OVERVIEW
Objective
¾
To describe the accounting for leases from the viewpoint of the lessee.TYPE OF ARRANGEMENT
LESSEE ACCOUNTING FOR AN OPERATING
LEASE LESSEE ACCOUNTING
FOR A FINANCE LEASE
SALE AND LEASEBACK TRANSACTIONS
¾ Lease classification; 2 types ¾ Risks and rewards of ownership ¾ Indicators
¾ Terms of the lease
¾ Comment on classification
¾ Land and buildings
¾ Principles
¾ Rentals in arrears ¾ Rentals in advance
¾ Disclosures – finance leases
¾ Background
¾ Sale and leaseback as finance lease ¾ Sale and leaseback as an operating lease
¾ Lessee accounting for an operating lease
¾ Disclosures
INTRODUCTION ¾ Traditional accounting for leases (pre IAS 17)
¾ Problem
¾ Overview
¾ Scope
1
INTRODUCTION
1.1
Traditional accounting for leases (pre IAS 17)
¾
In the books of the lessee: Statement of financial position Asset not included
Statement of comprehensive income Instalments due on an accruals basis.
1.2
Problem
¾
Certain types of lease resulted in the lessee owning the asset in SUBSTANCE and being liable to future payments.¾
For all practical purposes the lessee would own the asset but the statement of financial position would not show the asset nor the liability.
1.3
Overview
¾
Leases were the first transactions where an accounting standard specifically applied the principle of substance over form in order for the accounts to show a true and fair view.¾
The original IAS 1 specified substance over form as a general consideration governingthe selection of accounting policies.
¾
Key ratios significantly affected by this treatment are gearing, and return on capital employed.
1.4
Scope
¾
IAS 17 applies to accounting for all leases except for lease agreements to explore for or use natural resources, such as oil, gas, timber, metals and other mineral rights
1.5
Definitions
¾
A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments, the right to use an asset for an agreed period of time.¾
Finance lease is a lease which transfers substantially all risks and rewards incident to ownership of an asset. Title may or may not eventually be transferred.¾
Operating lease is a lease other than a finance lease.¾
Lease term is the non-cancellable period for which the lessee has contracted to lease the asset, together with any further terms for which the lessee has the option to lease the asset, with or without further payment.¾
Minimum lease payments are the payments over the lease term that the lessee is or can be required to make (excluding costs for services and taxes to be paid by and be reimbursable to the lessor) together with in the case of the lessee, any amounts guaranteed by the lessee or by a party related to the lessee
in the case of the lessor, any residual value guaranteed to the lessor by either
−
the lessee,−
a party related to the lessee, or,−
an independent third party.¾
The inception of the lease is the earlier of the date of the lease agreement or of a commitment by the parties to the principal provisions of the lease.¾
Useful life is the estimated remaining period from the beginning of the lease term, without limitation by the lease term, over which the economic benefits embodied in the asset are expected to be consumed by the entity.¾
The interest rate implicit in the lease is the discount rate that, at the inceptionof the lease, causes the aggregate present value of:
the minimum lease payments, and the unguaranteed residual value
to be equal to the fair value of the leased asset.
2
TYPE OF ARRANGEMENT
2.1
Lease classification; 2 types
¾
Finance lease Is a lease that transfers substantially all of the risks and rewards incident to ownership of an asset
title may or may not eventually be transferred.
¾
Operating lease is a lease other than a finance lease.
2.2
Risks and rewards of ownership
¾
Risks may be represented by the possibility of losses from idle capacity or technological obsolescence variations in return due to changing economic conditions.
¾
Rewards may be represented by the expectation of profitable operation over the asset’s economic life
gain from appreciation in value or realisation of residual value.
2.3
Indicators
¾
IAS 17 lists the following as examples of situations where a lease would normally be classified as a finance lease: 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 bargain price and it seems likely
that, at the inception of the lease, that this option will be exercised
the lease term is for the major part of the useful life of the asset even if title is not transferred
at the inception of the lease, the present value of the minimum lease payments is greater than, or equal to substantially all of the fair value of the leased asset
the leased assets are of a specialised nature such that only the lessee can use them without major modifications being made
gains or losses from the fluctuation in the fair value of the residual fall to the lessee (for example in the form of a rent rebate equalling most of the sales proceeds at the end of the lease) and
the lessee has the ability to continue the lease for a secondary period at a rent which is substantially lower than market rent.
