LEASI

As a form of d

NG ebt
Reported By:
SHEILA MAE G. LA
CERONA
ADVANTAGES OF LEASING 2

The lessor may accept a lease arrangement or arrange a lease obligatio

n which is suitable for the lessees funds
The provisions of a lease obligation is less restrictive than those of bond
indenture
There may be no down payment requirement

The lessor may possess particular expertise in a given industry, the neg
ative effects of obsolescence may be reduced
Creditor claims on certain types of leases are restricted in bankruptcy a
nd reorganization proceedings
 3

It is an easy method of financing capital asset having a heavy cost involv

ed
It permits the lessee for alternative use of funds without incurring huge
capital investment on an asset
It spreads the capital cost over a period of the lease

The lease rentals can be restructured according to the needs of the less
ee
It helps to conserve the funds which can be used to improve the liquidit
y and can be used for some other urgent purposes

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 4

The lessee can avoid the risk of obsolescence by taking the asset on a l
ease basis
Leasing is free from restrictive covenants

Generally, lease or rent payments under operating lease are tax deducti
ble. Under finance lease, depreciation on leased property and interest
expense are tax deductible
A firm may wish to engage in a sale-leaseback arrangement, this provid
es the lessee with an infusion of capital, while allowing the lessee to co
ntinue the use of the asset
DISADVANTAGES OF LEASING 5

The main criticism of lease method of financing is that the accounting procedur
e adopted for recording lease method of financing is complicated
Lease financing compared to other methods is generally more costly for the less
ee
The financial lease has all the rigidities of other methods of financing

As the lessee is not the owner of the asset, technically he cannot enforce warran
ties or guarantees enforceable against the vendor
 6

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FINAN 7

CE LEA OPERA
SE TING LE
ASE
CONSIDERING A LEASE CONTRACT AS FINA8
NCE LEASE If any of the following conditions are met :

The lease transfers ownership of the asset to the lessee by the end of th
e lease term
The lessee has the option to purchase the asset at a price, which is exp
ected to be sufficiently lower than the fair value at the date the option b
ecame exercisable such that, at the inception of the lease, it is reasona
bly certain that the option will be exercised.

The length is for the major part of the economic life of the asset even if
title is not transferred. The length of lease should include a secondary r
ental. The second rental gives the lessee an option for renewal.
 9

At the inception of the lease, the present value of the minimum lease pa
yments amounts to at least substantially all of the fair value of the lease
d asset.
The leased assets are of as specialized nature such that only the lessee
can use them without major modifications being made.
Indicators of situations that individually or in combination could
10
also lead to a lease being classified as a finance lease:

If the lessee can cancel the lease, the lessors losses associated with th
e cancellation are borne by the lessee.

Gains or losses from the fluctuation in the fair value of the residual accr
ue to the lessee.

The lessee has the ability to continue the lease for a secondary period a
t a rent that is substantially lower than market rent.
Illustrative Problem 25-8. Reporting Finance Lease Liability 11

On January 1, 2017, Tungsten, Inc. signed a long-term lease for an office building. The term of th
e lease required Tungsten to pay P1,000,000 annually, beginning December 30, 2017 and contin
uing each for 30 years. The lease qualifies as finance lease. On January 1, 2017, the present value
of the lease payments is P1,125,000 at 8% interest rate implicit in the lease.
In Tungstens December 31, v2017 statement of financial position, how much should be the fina
nce lease liability ?

solution :

Total lease liability, January 1, 2017 P1,125,000

Less: Principal payment (2017):
Annual rental P100,000
Less: Interest (P1,125,000 x 8%) 90,000 10,000
Leash liability, December 31, 2017 P1,115,000
Illustrative Problem 25-9. Reporting Finance Lease Liability

On December 31, 2017, Topaz Corp. signed a 7-year finance lease for an airplane to transport its
1
sport item around the country. The airplanes fair value was P8,415,000. Topaz made the first ann 2
ual lease payment of P1,530,000 on December 31, 2017. Topazs incremental borrowing rate wa
s 12% and the interest rate implicit in the lease, which was known by Topaz, was 9%. The followin
g are the rounded present value factors for an annuity due: 9% for 7 years
5.5
12% for 7 years 5.5
What amount should Topaz report as finance lease liability in its December 31, 2018 statement of
financial position?

Solution:
Interest Carrying
Expense Principal Value (CV)
Annual Rental (9% x CV) Payments of Lease
December 31, 2017 P8,415,000
December 31, 2017 P1,530,000 P1,530,000 6,885,000
December 31, 2018 1,530,000 P619,650 910,350 5,974,650
Main Characteristics Of Operat
ing Lease 1
3

The lease can be cancelled by the lessee prior to its expiration at a short n
otice;
The lessor is responsible for upkeep and maintenance of the asset;

The lessee is not given any uplift to purchase the asset at the end of the le
ase period;
The sum of all the lease payments by the lessee does not necessarily fully
provide for the recovery of cost of the asset; and
The lessor has the option to lease out the asset again to another party.
 Operating lease is preferred in the following situations: 1
4

When the long-term suitability of asset is uncertain.

When the asset is subject to rapid obsolescence.

When the asset is required for immediate use to tie over a temporary probl
em.
Illustrative Problem 25-10. Reporting the Effect of New Operating Lease 15
On January 1, 2017, Norman Company signed a 10-year operating lease for office space at P576,
000 per year. The lease included a provision for additional rent of 5% annual company sales in ex
cess of P3,000,000. Normans sales for the year ended December 31, 2017 were P3,600,000. U
pon execution of the lease. Norman paid P144,000 as a bonus for the lease.

