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Leasing

Leasing. Chapter 18. By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases by the lessee; account for leases by the lessor; critically discuss the reasons for the proposed revision of IAS 17;

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Leasing

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  1. Leasing Chapter 18

  2. By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases by the lessee; account for leases by the lessor; critically discuss the reasons for the proposed revision of IAS 17; critically discuss the reasons for revising IAS 17. Objectives

  3. What is a lease? • Leases are defined in IAS 17: Leases as: • ... an agreement whereby the lessor conveys to the lessee in return for a payment or a series of payments the right to use an asset for an agreed period of time. (para 4) • This includes contracts for the hire of an asset that contain a provision giving the hirer an option to acquire title to the asset upon the fulfilment of agreed conditions. (para 6) • It is a legal agreement whereby the lessee (the user) obtains the right to use an asset for an agreed period.

  4. What is a lease? • The right to use the asset is passed from the lessor (the legal owner) of the asset to another party (the lessee). • Legal ownership is retained by the lessor – the person granting the lease. • In return for the right to use the asset, the lessee pays a rental to the lessor.

  5. Why did leasing become popular? In the UK, there were two major reasons: The tax advantage to the lessor (the lessor could claim depreciation tax allowances and pass these on to the lessee in the form of a reduced rental charge) and The commercial advantage to the lessee.

  6. Why did leasing become popular? (Continued) Commercial advantage Tax benefits gradually diminished but the benefit of spreading cash payments over the lease period instead of making a one-off lump sum payment included: • Cash flow management – more working capital is available • Conservation of capital – Lines of credit are kept open and may be used for purposes where finance might not be available easily • Continuity – an overdraft facility may be terminated – a lease agreement has an agreed life span • Flexibility of the asset base – non-current assets more easily expanded and contracted • Off statement of financial position financing – leasing provides the lessee with the possibility of off statement of financial position financing.

  7. Why was IAS 17 necessary? No uniformity in the treatment and disclosure of leasing transactions Massive growth in the leasing industry as a material economic resource Accounting treatment distorted financial reports – not a true and fair view Concern about undesirable economic consequences, for example inclusion of the lease obligation might: affect the lessee company’s gearing adversely and cause it to exceed its legal borrowing powers However, growth continued because of the commercially attractive reasons and lease agreements being structured to get around the standard.

  8. What is the main thrust of IAS 17? IAS 17 defined two types of lease – finance and operating – and recommended different accounting treatments: Finance lease: a lease that transfers substantially all the risks and rewards of ownership of an asset to the lessee Operating lease: a lease other than a finance lease.

  9. Types of lease • Finance leases • Sometimes called ‘capital’ or ‘financial’ leases because, in an economic sense, they are a form of borrowing. The lease payments contain both principal and interest portions, similar to a table mortgage. • A lease asset and liability appear on the Balance Sheet, and interest expense on the Income Statement. • IAS 17 defines this type of lease as: • a lease that transfers substantially all the risks and rewards incidental to ownership of an asset to the lessee. Title may or may not eventually be transferred. (para 4)

  10. Types of lease • Operating leases • IAS 17 defines this type of lease as: • A lease other than a finance lease. (para 4) • An operating lease is a rental agreement. • The lessee obtains the right to use the asset in return for rental payments, but the risks and rewards of ownership are not transferred to the lessee. An example is a business renting a shop from a landlord. Nothing appears on the Balance Sheet and the full rent expense appears on the Income Statement.

  11. Types of lease • Differences between the types of lease • In a finance lease the lessee obtains practical ownership. • Legal ownership of the asset stays with the lessor. • The transfer of substantially all the risks and rewards of ownership (that come with practical ownership) means that the lessee carries losses from such things as idle capacity, technological obsolescence, or changed economic conditions. • The lessee receives any rewards expected from profitable operations over the asset’s useful life. • The lessee might also be entitled to any gains from appreciation in value or realisation of a residual value at the end of the lease.

  12. Types of lease • The cancellation of a finance lease is only possible: • (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. (para 4) • An operating lease can be cancelled at any time by either party – usually with one month’s notice.

