1. 10-1 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Accounting for Leases Chapter 10

2. 10-2 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Learning objectives Understand the differences between operating leases and financial leases Understand how lessors and lessees should account for financial leases Understand how lessors and lessees should account for operating leases Understand the implications that lease recognition will have for a reporting entity’s financial statements

3. 10-3 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases Accounting for leases is governed by NZ IAS 17 Applies to accounting for leases other than: – Leases to explore for or use minerals, oil, natural gas and similar non-regenerative assets – Licensing agreements for such items as motion picture films, video recordings, plays, manuscripts and copyrights Lease defined (NZ IAS 17, par. 4): An agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time (Continues)

4. 10-4 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Central accounting issue Whether or not the leased assets and the associated commitments relating to the lease arrangement should appear in the reporting entity’s balance sheet Should lack of legal ownership preclude the lessee’s reporting of the asset and the related liability in the balance sheet? (Continues)

5. 10-5 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Question of ‘control’ and not ‘ownership’ A firm may recognise assets it does not own as long as it is able to control their use Do leases transfer control of the asset to the lessee? – Depends on the terms of the lease agreement – It is, in fact, possible for control of the asset to be vested in the lessee (Continues)

6. 10-6 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Central issue concerns whether lease is: – A finance lease; or – An operating lease Finance leases (under NZ IAS 17) must be disclosed in the balance sheet: – Lease asset – Corresponding lease liability Finance lease – A lease that transfers substantially all the risks and rewards incidental to ownership of an asset – Title may or may not be eventually transferred (Continues)

7. 10-7 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Risks and rewards of ownership central to the application of NZ IAS 17 – If the lessee holds the risks and rewards of ownership, the lessee’s risk exposure is basically what it would be if the lessee acquired the asset by way of a purchase transaction – If the risks and benefits of ownership are transferred in substance to the lessee, the lessee’s risk exposure in relation to holding the asset is basically equivalent to what it would have been if the lessee had acquired the asset for cash or by way of a loan (Continues)

8. 10-8 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Risks and rewards of ownership (cont.) – Not always a straightforward exercise to determine whether the risks and rewards incidental to ownership have passed substantially to the lessee – Often requires professional judgment – Guidance offered in NZ IAS 17 (pars 10–12) to determine whether finance or operating lease (Continues)

9. 10-9 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) NZ IAS 17 (par. 10) Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract. Examples of situations that, individually or in combination, would normally lead to a lease being classified a finance lease are: (a) The lease transfers ownership of the asset to the lessee by the end of the lease term (b) 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 (c) The lease term is for the major part of the economic life of the asset even if the title is not transferred (Continues)

10. 10-10 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) NZ IAS 17 (par. 11): Indicators of situations that, individually or in combination, could also lead to a lease being classified a finance lease are: (a) If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee (b) Gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (for example, in the form of a rent rebate equalling most of the sale proceeds at the end of the lease); and (c) The lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than the market rent (Continues)

11. 10-11 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Note (NZ IAS 17, par. 12): The examples and indicators in paragraphs 10 and 11 are not always conclusive If it is clear from other features of the lease that the lease does not transfer all risks and rewards incidental to ownership, the lease is classified an operating lease This might be the case, for example, if ownership of the asset transfers at the end of the lease for a variable payment equal to its then fair value or if there are contingent rents, as a result of which the lessee does not bear substantially all such risks and rewards (Continues)

12. 10-12 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Operating vs finance lease If lease is cancellable at limited cost to lessee, the lessee has limited risks and the lease is considered an ‘operating’ lease For the lessee to be considered to bear the risks associated with asset ownership there should be costs for the lessee should the lessee choose to cancel the lease Thus, par. 11(a) is considered an important consideration in determining whether a lease is a ‘finance’ lease Classification of lease a matter of professional judgment, i.e. depends on economic substance of the lease agreement Leases that do not appear to satisfy any of the criteria of NZ IAS 17 (paragraphs 10–12) will typically be classified and accounted for by the lessee as ‘operating’ leases They will not require disclosure within the balance sheet, lease payments are typically treated as rental expenses (Continues)