2.4
Terms of the lease
¾
The status of the lease may often be determined from an examination of the lease terms. A transference of risks and rewards is assumed if the lessee will use the asset for most of its useful economic life
the lessee bears the cost normally associated with ownership (eg insurance, maintenance, idle capacity)
the present value of the amounts guaranteed by the lessee is materially equivalent to the cost of purchase
any amounts accruing to the lessor at the end of the lease are relatively small.
2.5
Comment on classification
¾
The criteria concentrates on the major risk of purchase – that of bearing the capital cost.¾
If the lessee guarantees to bear substantially all of the capital cost of the asset (fair value)then it should be treated as a purchase ie a finance lease. (IAS 17 does not specify what “substantially all” means but it is often set at 90% or more in the GAAP of individual countries)
¾
If a lessee bears substantially all of the cost then he would only do so if he was getting substantially all of the use of the asset i.e. if in substance he owned the asset.2.6
Land and buildings
2.6.1
Land
¾
Normally has an indefinite useful life.¾
If title does not pass at the end of the lease term risks and rewards are not passed therefore the lease will normally be classified as an operating lease.2.6.2
Buildings
¾
Useful life will probably extend well beyond the lease term.2.6.3
Separation
¾
The land and buildings value inherent in the lease shall be accounted for separately. The lease payments shall be allocated between the two elements based on the relative fair values of the land and buildings elements.¾
If title of both elements is expected to pass on completion of the lease both parts shall be classed as finance leases.¾
If title does not pass and the land has an indefinite life then the land element shall be treated as an operating lease, the building element will be classed in accordance with the normal rules of IAS 17.¾
If it is not possible to allocate the lease payments between the land and buildings element then the lease shall be treated as a finance lease unless it is clear that both elements are an operating lease.2.6.4
Investment property
¾
The lessee may treat the asset as an investment property in accordance with IAS 40.¾
The lessee, however, must treat the lease as a finance lease, even if it would notnormally be classed as a finance lease and the investment property must be valued using the fair value model under IAS 40.
3
LESSEE ACCOUNTING FOR A FINANCE LEASE
3.1
Principles
¾
Record the asset and the finance lease payable at the lower of the present value of amounts guaranteed by the lessee (Minimum lease payments), or the fair value of asset
¾
Depreciation should be charged on a consistent basis with those assets that are owned and in accordance with IAS 16.¾
After initial recognition the carrying value of the asset and the liability will not be the same amount as the depreciation charge will not match the amount of capital repaid each period.¾
If there is no reasonable certainty that the lessee will obtain ownership by the end of the lease term depreciate the asset over:The shorter of
Lease term Useful
¾
Rentals repay capital and finance charge (interest)¾
Interest should be allocated to profit or loss so as to give constant rate of charge on outstanding balance, or an approximation thereto.Use
OR Actuarial method (this uses the interest rate implicit in the
lease)
Sum of the digits (this can be an effective approximation to
the actuarial method)
Note that straight line recognition is generally not acceptable
Commentary
Rentals in arrears
¾
Interest is carried by each of the rentals Rentals in advance¾
The first payment is capital only. Interest is carried by each of the rentals except the first3.2
Rentals in arrears
Example 1
H entered into a finance lease on 1st July 2007. The terms of the lease were 6
payments of $200 payable annually in arrears. The cash price of the asset was $870.
The interest rate implicit in the lease is 10%.
Required:
(a) Show the interest allocation using the actuarial method
(b) Show how the lease would be carried in the financial statements of H as at 30th June 2008.
Commentary
Solution a
W1 Total finance charge
$ Rentals
Cash price of the asset
W2 Allocation of interest – actuarial method
Period Amount owed at the
start of the period Interest @ 10% Rental Amount owed at the end of the period 1
2 3 4 5 6
Solution b
Finance lease payable
1/7/07 Non current assets
30/06/08 Cash 30/06/08 Interest
30/06/08 Bal c/d
01/07/08 Bal b/d
Tutorial note:
30/06/09 Cash 30/06/09 Interest
Analysis of payable
Current
=
Non Current
Disclosure
The minimum lease payments and their present values should be disclosed for all payments falling due within the next year, within years 2 to 5 and after year 5.
Depreciation
3.3
Rentals in advance
Example 2
H entered into a finance lease on 1st July 2007. The terms of the lease were 6
payments of $200 payable annually in advance. The cash price of the asset was $870.
The interest rate implicit in the lease is 15%.