  13. Types of lease • Other differences - with a finance lease: • 1 substantially all of the risks and rewards of ownership are transferred to the lessee, and • 2 the lessor can ascertain the lease costs with reasonable certainty, and either: • a the lease transfers ownership of the asset to the lessee by the end of the lease term, or • b the lessee has the option to purchase the asset at a bargain basement price, or

  14. Types of lease • c the lease term is for the major part (usually considered to be 75% or more) of the economic life of the asset even if title is not transferred, or • d at the inception of the lease the present value of the minimum lease payments is substantially all (normally not less than 90%) of the fair value of the leased asset, or • e the leased assets are of a specialised nature such that only the lessee can use them without major modifications being made.

  15. Types of lease • Legal ownership of the asset may or may not be transferred. • When legal ownership is expected to transfer, the finance lease is another way of using debt to finance the purchase of the asset. Thus, both the asset and the liability should be shown on the lessee’s Balance Sheet – just like any other asset bought with debt is treated. • Lease term and present value of minimum lease payments. • Where these payments have determined the existence of a finance lease, IAS 17 requires the economic resources available to and the level of obligations of the lessee to be recorded as an asset and liability on the Balance Sheet (para 22).

  16. What is the main thrust of IAS 17? (Continued) Finance leases accounting treatment: Capitalised in the lessee’s accounts, that is, the leased item is recorded as an asset in the statement of financial position and the obligation for future payments should be recorded as a liability in the statement of financial position. • Operating leases accounting treatment: • Lessee is required to expense the annual payments as a rental through the income statement.

  17. Why was the IAS 17 approach so controversial? The IASB Framework, para. 35 states: If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. A substance over form approach to accounting treatment is completely different to the traditional approach, which has strict regard to legal owners.

  18. The IASB argument was that there were two separate transactions taking place: The company was borrowing funds to be repaid over a period and It was making a payment to the supplier for the use of an asset The correct accounting treatment for the borrowing transaction, based on its substance, was to include in the lessee’s statement of financial position a liability The correct accounting treatment for the asset acquisition transaction, based on its substance, was to include an asset representing the asset supplied under the lease. Why was the IAS 17 approach so controversial? (Continued)

  19. IAS 17 – classification of a lease Factors in determining transfer of risks and rewards Ownership of the asset transferred to the lessee by the end of the lease term The lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised.

  20. IAS 17 – classification of a lease (Continued) The lease term is for the major part of the economic life of the asset even if the 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 and The leased assets are of such a specialised nature that only the lessee can use them without major modifications.

  21. IAS 17 leases • Rationale for including in accounts • Economic substance • Long-term commitment • Similar to buying asset with a loan • IASB Framework defines asset and liability • Liability is a present obligation for outflow of resources • Asset is a resource controlled by an enterprise.

  22. Recognition of an asset • Finance lease • Gives control of asset • Transfers all the risks and rewards of ownership • Asset is the benefits conferred by use • Include at Fair Value • Annual depreciation charge.

  23. Recognition of a liability Commitment to future obligations Payments under lease Liability measured as PV of obligations.

  24. Categorising as finance or operating lease Figure 18.1 IAS 17 aid to categorising operating and finance leases

  25. Accounting requirementsfor operating leases Treatment conforms to the legal interpretation and corresponds to the lease accounting practice that existed before IAS 17 No asset or obligation is shown on the statement of financial position The operating lease rentals payable are charged to the income statement on a straight-line basis.

  26. Disclosure requirementsfor operating leases Disclose: Total of rentals charged as an expense in the income statement Payments committed to make during the next 5 years, in the second to fifth years inclusive, and over 5 years.

  27. Operating lease illustration Clifford plc negotiates a lease to begin on 1 January 20X1 with the following terms: Terms of lease – 4 years Estimated useful life of machine – 9 years Age of machine on inception of lease – 4 years Purchase price of new machine – £75,000 Annual payments – £8,000.

  28. Operating lease illustration (Continued) Classify as an operating lease because: It applies only to a part of the asset’s useful life and The present value of the lease payments does not constitute substantially all of the fair value The amount of the annual rental paid – £8,000 p.a. – will be charged to the income statement and disclosed There will also be a disclosure of the ongoing commitment with a note that £8,000 is payable within 1 year and £24,000 within 2 to 5 years.

  29. Statement of financial positionsteps for a finance lease Step 1 The leased assets should be capitalised at the lower of the present value of lease payments and its fair value Step 2 The annual depreciation charge for the leased asset should be calculated by depreciating over the shorter of the estimated useful life of the asset or the lease period Step 3 The net book value of the leased asset should be reduced by the annual depreciation charge.