13. 10-13 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Key terms 1. Fair value – The amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction – Necessary for determining the amount to be included for the leased asset in the balance sheet of the lessee (Continues)

14. 10-14 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Key terms (cont.) 2. Non-cancellability A non-cancellable lease is a lease that is cancellable only: (a)Upon 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 (Continues)

15. 10-15 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Key terms (cont.) (d) Upon payment by the lessee of such an additional amount that at inception of the lease, continuation of the lease is reasonably certain Important because if the lessee was able to cancel the lease at short notice with limited penalty the lessee would not be considered to be holding the risks and rewards associated with asset ownership—lease would be considered an operating lease If lease cancellable—regardless of remaining terms the lease would be considered to be an operating lease (Continues)

16. 10-16 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Key terms (cont.) 3. Contingent rent (NZ IAS 17, par. 4) That portion of the lease payments that is not fixed in amount but is based on the future amount of a factor that changes other than with the passage of time (e.g. percentage of future sales, amount of future use, future price indices, future market rates of interest) Why important? When the amount of rent paid by the lessee is contingent upon the amount of future sales, future use, future interest rates, etc., there is effectively a shift of some of the risks and rewards of ownership back to the lessor ‘Contingent rent’ therefore decreases the likelihood that the lease will be a ‘finance’ lease (Continues)

17. 10-17 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Key terms (cont.) 4. Transfer of ownership If lease transfers ownership of the asset to the lessee at the end of the lease term it is considered a finance lease (NZ IAS 17, par. 10a) If the lease is also non-cancellable, the lease is really only another type of debt agreement with title passing after last payment is made (Continues)

18. 10-18 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Key terms (cont.) 5. Bargain purchase option Considered in NZ IAS 17 (par. 10b) A provision that allows a lessee to purchase a leased property for a price expected to be far lower than the expected fair value of the property at the date the option becomes exercisable Difference between the option price and expected fair market value must be large enough to make exercise of the option reasonably assured— evaluation made at inception of lease If exercise of option is likely (bargain) it is also likely that transfer of ownership will occur—risks and rewards of ownership are assumed to be transferred Included in the calculation of minimum lease payments because the exercise of a ‘bargain’ option is reasonably assured and it is therefore probable that the amount will ultimately be paid by the lessee (Continues)

19. 10-19 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Key terms (cont.) 6. 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 reasonably certain that the lessee will exercise the option (Continues)

20. 10-20 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Key terms (cont.) 7. Economic life Either: (a) The period over which an asset is expected to be economically usable by one or more users; or (b) the number of production or similar units expected to be obtained from the asset by one or more users (Continues)

21. 10-21 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Key terms (cont.) 7. Economic life (cont.) Why important? NZ IAS 17, par. 10(c) If the non-cancellable lease term is for the major part of the economic life of the asset the lease is generally considered a finance lease Note: ‘Major part’ not defined but generally accepted that if lease term is greater than or equal to 75% of the economic life of the leased asset risks and rewards are effectively transferred to the lessee (finance lease) (Continues)

22. 10-22 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Key terms (cont.) 8. Minimum lease payments NZ IAS 17 (par. 4) The payments over the lease term what the lessee is or can be required to make, excluding contingent rent, costs for services and taxes paid by and reimbursed to the lessor together with: (a) For the lessee, any amounts guaranteed by the lessee or by a party related to the lessee; or (b) for a lessor, any residual value guaranteed to the lessor by: (i) the lessee (ii) a party related to the lessee; or (iii) a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee (Continues)

23. 10-23 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Key terms (cont.) 8. Minimum lease payments (cont.) Why important? The present value of the minimum lease payments is used to determine whether a lease is a finance or operating lease—NZ IAS 17, par. 10(d): – If at the inception of the lease the present value of the minimum lease payments amounts to at lease substantially all of the fair value of the asset—normally leads to lease classified as ‘finance’-type lease – If a finance lease the amount to be initially recognised in the balance sheet for the asset and liability is (par. 20) the fair value of the leased property or, if lower, the present value of the minimum lease payments as determined at inception of lease (Continues)

