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Consider the impacts of asset financing methods

The method of financing an asset not only has an impact on a company’s cash flow, but also on its financial statements (the net asset value of the company) and its taxable income.

When acquiring an asset, there are various ways to finance the acquisition. This includes entering into an agreement for an operating lease, a finance lease or an instalment sales agreement.

An operating lease provides the lessee with the right to use the asset for a determined period of time without the lessee taking on the owner’s responsibilities. At the end of the rental agreement, the asset is returned to the lessor. This will most probably be the case when leasing an office building. From an accounting perspective, the asset won’t be capitalised and the monthly payments will be recognised as an expense in the financial statements. The lessee will be able to claim these payments as an income tax deduction.

Like an operating lease, a finance lease provides the use of an asset for an agreed period in return for a monthly rental. At the end of the term, the asset can either be returned, ownership may be acquired by the lessee, or the lease term may be extended. From an accounting perspective however, a finance lease transfers all the risks and rewards incidental to the ownership of an asset regardless of whether ownership passes at the end of the lease or not. The implications are that the asset will be capitalised in the financial statements. From an income tax perspective, the lessee does not obtain ownership of the asset and is not allowed to claim capital allowances. Only the monthly rental payments will be allowed as a deduction.

An instalment sales agreement means that an asset is acquired by paying instalments over an agreed period. At the end of the term, ownership of the asset automatically passes to the lessee after the full amount has been paid. The asset is capitalised in the financial statements of the company when entering the agreement. From an income tax perspective, the acquirer is regarded as the owner of the asset and may therefore claim capital allowances and finance costs related to the acquisition of the asset. No deduction will be allowed for the monthly instalment.

For VAT purposes, finance leases and instalment sales agreements are treated similarly. The lessee/acquirer may claim the input tax on the full purchase price of the asset at the commencement of the lease. Under an operating lease, the lessee will only be permitted to claim the input tax deduction when the monthly rentals are paid.

It is evident that the method of asset financing has an impact on a company’s cash flow, its financial statements and its taxable income. These should be considered before deciding how to finance an asset.

Article written by Charlotte Hanekom

For more information please contact Alro de Swardt or Charlotte Hanekom of Tenk Loubser & Associates (Somerset West) on 021 852 0382.

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