Week 9

1. Week 9 Accounting for Leases

2. Learning objectives Upon completing this topic you should have be able to: • Understand and discuss the difference between operating and finance leases; • Apply relevant accounting standards to account for leases by both lessees and lessors; • Discuss the implications of lease recognition for an entity’s financial statements.

3. Where does this fit into unit learning goals? • apply a range of theories of accounting to explain financial accounting and reporting practices and appreciate the judgements, estimations and assumptions influencing accounting numbers; • critically assess and appreciate changing influences in standard setting; the compliance regime in capital markets and impacts of regulatory requirements on financial reporting practices; • assess the role of financial accounting in sustainable development and corporate social and environmental performance reporting; • analyse a range of financial reporting issues, including intangible assets, financial instruments and foreign currency transactions, from both a practical and theoretical perspective; and • demonstrate effective individual research skills to produce professional quality business documents to solve financial accounting problems; and demonstrate in individual summative assessment tasks the acquisition of a comprehensive understanding of the topics covered by this unit.

4. AASB 117 Leases • First Issued July 2004 - Supersedes AASB 1008. • Applies to annual reporting periods beginning 1 January 2005. • This standard is compatible with IAS17.

5. AASB 117 Leases Definition of Lease (Para 4) • A lease is an agreement whereby the lessor conveys to the lessee for a payment or series of payments the right to use an asset for an agreed period of time. • Two parties involved:- Lessor:- This is the party that leases the asset out and receives payment Lessee:- The party that hires/rents the leased asset and uses this asset in their business

6. AASB 117 - Application The standard applies to all leases except: • Leases to explore for or use minerals, oil, natural gas and similar regenerative resources; and • Licensing agreements for such items as motion pictures video recordings, play manuscripts, patents and copy rights. It shall further not be applied as a basis of measurement for: • Property held by lessees that is accounted for as an investment property. • Investment property provided by lessors under operating leases. • Biological assets provided by lessors under an operating lease.

7. AASB 117 - Classification of Leases • Finance Lease: is a lease where the lessortransfers substantially all the risks and rewards of ownership of an asset to the lessee. Title may or may not eventually be transferred. • Operating Lease: A lease other than a finance lease. Example: Lease of an office building, factory site or motor vehicle.

8. AASB 117 – Determining the Existence of a Finance Lease • A lease could be assumed to be a finance lease where (para 10): • The lessortransfers 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 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; • The lease term is for the major part of the economic life of the asset even if title is not transferred. • As a major part is not defined in AASB 117 it is generally accepted that if a lease term is greater or equal to 75% of the economic life of the leased asset, then the risks and rewards are effectively transferred to the lessee and it is therefore a finance lease.

9. AASB 117 – Determining the Existence of a Finance Lease (cont’d) • The leased assets are of such a specialised nature that only the lessee can use them without major modification. • 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 assets. • In practice 90% or greater constitutes substantial. • The rationale for this test is that if the PV or the MLP is reasonably close to market price of the asset, the asset is essentially being purchased, as the market price is being paid for the leased asset through the lease payments.

10. AASB 117 – Determining the Existence of a Finance Lease (cont’d) • Other indicators (para 11) that may exhibit the lease as being a finance classification are:- a) If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee. • A non-cancellable lease is one that is cancellable only: • Upon the occurrence of some remote contingency; • With the permission of the lessor; • If the lessee enters into a new lease for the same or an equivalent asset with the same lessor; or • Upon payment by the lessee of such an additional amount that at the inception of the lease, continuation of the lease is reasonably certain. • The lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent.

11. AASB 117 - Types of Leases • Direct-financing lease: The lessor provides the finance to acquire the asset and enters into a lease agreement to lease the asset to the lessee. No sale is recorded, but the lessor derives income through periodic interest revenue. • Sales type lease: this lease involves manufacturers /dealers. It is where the fair value of the property being leased differs from the cost of the leased asset to the lessor. This is because the lessor has directly made the asset instead of purchasing it. • Sale and leaseback transaction: A sale and leaseback transaction is one which first involves the sale of property, with all or part of that property being leased back to the seller (lessee) by the purchaser (lessor). Depending upon the circumstances, the leaseback may be classified as a finance or operating lease.