24. 10-24 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Key terms (cont.) 8. Minimum lease payments (cont.) Expressly exclude contingent rent Include guaranteed residual values (a) Guaranteed residual value defined for the lessee That part of the residual value that is guaranteed by the lessee or by a party related to the lessee (the amount of the guarantee being the maximum amount that could in any event become payable (Continues)

25. 10-25 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Key terms (cont.) 8. Minimum lease payments (cont.) (b) Guaranteed residual value defined for the lessor: That part of the residual value that is guaranteed by the lessee or by a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee (Continues)

26. 10-26 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) (c)Amount of a guaranteed residual value The amount that the lessor has the right to require the lessee or a related party to the lessee to pay at the end of the lease term Payment of this residual will often lead to the asset being legally transferred to the lessee Minimum lease payments Do not include costs for services and taxes (executory costs) that are paid to the lessor in reimbursement (Continues)

27. 10-27 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Introduction to accounting for leases (cont.) Key terms (cont.) 9. Guaranteed/Unguaranteed residual (a) Guaranteed residual The maximum amount that could become payable— included in the minimum lease payments as its payment is reasonably assured (b) Unguaranteed residual Not included in minimum lease payments as there is not sufficient certainty that the amount will be paid (Continues)

28. 10-28 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Interest rate for determining the present value of minimum lease payments Why interest in present value of minimum lease payments? – NZ IAS 17 (par. 20): At commencement of lease term lessees are to recognise finance leases as assets and liabilities in their balance sheets at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum lease payments – Discount rate to be used in calculating present value:  Interest rate implicit in the lease (if this is practical to determine); or  If not, the lessee’s incremental borrowing rate to be used (Continues)

29. 10-29 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Interest rate for determining the present value of minimum lease payments (cont.) Interest rate implicit in the lease (NZ IAS 17): – The discount rate that, at the commencement of the lease term, causes the aggregate present value of:  the minimum lease payments; and  the unguaranteed residual value to be equal to the sum of: (i)the fair value of the leased asset; and (ii)any initial direct costs of the lessor (Continues)

30. 10-30 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Interest rate for determining the present value of minimum lease payments (cont.) Fair value of asset cannot be determined by lessee at inception of lease: – Implicit interest rate cannot then be determined – Lessee to discount the minimum lease payments by using incremental borrowing rates Incremental borrowing rate defined: – The rate of interest the lessee would have to pay on a similar lease or, if not determinable, the rate that, at the inception of the lease, the lessee would incur to borrow over a similar term, with similar security, the funds necessary to purchase the asset Refer to Worked Example 10.1 on pp. 433 – 4: Example of computing discount rate Refer to Worked Example 10.2 on pp. 334 – 5: Classification of a lease as a finance or operating lease

31. 10-31 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessee accounting for finance leases Overview Essentially the same as acquiring the asset by way of a long-term loan Lessee records an asset (leased) and a lease liability Asset and liability recorded at the fair value of the leased property or, where lower, at the present value of the minimum lease payments Consideration to be given to present value of future cash flows (Continues)

32. 10-32 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessee accounting for finance leases (cont.) Overview (cont.): Unguaranteed residual excluded from the amount recognised for the lease asset and lease liability in financial statements of lessee Rental payments to lessor include payment of principal plus interest—to be apportioned by lessee Interest expense calculated by applying the interest rate implicit in the lease to outstanding lease liability at beginning of each lease period Balance of payment represents a reduction of principal of lease liability (Continues)

33. 10-33 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessee accounting for finance leases (cont.) Amortisation of leased assets Leased assets should be amortised using the depreciation (amortisation) policies normally followed by the lessee Period of amortisation—number of accounting periods that are expected to benefit from the asset’s use Amortisation can be over useful life of asset, i.e. when reasonable assurance that lessee will obtain ownership at end of lease term (e.g. bargain purchase option), otherwise amortisation over lease term (continues)

