Accounting for LEASES IAS 17

IAS 17 Leases sets out the treatment for reporting lease transactions in the financial statements. Leases are a major source of finance to a business and it is important that the financial statements disclose sufficient information to the readers of the financial statements.

Doesn’t cover: Leases to explore or use mining, oil, gas resources Licencing agreements such as: motion picture films, plays, patents, copyrights Property held by a leasee that is accounted for as an investment property Biological assets held by leasee under finance leases or operting leases.

2 Types IAS 17 distinguishes between two types of lease transactions: A finance lease Operating lease

Substance over form Information in the financial statements should represent transactions in accordance with their commercial substance not merely their legal form. Eg lease vs rental The accounting for leases is the application of this concept, as the classification of a lease as either a finance lease or an operating lease, depends on the substance of the transactions rather than the legal form of the contract.

Finance Lease A finance lease “is a lease that transfers substantially all the risks and rewards inherent to ownership of the asset”.

Operating lease An operating lease is a lease other than a finance lease. The classification of a lease is crucial, as different accounting, approaches are required for the different types of leases.

Characteristics that imply a Finance Lease 1. Ownership of the asset will pass to the lessee at the end of the lease. 2. The lessee has an option to purchase the asset at a cost significantly below the fair value of the asset. 3. The term of the lease is for the major part of the economic life of the lease. 4. On commencement, the present value of the minimum lease payments amounts to substantially all the minimum fair value of the lease. 90% - The leasee is paying all of the fair value or cost of the asset over the life of the lease

5. The lease assets are of a special nature. Only the leasee can use them without substantial modification 6. The Leasee is entitled to cancel the lease. 7. If a lease transfers substantially all the risks and rewards, associated with ownership of an asset the lease should be classified as a finance lease. Risks involve meeting the costs of maintaining the asset or suffering the fall in value of the asset through technological obscelecence. Rewards include using the asset for substantially the whole of its useful life, and accruing the profits from the use of the asset

8. Gains or losses from the residual value of the asset fall to the leasee. 9. Whether the lessee has the option to extend the lease for a secondary period at a “peppercorn rent” (below the market rent). All characteristics do not need to be present

Accounting for Finance lease Debit leased asset account (Leased Asset) Credit the Finance Lease account (Long term liability) At the lower of: The fair value of the leased asset or the present value of the minimum leased payments Any direct costs of the lease are added to the amount recognised as an asset eg interest Yearly interest is to be charged to each period during the lease so as to produce a constant periodic rate of interest on the remaining balance

Accounting for Finance lease The asset is depreciated over: – The assets estimated useful life – Or the term of the lease Whichever is shorter

Calculating Interest – 2 Methods Actuarial Methods The actuarial method charges interest at a constant percentage on the outstanding liability and matches the interest to the loan balance. The rate of interest implicit in the lease is required. The interest charged for each period is the interest rate multiplied by the balance remaining immediately after the rental payment is made. Sum of the Digits Methods This method approximates the interest charge for each period by weighting the period in reverse order so that the most interest is charged in earlier periods. 5 year lease: = 15 year 1: 5/15 of interest year 2: 4/15 of interest etc (½ x n) x (n+1) where n is number of instalments

ABC Ltd entered into a fiver year lease for a new machine on 1/1/2011. ABC Ltd has to make 5 annual payments of €30,000 payable in advance. The present value of the minimum lease payments is €125,096. The implicit interest rate is 10% Year Present Value125,096104,60682,06757,27430,000 Advance pay30,000 95,09674,60652,06727,2740 Interest 10%9,5107,4615,2072,726 Owing104,60682,06757,27430,0000

Finance Lease Account DATEDETAILS€DATEDETAILS€ 1/1/11Bank30,0001/1/11Machinery125,096 31/12/11Balance104,60631/12/11Interest9, ,606 1/1/12Bank30,0001/1/12Balance104,606 31/12/12Balance82,06731/12/12Interest7, ,067 1/1/13Bank30,0001/1/13Balance82,067 31/12/13Balance57,27431/12/13Interest5,207 87,274 1/1/14Bank30,0001/1/14Balance57,274 31/12/14Balance30,00031/12/14Interest2,726 60,000 1/1/15Bank30,0001/1/15Balance30,000 31/12/15Balance31/12/15Interest 30,000

ABC Ltd entered into a fiver year lease for a new machine on 1/1/2011. ABC Ltd has to make 5 annual payments of €30,000 payable year end. The present value of the minimum lease payments is €113,724. The implicit interest rate is 10% Year Present Value113,72495,09674,60652,06727,274 Interest 10%11,3729,5107,4615,2072, ,096104,60682,06757,27430,000 Payments in arrears30,000 Owing95,09674,60652,06727,2740

Finance Lease Account DATEDETAILS€DATEDETAILS€ 31/12/11Bank30,0001/1/11Machinery113,724 31/12/11Balance95,09631/12/11Interest11, ,096 31/12/12Bank30,0001/1/12Balance95,096 31/12/12Balance74,60631/12/12Interest9, ,606 31/12/13Bank30,0001/1/13Balance74,606 31/12/13Balance52,06731/12/13Interest7,461 82,067 31/12/14Bank30,0001/1/14Balance52,067 31/12/14Balance30,00031/12/14Interest5,207 57,274 31/12/15Bank30,0001/1/15Balance27,274 31/12/15Balance31/12/15Interest2,726 30,000

Finance Lease Disclosure The company needs to disclose the net carrying amount of the asset held under a finance lease (split between their current and non-current components), present a reconciliation of the future minimum payments due at the end of the reporting period, and allocate these values to: 1.within one year 2.within two to five years 3.after more than five years A description of the company’s significant lease arrangements should be presented.

Operating Leases Any lease agreement falling outside the requirement of a finance arrangement is an operating lease. The asset is treated as if it is not purchased. Payments (rent) are charged against profit each year. DROperating Lease A/C (P&L) CRBank

3 year lease payable as follows: Year 1 31/12/1118,000 Year 231/12/1216,500 Year 331/12/1316,500 TOTAL51,000 / 3 = 17,000 write off each year

Operating Lease Account DATEDETAILS€DATEDETAILS€ 31/12/11Bank18,00031/12/11P&L17,000 31/12/11Balance1,000 18,000 31/12/12Balance1,00031/12/12P&L17,000 31/12/12Bank16,50031/12/12Balance500 17,500 31/12/13Balance50031/12/13P&L17,000 31/12/13Bank16,50031/12/13Balance 17,000 31/12/11 €1000 PREPAYMENT 31/12/12 €500 PREPAYMENT

Operating Lease Disclosure 1.The total operating lease rentals paid during the year 2.If there are any operating leases that will last more that 1 year 3.Commitments should be broken down between leases that expire within one year, 2-5 years, greater than 5 years.