Leasing and Deferred Tax: Financial Accounting Study Notes

Leasing in Financial Accounting

Definition and Overview

Leasing is a contractual arrangement where the lessee (tenant) pays rent to the lessor (property owner) for the use of an asset. Leasing enables the lessee to utilize assets without large upfront payments required by purchase agreements.

• Lease: A rental agreement for asset use.

• IAS 17/IFRS 16: International standards governing lease accounting.

• Categories:

  1. Operating Lease

  2. Capital (Financial) Lease

Operating Lease

Operating leases are essentially rental agreements where the lessor retains the risks and rewards of ownership.

• Bookkeeping:

  • Lessee records Rent Expense (Debit) against Cash (Credit) for each payment.

  • No liabilities or asset recognition other than cash.

• Disclosure: IAS 17 requires disclosure of operating lease commitments.

• Example:

  • Annual payment of $10,000 for five years is recorded as rent expense and cash outflow each year.

Capital (Financial) Lease

Capital leases transfer the risks and rewards of ownership to the lessee, who must capitalize the asset and recognize related liabilities.

• Bookkeeping at Contract Signature:

  • Recognize Asset at the present value of lease payments.

  • Recognize Liability at the present value of lease payments.

  • Depreciate asset according to standard policy.

  • Lease payments split between interest expense and liability reduction.

• Example Journal Entries:

  • On signing: Lease Asset and Lease Liability at present value.

  • On payment: Lease Liability, Interest Expense, and Cash.

Lease Amortization Schedule

Shows the breakdown of each payment into interest and principal, and the reduction of lease liability over time.

Period	Begin LL	Payment	Interest	Principal	End LL
1	43,295	10,000	2,165	7,835	35,460
2	35,460	10,000	1,773	8,227	27,232
3	27,232	10,000	1,362	8,638	18,594
4	18,594	10,000	930	9,070	9,524
5	9,524	10,000	476	9,524	0

Criteria for Capital Lease (IAS 17)

• Transfers substantially all risks and rewards to lessee.

• Transfers ownership at lease end.

• Lease term covers substantial part of asset’s useful life.

• Present value of payments is substantial part of asset’s fair value.

Time Value of Money

Present Value (PV) Concept

The present value is the current worth of future cash flows discounted at a specified rate. The higher the discount rate, the lower the present value.

• Key Factors:

  • Amount of future payment

  • Length of time

  • Interest rate

• Formula: $DCF = \frac{CF_1}{(1+K)^1} + \frac{CF_2}{(1+K)^2} + \frac{CF_3}{(1+K)^3} + \frac{CF_4}{(1+K)^4} + \frac{CF_5}{(1+K)^5}$ Where K is the effective interest rate.

Leasing and Tax

Deferred Tax

Deferred tax arises when there are differences between accounting and tax reporting, particularly in the timing of income and expense recognition.

• Calculated Tax: Tax rate × accounting taxable income (from IS).

• Payable Tax: Tax rate × taxable income (from tax reporting).

• Deferred Tax: Difference between calculated and payable tax.

• Deferred Tax Equation: $\text{Deferred tax}_{\text{ultimo}} = \text{Deferred tax}_{\text{primo}} + \text{change in deferred tax}$

• Calculated Tax Formula: $\text{Calculated tax} = \text{Payable tax} + \text{change in deferred tax}$

Permanent vs. Temporal Differences

• Permanent Differences: Income/expenses only in one account (e.g., entertainment, dividends). Do not affect deferred tax.

• Temporal Differences: Income/expenses included in both accounts but recognized in different periods (e.g., depreciation methods). Cause deferred tax.

Examples of Deferred Tax

• Positive Temporary Differences (Liability):

  • Slower depreciation in financial reporting than tax reporting.

  • Asset revaluation not taxed until disposal.

  • Revenue recognized in IS before tax reporting.

• Negative Temporary Differences (Asset):

  • Faster depreciation in IS than for tax purposes.

  • Provisions for bad debts or warranties recognized earlier in IS than tax reporting.

Financing Operations

Main Methods

• Retained earnings

• Issuing shares

• Issuing bonds or notes payable

Key Ratios

• Debt Ratio: $\text{Debt Ratio} = \frac{\text{Total liabilities}}{\text{Total assets}}$

• Times-Interest-Earned Ratio: $\text{Times-Interest-Earned Ratio} = \frac{\text{Operating Income}}{\text{Interest Expense}}$

Summary Table: Operating vs. Capital Lease

Feature	Operating Lease	Capital Lease
Asset Recognition	No	Yes (PV of payments)
Liability Recognition	No	Yes (PV of payments)
Expense	Rent Expense	Interest + Depreciation
Ownership Risks/Rewards	Lessor	Lessee

Conclusion

Understanding the distinction between operating and capital leases, the calculation of present value, and the treatment of deferred tax is essential for accurate financial accounting and reporting. These concepts impact both the balance sheet and income statement, as well as tax planning and compliance.