12. Leasing Terminology: Transfer of Ownership • If the lease transfers ownership at the end of the lease term, then the lease is viewed as another type of debt agreement with title transfer occurring after the final payment has been made. • It is important to identify if ownership will transfer to the lessee at the end of the lease as this may demonstrate the lease as a finance lease.

13. Leasing Terminology: Bargain Price Option • Although not explicitly used in AASB 117, its existence is implied • A provision in the lease agreement that permits the lessee to purchase the leased asset at a price expected to be significantly below the fair value of the asset at the date the bargain price option becomes exercisable • Will virtually guarantee transfer of ownership to take place • Example: Expected fair value $50,000 at time option can be exercised, however price option is $10,000. A rational party would not forgo a bargain and is highly likely that a transfer will occur.

14. Leasing Terminology: Lease Term • 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 continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonablycertain that the lessee will exercise the option.

15. Leasing Terminology: Contingent Rentals • The proportion of the lease payment that changes based on some future factor or event • Not related to passage of time • May change because of, for example: • Percentage of future sales • Amount of future use • Future price indices • Future market rates of interest

16. Leasing Terminology: Economic Life • The period over which an asset is expected to be economically usable by one or more users; or • The number of production or similar units expected to be obtained from the asset by one or more users. The lease term and economic life may not be the same

17. Lease Terminology: Discount Rate • The implicit rate is the rate that when applied to the minimum lease payments plus any unguaranteed residual causing the sum of these present values to equal the fair value of the asset at lease inception.

18. Leasing Terminology: Fair Value • The amount for which an asset could be exchanged between a knowledgeable willing buyer, and a knowledgeable willing seller, in an arm’s length transaction.

19. Leasing Terminology:Minimum Lease Payments (MLPs) • Determining MLPs and the present value of MLPs is important: • Present value of MLPs used to determine if a lease is a finance or operating lease • If the lease is a finance lease, the amount initially recognised for the asset or liability is: • The fair value of the leased asset or, if lower, the present value of the MLPs

20. Minimum Lease Payments include: • Payments over the lease term the lessee is required to make, excluding any costs for services and taxes, and contingent rent PLUS • Any guaranteed residual value • Guaranteed residual has a different meaning for the lessor and the lessee • Guaranteed residual for lessor: • Any amounts guaranteed to the lessor by: the lessee, a party related to the lessee or a third party unrelated to the lessor but who is financially capable of discharging the obligations • Guaranteed residual for lessee: • Any amounts guaranteed to the lessor by: the lessee, a party related to the lessee

21. Leasing Terminology: Residual value • Estimated fair value of the leased asset at end of lease term based on price levels and market conditions existing at the beginning of the lease. • May be guaranteed by the lessee at the end of lease term • Payment of the residual will normally lead to the asset being legally transferred to the lessee • Guaranteed residuals are included in the calculation of MLP’s whereas unguaranteed residuals are not, as there is no certainty of the amount being paid

22. Activity • Question 9 from Chapter 11 of Deegan (2012) • Reproduced on your activity sheet

23. Accounting for Operating Leases • AASB 117 requires that under an operating lease, payment should be expensed on a straight-line basis over the term of the lease unless another systematic basis is more appropriate. • This type of accounting treatment is referred to as “off balance sheet financing”. As the lease payment only affects the profit/loss and does not appear as a liability in the balance sheet. Example • On 1 July 2012, Chardonnay Ltd (the lessee) enters into a lease agreement with Shiraz Ltd (the lessor) for the lease of a building over a three year period with an annual rental of $120,000. The estimated life of the building is 25 years. The lease is non-cancellable. Lease payments are to be made on the first of each month

24. Accounting for Operating Leases Required • Provide journal entries in the accounts of Chardonnay Ltd. • Whilst the lease is non-cancellable, it is too short a period to consider that risks and rewards have been transferred to the lessee. It is therefore treated as an operating lease.

