TAX AND ACCOUNTING

ASPECTS OF LEASES

Leasing assets involves a number of tax and accounting considerations, which

are examined in this section.
Tax Status of True Leases
• Annual lease payments are tax deductible for the
lessee if one crucial criterion is met: The IRS
must agree that a contract truly is a lease and
not just an installment loan called a lease. Before
embarking on a lease transaction, all involved
parties should obtain an opinion from the IRS
regarding the tax status of the proposed lease.
The opinion of the IRS normally revolves
primarily around the following general rules:
• The remaining useful life of the equipment at the end of the
lease term must be the greater of 1 year or 20 percent of its
originally estimated useful life. Leases in excess of 30 years
are not considered to be leases for tax purposes.

• The lease payments must provide the lessor with a fair market
rate return on the investment.

• This profit potential must exist apart from the transaction’s tax
benefits. Renewal options must be reasonable, that is, the
renewal rate must be closely related to the economic value of
the asset for the renewal period.

• If the lease agreement specifies a purchase option at the end of

the lease period, the purchase price must be based on the
asset’s fair market value at that time.
• The schedule of lease payments should not be very high early
in the lease and very low thereafter. Such a payment schedule
suggests that the lease structure is being used merely to avoid
taxes.
• In the case of a leveraged lease, the lessor must provide a
minimum of 20 percent equity.
• Limited-use property (valuable only to the lessee) may not be
leased.

If the IRS does not agree that a contract is truly a lease, taxes
are applied as if the property had been sold to the lessee and
pledged to the lessor as security for a loan.
Leases and Accounting Practices
• In recent years, firms have tended to disclose more
information regarding lease obligations.

• In November 1976, the Financial Accounting Standards

Board (FASB) issued Standard No. 13, which requires
lessees to capitalize certain types of leases, primarily
financial or capital leases. The capitalized value of lease is
determined by computing the present value of all
required lease payments, discounted at a rate equal to
the lessee’s incremental borrowing rate for a secured loan
over a term similar to the lease.
Example illustration of this procedure.
In addition to making these balance sheet adjustments, a firm must show
the following in the footnotes to the financial statements

• For financial leases:

• The gross amount of assets by major classes according to nature or use reported
under financial leases as of date of the balance sheet
• The amount of accumulated lease amortization
• Future minimum lease payments as of the date of the latest balance sheet
presented, in total and for each of the next five fiscal years

• For operating leases:

• Future rental payments required as of the date of latest balance sheet presented,
in total and for each of the following five fiscal years.
• The rental expense for each period for which an income statement is presented

• The lessee must also indicate in the notes to financial statements the
existence and terms of renewal or repurchase options and escalation
clauses, restrictions imposed by leases and any contingent rental
obligations.
 DETERMINING LEASE PAYMENTS:
THE LESSORS PERSPECTIVE

Step 1: Compute the lessor’s amount to be amortized.

Step 2: Compute the annual after-tax lease income.

Step 3: Convert the lease income requirement of the lessor to

lease payment requirement of the lessee.
LEASE-BUY ANALYSIS: THE LESSEE’S
PERSPPECTIVE
• Financial theorists and model builders have devoted a
substantial amount of time and effort to developing an
analytical framework within which the differential costs
associated with leasing versus buying can be compared.

• One of the most commonly used approaches to the analysis of

a lease versus purchase decision assumes that the appropriate
comparison should be between leasing and borrowing to buy.
Advocates of this approach argue that a financial lease is
much like a loan in that it requires a series of fixed payments.
Failure to make lease payments, like failure to make loan
payments, may result in bankruptcy.