Financial Accounting

(PGDM- 2018-20)

Session -18: Accounting for Lease and Income Tax

Sriranga Vishnu
Faculty (F&A Area)
 Lease - Introduction

• Lease is “an agreement whereby the Lessor conveys to the

Lessee, in return for a payment or series of payments, the
right to use an asset for an agreed period of time”

• Leasing facilitates acquisition of an useful asset without

having to invest own or borrowed funds

• Sectors making use of Leases in a big way include

Airlines, Shipping industry and Retailing. Several other
firms also utilize the services of leased vehicles,
photocopying facilities, etc.
 Lease - Introduction

• In a lease agreement, a variety of provisions are possible

• The duration of the lease may extend to the life of the
asset or may be less
• The lease rental may remain constant or may increase or
decrease during the lease period
• The contract of the lease will explicitly mention that
which party shall bear the expenses on tax, insurance,
maintenance, etc.
• The lease agreement may reflect upon the option to renew
the contract or sale of the asset after the lease term
 Lease - Introduction

• The lease contract may have different kinds of restrictive

clauses (new bank loans, payment of dividend, etc.) as
well as termination options
• The contract may also state about the penalty on the
lessee for early termination of the contract
• The lease contract may also contain provisions in case of
payment default by the lessee. Normally, the lessee is
required to pay all future payments immediately if there is
a case of default
• There is obligation on the part of the lessor to allow the
lessee to enjoy the leased property
 Advantages of Lease

• Generally lease contracts are less restrictive than debt

agreements
• In lease, complete cost of an asset may get financed. In
other debt arrangements, the level of financing is
generally low
• Since lessor retains the legal rights on the asset, they are
more secured than other investors
• Lease arrangement helps in buying new machines quickly
and remaining updated on the technology front
 Types of Leases

• Operating Lease – Leases having smaller contract period

ranging from a few days to one year

• Capital / Financial Lease – Leases that transfer

substantially all the risks and rewards incidental to
ownership of an asset

• Classification of lease is on the basis of principal of

substance which requires firms to identify transactions in
tune with their economic substance and reality and not
merely by their legal form
 Types of Leases

Criteria Capital Lease Operating Lease

Economic Effective transfer of

Rental arrangement
Substance ownership

Lease Term Typically Long Typically Short

Lease rentals are

Recognition of Leased
Accounting expensed as and
Assets and Obligations
when they incur
 Capital /Financial Lease
• Some identification criteria for Capital Lease:
– Asset is transferred to the lessee at the end of the period
– Lessee has a ‘bargain purchase’ option at the end of the
contract period
– Lease term is for the major part of the economic life of the
asset (75%)
– The lease payments covers a substantial portion of the fair
value of the asset (90%)
– The lease agreement is not cancelable
– Leased assets are of such specialize nature that only the
lessee can use them without major modifications
 Accounting for Lease
• In case of Operating Leases, the rentals are shown as
expense in quarterly/ semi-annual/ annual reports

• Capital/ Financing Lease: They must be recognized as an

asset and an obligation in the Balance Sheets of lessee.
This practice is called Lease Capitalization

• Capital leases are treated as if secured loan has been taken

which is being serviced in installments

• Leased assets are shown on the Assets side of B/S and are
depreciated over the period on contract
 Accounting for Lease
• Leased assets are shown on the Liabilities side of B/S as
Lease Repayments

• Capital Lease repayments include two components:

– Repayment of the Principal
– Repayment of the Interest

• The cost of the leased asset is taken as smaller of fair

value of the asset or the present value of the stream of
lease payments required by the contract
 Accounting for Lease
• Lease payments have strong effect on the Income
Statement and Balance Sheet

• For non-capitalized lease, the lease rental expense is

reflected over the period of agreement

• For Capitalized leases, depreciation and interest charges

affect the Income Statement apart from affecting the B/S.
The Debt to Equity ratio increases. The Return on Asset
decreases

• Consequences for raising money through bonds – Bond

covenants
 Accounting for Taxes

• Income Taxes is shown as ‘Provision for Income Tax’ on

Income Statement and as ‘Taxes Payable’ on B/S

• For most transactions, the taxable amount is same as

reported to tax authorities as well as to stakeholders

• Accounting of Depreciation: SLM for Financial reporting

and WDM for tax reporting

• Different effects on Income Statement and Balance Sheet

 Accounting for Taxes

• Reason for different reporting:

• For tax authorities – Shaping the behavior of taxpayers
• For Reporting Standards – Useful information to
stakeholders and creditors
• Case of Depreciation: WDM is permitted by law
• High Depreciation, Less Taxes
• Time value of money
• For Financial Reporting: Matching concept
• Differential Tax Reporting may lead to permanent and
temporary differences
 Accounting for Taxes

• Permanent Differences: Such differences refer to

revenues that will never be taxable and expenses that will
not be tax deductible
• Tax laws may prohibit certain deduction from taxable
income (Fines); and may permit certain revenues to be
excluded from taxable income (interest received on
municipal bonds, subsidy, )
• Permanent differences are irreversible
 Accounting for Taxes

• Temporary differences: Tax laws and financial reporting

standards permit revenues / expenses to be recognized in
different time periods. Such differences are reversed in
later years
• Some examples of temporary differences:-
• Revenue reporting through delivery method and tax
reporting on the basis of installments received
• Prepaid expenses may be tax deductible when paid but
recognized in accounting in relevant period
• Estimated warranty expenses are matched with sale of
warranted items but are deducted for tax in the period they
incur