Chapter 22

Leasing and Hire Purchase

 Chapter Objectives
• To understand
• Lease financing and its role in economic
growth
• Lease structure
• Types of leases
• Hire purchase
• Instalment system
 Lease Financing
• Contract between owner of an
asset(lessor) and the user of the
asset(lessee) under which the lessor gives
the right to the lessee to use the asset or
equipment for agreed period of time and
consideration called lease rental
• Depreciation can be claim by lessor not
lessee
 Leasing and Economic Growth
• Complementary tool to bank loan
• Promotes investment in capital
equipments
• Leaves line of credit free for working
capital requirements
• Helps startups and small businesses to
grow
• Contributes to country’s infrastructure
growth
 Types of Leases
• Financial Lease
• Operating Lease
• Sale and Leaseback
• Leverage leasing
• Close and open-ended lease
• Upfront and backend lease: More rentals in initial
years and less in later years of the contract in case of
upfront lease
• Percentage lease
• 3N lease
• Crossborder lease
 Finance lease
• A finance lease or capital lease is a type of lease. It is a commercial
arrangement where:
• the lessee (customer or borrower) will select an asset (equipment, vehicle,
software);
• the lessor (finance company) will purchase that asset;
• the lessee will have use of that asset during the lease;
• the lessee will pay a series of rentals or installments for the use of that
asset;
• the lessor will recover a large part or all of the cost of the asset plus earn 
interest from the rentals paid by the lessee;
• the lessee has the option to acquire ownership of the asset (e.g. paying the
last rental, or bargain option purchase price);
 Financial lease
• The lease period covers at least 75% of the useful life of
the asset; or
• There is an option to buy the leased asset following the
lease expiration at a below-market rate; or
• Ownership of the leased asset shifts to the lessee
following the lease expiration; or
• The present value of the minimum lease payments totals
at least 90% of the fair value of the asset at the
beginning of the lease.
• If an examination of these criteria indicate
that a leased asset is a capital lease, the
accounting for the lease is comprised of
the following activities
 Accounting in books of lessee
• Initial recordation. Calculate the present value of all
lease payments ; this will be the recorded cost of the
asset (capitalisation of asset).Future rental payment
as liability in balance sheet. Record the amount as a
debit to the appropriate fixed asset account, and a
credit to the capital lease liability account. For
example, if the present value of all lease payments
for a production machine is $100,000, record it as a
debit of $100,000 to the production equipment
account and a credit of $100,000 to the capital lease
liability account.
• Lease payments. As the company receives lease
invoices from the lessor, record a portion of each invoice
as interest expense and use the remainder to reduce the
balance in the capital lease liability account. Eventually,
this means that the balance in the capital lease liability
account should be brought down to zero. For example, if
a lease payment were for a total of $1,000 and $120 of
that amount were for interest expense, then the entry
would be a debit of $880 to the capital lease liability
account, a debit of $120 to the interest expense account,
and a credit of $1,000 to the accounts payable account.
• Depreciation. Since an asset recorded through a capital
lease is essentially no different from any other fixed
asset, it must be depreciated in the normal manner,
where periodic depreciation is based on a combination of
the recorded asset cost, anysalvage value, and its useful
life. For example, if an asset has a cost of $100,000, no
expected salvage value, and a 10-year useful life, the
annual depreciation entry for it will be a debit of $10,000
to the depreciation expense account and a credit to
theaccumulated depreciation account.
• Total lease payment is divided into
parts:Financial charges will be treat as
expense in P/L account and principal
amount will be deducted from liability side
of balance sheet.
 Accounting for lessor under
Financial lease
• Leased asset will be shown as receivable
in the books of lessor.
• Lease payment receivable as repayment
of principal
 Operating lease
• An operating lease is a lease whose term is
short compared to the useful life of the asset or
piece of equipment (an airliner, a ship, etc.)
being leased. An operating lease is commonly
used to acquire equipment on a relatively short-
term basis. Thus, for example, an aircraft which
has an economic life of 25 years may be leased
to an airline for 5 years on an operating lease.
 Accounting for lessee under
Operating lease
• Lease rentals under operating lease will
be treated as an expense in P/L account.
 Accounting for lessor under
Operating lease
• Assets as fixed asset in balance sheet and
depreciation will be charged
• Lease rentals will be treated as income in
P/L account.
 Hire Purchase
• A contract whereby the owner of the
goods lets them on hire to hire purchaser
on payment of rent, tobe paid in
instalments and the title in goods will pass
to the hirer on the payment of last
instalment
Difference between Lease and Hire
Purchase
• Lease transaction is a commercial arrangement, whereby an equipment owner or
manufacturer conveys to the equipment user the right to use the equipment in return
for rental.Hire purchase is a type of installment credit under which the hire purchaser
agrees to take the goods on hire at a stated rental, which is inclusive of the
repayment of principal as well as interest, with an option to purchase.Option to user
• Except the Finance lease. no option is provided to the lessee (user) to purchase the
goods.The person becomes owner of the asset after paying the last installment
Nature of expenditureLease rentals paid by the lessee are entirely revenue
expenditure of the lessee.Only interest element included in the Hire Purchase
installments is revenue expenditure in nature.
• Components:Lease rentals comprise of two elements (1) finance charge and (2)
capital recovery.Hire Purchase installments comprise of three elements (1) normal
trading profit (2) finance charge and (3) recovery of cost of goods/assets.
• Depreciation: Lessor can claim for the depreciation Hire purchaser can claim for the
depreciation
• Tax Benefit:In lease agreement, Lessor can claim depreciation and the lessee can
claim the maintenance and rentals from taxable income. Higher purchaser can claim
for depreciation and interest payment from the taxable income where as the seller
can claim for the interest on borrowed fund for purchasing assets.