As part of its business activities, an accounting entity continually reviews the “health” of its finances, cash flow movements, among other things, and seeks new sources of financing, either internal or external. There are many types of financing on the market, and one of them is a lease, which we will introduce today.

Definition of terms

The legal framework of leases can be found in the Accounting Act No. 563/1991 Coll. (hereinafter the “AA”); leases are also regulated by the Income Tax Act No. 586/1992 Coll. (hereinafter the “ITA”); it is also captured in the Czech Accounting Standards. Furthermore, Section 2201 of Act No. 89/2012 Coll., the Civil Code, applies to operating leases, whereas no contractual type is defined in the Civil Code for finance leases, which are therefore concluded as unnamed.

The concept of leases does not need any long introduction. This is a type of external equity financing. In simple terms, we can say that it is a kind of lease, with or without the option/obligation to buy at the end of the agreed lease term. In particular, it helps us to reduce the capital intensity of the investment, given the small outlay at the beginning of the lease. Most often, company cars, production lines, machinery, equipment, etc. are purchased on lease. In the Czech Republic, the most common types of leases include financial and operating leases. However, there are also other types of leases, such as leaseback, which we will talk more about next time.

According to Section 28(3) of the AA, financial lease means “the provision of property for use for consideration, if the user is entitled or obliged to acquire ownership of the property provided during or after the use.” A typical example is the purchase of a new car, which is paid off by regular instalments over a set period of time (e.g. 3 years) and then we buy the car (become its owner) for the agreed price. The ITA defines financial lease as follows – “Financial lease means the transfer of tangible property by the owner for use by the user for consideration”.

The basic characteristics of a finance lease include:

• the option/obligation to purchase the leased item at the end of the lease,
• assumption of all responsibilities and obligations for the asset acquired under the lease.

According to the ITA, financial lease must meet the following conditions, among others:

• the lease term cannot be shorter than the minimum depreciation period of the tangible asset,
• the purchase price must be higher than the tax residual value of the asset in case of straight-line depreciation.

Specific conditions are set out in Section 21 of the ITA. If these conditions are not met, the transaction is classified as a standard lease.

An operating lease is the provision of an asset for use for consideration without the assumption of subsequent purchase. In other words, at the end of the lease contract, the asset is returned to the leasing company, so only the leasing company is the owner of the asset at all times. The main advantage for the tenant is the fact that he pays only the real depreciated part of the rental price, i.e. the difference between the purchase price and the residual value.

The basic characteristics of an operating lease include:

• it is not possible to buy the leased item at the end of the lease,
• the lease is “enriched” by the services offered in connection with the leased item – service, maintenance, storage, insurance, administration (always defined in the contract).

Lease and accounting

An asset that we have financed through a lease in the Czech Republic under Czech accounting standards is classified and depreciated only by its owner, in this case the leasing company, even though all responsibilities and obligations associated with the use of the asset may be transferred to the user (in the case of financial lease).

The accounting therefore reflects both the down payment paid (if agreed) and the regular monthly instalments. Charges that are paid in advance (prepayments) are accrued through account 381 – Accrued costs. The regular monthly lease payments are part of the cost of the period, to which they relate in time and substance. Other lease accounting is only in off-balance sheet accounts.

In this context, it should be noted that finance lease costs must be booked evenly over the term of the lease agreement. Therefore, if the terms of the lease contract change during the term of the lease agreement, the individual items must be recalculated (both the amount of the down payment and the interim payments) to ensure that the lease costs continue to be recognised evenly in the accounting from period to period.

In practice, we may encounter, among other things, a situation where the term of the lease agreement will be different from the payment schedule. An example might be a lease agreement for a production machine, where the payments (according to the payment schedule) are fixed for 60 months, with a low down payment, but the lease agreement is for 120 months. Therefore, at the inception of the lease relationship, the accounting entity (lessee) may be required to account for accrued costs (account 383) to ensure that the cost of the finance lease is spread evenly over the accounting periods, in which the lease is used.

The cost of operating leases is booked according to “the services provided by the leasing company” in the period and is recognised directly in the current period expenses of the accounting entity. The cost account 518 is usually used.

In accounting for finance leases, as mentioned above, the Accrued costs account is also used because of the need to pay in advance (prepayment). An example of the accounting is shown below:

*Items 2 to 4 are recorded in the accounts on a regular basis (monthly/quarterly) according to the agreed lease payments.

Although the subject of the lease (operating/financial) is not part of the balance sheet of the accounting entity (in assets or liabilities), its accounting and related information (for example the amount of the lease payment – total recorded/received/payable in the future) should be disclosed in the notes to the financial statements.

What to say in conclusion

Leases are widely used in business relationships primarily to reduce the capital burden of investments and to spread expenditure over time. Compared to loans, they are tied to a specific asset, but it is much easier and less administratively demanding to obtain a lease. Although from a legal point of view, operating and finance leases are different, from the accounting perspective (Czech accounting regulations), there is no significant difference between them. On the other hand, differences in income tax may be recorded, in particular because operating leases are treated as a standard service received, whereas finance leases have to meet certain conditions for tax deductibility of costs.

The issue of leases in any form is a complex matter, so if you are unsure about leases, either as a leasing company or a lessee, do not hesitate to contact us.

Author: Michal Kováč, Petra Stumpfová