How much should be Normans rent expense for the year ended December 31, 2017 ?

Solution:

Annual rental P576,000

Additional rental (P3,600,000 P3,000,000 x 5%) 30,000
Amortization of lease bonus (P144,000/10) 14,400
Total rent expense P620,000
Illustrative Problem 25-11. Reporting the Effect of an Operating Lease 1
6
As an inducement to enter a lease , Marina, a lessor, grants Zocorro Corp, a lessee, 9 months of fr
ee rent under a 5-year operating lease. The lease is effective July 1, 2017 and provides for a mont
hly rental of P20,000 to begin April 1, 2018.

In Zocorros income statement for the year ended June 30, 2019, how much should be reported a
s rent expense ?

Solution:
Lease term (5 years) 60 months
Less: Rent-free months 9 months
Number of lease payments 51
x Monthly rental P 20,000
total rentals P1,020,000
Lease term 5
Annual rent expense P 204,000
 Evaluation of lease or Bu
1
y Decision 7
Different Methods Used

1 Present Value Method

the present value of lease rentals are compared with the present value of
the cost of an asset acquired on outright purchase by availing a loan

2 Cost of Capital Method

the rate of cost of capital is calculated for the payments of installments a
nd then it is compared with the cost of capital of the other available sour
ces of finance

3 Bower-Herringer-Williamson Method
the financial and tax aspects of lease financing are considere
d separately
Illustrative problem 25-12

A firm has the choice of buying a piece of equipment at a cost of P100,000 with borrowed funds at
a cost of 18% repayable in five annual installments of P32,000, or take on a lease the same on an
annual rental of P32,000. the firm is in the tax-bracket of 40%.

Assume:
1. The salvage value of the equipment at the end of the period is zero. 2. The firm uses straight
line depreciation.
3. Dicounting factors are:
@ 9% 0.917 0.842 0.772 0.708 0.65
@ 11% 0.901 0.812 0.731 0.659 0.593
@ 18% 0.847 0.718 0.609 0.516 0.437

Which alternative do you recommend?

Solution:
Cost of Borrowed Funds
I(1-T)= 18%(1-0.40)
= 18%(0.60)
= 10.8% or 11%
 Computation of Cost of Owning

Annual Cost of
Years Payment Interest Amortization Depreciation Tax Savings Owning
1 P 32,000 P 18,000 P 14,000 P 20,000 P 15,200 P 16,800
2 32,000 15,480 16,520 20,000 14,192 17,808
3 32,000 12,506 19,494 20,000 13,002 18,998
4 32,000 8,997 23,003 20,000 11,599 20,401
5 32,000 4,857 26,983 20,000 9,943 21,897
Total P159,840 P59,840 P100,000 P100,000 P63,936 P95,904

Inceremental Cost of Leasing Over Cost of Owning

Cost of Net of Tax Advantage of Present Value of

Years Owning Payments Owning D.F. @ 11% Advantage
1 P 16,800 P 19,200* P2,400 0.901 P2,162
2 17,808 19,200 1,392 0.812 1,130
3 18,998 19,200 202 0.731 148
4 20,401 19,200 (1,201) 0.659 ( 799)

5 21,897 19,200 (2,697) 0.593 (1,599)

Total P95,904 P 96,000 P 96 P1,050
 Analysis:
It is advantageous to purchase the asset on bo
rrowed funds, as the present value of advanta
ges is positive.
Illustrative Problem 25-13 Bank Loan or Lease Decision

The Limeta Company is in the tax bracket of 35% and discounts its cash flows at 16%. In the
acquisition of an asset worth P1,000,000, it is given two offers - either to acquire the asset by
taking a bank loan @ 15% repayable in five yearly installments of P200,000 each plus interest or to
lease-in the asset at yearly rentals of P324,000 for five years. in both cases, the installment is
payable at the end of the year. Applicable rate of depreciation is 15% using "written down value"
method. you are required to suggest the better alternative.

Year 1 2 3 4 5
PV factor @ 16% 8.862 0.743 0.641 0.552 0.476
Solution:
Alternative I: Acquire the asset by taking a Bank Loan

Years 1 2 3 4 5
Interest
(@ 15%) [a] P150,000 P120,000 P 90,000 P 60,000 P 30,000
Depreciation
(@ 15%WDV) 150,000 127,500 108,375 92,118 78,301
300,000 247,500 198,375 152,118 108,301
Less: Tax Shield
(@ 35%) [b] 105,000 86,625 69,431 53,241 37,905

Interest less tax shield

[a] - [b] 45,000 33,375 20,569 6,759 ( 7,905)
Princpal repayment 200,000 200,000 200,000 200,000 200,000
Total cash outflow 245,000 233,375 220,569 206,759 192,095
Discount factor
(@ 16%) 0.862 0.743 0.641 0.552 0.476
Present value P211,190 P173,397 P141,385 P114,131 P 91,437

PV of total cash outflows = P731,540

Aternative II: Acquire asset on Lease Basis

Tax Net
Shield Cash Discoun PV @
Year Rentals 35% Outflow t Rate 16%
1 P324,000 P113,400 P210,600 0.862 P181,537
2 324,000 113,400 210,600 0.743 156,476
3 324,000 113,400 210,600 0.641 134,995
4 324,000 113,400 210,600 0.552 116,251
5 324,000 113,400 210,600 0.476 100,246
Total P689,505
Analysis:
The present value of Alternative II i
s lower by P42,035 (P731,540 P68
9,505). It is suggested to acquire t
he asset on lease basis.