Report on Leasing (1705659)
Leasing an asset in business is an important decision. A small business generally seeks for leasing alternatives as to why they hold limited resources to utilize. At the same time, they want fewer investments in order to conduct business and cost-effective functioning.
Therefore, they opt the leasing option when required for the business. In this report, the analysis of the leasing concept with respect to finance and the operating lease will be presented with their significance and drawbacks (Neuberger and Räthke-Döppner, 2013).
Apart from this, the analysis of these two different leasing types will be a help to B Ltd in order to adopt one of these options and effective handing in cash flows challenges in business. It will be to important business decisions to further growth and success.
In order to make prominent business leasing decision; manager of B Ltd needs to understand what exactly they are:
Generally, Finance lease is given by finance company to a user for a longer period of time and share the economic risks and returns according to change in valuation of the underlying asset.
In other words, a commercial contract takes place between lessor and lessee for using an asset in lieu of periodical payments for long time duration and ownership of asset transfer to lessee Bohušová, 2015). In this context, the finance company is called as lessor and user as lessee.
Basically, it means to rent the asset to the user in exchange for lease payments to the owner. In addition to this, operating lease is a contract wherein lessee agrees to rent an asset from the lessor however, right of ownership lies with lesser (Jennings and Marques, 2012). Moreover, it is a short term contract and known as a rental contract.
Thus, it can be identified that the main difference between these lease options is right of ownership that remains with lessor in case of operating lease and transfer to the lessee when finance leasing takes place.
Advantages and Disadvantages of Finance Lease
While determining the business decision manager must aware about the pros and cons of finance lease in their nature of business. Also, it is necessary to assess suitability as per the size and scale of business.
Advantages
Preservation of Ownership
In a finance lease, all risk and rewards are rendered to from lessor to lessee without transferring the right of ownership, in this way, the right of ownership lies of with the lessor.
High profitability
Finance lease is highly profitable as the rate of return is based on the lease rental (Mikic et al 2015). At the same time, lease rental is higher than the interest rate payable for fiancé the asset.
High potential for growth
In this type of lease contract, there is an increasing possibility of further business of growth. A to why there is a huge demand for leasing due to its cost economic feature and efficient form of finance. The major benefits are that business growth can be maintained even in the duration of depression.
Tax benefits
Finance lease is considered as business expense this is how lessee able to enjoy the tax advantage on lease payments (Karampinis and Hevas, 2013). It is not presented in the balance sheet and treated as an expense instead.
Economical
During various research based on leasing and market, it is identified that it is the best and most economical leasing type in comparison to others for the lessor.
Inflation Friendly
It is considered as inflation friendly lease type as to why the lessee needs to pay an only a fixed amount of rent amount every year even through asset value increases.
Ownership
The most significant benefit is that after the expiry of the lease agreement, the lessor offers the lease for purchasing the rented asset at economical rates
Disadvantages
Compulsion
The biggest drawback is that the fiancé lease is not cancelable (Wong and Joshi, 2015). Once the contract takes place lessee has to pay rent even not willing to use the asset.
Ownership
The lessee will not become the owner of the asset at the time of completion of the lease until the user purchases it.
Understatement of Asset
The major limitation is that due to the absence of ownership rights lessee cannot become the owner of the asset. Hence, it cannot be shown as balance sheet leads to an understatement of assets.
Advantages and Disadvantages of Operating Lease
On the other hand, the benefits and limitations of the operating lease have been discussed as follows:
Advantages
Ownership rights
The most important aspect of this operating lease is that lessor holds the right of ownership and gets the regular source of income even after termination of the contract.
Reduces taxable income
It is helpful in order to reduce the tax bracket on taxable income. As to why, it is treated as a business expense and rental and not shown in the balance sheet (Fitó et al, 2013. In this way, it reduces the taxable income and enjoys the less interest rate.
Flexible
It is comparatively flexible in comparison to the finance lease as there is no such foundation to continue the lease contract and pay the rental charges. At the same time, the lessor can also cancel the contract.
Risk of Obsolesce
Another significance is that the risk of obsolesce is leis with the lessor. At the same time, the lessor has to take care of the leased asset and maintain it. Thus, it is economical for the lessee point of view.
Simple and convenient
It is a very simple method for leasing the asset as it is comparatively taking place for a shorter period of time (Jennings, R. and Marques, 2013). If in case business owner rents it and the possibility to continue further the lessee can renew the contract further.
Disadvantages
Increased Expenses
The biggest disadvantage of operating lease is that it involves a higher level of expenses. These expenses are shown in the company’s income statement hence it increases the operating expenses and reduces the net income.
Lack of Continuity
There is a lack of continuity and it happened as temporary arrangements between lessor and lessee, whenever it terminates leads to various negotiations regarding terms and relations (Andrade et al 2014). Hence, it becomes an irregular and tough process for the lessee.
