Leases and Liabilities - Assignment Example

Leases and Liabilities Name of the Student Name of the Institution Introduction In the present global economies, most organizations are mainly concerned with increasing profit or income as well as minimizing expenditures. The decision to whether purchase or lease an asset lays solely upon the concerned management. Drawing on lease models advocated by Drury and Braund (1990), organizations do not possess unlimited borrowing potential or capacity and since leasing commits an organization to a broad range of fixed payments, leasing is equated as borrowing. Ullsperger (2016) defines a lease as a prescribed agreement between a user (lessee) and an asset owner (lessor). The agreement calls upon the user (lessee) to pay the owner (lessor) for the asset use. Buildings, property, business or industrial equipment and vehicles are the commonly leased assets. Borrowing from Ullsperger (2016), an organization can benefit from leasing of assets in the following ways: 1 (a) Benefits of leasing i. Elimination of Outdated Equipment Leasing promotes technological advancement of an organization. In return this enables an organization to maximize effectiveness and productivity. Technologically advanced organization is likely to comply with issue like regulation on e-waste disposal as opposed to organizations that use obsolete technology. Lastly an organization can upgrade equipment to the latest technologies by modifying the lease as opposed to buying on the same. ii. Flexibility Leases allow an organization to spread the total asset leasing cost across the lease period. This option promotes flexible monthly payment and reduces high upfront cost. The amount paid monthly, quarterly or yearly can as well be customized to favour organizational budget levels. iii. Fixed Payments Lease agreement indicates the amount payable by the lessee to the lesser for the entire lease period. This amount is fixed hence enables an organization to effectively and consistently budget for its cash flow. The fixed amount payable protects an organization from increased interest rates. iv. Lower up-front Costs Leasing allows an organization to acquire needed solution in spite of the fact that their current budget does not allow cash outright purchase. Operational credit lines line and working capital can be preserved through lease financing and considering the fact that leases requires no or little down payment. This option makes money available to finance other operational expenditures (Ullsperger, 2016). 1 (b) Finance and operational leases According to Carson, R., & Partners, S.E. (2010), financial lease is a lease in which the owner (lessor) permits the user (lessee) to pay rent and use an asset for greater period of its economic life. Operating lease is a lease in which the owner (lessor) allows the user (lessee) to use an asset for lesser period of time than its economic life against rent payment. A finance lease is a lease whereby substantially all risks and rewards related to a leased asset ownership are transferred to the lessee. In accordance to the authors, the following characteristics can be used to evaluate if a lease is a financial or operating lease. a) Asset Ownership A lease is classified a finance lease if the lessee has the option of purchasing the asset at a price considered significantly lower than its fair value although title of the asset may remain with the owner (lessor). In operating lease, ownership of the leased asset remains in the lessor’s custody and the lesser does not have an option to purchase the asset at the completion of the lease period. b) Accounting Effects Finance lease is treated as a loan and the asset ownership is perceived as for the lessee therefore the asset is incorporated in their balance sheet. On the other hand, operating lease is considered as rental and payment of the leased asset is viewed as operating expenses and the asset does not appear on the balance sheet. c) Expenses In operating lease, only monthly payments are made by the lessee while in financial lease the lessee bears maintenance, taxes and insurance expenses. Furthermore, in financial lease the lessee is entitled to both depreciation and interest since the lease is considered as a loan, while in operating lease, payment of lease is considered as an expense therefore claims on depreciation cannot be made. d) Lease period Operating lease period is usually shorter as compared to finance lease which is for long term and it covers maximum period of the assets’ life. Financial lease is not flexible and can be easily altered or terminated. Financial lease can only be terminated under specified conditions and in such a case, any losses that maybe incurred to the owner (lessor) are borne by the user (lessee). e) Tax benefits Operating lease is generally considered as renting and the lease payment is considered as an expense, there are no depreciation claims involved. In financial lease, the lessee (user) can claim depreciation since the lease is treated as a loan (Carson and partners, 2010). 