Chapter 18 Leasing

By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases by the lessee; critically discuss the reasons for the proposed revision of IAS 17.

What is a lease? Leases are defined in IAS 17 ... an agreement whereby the lessor conveys to the lessee in return for a payment or a series of payments the right to use an asset for an agreed period of time. This includes contracts for the hire of an asset that contain a provision giving the hirer an option to acquire title to the asset upon the fulfilment of agreed conditions. It is a legal agreement whereby the lessee (the user) obtains the right to use an asset for an agreed period.

What is a lease? The right to use the asset is passed from the lessor (the legal owner) of the asset to another party (the lessee). In return for the right to use the asset, the lessee pays a rental to the lessor. Legal ownership is retained by the lessor – the person granting the lease.

Types of leases Finance lease Operating lease transfers substantially all the risks and rewards incidental to ownership of an asset to the lessee. Title may or may not eventually be transferred. The lessee obtains practical ownership. Operating lease A lease other than a finance lease. An operating lease is a rental agreement. Finance Lease Sometimes called ‘capital’ or ‘financial’ leases because, in an economic sense, they are a form of borrowing. The lease payments contain both principal and interest portions, similar to a table mortgage. A lease asset and liability appear on the Balance Sheet, and interest expense on the Income Statement. lessee carries losses from such things as idle capacity, technological obsolescence, or changed economic conditions. The lessee receives any rewards expected from profitable operations over the asset’s useful life. The lessee might also be entitled to any gains from appreciation in value or realisation of a residual value at the end of the lease. Operating lease The lessee obtains the right to use the asset in return for rental payments, but the risks and rewards of ownership are not transferred to the lessee. An example is a business renting a shop from a landlord. Nothing appears on the Balance Sheet and the full rent expense appears on the Income Statement.

Figure 18.1 IAS 17 aid to categorising operating and finance leases

Lease cancellation Operating lease Finance lease only possible: (a) upon the 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 (d) upon payment by the lessee of such an additional amount that, at inception of the lease, continuation of the lease is reasonably certain. Operating lease can be cancelled at any time by either party – usually with one month’s notice. Finance Lease Sometimes called ‘capital’ or ‘financial’ leases because, in an economic sense, they are a form of borrowing. The lease payments contain both principal and interest portions, similar to a table mortgage. A lease asset and liability appear on the Balance Sheet, and interest expense on the Income Statement. lessee carries losses from such things as idle capacity, technological obsolescence, or changed economic conditions. The lessee receives any rewards expected from profitable operations over the asset’s useful life. The lessee might also be entitled to any gains from appreciation in value or realisation of a residual value at the end of the lease. Operating lease The lessee obtains the right to use the asset in return for rental payments, but the risks and rewards of ownership are not transferred to the lessee. An example is a business renting a shop from a landlord. Nothing appears on the Balance Sheet and the full rent expense appears on the Income Statement.

Situations and Indicators of Finance Lease IAS 17 outlines examples of situations that would normally lead to a lease being classified as a finance lease: The lease transfers 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 of the option exercisability. It is 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 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 specialized nature that only the lessee can use them without major modifications. http://www.ifrsbox.com/summary-of-ias-17-leases/

Situations and Indicators of Finance Lease IAS 17 also lists 3 indicators that could also lead to lease being classified as a finance, but those are not always conclusive: If the lessee is entitled to cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee. Gains or losses from fluctuations in the fair value of the residual fall to the lessee (for example, by means of a rebate of lease payments). The lessee has the ability to continue to lease for a secondary period at a rent that is substantially lower than market rent. http://www.ifrsbox.com/summary-of-ias-17-leases/

Capitalised in the lessee’s accounts: the leased item is recorded Finance lease Capitalised in the lessee’s accounts: the leased item is recorded as an asset and the obligation for future payments should be recorded as a liability in the statement of financial position. Operating lease Lessee is required to expense the annual payments as a rental through the income statement. Rationale for including in accounts Economic substance Long-term commitment Similar to buying asset using a loan IASB Framework defines asset and liability Liability is a present obligation for outflow of resources Asset is a resource controlled by an enterprise. Commitment to future obligations Payments under lease Liability measured as PV of obligations.

No asset or obligation is shown on the statement of financial position 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 statement of financial position The operating lease rentals payable are charged as expenses to the income statement on a straight-line basis. Rationale for including in accounts Economic substance Long-term commitment Similar to buying asset using a loan IASB Framework defines asset and liability Liability is a present obligation for outflow of resources Asset is a resource controlled by an enterprise. Commitment to future obligations Payments under lease Liability measured as PV of obligations.

