Question

The Strill Oil Company is trying to decide whether to lease or buy a new computer-assisted drilling system for its oil exploration business. Management has decided that it must use the system to stay competitive; it will provide RM1,200,000 in annual pretax cost savings. The system costs RM6,700,000 and will be depreciated straight-line to zero over 4 years. Strill's tax rate is 35 percent, and the firm can borrow at 11 percent. Nexgain Leasing Company has offered to lease the drilling equipment to Strill for payments of RM1,750,000 per year.

Required:

1. Determine the net advantage to leasing (NAL) and should the Still Oil Company lease or buy the drilling system?                                                                                       

2. Leasing is a way businesses finance plan, property and equipment. Any asset can be purchased or leased. Explain the TWO (2) differences between purchasing an asset and leasing an asset. If the company decided to lease the asset, discuss the accounting criteria for determining whether or not a lease must be reported on the balance sheet.

                                                                                                                                     

Answer 1

The pretax cost savings are not relevant to the lease versus buy decision, since The Strill Oil Company use the system and realize the savings regardless of the financing choice made.

Depreciation tax shield lost = (RM6,700,000/4)(0.35) = RM586,250

After tax lease payment = RM1,750,000(1 – 0.35) = RM1,137,500

After tax debt cost = 0.11(1 – 0.35) = .0715 or 7.15%

With these cash flows, the NAL is:

NAL = RM6,700,000 – 1,137,500 – RM1,137,500 (PVIFA7.15%,3) – RM586,250 (PVIFA7.15%,4) = RM606,456

The system should be leased.

Differences between purchasing an asset and leasing an asset:

1. Leasing allows you to use the assets immediately without paying a hefty amount. Buying allows you to own a assets not for immediate need but for long term purpose.

2. The other difference between buying and leasing is ownership. Buying gives you complete ownership to do what you want with it, while leasing only gives you temporary ownership with restrictions on what you can do with it.

Accounting criteria for determining whether or not a lease must be reported on the balance sheet

Finance lease id reported on the balanceshhet. A lease is classified as a finance lease if it transfers substantially all the risks and rewards incident to ownership. Situations that would normally lead to a lease being classified as a finance lease include the following:

• the lease transfers ownership of the asset to the lessee by the end of the lease term
• the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that the option will be exercised
• the lease term is for the major part of the economic life of the asset, even if title is not transferred
• at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset
• the lease assets are of a specialised nature such that only the lessee can use them without major modifications being made

Other situations that might also lead to classification as a finance lease are: [IAS 17.11]

• if the lessee is entitled to cancel the lease, the lessor's losses associated with the cancellation are borne by the lessee
• gains or losses from fluctuations in the fair value of the residual fall to the lessee (for example, by means of a rebate of lease payments)
• the lessee has the ability to continue to lease for a secondary period at a rent that is substantially lower than market rent