25. Accounting for Finance Leases • Initial recognition • At the commencement of the lease, the lessee shall recognise a finance lease as an asset and liability in their balance sheet at an amount equal to the fair value of the leased property or if lower, the PV of MLP’s (para 20). This is known as capitalising the lease. • Subsequent measurement • Minimum lease payments apportioned between the finance charges (interest) and reducing the outstanding liability. The finance charge are allocated to each period during the lease term so as to produce a constant periodic rate of interest on the remaining balance of the liability (para 25). • Depreciation • A finance lease gives rise to an depreciation expense for the leased asset as well as a finance expense for each reporting period • Use same method as in AASB116 Property, Plant and Equipment

26. Accounting for Finance Leases - Lessee • Prepare Lease Payment Schedule Use the above to provide data for journal entries. Calculate Depreciation. Depreciation is calculated over the economic life of the asset if the lessor intends to transfer ownership, otherwise the leased asset should be depreciated over the period of the lease. Record accrual payments of applicable executory costs.

27. Accounting for Finance Leases – Lessee (cont’d)

28. Accounting for Finance Leases – Lessee (cont’d)

29. Initial Direct Costs • Initial direct costs are relating to initially negotiating and arranging the lease • Include commissions, legal fees and costs of preparing documentation • Required to be capitalised by lessee as part of the cost of the leased asset • Therefore leased asset value comprises: • Present value of MLPs • Initial direct costs incurred

30. Accounting for Financial Leases –Illustrative Example 1 • A Ltd acquired an asset on 29 June 2012 with the intention of leasing it to B Ltd. To this end, A Ltd (Lessor) and B Ltd (Lessee) signed a lease agreement dated 30 June 2012. The lease agreement contains the following terms and provisions: • Theterm of the lease is 5 years from 30 June 2012 and the lease agreement is non-cancellable, requiring equal rental payments of $24,000 at the beginning of each year, including an immediate down payment of $24,000 on signing the contract. This payment includes $2,000 for insurance each year (refer point 3 later). • The asset has a fair market value at the inception of the lease of $92,980 and an estimated economic life of 6 years. Its estimated salvage value at this time is $1,000.

31. Illustrative Example 1 (cont’d) • B Ltd pays costs (such as maintenance etc) directly to third parties. A Ltd however prefers to pay for the insurance on the asset of $2,000 per year, and then invoice B Ltd: B Ltd reimburses A Ltd and this amount is included in the annual payment of $24,000. • The lease provides for a guaranteed residual value of $2,000* at the end of the lease contract. • The rate of interest implicit in the lease is 10%. • B Ltd depreciates similar assets that it owns on a straight-line basis. • B Ltd intends to take over the asset at the conclusion of the lease. * Do not confuse the $2,000 residual at the end of the lease period (5 years) with the salvage value of $1,000 estimated to be the scrap value at the end of the useful life of the asset (6 years) used to calculate depreciation.

32. Illustrative Example 1 (cont’d) Required • For the purposes of AASB 117, is the lease finance or operating from B Ltd’s perspective? • Prepare a lease repayment Schedule for the life of the lease in B Ltd’s accounts. • Show journal entires in the books of both A Ltd and B Ltd to record the entries for the first two years of the lease. Show the note required to the accounts of A Ltd (lessee) under para 31(b) of AASB 117.

33. Solution to Illustrative Example 1 • You will normally be supplied with the Present Value of the lease obligation and not be required to refer to PV tables, however the following shows how you would proceed, if you were asked to establish the PV of the lease obligation. • The capitalised amount of the leased asset is calculated as the PV of the Minimum Lease Payment (always excluding Executory Costs – insurance costs of $2,000 in this case), plus the PV of the obligation for guaranteed residual value. • The lease requires a down-payment of $24,000 and $24,000 at the beginning of each subsequent years (which constitutes $22,000 lease payment and $2,000 executory costs).

34. Solution to Illustrative Example 1 Using Present Value Tables to establish PV of Lease Liability • Look under the 5 years (row) and 10% (column). The PV factor is 3.7908. • This factor cannot be used because these tables assume that the receipt (or payment) is at the END of year, whereas in the given example the lessee pays at the beginning of each year. • In other words, there is one down payment plus four other payments at the end of remaining 4 years. So, one must use PV factor 3.1699 (factor for 4 years @ 10%) • The first payment is on 30 June 2012. The second payment is on 30 June 2013, and so on.

