2. Objectives method is used.
To define what is leasing and in what business this finance
method is used.
To differentiate finance lease from operating lease.
To let students know what are the accounting treatments for
finance and operating lease.
To show the accounting treatments from both the lessor’s and the
lessee’s perspectives.
To let students know what are the disclosure requirements.
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3. Why did leasing become popular?
In the UK, there were two major reasons:
the tax advantage to the lessor;
the commercial advantage to the lessee.
The importance of FRS 117 or IAS 17 or MASB 10
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4. Why did leasing become popular? (contd.)
Tax advantage
Initial stimulus to the leasing industry in 1972 was first year allowances (FYAs) on equip that were increased to 100%.
These allowances could be offset against taxable profits, which reduced a company’s tax bill – however,
Companies with tax losses in preceding years could not utilise the tax benefits of FYAs.
So lessors claimed the FYAs and then leasing out equipment to the companies with losses at a reduced rental
thus enabling both lessors and lessees to benefit from a leasing agreement.
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5. Why did leasing become popular? (contd.)
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 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 balance sheet financing. Leasing provides the lessee with the possibility of off balance sheet financing.
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6. 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 e.g. 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 commercially attractive lease agreements structured to circumvent the standard.
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7. 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.
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8. What is the main thrust of IAS 17? (contd.)
Finance leases accounting treatment:
capitalised in the lessee’s accounts i.e.
the leased item is recorded as an asset in the balance sheet, and
the obligation for future payments should be recorded as a liability in the balance sheet.
Operating leases accounting treatment:
lessee is required to expense the annual payments as a rental through the income statement.
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9. Why was the IAS 17 approach so controversial?
The IASC 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 legal form.
Substance over form approach to accounting treatment that was completely different to traditional approach, which has strict regard to legal owners.
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10. Why was the IAS 17 approach so controversial? (contd.)
The IASC 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 balance sheet 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.
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11. 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.
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12. IAS 17 – classification of a lease (contd.)
Factors in determining transfer of risks and rewards (contd.):
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
the leased assets are of such a specialised nature that only the lessee can use them without major modifications.
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13. IAS 17 Leases Rationale for including in accounts
Economic substance
Long-term commitment
Similar to buying asset with a loan
IASC Framework defined asset and liability
Liability is a present obligation for outflow of resources
Asset is resource controlled by an enterprise.
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14. 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 FV
Annual depreciation charge.
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15. Recognition of a liability
Report at no more than recoverable amount
Higher of net selling price and value in use
Net selling price
Disposal value less direct selling costs
Value in use
PV of future cash flows
Discounted at rate for equally risky investment.
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16. Categorising as Finance or Operating Lease
Figure IAS 17 aid to categorising operating and finance leases
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17. Accounting requirements for 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 balance sheet.
The operating lease rentals payable are charged to the income statement on a straight-line basis.
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18. Disclosure requirements for operating leases
Disclose:
total of rentals charged as an expense in the income statement
payments committed to make during the next five years, in the second to fifth years inclusive, and in over five years.
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19. 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.
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20. Operating lease illustration (contd.)
Classify as an operating lease because:
it applies only to a part of the asset’s useful life,
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 one year and £24,000 within two to five years.
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21. Balance sheet steps 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 be 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.
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22. Balance sheet steps (contd.)
The finance lease obligation is a liability.
At the start of the lease the value of the leased asset and the leased 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 payments if 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.
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23. Balance sheet steps (contd.)
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.
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 charge.
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24. Finance charge allocation using actuarial method
Period Obligation Rentals Obligation Finance Obligation
(start) paid (during) 9.7% (end)
£ £ £ £ £
Year 1 35,000 10,000 25,000 2,425 27,425
Year 2 27,425 10,000 17,425 1,690 19,115
Year 3 19,115 10,000 9, ,000
Tear 4 10,000 10,000 – – –
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25. Extract from the Nestlé Group Annual Report and Accounts 2003
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.
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26. Finance lease illustrated
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
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27. Finance lease accounting illustrated
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28. Example – Clifford plc Lease commencing on 1 January 20X1 Term 3 years
Purchase price of asset 16,500
Annual payments (in advance) 6,000
Clifford’s borrowing rate %
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29. Compare FV with PV of minimum lease payment
FV of asset ,500
PV ( / /(1.15) ,754
PV is approx 95%
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30. Clifford example – Step approach
Step 1 Capitalise lease at FV = 16,500
Step 2 Straight-line depreciation = 5,500
Step 3 Asset in balance sheet
Year , ,500 = 11,000
Year , , = 5,500
Year , , =
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31. Clifford example – Step approach (contd.)
Step 4 Obligation at inception 16,500
Step 5 Finance charge (sum of digits)
Total payments ,000
Asset value , ,500
Allocate
Year 1 2/(1+2) x 1, ,000
Year 2 1/(1+2) x 1,
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32. Clifford example – Step approach (contd.)
Step 6 Reduce the obligation
Year ,500 – 6,000 = ,500
Add Finance charge ,000
11,500
Year ,500 – 6, = ,500
Add Finance charge
6,000
Year ,000 – 6, =
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33. Clifford example – Income Statement entries
Year Year 2 Year 3
Depreciation , , ,500
Finance charge ,
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34. Accounting for the lease of land and buildings
• Land and buildings are dealt with separately.
• Each has to be reviewed to determine whether to classify as an operating or finance lease.
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35. Example – The Warehouse Company
Let us assume that
the Warehouse Company Ltd, whose borrowing rate was 10% per annum, entered into a 10-year lease under which it made payments of $106,886 annually in advance.
the present value of the land was $500,000 and of the buildings was $500,000.
the value of the land at the end of ten years was $670,000 and the value of the buildings was $50,000.
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36. The Warehouse Company – Classifying the land segment of the lease
As 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.
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37. 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 x ).
This means that 96% of the benefit has been transferred (500, ,275)
The building segment is, therefore, a finance lease.
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38. 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 (670,000X0.3855) 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.
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.
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39. The Warehouse Company – How to report in the balance sheet
For the finance lease covering the building :
the lessee will have to show a $480,725 asset initially.
this will be depreciated over the ten 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.
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40. G4 + 1
Non-cancellable operating leases to be treated the same way as finance leases
Rationale: rights and benefits meet definition of asset and liability
Prevents current practice of formulating lease contracts so as to technically fall within operating classification
Prevents this form of off balance sheet financing.
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41. Do you agree or disagree with the following?
All leases should be treated as assets with accompanying liability in the balance sheet.
Including operating leases in the balance sheet will distort inter-company ratio comparisons.
Investors will be misled if operating leases are capitalised.
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42. Review Questions
Consider the importance of categorisation of lease transactions into operating lease or finance lease decisions when carrying out financial ratio analysis. What ratios might be affected?
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43. The End
End of Chapter 7
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