ACCOUNTING FOR LEASES.docx

ACCOUNTING FOR LEASES.docx

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ACCOUNTINGFORLEASES

ACCOUNTINGFORLEASES

heaccountingtopicofleasesisapopularPaperF7examareathatcouldfeaturetovaryingdegreesinQuestions2,3,4or5oftheexam.ThistopicareaiscurrentlycoveredbyIAS17, Leases.IAS17, Leases takestheconceptof substanceoverformandappliesittothespecificaccountingareaofleases.

Whenapplyingthisconcept,itisoftendeemednecessarytoaccountforthesubstanceofatransaction–ieitscommercialreality,ratherthanitsstrictlegalform.Inotherwords,thelegalbasisofatransactioncanbeusedtohidethetruenatureofatransaction.Itisarguedthatbyapplyingsubstance,thefinancialstatementsbecomemorereliableandensurethattheleaseisfaithfullyrepresented.

WHYDOWENEEDTOAPPLYSUBSTANCETOALEASE?

Aleaseagreementisacontractbetweentwoparties,thelessorandthelessee.Thelessoristhelegalowneroftheasset,thelesseeobtainstherighttousetheassetinreturnforrentalpayments.

Historically,assetsthatwereusedbutnotownedwerenotshownonthestatementoffinancialpositionandthereforeanyassociatedliabilitywasalsoleftoutofthestatement–thiswasknownas‘offbalancesheet’financeandwasawaythatcompanieswereabletokeeptheirliabilitieslow,thusdistortinggearingandotherkeyfinancialratios.Thisformofaccountingdidnotfaithfullyrepresentthetransaction.Inrealityacompanyofteneffectively‘owned’theseassetsand‘owedaliability’.

UndermoderndayaccountingtheIASBframeworkstatesthatanassetis‘aresourcecontrolledbyanentityasaresultofpasteventsandfromwhichfutureeconomicbenefitsareexpectedtoflowtotheentity’andaliabilityis‘apresentobligationoftheentityarisingfrompastevents,thesettlementofwhichisexpectedtoresultinanoutflowfromtheentityofresourcesembodyingeconomicbenefits’.Thesesubstance-baseddefinitionsformtheplatformforIAS17, Leases.

SOHOWDOESIAS17WORK?

IAS17statesthattherearetwotypesoflease,afinanceleaseandanoperatinglease.Thedefinitionsoftheseleasesarevitalandcouldberequiredwhenpreparingananswerintheexam.

Financelease

Afinanceleaseisaleasethat transferssubstantiallyalltherisksandrewardsincidentaltoownershipofanassettothelessee.

Operatinglease

Anoperatingleaseisdefinedasbeing anyleaseotherthanafinancelease.

Classificationofalease

Inordertogainclassificationofthetypeofleaseyouaredealingwith,youmustfirstlookattheinformationprovidedwithinthescenarioanddetermineiftherisksandrewardsassociatedwithowningtheassetarewiththelesseeorthelessor.Iftherisksandrewardsliewiththelesseethenitissaidtobeafinancelease,ifthelesseedoesnottakeontherisksandrewards,thentheleaseissaidtobeanoperatinglease.

Financeleaseindicators

Therearemanyrisksandrewardsoutlinedwithinthestandard,butforthepurposeofthePaperF7examthereareseveralimportantareas.Themainrewardiswherethelesseehastherighttousetheassetformostof,orallof,itsusefuleconomiclife.Theprimaryrisksarewherethelesseepaystoinsure,maintainandrepairtheasset.

Whentherisksandrewardsremainwiththelessee,thesubstanceissuchthateventhoughthelesseeisnotthelegalowneroftheasset,thecommercialrealityisthattheyhaveacquiredanassetwithfinancefromtheleasingcompanyand,therefore,anassetandliabilityshouldberecognised.

Otherindicatorsthataleaseisafinanceleaseinclude:

∙Attheinceptionoftheleasethepresentvalueoftheminimumleasepayments*amountstosubstantiallyallofthefairvalueoftheasset

∙Theleaseagreementtransfersownershipoftheassettothelesseebytheendofthelease

∙Theleasedassetisofaspecialisednature

∙Thelesseehastheoptiontopurchasetheassetatapriceexpectedtobesubstantiallylowerthanthefairvalueatthedatetheoptionbecomesexercisable

FINANCELEASEACCOUNTING

Initialaccounting

Theinitialaccountingisthatthelesseeshouldcapitalisethefinanceleasedassetandsetupaleaseliabilityforthevalueoftheassetrecognised.Theaccountingforthiswillbe:

DrNon-currentassets

CrFinanceleaseliability

（Thisshouldbedonebyusingthelowerofthefairvalueoftheassetorthepresentvalueoftheminimumleasepayments*.）

*Note:

Thepresentvalueoftheminimumleasepaymentsisessentiallytheleasepaymentsoverthelifeoftheleasediscountedtopresentvalue–youwilleitherbegiventhisfigureinthePaperF7examor,ifnot,usethefairvalueoftheasset.Youwillnotbeexpectedtocalculatetheminimumleasepayments.