34. 10-34 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessee accounting for finance leases (cont.) Journal entries To record the leased asset and lease liability (at PV of minimum lease payments): DrLeased asset CrLease liability To record lease amortisation expense: DrLease amortisation expense CrAccumulated amortisation (Continues)

35. 10-35 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessee accounting for finance leases (cont.) Journal entries (cont.) To record the lease payment, with the payment being allocated between principal and interest: DrLease liability DrInterest expense CrCash To record payment of executory costs: DrExecutory expenses CrCash (Continues)

36. 10-36 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessee accounting for finance leases (cont.) Initial indirect costs (NZ IAS 17): Costs directly associated with negotiating and executing a lease agreement Include commissions, legal fees, costs of preparing and processing documentation Initial direct costs relating to a finance lease must be capitalised as part of the leased asset Where such costs are incurred the lease asset comprises the present value of the minimum lease payments and the amount of the initial direct costs incurred—total amount subject to amortisation

37. 10-37 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessee accounting for operating leases A lease that does not substantially transfer all the risks and rewards incidental to ownership of the asset to the lessee Lease payments are expensed on a basis representative of the pattern of benefits derived from the leased asset If lease payments do not represent prepayments, they should be expensed in the period made (Continues)

38. 10-38 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessee accounting for operating leases (cont.) AASB 117 (par. 33): Lease payments under an operating lease are to be recognised as an expense on a straight-line basis over the lease term, unless another systematic basis is more representative of the time pattern of the user’s benefits Journal entry: DrRental expense CrCash Refer to Worked Example 10.4 on p. 442: Accounting for an operating lease

39. 10-39 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessee accounting for sale and leaseback transactions Occurs when the owner of a property (seller/lessee) sells the property to another party and simultaneously leases it back from the purchaser/lessor (the legal owner) Seller does not lose control of the asset if a finance lease Property often sold at a price equal to or greater than current market value—leased back for a term approximating useful life (Continues)

40. 10-40 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessee accounting for sale and leaseback transactions (cont.) Lease payments sufficient to repay the buyer for cash invested plus reasonable return on investment Lessee typically pays all executory costs as if title remained with lessee Often considered a useful way of obtaining funds while allowing recipient of the funds to maintain control of the asset (Continues)

41. 10-41 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessee accounting for sale and leaseback transactions (cont.) Finance lease Where substantially all risks and rewards incidental to ownership remain with lessee—represents refinancing of an asset Any profit or loss on sale deferred in the balance sheet and amortised to the profit and loss over the term of the lease (NZ IAS 17, par. 59) Asset considered not to have been ‘sold’ to lessor, therefore inappropriate to recognise profit or loss (NZ IAS 17, par. 60) (Continues)

42. 10-42 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessee accounting for sale and leaseback transactions (cont.) Operating lease Where substantially all risks and rewards incidental to ownership effectively pass to lessor NZ IAS 17 (par. 61) If a sale and leaseback transaction results in an operating lease, and it is clear that the transaction is established at fair value, any profit and loss shall be recognised immediately If the sale price is below fair value, any profit or loss shall be recognised immediately, except that, if the loss is compensated for by future lease payments at below market price, it shall be deferred and amortised in proportion to the lease payments over the period for which the asset is expected to be used If the sale price is above fair value, the excess over fair value shall be deferred and amortised over the period for which the asset is expected to be used (Continues)

43. 10-43 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessee accounting for sale and leaseback transactions (cont.) Operating lease (cont.) AASB 117 (par. 63) For operating leases, if the fair value at the time of the sale and leaseback transaction is less than the carrying amount of the asset, a loss equal to the amount of the difference between the carrying amount and fair value is to be recognised immediately (Continues)

44. 10-44 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessee accounting for sale and leaseback transactions (cont.) Journal entries To record the sale of an asset (any profit on sale is deferred and recognised throughout lease term): DrCash DrAccumulated depreciation Cr Asset Cr Deferred gain (Continues)

45. 10-45 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessee accounting for sale and leaseback transactions (cont.) Journal entries (cont.) To record finance lease: DrLeased asset CrLease liability To recognise periodic lease repayment: DrInterest expense DrLease liability CrCash (Continues)