  30. Balance Sheet steps (Continued) Step 4 The finance lease obligation is a liability At the start of the lease, the value of the leased asset and theleased liability will be the same Step 5 The finance charge for the finance lease should be calculated as the difference between the total of the minimum lease payments and the fair value of the asset (or the present value of these lease paymentsif lower) It should be allocated to the accounting periods over the term of the lease. Three methods for allocating finance charges are used in practice: Actuarial Sum of the digits Straight-line.

  31. Actuarial method. This applies to a constant periodic rate of charge to the balance of the leasing obligation calculated by applying present value tables to annual lease payments Sum of digits method. This method (‘Rule of 78’) is much easier to apply than the actuarial method. The finance charge is apportioned to accounting periods on a reduced scale – method used by Elliott & Elliott Straight-line method. This spreads the finance charge equally over the period of the lease (only acceptable if immaterial). Step 6 The finance lease obligation should be reduced by the difference between the lease payment and the finance lease. Balance Sheet steps (Continued)

  32. Finance charge allocation using actuarial method Figure 18.2 Finance charge allocation using actuarial method

  33. Extract from the Nestlé group annual report and accounts 2008 Accounting policies Leased assets Assets acquired under long-term finance leases are capitalised and depreciated in accordance with the Group’s policy on property, plant and equipment. The associated obligations are included in financial liabilities.

  34. Finance lease illustrated – similar to Clifford example pp.478-480 Boonaloo Ltd entered into a lease on following terms: Fair value of the leased asset 20,000 Term of the lease 5 years Annual lease payments in arrears £4,500 Expected value of asset at lease end nil Implicit rate of interest 4%

  35. Boonaloo Ltd - Compare FV with PV of minimum lease payment • FV of lease £ 20,000 • PV of instalments: • 4500/[(1.04) + (1.04)2 + (1.04)3 + (1.04)4 + 1.04)5] = 20,033 • PV is very close to fair value, therefore capitalise at fair value.

  36. Boonaloo Ltd – step approach • Step 1 Capitalise lease at FV = £20,000 • Step 2 Straight-line depreciation = £4,000 • Step 3 Asset in statement of financial position • Year 1 20,000 – 4,000= £16,000 • Year 2 16,000 – 4,000 = £12,000 • Year 3 12,000 – 4,000 = £8,000 • Year 4 8,000 – 4,000 = £4,000 • Year 5 4,000 – 4,000 = 0

  37. Boonaloo Ltd – step approach • Step 4 Obligation at inception £20,000 • Step 5 Finance charge (sum of digits) • Sum of digits = 1 + 2 + 3 + 4 + 5 = 15 • Or, by formula: n(n +1)/2 = 5(6)/2 = 15 • Total to be paid £22,500 • Fair value of asset £20,000 • Finance charge £2,500 Allocate as follows: Year 1 5/(15) × 2,500 £(833) Year 2 4/(15) × 2,500 £(667) Year 3 3/(15) × 2,500 £(500) • Year 4 2/(15) × 2,500 £(333) • Year 5 1/(15) × 2,500 £(167)

  38. Boonaloo Ltd – step approach • Step 6 Reduce the obligation Year 1 20,000 − 4,500 = £15,500 Add Finance charge £833 £16,333 Year 2 16,333 − 4,500 = £11,833 Add Finance charge 667 £12,500 Year 3 12,500 – 4,500 = £ 8,000 Add Finance charge 500 £ 8,500 Year 4 8,500 – 4,500 = £ 4,000 Add Finance charge 333 £ 4,333 Year 5 4,333 – 4,500 = £ (167) Add Finance charge 167 £ 0

  39. Boonaloo Ltd– income statement entries Year 1 Year 2 Year 3 Year 4 Year 5 Depreciation 4,000 4,000 4,000 4,000 4,000 Finance charge833 667 500 333 167

  40. Accounting for the lease of landand buildings • Land and buildings are dealt with separately • Each has to be reviewed to determine whether to classify as an operating or finance lease.

  41. Example – the Warehouse Company • Let us assume that • The Warehouse Company Ltd, whose borrowing rate is 10% per annum, entered into a 10-year lease, with Lessor Ltd, under which it will make payments of $106,886 annually in advance • The present value of the land is $500,000 and of the buildings is $500,000 • The expected value of the land at the end of 10 years will be $670,000 and the expected value of the buildings will be $50,000.