Operating leases disclosure Total of rentals charged as an expense in the income statement Payments committed to make during the next year, in the second to fifth years inclusive, and over 5 years. Rationale for including in accounts Economic substance Long-term commitment Similar to buying asset using a loan IASB Framework defines asset and liability Liability is a present obligation for outflow of resources Asset is a resource controlled by an enterprise. Commitment to future obligations Payments under lease Liability measured as PV of obligations.

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 at inception of lease – 4 years Purchase price of new machine – £75,000 Annual payments – £8,000.

Operating lease illustration (Continued) Classify as an operating lease because: It applies only to a part of the asset’s useful life and 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 – 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 1 year and £24,000 within 2 to 5 years.

Finance lease

Finance lease At the commencement of the lease term, lessee should recognize an asset and a lease liability at the lower of the fair value of the asset and the present value of the minimum lease payments. The discount rate for calculating the present value of the minimum payments is the interest rate implicit in the lease. The accounting entry is as follows:                                                                                                                                                                     http://www.ifrsbox.com/summary-of-ias-17-leases/

Finance lease Subsequent Measurement There are 2 things to take care about after initial recognition: Minimum lease payments should be apportioned between the finance charge (interest) and the reduction of the outstanding lease liability. The finance charge should be allocated so as to produce a constant periodic rate of interest (interest rate implicit in the lease) on the remaining balance sheet liability. In practice, actuarial method is used a lot to work out the allocation. The basic accounting entry of minimum lease payment paid to the lessor is as follows:                                                                                                                                     Lessee should charge the depreciation expense related to the assets held under finance leases. http://www.ifrsbox.com/summary-of-ias-17-leases/

Finance lease Present value (PV) lease payments or Fair value Asset cost lowest of Depreciation period shortest of Estimated useful life Or Lease period Net book value = Asset cost - Depreciation Liability at a lease date = Asset cost

Finance lease Finance charge = Total minimun lease payments Less Asset cost Finance charge allocated over the term of the lease Acturial Sum of digits Straight line Liability reduced by (Finance lease – Lease payment)

Finance lease Acturial This applies a constant periodic charge to the balance of the leasing obligation and is calculated by applying present value factors to the annual lease payments Sum of the digits This method (‘Rule of 78’) is much easier to apply than the actuarial method. The finance charge is apportioned to accounting periods on a reducing scale – method used by Elliott & Elliott Straight line This spreads the finance charge equally over the period of the lease.

On calculator Pmt 10 000 N 3 I 15 Comp PV 22830 so annuity factor is 2.283 Then to find the 9,7% PV +/- 25000 PMT 10000 FV 0 Comp i 9.7

Finance charge allocation using actuarial method pp480-481(pp335-336) Figure 18.2 Finance charge allocation using actuarial method, Interest amount is finance charge for each year.

Finance lease illustrated – similar to Clifford example pp.478-480 (pp.333-336) 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 Implicit rate of interest 4%

Boonaloo Ltd - Compare FV with PV of minimum lease payment FV of lease £ 20,000 PV of instalments: 4500/(1.04) + 4500/(1.04)2 + 4500/(1.04)3 + 4500/(1.04)4 + 4500/(1.04)5 = 20,003, or 4500(PVIFA4%,5) = 4500 x 4.452 = 20,034 PV is very close to fair value, therefore capitalise at fair value.

Boonaloo Ltd – step approach Step 1 Capitalise lease at FV = £20,000 Step 2 Straight-line depreciation = £4,000 Step 3 Asset in statement of financial position Year 1 20,000 – 4,000 = £16,000 Year 2 16,000 – 4,000 = £12,000 Year 3 12,000 – 4,000 = £8,000 Year 4 8,000 – 4,000 = £4,000 Year 5 4,000 – 4,000 = 0

Boonaloo Ltd – step approach Step 4 Obligation at inception £20,000 Step 5 Finance charge (sum of digits) Sum of digits = 1 + 2 + 3 + 4 + 5 = 15 Or, by formula: n(n +1)/2 = 5(6)/2 = 15 Total to be paid (4,500 x 5) = £22,500 Fair value of asset £20,000 Finance charge £2,500 Allocate as follows: Year 1 5/(15) × 2,500 £(833) Year 2 4/(15) × 2,500 £(667) Year 3 3/(15) × 2,500 £(500) Year 4 2/(15) × 2,500 £(333) Year 5 1/(15) × 2,500 £(167) Take note: If payments were made in advance, there would be only 4 years to be considered .