46. 10-46 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessee accounting for sale and leaseback transactions (cont.) Journal entries (cont.) To record amortisation of leased asset: DrAmortisation of leased asset CrAccumulated lease amortisation Recognition of deferred gain (on straight-line basis): DrDeferred gain CrProfit on sale of leased asset Refer to Worked Example 10.5 on p. 448: Sale and leaseback transaction

47. 10-47 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessee disclosure requirements Finance lease – Numerous disclosures required—Refer to NZ IAS 17, par. 31 Operating lease – Numerous disclosures required—Refer to AASB 117, par. 35 Refer to Exhibit 10.1 on page 450—Lease notes in Air New Zealand Ltd’s 2004 Financial Statements. Refer to Worked Example 10.6 on p. 452: Comprehensive illustration of accounting for leases by a lessee

48. 10-48 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Accounting by lessors Lessor’s perspective Leases classified either as operating leases or finance leases Adoption of same criteria for non-cancellable lease as for lessee Factors addressed in NZ IAS 17, pars 10–12 Finance leases can be further classified into: Leases involving manufacturers or dealers Direct finance leases

49. 10-49 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessor accounting for direct financing leases Direct financing lease A lease where the lessor provides the financial resources to acquire the asset Lessor typically acquires the asset, giving the lessor legal title, then enters a lease agreement to lease the asset to the lessee, who subsequently controls the asset No sale is recorded Lessor derives income through periodic interest revenue Where risks and rewards of ownership are held by the lessee, the lessor substitutes lease receivable for the underlying asset (Continues)

50. 10-50 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessor accounting for direct- financing leases (cont.) Direct financing lease (cont.) NZ IAS 17 (par. 36) Lessors are to recognise assets held under a finance lease in their respective balance sheets and present them as a receivable at an amount equal to the net investment in the lease Net investment in lease (NZ IAS 17, par. 4) The gross investment in the lease discounted at the interest rate implicit in the lease (Continues)

51. 10-51 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessor accounting for direct- financing leases (cont.) Direct financing lease (cont.) Gross investment in the lease The aggregate of: (a) the minimum lease payments receivable by the lessor under a finance lease; and (b) any unregulated residual value accruing to the lessor. Interest earned by lessor over lease term – Difference between fair value of leased asset and sum of the undiscounted minimum lease payments and any unregulated residual value (Continues)

52. 10-52 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessor accounting for direct- financing leases (cont.) Direct financing lease (cont.) Initial indirect costs incurred by lessor – Incremental costs that are directly attributable to negotiating and arranging a lease, except for such costs incurred by manufacturer or dealer lessors – Includes commissions, legal fees, and costs associated with processing new leases – If material, are to be included in the lessor’s investment in the lease (refer to NZ IAS 17, par. 38) Recovery of executory costs Costs that are related specifically to the operation and maintenance of the leased property, e.g. insurance, maintenance and repairs – Should be treated as revenue by lessor in financial years in which related costs are incurred (Continues)

53. 10-53 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessor accounting for direct- financing leases (cont.) Direct financing lease—Net vs gross method Either net method or gross method can be used to record the lease Net method – Most commonly used – Lease receivable recorded at its present value and does not use contra account (unearned interest revenue) (Continues)

54. 10-54 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessor accounting for direct- financing leases (cont.) Direct financing lease—Net vs gross method (cont.) Gross method – Lease receivable recorded at the sum of the undiscounted minimum lease payments and the unguaranteed residual – Unearned interest revenue also recorded (contra account) and amortised to interest revenue over the lease term – Unearned interest revenue is subtracted from lease receivable to determined carrying (present value) of the lease receivable (Continues)

55. 10-55 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessor accounting for direct- financing leases (cont.) Net method To record initial acquisition of asset: DrAsset CrCash/Payables etc. To record lease receivable at inception: DrLease receivable CrAsset (Continues)

56. 10-56 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessor accounting for direct- financing leases (cont.) Net method (cont.) To record receipt of lease payment: DrCash CrLease receivable CrInterest revenue (Continues)

