Please view more updated version of this article: ITA vs IFRS: Interest Costs on Debts
Some important concepts @ first
Meaning of:
Holding title of an asset: Holding document that gives legal right over the asset. (Ownership De Jure)
Owning an asset: Gaining reward and accepting risks of an asset, substantially, by assuming control over the asset. There is no need to hold title of an asset to assume ownership over it. (Ownership De Facto)
Using an asset: Taking hold of an asset to employ it for specific purpose without assuming risks and reward incidental to ownership of the asset.
So what is “risk and reward incidental to ownership” of the asset?
Risk is simply the risk of bearing the losses connected with the asset or lease agreement. For example the person who is responsible for the following losses or expenses is the person who is bearing the risks:
● person responsible for upkeep of asset i.e. repairs or
● person responsible for securing the asset i.e. insurance premium or
● the person who will bear the loss in case asset is stolen
● possible losses from idle capacity
● devaluation in asset because of technological obsolescence
● fluctuations in returns because of changing economic conditions
Reward simply means economic benefits that can be rendered from the asset. For example the person who is responsible for the following benefits is person enjoying the benefits from the assets:
● earning revenue profitably by selling goods produced, constructed by using the asset
● earning rental income by letting or sub-letting the asset
● appreciation in the value of asset (revaluation gain)
● appreciation in the residual value (sales value) of asset
Let's dive in, What can a title holder do with his asset?
A title holder is the person who has the right to own an asset and has a document to prove such right.
Someone as a title holder, what can he do with his asset?
He can, Use the asset
Well this is a no-brainer. A title holder of an asset may use the asset, own the asset, reap benefits from its use, assume its risks and rewards.
He can, Lease the asset
The title holder may enter into an operating lease arrangement to lease the asset outright. In an operating lease arrangement, lessor retains the ownership of the asset.
He can, Loan the asset
The title holder may enter into an finance lease arrangement to loan the asset outright. Loaning an asset is a form of financial arrangement that provides the lessee the right to own the asset without having title of the asset. Hire purchase arrangement is also a form of finance lease arrangement. In a financial lease arrangement, lessee retains the ownership of the asset.
He can, Sell the asset
The title holder may enter into a sales arrangement to sell the asset outright. The sales arrangement maybe in form of cash or credit. Instalment sales arrangement is also a form of credit sales arrangement.
How to differentiate operating lease and finance lease?
Basically, in an operating lease arrangement, lessor retains the ownership of the asset. In a financial lease arrangement, lessee retains the ownership of the asset.
Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract. Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease are:
a. the lease transfers ownership of the underlying asset to the lessee by the end of the lease term;
b. the lessee has the option to purchase the underlying asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception date, that the option will be exercised;
c. the lease term is for the major part of the economic life of the underlying asset even if title is not transferred;
d. at the inception date, the present value of the lease payments amounts to at least substantially all of the fair value of the underlying asset; and
e. the underlying asset is of such a specialized nature that only the lessee can use it without major modifications.
For the purpose of Income Tax, Section 32(5) of Income Tax Act 2058: Any of the following conditions shall be required to be satisfied while conducting finance lease:
a. Arrangement is made in the lease agreement provides for transfer of ownership following the end of the lease term where, the lessee has an option to purchase the asset after expiry of the lease term for a fixed or presupposed price;
b. The lease term exceeds 75% of the useful life of the asset;
c. The estimated market value of the asset after expiry of the lease term is less than 20% of its market value at the commencement of the lease;
d. In the case of a lease that commences before the last 25% of the useful life of the asset, the present value of the minimum lease payments equals or exceeds 90% of the market value of the asset at the commencement of the lease term; or
e. The asset is custom-made for the lessee and after expiry of the lease term the asset will not be of practical use to anyone other than the lessee.
