Debt finance and leasing - Finance vs operating leases

Learning Outcomes

After reading this article, you will be able to distinguish between finance and operating leases, explain the criteria for their classification, and assess the advantages and disadvantages of each for business finance. You will be able to compare leasing with outright purchase using NPV techniques and identify how each lease type affects financial statements and taxation positions.

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand the role of leasing in business finance. In this article, make sure you focus on:

• The main types of lease: finance and operating leases, and how they differ
• The decision-making process of leasing versus buying an asset
• The impact of leasing on financial statements and tax
• The calculation and comparison of NPVs for lease and buy options
• The benefits and risks associated with each leasing arrangement

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which key feature distinguishes a finance lease from an operating lease?
   1. Lease period covers most of the asset's useful life
   2. Maintenance is always the lessee’s responsibility
   3. Lessor cannot reclaim the asset
   4. Lease payments are based on asset usage only
2. A company is considering leasing or buying equipment. What cash flows should be INCLUDED in a lease vs buy NPV analysis?
   1. Tax savings from lease payments
   2. The estimated resale value of a leased asset
   3. Sunk costs
   4. Allocated overheads not affected by the decision

3. True or False? Tax-allowable depreciation is available to the lessee in an operating lease.

4. Briefly explain one potential benefit of an operating lease compared to a finance lease.

Introduction

Leasing is a key source of business asset finance. Many companies face the choice of leasing or borrowing to buy equipment. Understanding the difference between finance leases and operating leases is fundamental for ACCA Financial Management. Correctly classifying a lease type, recognising the relevant costs and benefits, and selecting the most cost-effective option are all important for passing the exam and making sound business decisions.

Key Term: lease
A contract that allows one party (the lessee) to use an asset owned by another party (the lessor) for an agreed period, in exchange for regular payments.

TYPES OF LEASE: FINANCE VS OPERATING

Leases fall into two broad categories: finance leases and operating leases. The distinction is essential for accounting, tax, and decision-making.

Finance Lease

A finance lease transfers substantially all the risks and rewards of ownership of an asset to the lessee. Typically:

• Lease term covers the major part of the asset's useful life
• Lease payments allow the lessor to recover most (if not all) of the asset’s value
• Lessee is responsible for maintenance, insurance, and repair

Key Term: finance lease
A lease arrangement whereby the lessee assumes most of the risks and rewards of ownership, even though legal title may not pass.

Operating Lease

An operating lease does not transfer substantially all risks and rewards. Its features include:

• Lease term shorter than the asset's economic life
• Lessor expects the asset to have significant residual value
• Lessor typically maintains and insures the asset
• Lessee can often cancel or extend the lease

Key Term: operating lease
A lease agreement in which the lessor retains the risks and rewards of ownership and the asset is returned at lease end; lease terms are typically much shorter than the asset’s useful life.

LEASE VS. BUY DECISIONS

Choosing between leasing and buying requires comparing the present values of the alternatives. Only cash flows directly affected by the decision are relevant: initial outlays, lease payments, tax effects, and residual values.

Lease

• Lessee pays rentals over the lease term
• Lease payments are typically tax-deductible for the lessee (especially in operating leases)
• The asset remains on the lessor’s balance sheet (in operating leases; in finance leases, the lessee may be required to record the asset and liability)

Buy

• Buy outright using cash or loan
• Lessee may claim tax-allowable depreciation
• May be a loan interest tax deduction if financed by debt
• Lessee has access to any future residual value

Worked Example 1.1

A business is considering whether to lease or buy a machine. The machine costs $50,000. Option 1: Buy with a 10% loan. Option 2: Lease for $13,000 per annum, payable at year end for 5 years. Tax is 30%, paid one year in arrears. The asset’s useful life is 5 years, no residual value. Tax-allowable depreciation is straight-line over 5 years. The after-tax cost of borrowing is 7%.

Should the company lease or buy?

Answer:
Calculate the NPV for both options using after-tax cash flows and the post-tax cost of debt as a discount rate.

Buy: Deduct tax savings on both depreciation and interest, add initial outlay.
Lease: Deduct tax savings from lease payments (as they are tax-deductible), add annual payment.
Discount all relevant flows at 7%.
The option with the lower NPV cost is preferred—typically, if tax benefits from buying are large, buying may be favoured; if the lessor is more tax-efficient, leasing may be cheaper.

ACCOUNTING AND TAX IMPLICATIONS

Proper lease classification affects financial statements and taxation.

• Finance leases: Lessee records the asset and liability; can claim interest and depreciation for tax (if allowed by local tax law).
• Operating leases: Off-balance-sheet for lessee; only lease payments are expensed; no depreciation or interest deduction.
• Tax relief: For finance leases, tax-allowable depreciation is usually available to the lessee. For operating leases, only lease rentals are tax-deductible.

Worked Example 1.2

A company enters a finance lease. The annual lease payment is $20,000. The asset’s useful life and lease term are both five years. The lessee’s tax rate is 25%, tax paid one year in arrears.

What is the after-tax annual cash outflow related to the lease payment?

Answer:
Lease payment = $20,000
Tax relief in following year = $20,000 × 25% = $5,000
Net outflow in each year = $20,000 – $5,000 = $15,000 (timing of tax effect considered in NPV)

Advantages and Disadvantages of Each Lease Type

Exam Warning

Do not confuse operating and finance leases in NPV calculations:
For a finance lease, consider the after-tax lease payments and include any tax-allowable depreciation if relevant.
For an operating lease, claim tax relief on rental payments only.

Summary

Understanding the distinction between finance and operating leases is key in assessing business asset finance options. Finance leases transfer most risks and rewards to the lessee, while operating leases are shorter, more flexible, and keep the asset off the lessee's balance sheet. Lease vs buy decisions should compare all relevant, after-tax cash flows, discounted appropriately.

Key Point Checklist

This article has covered the following key knowledge points:

• Distinguish between finance and operating leases, including their key characteristics
• Determine the tax and accounting treatment for each lease type
• Explain the relevant cash flows for lease vs buy decisions
• Perform basic NPV analyses for lease and purchase alternatives
• Identify the main business considerations in selecting leasing as a source of finance

Key Terms and Concepts

• lease
• finance lease
• operating lease