57. 10-57 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessor accounting for direct- financing leases (cont.) Gross method To record initial acquisition of asset: DrAsset CrCash/Payables etc. To record lease receivable: DrLease receivable CrAsset CrUnearned interest revenue (Continues)

58. 10-58 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessor accounting for direct- financing leases (cont.) Gross method (cont.) To record receipt of lease payment: DrCash CrLease receivable DrUnearned interest revenue CrInterest revenue (Continues)

59. 10-59 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessor accounting for direct- financing leases (cont.) Lessor disclosure requirements for finance lease NZ IAS 17, par. 47 Lessors, in addition to meeting the requirements in NZ IAS 32, disclose the following for finance leases: (a) A reconciliation between the gross investment in the lease at the balance sheet date, and present value of minimum lease payments receivable at the balance sheet date. In addition, an entity shall disclose the gross investment in the lease and the present value of minimum lease payments receivable at the balance sheet date, for each of the following periods:  not later than one year  later than one year and not later than five years  later than five years (Continues)

60. 10-60 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessor accounting for direct- financing leases (cont.) Lessor disclosure requirements for finance lease (cont.): (b) Unearned finance income (c) The unguaranteed residual values accruing to the benefit of the lessor (d) The accumulated allowance for uncollectible minimum lease payments receivable (e) Contingent rents recognised as income in the period (f) A general description of the lessor’s material leasing arrangements Refer to Worked Example 10.7 on p. 457: Comprehensive illustration of accounting for leases by lessor (Continues)

61. 10-61 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Accounting for lessors that are manufacturers or dealers of the leased asset Where fair value of the property at the inception of the lease differs from its cost to the lessor (dealer or manufacturer) Represents a finance lease Two parts of the transaction: 1. A sale with a resulting gain (fair value vs cost to dealer/manufacturer) 2. A lease transaction that will provide interest revenue over the period of the lease (Continues)

62. 10-62 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Accounting for lessors that are manufacturers or dealers of the leased asset (cont.) Lessor’s investment in lease accounted for in same manner as direct financing lease: – Value of sale recorded as fair value of asset at date of sale (equal to present value of minimum lease payments) – Indirect costs (e.g. commissions, legal fees, etc.) accounted for by lessor as a cost of sales in year in which transaction occurs—not as part of net investment in lease receivable (NZ IAS 17, par. 38) – Lease rentals representing a recovery of executory costs (if material) to be treated by lessor as revenue in year in which costs incurred (Continues)

63. 10-63 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Accounting for lessors that are manufacturers or dealers of the leased asset (cont.) Lessor’s journal entries for a lease involving a dealer or manufacturer—Net method To record receipt of lease payment: DrCash CrLease receivable CrInterest revenue (Continues)

64. 10-64 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Accounting for lessors that are manufacturers or dealers of the leased asset (cont.) Lessor’s journal entries for a lease involving a dealer or manufacturer—Net method (cont.) To record sale and lease receivable: DrLease receivable DrCost of goods sold CrInventory CrSales Cost of sales will represent the cost of the asset to the lessor—assumed that asset being sold was part of the inventory of the lessor (Continues)

65. 10-65 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Accounting for lessors that are manufacturers or dealers of the leased asset (cont.) Lessor’s journal entries for a lease involving a dealer or manufacturer—Gross method To record sale and lease receivable: DrLease receivable DrCost of goods sold CrInventory CrSales CrUnearned interest revenue Cost of sales represents the cost of the asset to the lessor—unearned interest revenue represents the gross amount of interest to be earned throughout the term of the lease (Continues)

66. 10-66 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Accounting for lessors that are manufacturers or dealers of the leased asset (cont.) Lessor’s journal entries for a lease involving a dealer or manufacturer—Gross method (cont.) To record receipt of lease payment: DrCash CrLease receivable DrUnearned interest revenue CrInterest revenue Refer to Worked Example 10.8 on p. 461: Example of lease involving a dealer or manufacturer

