FINANCIAL LIABILITY: Accounting for Lease by the Lessee

1. FINANCIAL LIABILITY:Accounting for Lease by the Lessee FRS 117 : LEASES

2. DEFINITION (Para 4) • Lease is an agreement whereby the lessor conveys to the lessee in return for a payment or a series of payments the rights to use an asset for an agreed period of time.

3. Classification of leases Finance lease • Lease that transfers substantially, all of the risks and rewards incident to ownership of an asset. Title may or may not eventually be transferred. ( substance over form principle) Operating lease • Lease that not transfers all of the risks and rewards incident to ownership of an asset. A non-cancellable lease is a lease that is cancellable only: (a)upon the occurrence of some remote contingency; (b)with the permission of the lessor; (c)if the lessee enters into a new lease for the same or an equivalent asset with the same lessor; or (d)upon payment by the lessee of such an additional amount that, at inception of the lease, continuation of the lease is reasonably certain.

4. Criteria to classify lease as a finance lease • At least one of the following criteria is satisfied. • The ownership of the asset is transferred to the lessee by the end of the lease term; • The lessee has the option to purchase the asset, and at the inception of the lease, it is certain that the option will be exercised • The lease term is for the major part of the economic life of the asset • PV of the minimum lease payments amounts to or at leastsubstantially equal to asset’s fair value (>90% of the assets fair value) • the leased assets are of such a specialised nature that only the lessee can use them without major modifications.

5. FINANCE LEASES Recognition and measurement by Lessee • Recognition; • On Balance Sheet: As assetsand liabilities • Measurement at inception date; the lower of: • fair value of the lease assets, and • Present Value of the minimum lease payments.

6. Minimum lease payment • Should include; • payment of rental over the lease term and plus if any, purchase option price; • excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor, together with:(a)for a lessee, any amounts guaranteed by the lessee or by a party related to the lessee; or(b)for a lessor, any residual value guaranteed to the lessor by: (i)the lessee; (ii)a party related to the lessee; or (iii)a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee.

7. Present Value of the minimum lease payments Vb= ∑ lease rental + purchase option t =1 (1+ r )t (1+ r )n = lease rental (PVIFA r , n) + purchase option(PVIF r , n) r = interest rate t = time of lease payment n = lease period

8. Journal Entry Dr. Asset under finance lease RM xxx Cr. Liability under finance lease RM xxx • THE ASSET should be recognised as fixed asset and accounted for according to FRS 116- PPE • The lease asset should be depreciated over its useful life (if ownership is transferred); • Otherwise it should be depreciated over the shorter of the leases term or its useful life

9. FINANCE LEASE LIABILITY • The lease liability should be recorded at the same amount as the leased asset. • The lease payment – apportioned between • Finance charge • Reduction of outstanding lease liability • INTEREST / FINANCE CHARGEis the different between the sum of the gross lease payments and the fair value of the leases asset. • This finance charge should be recognised over the lease term to produce a constant periodic rate of interest on the remaining balance of the lease liability.

10. Method in allocating the finance charge; • Amortisation schedule using the effective/implicit interest rate • Sum year digit • Straight line method (only if finance charge is not material) • Standard requires the 1st method to be used to produce a constant periodic rate of interest.

11. Entry • when lease payment is made Dt. Liability under finance lease Cr. Cash • When finance charge is recognised Dt. Lease interest expense Cr. Liability under finance lease

12. Example • Example text book – page 275 • Illustration 1

13. Illustration 1 • ABC enters into a finance lease with XYZ on 1 Jan. 2006 for an item of machinery. The lease terms are as follows: • Lease rental of RM50,000 per year for 5 years, payable in advance and the first rental is due on 1 Jan. 2006. • The useful life of the machine is 5 years with zero residual value. The machine could be bought for cash of RM200,000. ABC adopts a straight-line method depreciation policy for fixed assets. Its financial year ends on 31 Dec. • Implicit interest rate 12.6%

14. Required: • Show the journal entry in ABC’s account to record the lease transaction at its inception date • Calculate the depreciation required for lease assets • Record the lease liability and the allocation of the finance charge in each period using: • Interest rate method; and • The sum-of-digit method

15. Illustration 2 • Lapton Bhd. enters into a leasing with Boh Bhd. on 1 Jan. 2006 for an equipment costing RM100,000. The lease terms are as follows: • Lease rental of RM25,000 per year for 5 years, payable in arrears at the end of respective years. • After the end of the lease period, the lessee has the right to purchase the asset at a bargain price of RM20,000, and it was certain that Lapton will exercise the right. • PV of Min Lease Pay (MLP) is RM96,215 • The useful life of the machine is 8 years with zero residual value. Lapton adopts a straight-line method depreciation policy for fixed assets. Its financial year ends on 31 Dec. • Implicit interest rate 14%

16. Required: • Show the journal entry in ABC’s account to record the lease transaction at its inception date • Calculate the depreciation required for lease assets • Record the lease liability and the allocation of the finance charge in each period using: • Interest rate method; and

17. OPERATING LEASE • Lessee should not capitalise operating lease • Lease payment should be recognised as an expense in IS. • Standard requires that the lease rental expense should be recognised on a straight line basis over the lease term

18. DISCLOSURE by lessee: FRS 7: Financial Instrument Disclosure • Finance lease [31] • Disclosure as per FRS 116 – PPE at Net Carryg Amt. • Reconciliation between total of future MLP payment and their PV. To present these info for each of following periods: a) no later than one year b) later than one year but no later than 5 years c) later than 5 years

19. DISCLOSURE by lessee • Finance lease [31] • Contingent rents recognised in income statement for the period • Total future min sublease payments expected to be received under non-cancellable sublease at the BS date • General description of the lessee’s material leasing arrangements, namely: (i) basis on which contingent rent payable is determined

20. DISCLOSURE by lessee • Operating lease [35] • Total future MLP under the non-cancellable operating lease for each of the following periods: i) no later than one year ii) later than one year but not later than 5 years iii) later than 5 years • Total future minimum sublease payments expected to be received under non-cancellable sublease at the BS date

21. DISCLOSURE by lessee • Operating lease [35] • Lease and sublease payments recognised as expense in the period, with separate amounts of MLP, contingent rents and sublease payments • General description of the lessee’s significant leasing arrangements, namely: (i) Existence and terms of renewal or purchase options and escalation clauses