35. Solution to Illustrative Example 1 • The answers to questions (a) to (c) are: • The lease meets the criteria for classification as a finance lease because: • The lease is non-cancellable; • The lease term of 5 years, being equal to 83% (% = 83.33%) of the equipment’s estimated economic life of 6 years, indicates that the lease term is for the major part of the economic life of the asset* • The present value of minimum lease payments ($92,980) equals the fair value of the property. Where the residual is guaranteed, the PV of the MLP’s will equal the fair value of the property • The above criteria would be enough to conclude that the lease is a finance lease. * it is generally held that 75% or more of the economic life is sufficient to qualify as a finance lease

36. Solution to Illustrative Example 1 Lease Payments • Each lease payment of $24,000 consists of three elements: • Cost of insurance reimbursement to lessor (executory costs $2,000) • A financing cost (interest expense @ 10% on outstanding balance); and • A reduction in the lease obligation (similar to the repayment of principal in a home loan).

37. Solution to Illustrative Example 1Calculation of PV of Lease Liability

38. Solution to Illustrative Example 1

39. Solution to Illustrative Example 1 • Table1 : Lease Repayment Schedule • Notes: • Lease payments as required by the contract (net of executory costs) • Ten percent of the outstanding preceding balance of (e), except for the down-payment on 30 June 2012, which attracts no interest. • (a) less (b) = (c) • Preceding outstanding balance less (d) * Includes a rounding adjustment of $3

40. Solution to Illustrative Example 1 Journal Entry in the accounts of the Lessee The entry to record the finance lease

41. Solution to Illustrative Example 1 92,980 – 1,000 6 { } = 15,330

42. Sale & Leaseback Transactions • Occurs when the owner of a property (seller/lessee) sells the property to another party and then leases it back from the purchaser/lessor (the legal owner). The seller/lessee does not lose control of the asset if the lease is regarded as a finance lease. • The lessor is providing finance to the lessee with the asset as security.

43. Sale & Leaseback Transactions (cont’d) • In such a transaction the property is sold at a price equal to or greater than current market value and is leased back for a term approximating the property’s useful life and for lease payments sufficient to repay the buyer and a reasonable return on investment.

44. Sale – Leaseback (cont’d) • When substantially all the risks and rewards effectively pass to the lessor as a result of a sales and leaseback transaction, the lease will be classified as an operating lease. If the selling price for the property is at fair value at the date of sale this would constitute a normal sales transaction and the profit is recognised immediately. • Whereas if the lease is classified as a finance lease the profit on sales is deferred in the balance sheet and amortised to the income statement over the term of the lease.

45. Sales – Leaseback (cont’d) • Accounting entry: finance lease • Recording the sale of the building to X Ltd; as the lease is a finance lease any profit on sale is deferred and recognised throughout the lease term

46. Sale Leaseback (cont’d) • Accounting entry: operating lease • When the sale and leaseback is at fair value there are no intention by the lessee to resume ownership of the property (i.e., the risk and rewards pass to the lessor), the profit on sales is recognised in the accounts of the lessee.

47. Accounting for Finance Leases - Lessor • The lessor will account for the lease as either a Direct-financing lease or as a “Sales-type” lease (dealer or manufacturer). • Direct Finance Lease • A Finance Company purchases the asset from a third party and then leases it to the lessee. • Dealer or Manufacturer Lease (sales type lease) • Involves a profit margin such as where a manufacturer leases trading stock or manufactured capital equipment to lessee.

48. AASB 117 – Accounting for Leases – Lessor (Direct Finance Lease) • If a Direct-financing lease, the lessor will be a financial intermediary and the finance leases would be recorded as receivable and interest revenue would be accounted for on a yield basis. • This approach recognises that the financial intermediary is in the business of making a profit through interest on leases, loans and other financing ventures.

49. Accounting for Direct Financing Lease Lessor’s Accounts • Use the net method - records the lease receivable at its present value and does not use a contra account. This method is preferred. • We will not use the alternative gross method Accounting for Lease receivable • The lease receivable is an amount equal to the ‘net investment in the lease’. • determined as the ‘gross investment in the lease discounted at the interest rate implicit in the lease’. • Calculated by adding the minimum lease payments receivable (remember this includes both the annual payments plus any guaranteed residual); and any unguaranteed residual value.

50. Accounting for Direct Financing Lease (cont’d)