Difference between Hire Purchase Arrangement and Instalment Sales Arrangement
Hire purchase arrangement is a form of finance lease arrangement. Instalment sales arrangement is a form of credit sales arrangement. Hire purchase is an agreement to hire and later to buy. Installment is an agreement to buy. In hire purchase, the ownership transfers from the seller to the buyer on the payment of the last installment. In Installment sale, the ownership transfers outright on the date of entering into instalment sales arrangement. In hire purchase, when there is a default in payment, the financier will take back the goods from the buyer. In installment sale, if there is a default of payment, the seller cannot take back the goods, but can only sue the buyer. Buyer cannot sell the goods to any third party until he pays the last installment to the financier in hire purchase. In case of installment sale, the buyer can sell to any third party as he is the owner of the goods.
Accounting and Taxation Impact
Operating Lease
Point of Transaction | Lessor | Lessee | ||
Accounting | Taxation | Accounting | Taxation | |
Entering Lease with Liability of Decommissioning Cost (DC) | – | – | Dr. RoUA [PV(LP,DC)+DP] | – |
Down Payment (DP) | – | – | – | – |
Lease Payment (LP) Accrued | Dr. Lessee | Dr. Lessee | – | Dr. Lease Expense |
Depreciation Cost | – | – | Dr. Depreciation | – |
Unwinding Cost | – | – | Dr. Unwinding Cost | – |
Lease Payment (LP) Made | Dr. Bank | Dr. Bank | Dr. Lease Liability | Dr. Lessor |
Exiting Lease with Incurring of DC | – | – | Dr. Lease Liability | Dr. DC |
Finance Lease
Also applicable for Hire Purchase Arrangement as hire purchase is also effectively a form of Finance Lease.
Point of Transaction | Lessor | Lessee | ||
Accounting | Taxation | Accounting | Taxation | |
Entering Lease with Liability of Decommissioning Cost (DC) (XP being exercise price of the option to purchase the asset under lease, TP being the termination price of the lease) | Dr. Lessee [PV(LP,GRV,XP/TP)] | Dr. Lessee MV of Asset (If IRR is not determinable, then 15% p.a. is used) | Dr. RoUA [PV(LP,DC)+DP] | Dr. Asset [MV of Asset] (If IRR is not determinable, then 15% p.a. is used) |
Down Payment (DP) | – | – | Dr. Lease Liability | Dr. Lessor |
Lease Payment (LP) Accrued | – | – | – | – |
Depreciation Cost | – | – | Dr. Depreciation | Dr. Depreciation |
Unwinding Cost | Dr. Lessee | Dr. Lessee | Dr. Unwinding Expense | Dr. Unwinding Expense |
Lease Payment (LP) Made | Dr. Bank | Dr. Bank | Dr. Lease Liability | Dr. Lessor |
Exiting Lease with Incurring of DC | – | – | Dr. Lease Liability | Dr. DC |
Normal Sales
Point of Transaction | Seller | Buyer | ||
Accounting | Taxation | Accounting | Taxation | |
At the point of Sales | Dr. Receivable | Dr. Receivable | Dr. Asset | Dr. Asset |
Sales with Deferred terms of Payment
Also applicable for Instalment Sales Arrangement as instalment sales is also effectively a form sales with deferred terms of payment.
Point of Transaction | Seller | Buyer | ||
Accounting | Taxation | Accounting | Taxation | |
At point of Sales | Dr. Receivable [PV(IP)+DP] | Dr. Receivable (If IRR is not determinable, then 15% p.a. is used) | Dr. Asset | Dr. Asset (If IRR is not determinable, then 15% p.a. is used) |
Down Payment (DP) | – | – | Dr. Payable | Dr. Payable |
Instalment Payment (IP) Accrued | – | – | – | – |
Depreciation Cost | – | – | Dr. Depreciation | Dr. Depreciation |
Unwinding Cost | Dr. Receivable | Dr. Receivable | Dr. Unwinding Expense | Dr. Unwinding Expense |
Instalment Payment (IP) Made | Dr. Bank | Dr. Bank | Dr. Payable | Dr. Payable |