Required:
Show the interest allocation using the actuarial method.
¾
The first payment is capital only¾
Interest is not allocated to the final period because the loan was completely repaid at the beginning of that period.W1 Total finance charge
$ Rentals
Cash price of the asset
W2 Allocation of interest – actuarial method
Period Amount owed at the start of the
period
Rental Interest
@ 15% Amount owed at the end of the period 1
2 3 4 5 6
3.4
Disclosures — finance leases
¾
For each class of asset the net carrying amount of assets at each reporting date.¾
It is appropriate that the amount of assets used by the lessee that are the subject of provide the same table reconciling opening and closing cost and depreciation as is given for owned assets, or
combine with owned assets and make disclosure of the total.
“Of the total net book value of $X, $Y relates to assets held under finance leases.”
¾
Liabilities related to these leased assets should be shown separately from other liabilities, differentiating between the current and long-term portions.¾
Repayment terms and interest rates for loans falling due in more than one year.¾
A reconciliation between the total of minimum lease payments at the end of thereporting period, and their present value.
¾
In addition, an entity should disclose the total of minimum lease payments at the end of the reporting period, and their present value, for each of the following periods: not later than one year
later than one year and not later than five years later than five years.
4
LESSEE ACCOUNTING FOR AN OPERATING LEASE
4.1
Lessee accounting for an operating lease
¾
Rentals are charged as an expense in profit or loss on a straight line basis over the lease term unless another systematic basis is representative of the time pattern of the users benefit.¾
No balances appear in the statement of financial position other than accruals and prepayments on rented rather than owned assets.Example 3
Under a lease agreement Williamson plc pays an initial installment of $100,000 and then 3 years rental of $100,000 pa on the first day of each year. The asset has a life of 6 years.
Required:
Solution
Charge
_______ $ Statement of financial position at end of 1st year
_______ _______
4.2
Disclosures
¾
Lessees should make the following disclosures for operating leases: the total of future minimum lease payments under non-cancellable operating leases for each of the following periods:
−
not later than one year−
later than one year and not later than five years−
later than five years.5
SALE AND LEASEBACK TRANSACTIONS
5.1
Background
¾
Occurs where company transfers legal title to an asset to another party but retains use of asset on a lease. Usual purpose is to raise finance.¾
The rentals and the sale price are usually interdependent as they are negotiated as a package and need not represent fair values.¾
Accounting treatment depends on whether the leaseback is finance or operating.5.2
Sale and leaseback as finance lease
¾
The substance of the transaction is that there is no sale - risks and rewards of ownership have not passed from the original lessee.¾
Any excess of sales proceeds over the carrying amount shall not be immediately recognised as income in the financial statements of a seller-lessee. If such an excess is recognised, it shall be deferred and amortised over the lease term.¾
If the leaseback is a finance lease, the transaction is a means whereby the lessor provides finance to the lessee, with the asset as security.¾
Treat the transaction as a sale followed by a leaseback A “profit” is recognised but deferred. ie it is carried as a credit balance in the statement of financial position and released to the statement of comprehensive income over the life of the lease.
Example 4
Olga Inc disposes of an asset by way of a finance lease. The net book value is $70,000, the sale proceeds are at fair value of $120,000 and the useful economic life is 5 years. There are 5 annual rentals of $28,000.
Required:
Set out the journal entries on disposal, and spreading finance charges and depreciation on a straight line basis, calculate the effect on profits for the first year.
Treat as a sale followed by a leaseback
Journal entries on disposal$ $
Dr Cr Dr Cr
Impact on profit
$
5.3
Sale and leaseback as an operating lease
¾
Substance of the transaction is that there is a sale and profit may be recognised.¾
If the leaseback is an operating lease, and the rentals and the sale price are established at fair value, there has in effect been a normal sale transaction and any profit or loss is recognised immediately.¾
If the sale price is below fair value, any profit or loss shall be recognised immediately except that: if the transaction results in a loss, which is then compensated by future rentals at below market price, it shall be deferred and amortised in proportion to the rental payments over the period for which the asset is expected to be used.
¾
If the sale price is above fair value, the excess over fair value shall be deferred and amortised over the period for which the asset is expected to be used.Example 5
Friends Inc has an asset with a net book value of $70,000. The fair value is $100,000. It would like to enter into a sale and operating leaseback agreement and it has been offered the following from three different banks.