Boonaloo Ltd – step approach Step 6 Reduce the obligation Year 1 20,000 − 4,500 = £15,500 Add Finance charge £833 £16,333 Year 2 16,333 − 4,500 = £11,833 Add Finance charge 667 £12,500 Year 3 12,500 – 4,500 = £ 8,000 Add Finance charge 500 £ 8,500 Year 4 8,500 – 4,500 = £ 4,000 Add Finance charge 333 £ 4,333 Year 5 4,333 – 4,500 = £ (167) Add Finance charge 167 £ 0

Boonaloo Ltd– income statement entries Year 1 Year 2 Year 3 Year 4 Year 5 Depreciation 4,000 4,000 4,000 4,000 4,000 Finance charge 833 667 500 333 167

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.

Example – the Warehouse Company pp.482-483 (pp.337-338) Let us assume that The Warehouse Company Ltd, whose borrowing rate is 10% per annum, entered into a 10-year lease for land and buildings, with Lessor Ltd, under which it will make payments of $106,886 annually in advance The present value of the land is $500,000 and of the buildings is $500,000 The expected value of the land at the end of 10 years will be $670,000 and the expected value of the buildings will be $50,000.

The Warehouse Company – classifying the land segment of the lease 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.

The Warehouse Company – classifying the building segment of the lease The building segment of the lease is different To evaluate if the benefit has been transferred. The residual value has fallen after 10 years to $50,000. The present value is $19,275 (50,000 × 0.3855) The factor 0.3855 = 10% present value discount factor [1/(1.1)10] Therefore 96% of the benefit has been transferred (500,000 – 19,275) = $480,725 The building segment is a finance lease. On calculator FV +/- 50000 N 10 I 10 PMT 0 COMP PV ANSWER 19,277.16

The Warehouse Company – how to apportion the lease payment in the income statement Now we split the yearly payment of $106,886 between the land and the building based on their fair value minus their discounted residual value at the end of the contract. LAND $500,000 - $258,285 (670,000 × 0.3855) = $241,715 represents the present value of the operating lease BUILDING $500,000 – $19,275 = $480,725 (slide32)

Total Land and Building $241,715+480,725=$722,440 Land The Warehouse Company split the yearly payment of $106,886 Total Land and Building $241,715+480,725=$722,440 Land $241,715/$722,440*$106,886= $35,763 Building $480,725/$722,440*$106,886= $71,123

The Warehouse Company – how to report in the statement of financial position For the finance lease covering the building: The lessee will have to show a $480,725 asset initially This will be depreciated over the 10 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 – in the same way as shown in the Boonaloo example earlier.

The Warehouse Company – how to report in the income statement The income statement would show a finance charge for each year of: Step 5 Finance charge (sum of digits) Sum of digits = n(n + 1)/2 = 9(10)/2 = 45 Total to be paid (71,123 x 10) £711,230 Fair value of asset £480,725 Finance charge £230,505 Year 1 (9/45 x 230,505) £ 46,101 Year 2 (8/45 x 230,505) £ 40,979 Year 3 (7/45 x 230,505) £ 35,856 Year 4 (6/45 x 230,505) £ 30,734 Year 5 (5/45 x 230,505) £ 25,612 Year 6 (4/45 x 230,505) £ 20,489 Year 7 (3/45 x 230,505) £ 15,367 Year 8 (2/45 x 230,505) £ 10,245 Year 9 (1/45 x 230,505) £ 5,122 230,505 Take note: payments were made in advance, there will be only 9 years to be considered

The Warehouse Company – steps 6 and 7 Liability Rent paid Lease liability balance Finance charge Total obligation 1 480725 71123 409602 46101 455703 2 384580 40979 425559 3 354436 35856 390292 4 319169 30734 349903 5 278780 25612 304392 6 233269 20489 253758 7 182635 15367 198002 8 126879 10245 137124 9 66001 5122 10 Step 7 Income statement Depreciation Finance charge 1 48073 46101 2 40979 3 35856 4 30734 5 25612 6 20489 7 15367 8 10245 9 5122 10

Lease of Land and Building When a lease includes both land and building elements, then the classification of each element as a finance lease or an operating lease shall be assessed separately. Land has an indefinite economic life and therefore the land element is normally classified as an operating lease (unless legal title is expected to pass to the lessee by the end of the lease term). The minimum lease payments are allocated between the land and the buildings element in proportion to the relative fair values of the leasehold interests in the land and building elements at the inception of the lease.