2 (a) Liabilities, provisions and contingent liabilities Bolton, P., & Freixas, X. (2000), elaborated definitions of liability, provision and contingent liability in the following ways; Liabilities A liability is termed as a current obligation of an organization as a result of previous events. Liability settlement expectations are high overflow of organizational resources affecting economic benefits especially in monetary aspects. Liability has characteristics such as; it embodies current responsibilities to other entities like assets, it requires that the responsibility obligates a given entity leaving it without discretion of avoiding future sacrifice or expenses. An example being a situation where a company has a policy to compensate its customers due to service interruption. Provision Provision is a liability which can only be measured using some degree of uncertainty. It’s a considered as being a subclass of liability, and it records present liability of a given entity. Provision has characteristics of uncertainty on the amount to be settled and the time for settlement. An example of a provision is money set aside for future eventualities like losses, deferred taxes or guarantees. Contingent liability Contingent liability can be defined as certain obligations that are not recognized as liabilities on organizational financial statements but should be reflected in the books of account. Contingent liability is a liability with high chances of occurrence depending on the out-come future uncertain event. An example being outstanding product warrantees. (Bolton, P., & Freixas, X. 2000). 2 (b) Preferred Shares and Ordinary Shares Levintal, O. (2011), stated that preferred shares are also known as preferred shares. In case of organizational solvency, they have an advantage of priority claim to organizational assets that is higher than that of ordinary share. They also receive a distribution of dividend that is fixed as opposed to ordinary shares which receive dividends at the preference of the management. Preference shares can be changed into ordinary shares and they lack voting rights as opposed to ordinary shares that have one vote per every share. Preference shares dividends are set at specific rates even though dividend payment is not guaranteed by simply owning them. On the other hand preference shares can either be noncumulative or cumulative (Levintal, O. 2011). Schon, W. (n.d.), stated that in case of liquidation or bankruptcy, per value is used to determine the amount paid per preference share. This is done after paying outstanding dues to bond holders, after payment of preference shares is complete then ordinary shares can be paid Schon, W. (n.d.). 2 (c) Debt Capital and Equity Capital According to Kelly, M & Kelly, M. (n.d.), preference shares are classified as debt capital if it prompts the issuer to compulsory redeem the issued share. The issuer is required to repay the principle or capital amount of money borrowed to facilitate the issue of the preference shares. Secondly, preference share is classified debt capital if it requires coupons or dividends to be paid yearly regardless if of whether it’s a noncumulative or cumulative share. Preference share is classified equity if it does not require compulsory redemption and coupon or dividend repayment. Preference shares can also be classified equity capital if it does not have liability components and has no obligation of cash delivery. It is advisable to calculate the preference shares’ liability component and the remaining quota of their fair value should be allocated to equity (Kelly, M & Kelly, M. (n.d.). 2 (d) Revenue and Gains According to European Union international accounting standards, revenue is defined as the gross in-flow realized form economic benefits receivable and received by an entity’s own account. The inflows should increase equity and not increase related to contribution from an equity participant. Amounts collected by third party such as taxes on goods and services, sales taxes and value added tax (VAT) do not increase equity and do not qualify as economic benefits. Gain is income generated through peripheral business activity, it is consequently identified as money received being an excess of an assets book value. European Union international accounting standards. In reference to TG Ltd sale of machine I am of the opinion that it was revenue generated but of negative impact. This is due to the fact that since purchase to disposal the machine had. References Bolton, P., & Freixas, X. (2000). Equity bonds, and banks debt: Capital structure and financial market equilibrium under asymmetric information. Journal of Political Economy, 108(2), 324-351. Carson, R., & Partners, S.E. (2010). Equipment and leasing. Retrieved from https://www.slaughterandmay.com/media/39003/equipment_leasing_aug_2010.pdf Creamer, D., Dobrovolsky, S., & Borenstein, I. (1960). Capital in manufacturing and mining: Its formation and financing. Princeton University Press Drury, C., & Braund, S. (1990). The leasing decision: A comparison of theory and practice. Accounting and Business Research, 20(79), 179-191. Kelly, M & Kelly, M. (n.d.): Accounting for leases- IAS 17 leases. Retrieved from: http://www.cpaireland.ie/docs/default-source/Students/Study-Support/P2-Advanced-Corporate-Reporting/accounting-for-leases---ias-17-leases-nbsp-.pdf?sfvrsn=0 Levintal, O. (2011). Equity capital, bankruptcy risk and the liquidity trap. Retrieved from: http://www.biu.ac.il/soc/ec/levintal/data/liquidity_trap_Nov11_source_AEJ.pdf Schon, W. (n.d.). Debt and equity: What’s the differences? A comparative view. Retrieved From: http://www.sbs.ox.ac.uk/sites/default/files/Business_Taxation/Events/conferences/summer_conference/2009/schoen-paper.pdf Ullsperger, M. (2016). Reasons why leasing is an option for your business. Retrieved from https://www.gflesch.com/blog/why-leasing-is-an-option-for-your-business Legislations European Union international accounting standards Read More