ACCOUNTING FOR LEASES.docx
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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
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