Leasing: Effects and Advantages | Financial Management

In this article we will discuss about the effects and advantages of leasing.

Effects of Leasing in Financial Statements:

i. Effects on Profit and Loss Account:

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Accounting profit has tended to be higher under lease financing rather loan financing, only the lease payments were charged in the profit and loss account, whereas when a company borrows and buys both the interest payments and depreciation charges on the asset acquired are charged as an expense. Particularly in the early years of loan, accounting profit tended to be higher under the lease agreement.

ii. Effects on Balance Sheet:

The level of total assets appearing in the balance sheet has generally been lower under a lease arrangement than a loan arrangement. All loans appear in the balance sheet as sources of finance and all purchased assets appear as part of the total assets employed. However, with leased assets no lease obligation usually appears in the balance sheet.

Illustration 1:

Gupta Leasing Ltd. is proposing to acquire special purpose machinery. The initial cost of machine is Rs. 4,00,000. Depreciation allowance is given @ 20% p.a. on reducing balance method. To finance the entire cost, the company intend to get a loan of Rs. 4,00,000 on interest @ 18% p.a.

Another proposal has come for review to take the same machinery on lease basis on annual lease rentals of Rs. 1,20,000 for a period of 5 years. How would the acquisition of assets under the above two alternatives effect the profit and loss account and balance sheet.

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Solution:

(i) Effects on Profit and Loss Account:

 

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Tax Effects of Leasing:

The tax effects that arise from the lease transaction is studied from lessee and lessor point of view is given below:

(a) From the view point of Lessee:

The full amount of the annual lease payment is a deductible expense for computing taxable income.

(b) From the view point of Lessor:

The Lessor is entitled to claim the depreciation allowance and the lease rentals will be taken into consideration in computation of taxable income.

In the leasing situation, the lessor claims whatever capital allowances are available and may pass on some of the benefits via lower leasing charges to the lessee. The amount, if any, which is passed on will depend upon competition within the market and also on how close the lease is to the lessor’s year end.

A potential lessee should ideally seek a lessor just before the lessor’s year-end. If the lessor buys an asset just before a year-end, then the benefit of the tax allowance is received at the earliest possible opportunity, which is an inducement to the lessor to arrange the deal.

Advantages and Disadvantages of Leasing:

Advantages:

The advantages arising from the leasing of asset are as follows:

From the View Point of Lessee:

(a) It is an easy method of financing capital asset having a heavy cost involved.

(b) It permits the lessee for alternative use of funds without incurring huge capital investment on an asset.

(c) There is margin money or down payment required for acquiring the asset on lease.

(d) It spreads the capital cost over a period of the lease, so that sufficient flexibility is available by just making payment of periodical lease rentals.

(e) The lease rentals can be structured according to the needs of the lessee.

(f) It is comparatively a cheaper source of finance with less hassles particularly due to tax effect.

(g) It helps to conserve the funds which can be used to improve the liquidity and can be used for some other urgent purposes.

(h) The lessee can avoid the risk of obsolescence by taking the asset on lease basis.

(i) Leasing is free from restrictive covenants such as debt equity ratio, dividend declaration etc.

(j) The lessee can get lease finance upto 100% of the cost of asset.

(k) Small entrepreneurs and technocrats who have got uncertain income can able to get the necessary equipment on lease basis.

(l) The procedure is simple and documentation is minimum.

(m) Lease rentals are deductible expense for gaining tax shield.

(n) It is an ‘off-balance sheet’ financing and help to keep the debt equity ratio will not get effected.

(o) More beneficial to manufacturers to get plant and equipment on lease rather than purchas­ing it due to withdrawal of investment allowance.

From the View Point of Lessor:

(a) It is an asset based financing for a productive purpose and it is safer than normal course of financing business.

(b) The lessor can claim depreciation and will also enjoy the tax benefit.

(c) Lease rentals provide regular income and maintaining liquidity of the concern.

Disadvantages:

The leasing suffers from the following disadvantages:

(a) The main criticism of lease method of financing is that the accounting procedure adopted for recording lease method of financing is highly unsatisfactory.

(b) Lease financing, compared to other methods, is costly for the lessee.

(c) The financial lease has all the rigidities of other methods of financing.

(d) As the lessee is not the owner of the asset, technically he cannot enforce the warranties or guarantees enforceable against the vendor.

Leasing is a special type of transaction for asset acquisition and use. While the lessor is the owner of the asset, the possession and use of the asset remains with lessee. Therefore, the question of disclosure of the asset in the books of account, showing the depreciation and claiming tax benefits have become subject matter of controversy and debate.

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