No purchase option
There is no option similar to finance lease as lessor invite the lessee to buy the asset. This is one of the major difference lines between fiancé and operating lease alternative.
Finance and Operating Lease under ASC topic 842
A new financial accounting standards board (FASB) has declared an impact on the business significantly (Öztürk, M. and Serçemeli, 2016). According to this, new terms for Operating and finance lease are as following:
- Short term lease, not more than 12 months will be exempted and will be reflected off from balance sheet.
- Capital leases are termed as fiancé leases.
- Operating leases to be capitalized that possibly supersedes most existing operating leases.
- Fiancé leases must be the transfer of ownership, option to purchase the asset; lease covers the most of the asset life and possesses present value guarantee residual value.
Apart from that, there is a slight difference between FASB and IFRS (International Financial Reporting standards) application of standards. At the same time, IFRS has simpler standards for lease accounting and continuously reflect the net investment for finance lease (Bohušová, 2015).
It does not use terms like sales-type and direct financing leases. On the other hand, IFRS shows the interest on revenue and profit on sales on leased asset however, FASB uses the term sales-type and direct financing leases.
On the basis of above discussion and analysis of merits and demerits of operating and finance lease, it is determined that operating lease is suitable for short term leases however finance lease appropriate for longer period of time. In addition to this, both lease types are based on the right to use and transfer of ownership.
In the case of a finance lease, interest expenses are effective and front-loaded along with straight line expenses for the right to use the asset (Krische, 2012). Hence, expense in the income statement will be a higher initial stage but gradually slow down. On the contrary, the income statement expenses remain the same in operating lease from one accounting period of time.
Therefore, it can be advised that if B Ltd. leases the asset for a longer run could prefer finance leasing. The important aspect is that it might be costly in the initial stage but fruitful in later subsequent years of business. Apart from that, there is an option to purchase the leases asset depends on the lessee indent and business growth (Wong and Joshi, 2015).
Also, if the company wants to continue its business from the same location can buy the property. Even, the company not willing to buy the land it finance lease covers a major part of asset age, Hence, the lessee would be struggling with business stability.
In addition to this, the right to cancel the agreement lies with lease and the other big advantage is that the right of ownership transferred to the lessee. it is the most prominent option for small businesses as lessee does not only operates the business using the asset but also possess some shares and economic risks and returns with the change in the value of underlies asset. Thus, it can be concluded that a finance lease is the best option for B limited company.
Andrade, S.C., Henry, E. and Nanda, D., 2014. The impact of operating leases and purchase obligations on credit market prices.
Bohušová, H., 2015. Is Capitalization of Operating Lease Way to Increase of Comparability of Financial Statements Prepared in Accordance with IFRS and US GAAP?. Acta Universitatis Agriculturae et Silviculturae Mendelianae Brunensis, 63(2), pp.507-514.
Bohušová, H., 2015. Is Capitalization of Operating Lease Way to Increase of Comparability of Financial Statements Prepared in Accordance with IFRS and US GAAP?. Acta Universitatis Agriculturae et Silviculturae Mendelianae Brunensis, 63(2), pp.507-514.
Fitó, M.À., Moya, S. and Orgaz, N., 2013. Considering the effects of operating lease capitalization on key financial ratios. Spanish Journal of Finance and Accounting/Revista Española de Financiación y Contabilidad, 42(159), pp.341-369.
Jennings, R. and Marques, A., 2012. Amortized cost for operating lease assets. Accounting Horizons, 27(1), pp.51-74.
Karampinis, N.I. and Hevas, D.L., 2013. Effects of IFRS adoption on tax-induced incentives for financial earnings management: evidence from Greece. The International Journal of Accounting, 48(2), pp.218-247.
Krische, S.D., Sanders, P.R. and Smith, S.D., 2012. Lease transaction structuring, earnings management, and management credibility. Research in Accounting Regulation, 24(1), pp.33-39.
Mikic, M., Novoselec, T. and Primorac, D., 2014. Influence of financing source on the small business performance. Economic and Social Development: Book of Proceedings, p.283.
Neuberger, D. and Räthke-Döppner, S., 2013. Leasing by small enterprises. Applied Financial Economics, 23(7), pp.535-549.
Öztürk, M. and Serçemeli, M., 2016. Impact of New Standard” IFRS 16 Leases” on Statement of Financial Position and Key Ratios: A Case Study on an Airline Company in Turkey. Business and Economics Research Journal, 7(4), p.143.
Wong, K. and Joshi, M., 2015. The impact of lease capitalisation on financial statements and key ratios: Evidence from Australia. Australasian Accounting, Business and Finance Journal, 9(3), pp.27-44.
Wong, K. and Joshi, M., 2015. The impact of lease capitalisation on financial statements and key ratios: Evidence from Australia. Australasian Accounting, Business and Finance Journal, 9(3), pp.27-44.