SUBSEQUENTACCOUNTING

Depreciation

Followingtheinitialcapitalisationoftheleasedasset,depreciationshouldbechargedontheassetovertheshorteroftheleasetermortheusefuleconomiclifeoftheasset.Theaccountingforthiswillbe:

DrDepreciationexpense

CrAccumulateddepreciation

Leaserental/interest

Whenyoulookataleaseagreementitshouldberelativelyeasytoseethatthereisafinancecosttiedupwithinthetransaction.Forexample,acompanycouldbuyanassetwithausefuleconomiclifeoffouryearsfor$10,000orleaseitforfouryearspayingarentalof$3,000perannum.

Iftheleasingoptionischosen,overafour-yearperiodthecompanywillhavepaid$12,000intotalforuseoftheasset（$3,000pax4years）–iethefinancechargeinthisexampletotals$2,000（thedifferencebetweenthetotalleasecost（$12,000）andthepurchasepriceoftheasset（$10,000））.

Whenacompanypaysarental,ineffectitismakingacapitalrepayment（ieagainsttheleaseobligation）andaninterestpayment.Theimpactofthiswillneedtobeshownwithinthefinancialstatementsintheformofafinancecostinthestatementofprofitorlossandareductionoftheoutstandingliabilityinthestatementoffinancialposition.Inrealitythereareseveralwaysthatthiscanbedone,butthePaperF7examinerhasstatedthathewillexaminetheactuarialmethodonly.

Theactuarialmethodofaccountingforafinanceleaseallocatestheinteresttotheperioditactuallyrelatesto,iethefinancecostishigherwhenthecapitaloutstandingisgreatest,butasthecapitalgetsrepaid,interestpaymentsbecomelower（similartoarepaymentmortgagethatyoumayhaveonyourproperty）.Toallocatetheinteresttoaspecificperiodyouwillrequiretheinterestrateimplicitwithintheleaseagreement–againthiswillbe providedintheexam andyouarenotrequiredtocalculateit.

Oneoftheeasiestwaystoapplytheactuarialmethodintheexamistousealeasingtable.Pleasetakenoteofwhentherentalpaymentisactuallydue,isitinadvance（ierentalmadeatbeginningoftheleaseyear）orisitinarrears（ierentalmadeattheendoftheleaseyear）?

Thiswillaffectthecompletionoftheleasetableashighlightedbelow:

RENTALPAYMENTSINADVANCE

Year

B/fwd

Rental

Capitalo/s

Interest

（rategiven）

C/fwd

X

X

（X）

X

X

X

To statementof 

profitorloss

（financecosts）

Tostatement 

offinancial 

position 

（liability）

Rentalpaymentsinarrears

Year

B/fwd

Interest

（rategiven）

Rental

C/fwd

X

X

X

（X）

X

Toincome 

statement 

（finance 

costs）

Tostatement 

offinancial 

position 

（liability）

Tip:

tobetechnicallyaccuratetheleaseliabilityshouldbesplitbetweenanon-currentliabilityandacurrentliability.



Example1–Rentalsinarrearstreatment


On1April2009BushCoenteredintoanagreementtoleaseamachinethathadanestimatedlifeoffouryears.Theleaseperiodisalsofouryears,atwhichpointtheassetwillbereturnedtotheleasingcompany.Annualrentalsof$5,000arepayableinarrearsfrom31March2010.Themachineisexpectedtohaveanilresidualvalueattheendofitslife.Themachinehadafairvalueof$14,275attheinceptionofthelease.Thelessorincludesafinancecostof15%perannumwhencalculatingannualrentals.



HowshouldtheleasebeaccountedforinthefinancialstatementsofBushfortheyearend31March2010?

Solution


TheleaseshouldbeclassifiedasafinanceleaseastheestimatedlifeoftheassetisfouryearsandBushretainstherighttousethisassetforfouryearsinaccordancewiththeleaseagreementthereforeenjoyingtherewardsoftheasset.



Initialaccounting:

recognisetheassetandtheleaseliability

DrProperty,plantandequipment

14,275

CrFinanceleaseobligations

14,275

Subsequentaccounting:

depreciation


DrDepreciationexpense

（$14,275/4years）

3,568

CrAccumulateddepreciation

3,568

Subsequentaccounting:

leaserental/interest

Tip:

usetheleasetableandcompletenextyearaswelltohelpyoucompletethesplitbetweennon-currentandcurrentliabilities.

Year

B/fwd

Interest 

（15%）

Rental

C/fwd

1

14,275

2,141

（5,000）

11,416

2

11,416

1,712

（5,000）

8,128*

*NCL

Statementofprofitorlossextract

Depreciation

3,568

Financecosts

2,141

Statementoffinancialpositionextract

Non-currentassets

Carryingvaluemachine

（14,275–3,568）

10,707

Non-currentliabilities

Leaseobligation

8,128

Currentliabilities

Leaseobligation

Capital 

（11,416–8,128）

3,288

Example2–Rentalsinadvancetreatment

On1April2009ShrubCoenteredintoanagreementtoleaseamachinethathadanestimatedlifeoffouryears.Theleaseperiodisalsofouryearsatwhichpointtheassetwillbereturnedtotheleasingcompany.Shrubisrequiredtopayforallmaintenanceandinsurancecostsrelatingtotheasset.Annualrentalsof$8,000arepayableinadvancefrom1April2009.Themachi