Sale price Annual rental for 5 years (a) $100,000 $28,000
(b) $120,000 $28,000
(c) $80,000 $20,000 (ie below market price) (d) As (c) except that suppose the net book value was $95,000.
Required:
Solution
(a) Sale at fair value ($100,000)
Recording of transaction Profit or loss
$ $ Dr
Cr Cr
(b) Sale > fair value ($120,000)
Recording of transaction Profit or loss
$ $ Dr
Cr Cr Cr
(c) Sale < fair value ($80,000) with profit on sale
Recording of transaction Profit or loss
$ $ Dr
Cr Cr
(d) Sale < fair value ($80,000) with loss on sale and future rentals at < market price
Recording of transaction Profit or loss
$ $ Dr
FOCUS
You should now be able to:
¾
explain why recording the legal form of a finance lease can be misleading to users (referring to the commercial substance of such leases);¾
describe and apply the method of determining a lease type (i.e. an operating or finance lease);¾
discuss the effect on the financial statements of a finance lease being incorrectly treated as an operating lease;EXAMPLE SOLUTIONS
Solution 1
(a)
W1 Total finance charge
$
Rentals (6 × $200) 1,200
Cash price of the asset (870)
330
W2 Allocation of interest – actuarial method
Period Amount owed at the
start of the period Interest @ 10% Rental Amount owed at the end of the period
1 870 87 (200) 757
2 757 76 (200) 633
3 633 63 (200) 496
4 496 50 (200) 346
5 346 35 (200) 181
6 181 ___ 19 (200) 0
330 ___
(b)
Finance lease payable
1/7/07 Non current
assets 870
30/06/08 Cash 200 30/06/08 Interest 87
30/06/08 Bal c/d 757
957 957
01/07/08 Bal b/d 757
Tutorial note:
30/06/09 Cash 200 30/06/09 Interest 76
Analysis of payable
Current (200 – 76 ) 124
= 757
Non Current 633
Disclosure
The minimum lease payments and their present values should be disclosed for all payments falling due within the next year, within years 2 to 5 and after year 5.
Depreciation
years 6
870
$ = $145
Non current assets will include an amount of $725
Solution 2
W1 Total finance charge
$
Rentals (6 × $200) 1,200
Cash price of the asset (870)
330
W2 Allocation of interest – actuarial method
Period Amount owed at the start of the
period
Rental Interest
@ 15% Amount owed at the end of the period
1 870 (200) = 670 101 771
2 771 (200) = 571 86 657
3 657 (200) = 457 69 526
4 526 (200) = 326 49 375
5 375 (200) = 175 25 200
6 200 (200) = 0
330
Solution 3
Statement of comprehensive income =
years 3
$300,000 $100,000+
= $133,333
________
Statement of financial position $ at end of 1st year = 200,000 paid
(133,333) charged ________
Solution 4
Treat as a sale followed by a leaseback
Journal entries on disposal
$ $
Dr Cash 120,000
Cr Non current asset (NBV) 70,000 Deferred profit (120,000 – 70,000) 50,000
Dr Non current asset 120,000
Cr Lease creditor 120,000
Statement of comprehensive income $
Depreciation
5 000 , 120 24,000
Interest
(
)
× − 5 000 , 120 ) 000 , 28
5 4,000
Release of deferred profit 5 000 ,
50 (10,000) ______
18,000 ______
Solution 5
(a) Sale at fair value ($100,000)
Recording of transaction Profit or loss
$ $
Dr Cash 100,000
Cr Asset 70,000
Cr IS 30,000
$ Profit on disposal 30,000
Rental (28,000)
(b) Sale > fair value ($120,000)
Recording of transaction Profit or loss
$ $
Dr Cash 120,000
Cr Asset 70,000
Cr IS 30,000
Cr Deferred income 20,000
$ Profit on disposal
– immediate 30,000 – deferred
5 000 ,
20 4,000
Rental (28,000)
______ 6,000 ______
(c) Sale < fair value ($80,000) with profit on sale
Recording of transaction Profit or loss
$ $
Dr Cash 80,000
Cr Asset 70,000
Cr IS 10,000
$ Profit on disposal 10,000
Rental (20,000)
______ (10,000) ______
(d) Sale < fair value ($80,000) with loss on sale and future rentals at < market price
Recording of transaction Profit or loss
$ $
Dr Cash 80,000
Cr Asset 95,000
Dr Deferred loss 15,000
$ Deferred loss
5 000 ,
15 (3,000)
Rental (20,000)
______ (23,000)