  42. The Warehouse Company – classifying the land segment of the lease • There is no contract to pass title at the end of the contract and the land is expected to increase in value • The land segment of the contract does not involve the lessor transferring the risk and benefits to the lessee • This means that the lessee has to account for the lease of the land as an operating lease.

  43. The Warehouse Company – classifying the building segment of the lease • The building segment of the lease is different • The residual value has fallen to $50,000 which has a present value of $19,275 (50,000 × 0.3855) • 0.3855 = 10% present value discount factor [1/(1.1)10] • This means that 96% of the benefit has been transferred (500,000 – 19,275) • The building segment is, therefore, a finance lease.

  44. The Warehouse Company – how to apportion the lease payment in the income statement • Split the payment at commencement of lease according to the fair value of components • The present value of the land is $500,000 of which $258,285 (670,000 × 0.3855) represents the present value of the land at the end of the contract • So, the balance of $241,715 represents the present value of the operating lease • Similarly, the amount covered by the finance lease is $480,725 (i.e. 500,000 – 19,275) • Split the lease payment of $106,886 in those proportions (241,715 : 480,725) • This gives $35,763 for the land component and $71,123 for the finance lease representing the buildings leased.

  45. The Warehouse Company – how to report in the statement of financial position • For the finance lease covering the building: • The lessee will have to show a $480,725 asset initially • This will be depreciated over the 10 years of the lease according to the normal depreciation policy • At the same time, a liability representing an obligation to the legal owner of the buildings (the lessor) for the same amount will be created • As lease payments are made, the interest component will be treated as an expense and the balance will be used to reduce the liability – in the same way as shown in the Boonaloo example earlier.

  46. The Warehouse Company – how to report in the income statement • The income statement would show a finance charge for each year of: • Step 5 Finance charge (sum of digits) • Sum of digits = n(n + 1)/2 = 10(11)/2 = 55 • Total to be paid (71,123 x 10) £711,230 • Fair value of asset £480,725 • Finance charge £230,505 • Year 1 (10/55 x 230,505) £ 41,910 • Year 2 (9/55 x 230,505) £ 37,719 • Year 3 (8/55 x 230,505) £ 33,528 • Year 4 (7/55 x 230,505) £ 29,337 • Year 5 (6/55 x 230,505) £ 25,146 • Year 6 (5/55 x 230,505) £ 20,955 • Year 7 (4/55 x 230,505) £ 16,764 • Year 8 (3/55 x 230,505) £ 12,573 • Year 9 (2/55 x 230,505) £ 8,382 • Year 10 (1/55 x 230,505) £ 4,191

  47. Accounting for Leases - Lessor • In the books of the lessor • In accounting for a finance lease the lessor has an additional issue to deal with. • NZ IAS 17 recognises two types of finance lease: • • a direct finance lease such as would be provided by a bank or finance company • • a manufacturer’s or dealer’s lease, also known as a sales-type lease. • A direct finance lease is one where the lessor provides the finance to the lessee to buy the asset

  48. Accounting for Leases - Lessor • A sales-type lease is one where the cost of the asset to the lessor is different from the asset’s fair value and, as a consequence, the lessor receives two types of income. • One is the difference between the asset’s cost and sale prices (the treatment for which is the same as any sales and cost of sales transactions). • The other is the finance income over the term of the lease. • In these situations, the cost to the lessor is the cost of manufacturing the asset, or the cost charged by the manufacturer to the lessor as an importer or wholesaler. • The fair value in these cases is the fair retail price of the asset. • Consequently, the lessor is required to account for the normal surplus on the transaction with the lessee.

  49. Warehouse example – Lessor Accounting assuming a direct finance lease • For a direct finance lease, Lessor Ltd will show, in effect, a mirror image record of what The Warehouse Company shows in its accounts for the leased building; • Finance lease receivable (Building) £480,725 • Each year as the lease rental is received, this amount will be written down – just as other fixed assets are written down by the depreciation charge. The journal entries are (for year 1): • Bank £ 71,123 • Finance lease receivable £ 29,213 • Interest earned £ 41,910

  50. Warehouse example – Lessor Accounting • At the end of the lease, the finance lease receivable will be written down to zero, and the total interest earned will equal ₤230,505

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