67. 10-67 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessor accounting for operating leases Leased property accounted for as a non- current asset Required to depreciate if a depreciable asset Lease receipts treated as rental revenue NZ IAS 17 (par. 53) The depreciation policy for depreciable leased assets is to be consistent with the lessor’s normal depreciation policy for similar assets, and depreciation is to be calculated in accordance with NZ IAS 16 and NZ IAS 38

68. 10-68 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Leases involving land and buildings Land is an asset with an indefinite life Risks and benefits of land cannot be transferred to lessee unless the lease will, at completion, transfer ownership or has a bargain purchase option Treated as operating lease unless reasonably assured of transferring ownership Refer to NZ IAS 17 (par. 14) (Continues)

69. 10-69 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Leases involving land and buildings (cont.) Minimum lease payments must be allocated between land and buildings in proportion to their relative fair values at lease inception If lease not assured of transferring ownership of land and buildings at end of lease, lease payments allocated to land to be treated as operating lease Payments allocated to building (operating or finance lease) will depend on whether lease transfers risks and benefits of ownership to lessee (normal tests apply) (Continues)

70. 10-70 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Leases involving land and buildings (cont.) Exception: Where fair value of land is immaterial in relation to the fair value of total property, it may be treated as a unit for classification purposes and so land component may be ignored If lease then appears to transfer risks and benefits of ownership the total lease for land and buildings may be treated as a finance lease otherwise operating (refer to NZ IAS 17, par. 17) Refer to Worked Example 10.10 on p. 466: Accounting by the lessee for a lease involving land and buildings

71. 10-71 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessee accounting for lease incentives under a non-cancellable operating lease Incentives by lessor May offer incentives to enter non-cancellable operating leases (particularly for buildings) – Initial rent-free periods – Financial assistance for fitting out offices – Up-front cash incentives – Financial assistance to terminate existing lease agreements Lease incentives not specifically dealt with under NZ IAS 17 (Continues)

72. 10-72 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Lessee accounting for lease incentives under a non-cancellable operating lease (cont.) Incentives by lessee Generally in exchange for benefits, lessee pays higher lease payments than if no lease incentive were provided NZ SIC-15 provides guidance. Paragraph 3 states: – Incentives for the agreement of a new or renewed operating lease should be recognised as an integral part of the net consideration agreed for the use of the leased asset, irrespective of the incentive’s nature or form or the timing of payments.

73. 10-73 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Implications for accounting-based contracts Classification as finance rather than operating lease will affect debt–asset constraints Introduction of accounting standards requiring capitalisation of finance leases have negative cash-flow effects on firms Negative cash-flow effects found to have negative impact on security prices

74. 10-74 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Summary The chapter has addressed the treatment of accounting for leases A major issue in accounting for leases is whether the leased asset-related liability should appear on the balance sheet of the lessee Leases are classified as either operating leases or financial leases (Continues)

75. 10-75 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Summary (cont.) Finance lease – Transfers the risks and rewards of ownership from the lessor to the lessee – The leased asset and lease liability must appear in the balance sheet of the lessee – Where the lease is capitalised (on balance sheet) the amount to be capitalised is the present value of the minimum lease payments or the fair value of the leased asset, whichever is the lower – Where the lessee has capitalised a lease, the lease payments are to be apportioned between interest expense and the repayment of the lease liability, and the lessee must amortise the leased asset over its expected useful life to the lessee (Continues)

76. 10-76 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Summary (cont.) Operating lease – Does not transfer the risks and rewards of ownership to the lessee – No asset or liability is recognised in the accounts of the lessee (unless periodic lease payments are made in advance or in arrears) – Periodic lease payments are treated as an expense in the accounts of a lessee and as revenue in the accounts of the lessor (Continues)

77. 10-77 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider Summary (cont.) From the perspective of the lessor – Leases must be classified as either operating or financing – Finance leases can be further broken down into leases involving dealers or manufacturers or direct finance leases – If a finance lease, the underlying asset is removed from the balance sheet and the asset is replaced with a lease receivable – Periodic lease receipts from the lessee will be apportioned between interest revenue and the recoupment of the lease receivable