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Leases in the Financial Statements of Lessors Finance Lease Initial Recognition At the commencement of the lease term, lessor should recognize lease receivable in his statement of financial position. The amount of the receivable should be equal to net investment in the lease. Net investment in the lease equals to gross investment in the lease (minimum lease payments receivable by the lessor under the finance lease + any unguaranteed residual value accruing to the lessor) discounted by the interest rate implicit in the lease. The accounting entry is to debit Lease Receivable and credit Property, plant and equipment (sometimes directly cash). If lessor incurs any direct and incremental costs in negotiating leases, those must be recognized over the lease term and not to the expenses when incurred. http://www.ifrsbox.com/summary-of-ias-17-leases/

Subsequent Measurement The lessor should split minimum payments received into finance income and reduction of the lease receivable. Finance income shall be recognized based on a pattern reflecting constant periodic rate of return on the lessor’s net investment in the lease. The accounting entry is as follows:                                                                                                                                                                     Manufacturers or dealer lessor Manufacturers or dealer lessor should recognize profit or loss from sale in the same period as they would for an outright sale. If artificially low rates of interest are charged, selling profit should be restricted to that which would apply if a commercial rate of interest were charged. Costs incurred by manufacturers or dealer lessor in negotiating and arranging the lease shall be recognized as an expense when selling profit is recognized. http://www.ifrsbox.com/summary-of-ias-17-leases/

Sale and Leaseback Transactions A sale and leaseback transaction involves the sale of an asset and the leasing the same asset back. In this situation, a seller becomes a lessee and a buyer becomes a lessor. This is illustrated in the following scheme:                                                                                                                                                           Accounting treatment of sale and leaseback transactions depends on the character of the resulting lease. http://www.ifrsbox.com/summary-of-ias-17-leases/

Disclosures IAS 17 prescribes a full load of disclosures for every type of the lease. Except for general descriptions of the lease arrangements and other basic information about finance leases, both lessors and lessees are required to present reconciliation of future minimum lease payments (gross investment in the lease for the lessor) and their present value according to the period when they are due: not later than 1 year, later than 1 year and not later than 5 years; later than 5 years. The same applies to operating leases, however, here both lessors and lessees are required to present the future minimum lease payments under non-cancellable operating leases in the aggregate and for each of the following periods: not later than 1 year, later than 1 year and not later than 5 years; later than 5 years. http://www.ifrsbox.com/summary-of-ias-17-leases/

Accounting for Leases - Lessor In the books of the lessor In accounting for a finance lease the lessor has an additional issue to deal with. NZ IAS 17 recognises two types of finance lease: • a direct finance lease such as would be provided by a bank or finance company • a manufacturer’s or dealer’s lease, also known as a sales-type lease. A direct finance lease is one where the lessor provides the finance to the lessee to buy the asset

Accounting for Leases - Lessor A sales-type lease is one where the cost of the asset to the lessor is different from the asset’s fair value and, as a consequence, the lessor receives two types of income. One is the difference between the asset’s cost and sale prices (the treatment for which is the same as any sales and cost of sales transactions). The other is the finance income over the term of the lease. In these situations, the cost to the lessor is the cost of manufacturing the asset, or the cost charged by the manufacturer to the lessor as an importer or wholesaler. The fair value in these cases is the fair retail price of the asset. Consequently, the lessor is required to account for the normal surplus on the transaction with the lessee.

Warehouse example – Lessor Accounting assuming a direct finance lease For a direct finance lease, Lessor Ltd will show a mirror image record of what The Warehouse Company shows in its accounts for the leased building; Finance lease receivable (Building) £480,725 Each year as the lease rental is received, this amount will be written down – just as other fixed assets are written down by the depreciation charge. The journal entries are (for year 1): Bank £ 71,123 Finance lease receivable £ 29,213 Interest earned (see slide 38) £ 41,910 The value of the lease receivable reduces by £ 29,213 in year 1

Warehouse example – Lessor Accounting At the end of the lease, the finance lease receivable will be written down to zero, and the total interest earned will equal ₤230,505

IASB and FASB proposal 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 statement of financial position financing.

Off-Balance Sheet Financing Kallend Tiepins plc – p.484 (p.338) Machine cost: 100,000. Profit increase: 10%pa Current Buy Lease Operating profit 40,000 44,000 44,000 Equity capital 200,000 200,000 200,000 Long-term debt 100,000 200,000 100,000 Capital employed 300,000 400,000 300,000 Gearing ratio 0.5:1 1:1 0.5:1 ROCE 13.33% 11% 14.66%

Reference Elliott, Barry, Elliott Jamie, Financial Accounting and Reporting 15th Edition chapter 18