise revenue Preferential Tax Treatment may be given to Simulate Investments Stimulate the Leasing sector Key Taxes VAT VAT on Imports VAT on delivery Vat on Lease payments Customs Duties on Importation of Equipment Income Tax Deductibility of Lease Payments Lessor Profits
46 REMOVAL OF VAT ON IMPORTATION OF LEASE EQUIPMENTIssue: VAT charged on foreign equipment cannot be offset against domestic output VAT-equipment more expensive Exemption Stimulates investments as cost is reduced Increases quality of equipment imported and increases capacity and productivity Removal may benefit only companies with capacity to import
47 REMOVAL OF VAT ON DELIVERYIssue: Sale of Equipment VAT exempt-No VAT charged on final sale of equipment Breaks the chain of VAT reclamation and last link in the VAT chain (normally the dealer is unable to offset input VAT (paid on import of the equipment) successfully Making VAT reclaimable allows businesses to offset VAT with output VAT Non-VAT paying businesses are able to lease without incurring VAT (cheaper) Severely affects local equipment supplies
48 VAT TO BE CHARGED ONLY ON EQUIPMENT COSTMonthly leasing payment includes a portion of the capital (equipment) cost, the VAT on capital cost and interest on capital cost Leasing becomes uncompetitive against other forms of finance where VAT is not payable on the repayment Where lease is not classed as financial service (as opposed to a service), VAT charged not only on capital cost but on interest portion as well Where lease is classed as financial service, VAT not levied on the interest portion
49 Customs duty can be a barrier against imported EquipmentCustoms Duty can curtail opportunity to acquire high technology and improve productivity Removal of customs duty fully or partially, reduces the expense related to customs and thus, removes/reduces the barrier Import Duty Exemption-may benefit only those with sufficient assets to buy foreign goods
50 Annual Depreciation Expense is allowable against gross income All fixed assets of the business must be depreciated over the useful economic life Annual Depreciation Expense is allowable against gross income Effect: Reduction in the corporate income tax payable by a company Accelerated Depreciation- speeds up the rate at which an asset is depreciated Effect: An increased portion of the asset is allowed to be written off against corporate income, resulting in further reduction income tax payable
51 BALANCE SHEET TREATMENT FOR LEASESLessors can claim legal ownership Lessees assume all risks and enjoy all the rewards of ownership Both Can justifiably claim possession Thus, they can include assets under lease on their balance sheets This applies only to tax accounting and not to financial accounting IAS-17: Best Practice for accounting purposes- Balance Holder of a leased asset should be the the Lessee in a financial lease Lease Agreement should provide for the right of the parties to agree who shall include the leased asset on the balance sheet and thus claim the capital allowances.
52 INCOME TAX FOR LESSEES Accelerated Depreciation is deducted from Gross Income and income tax is reduced In addition, Lessee can deduct lease payments from Gross Income In some jurisdictions Lessees can claim the whole amount of payment against Income (corporate profits) tax Lessee can deduct the whole payment if the Lessor remains the balance holder for tax purposed of the leased asset.
53 Gives significant advantage to Lessors over other credit providersINCOME TAX FOR LESSORS Direct and Beneficial Allowance of not being subject tax can be enjoyed; Gives significant advantage to Lessors over other credit providers Cons: discourages them from developing or improving their business practices Not sustainable Can be a useful tool for tax avoidance