2. 2 What is a lease? A lease is an agreement where a lessor conveys to a lessee the right to use an asset for an agreed period of time in return for a payment or a series of payments The lessee does not acquire an asset, merely the right to use the asset for a period of time It may result in the eventual transfer of ownership – e.g. hire purchase agreement

3. 3 Introduction NZ IAS 17 governs accounting for leases Applies to all lease accounting except: Leases to explore for or use minerals, oil, natural gas and similar non-regenerative assets Licensing agreements for items such as motion picture films, video recordings, plays, manuscripts and copyrights (para 2)

4. 4 Reporting issue If the lessee doesn’t own the asset being leased, should this lack of legal ownership stop the lessee’s reporting of the asset and the related liability (from future commitments) in the balance sheet? An entity may recognise assets it doesn’t own as long as it is able to control their use Do leases transfer control of the asset to the lessee? This depends on the terms of the lease agreement

5. 5 Classification NZ IAS 17 recognises the following types of leases: Finance Operating Accounting treatment and disclosures required differ substantially for finance and operating leases Finance lease: transfers substantially all the risks and rewards incidental to ownership (with or without eventual title transfer) (para 4) Operating lease: does not transfer substantially all the risks and rewards incidental to ownership (para 8) – and is in effect a lease other than a finance lease (para 4) Classification is made at the inception of the lease (para 13)

6. 6 Finance Lease The lease is normally classified as a finance lease if it has one or more of the following: The lease is non-cancellable (see definition para 4) As per para 10: Ownership is to be transferred at end of lease term Option to purchase is at much lower than fair value so certainty of exercising option is reasonably certain Lease term covers a major part of the asset’s economic life The present value of the minimum lease payments (MLPs) represents substantially the asset’s fair value Leased assets are specialised and only useable by the lessee See the decision tree on p. 415 of Picker et al.

7. 7 Minimum lease payments Minimum lease payments (MLP) = Payments over lease term + Guaranteed residual value + Bargain purchase option – Contingent rent – Reimbursement of costs paid by lessor (executory costs)

8. 8 Guaranteed residual value At the commencement of the lease, the lessor estimates the residual value of the asset at the end of the lease term (based on market conditions). Under a finance lease the lessee guarantees that the lessor will realise at that amount. The guarantee may range from 1% to 100% of the residual value. The existence of a guaranteed residual value indicates that the lessor has transferred risks associated with movements in the residual value to the lessee.

9. 9 Further definitions… Bargain purchase option A clause in the lease agreement allowing the lessee to purchase the asset at the end of the lease term for a pre-set amount (which is less than the expected residual value) The option price is normally to be sufficiently lower than expected fair value so that the exercise of the option is reasonably certain Contingent rent Additional payments arising from increases/decreases in the schedule lease payments due to the occurrence of particular events specified in the lease agreement. Eg- lease of a photocopier may specify additional payments if the number of photocopies exceeds a certain amount in a month.

10. 10 Present value The present value (PV) of MLPs is determined by applying an appropriate discount rate. Discounting is not necessary if the lease agreement contains one of the following (as the PV of MLP = FV of the asset in such cases): a bargain purchase option; or a 100% guaranteed residual value The discount rate is based on the interest rate implicit in the lease.

11. 11 Example See Illustrative Example 12.1 p. 418 Picker et al. for example of lease classification

12. 12 Accounting - Lessees Finance lease Lessee recognises: an asset (to depreciate) liability (reduced by portion of lease payment representing a reduction in the principal) Operating lease All lease payments are expensed

13. 13 Misclassification Divergent accounting treatments provide an incentive to misclassify leases as operating leases. Classification as a finance lease may have the following adverse impacts on a lessee’s financial statements: Increases non-current assets – thus reducing return on asset ratios. Increases non-current liabilities – adversely affecting debt/equity ratios. Depreciation and interest charges may exceed lease payment in early years of lease – resulting in lower profits. NZ IAS 17 is currently being rewritten, but at the moment SIC 27 Evaluating the Substance of Transactions Involving the Legal Form of a Lease and IFRIC 3 Determining Whether an Arrangement Contains a Lease give additional guidance to classification

14. 14 Finance leases - lessees Initially determine and recognise the asset & liability There are different treatments prescribed for subsequent measurement of assets & liabilities For assets, determine Depreciation any impairment For liabilities: Calculate reduction of the lease liability interest expense incurred Expense contingent rent lessor costs

15. 15 Initial Recognition Initially determine and recognise a lease asset & liability Recorded at the lower of the Future Value (FV) of the asset and the Present Value (PV) of MLP (para 20) Note re Useful life If the lessee intends returning the asset at the end of the lease period the useful life will be the term of the lease. Where the lessee intends to purchase the asset at the end of the lease term, the useful life will be the economic life of the asset

16. 16 Journal Entries Journal entries for year ended 30 June 2014 – Tauranga Ltd DrLeased asset85,457 CrLease liability85,457 Recognition of the leased asset at lower of FV and PV of MLP DrLease liability22,000 DrPrepaid executory costs 1,900 CrCash23,900 Payment in advance of first annual lease payment

17. 17 Subsequent measurement For assets, determine: depreciation (over the useful life of the asset to the entity) any impairment For liabilities, lease payment to be allocated between: reduction of the lease liability interest expense incurred reimbursement of lessor costs (if applicable) contingent rent (if applicable)

18. 18 First year end entries… Journal entries at 30 June 2015 – Tauranga Ltd DrExecutory costs 1,900 CrPrepaid executory costs 1,900 Expensing prepaid executory costs DrLease liability17,558 DrInterest expense 4,442 DrPrepaid executory costs 1,900 CrCash23,900 Payment in advance of second annual lease payment

19. 19 Depreciation Depreciation charge at 30 June 2015: DrDepreciation expense 19,489 CrAccumulated depreciation 19,489 Annual depreciation charge ($85,457 - $7,500 guaranteed residual value) = $77,957 depreciable amount. $77,957/ 4 yrs = $19,489 N.B Depreciation is over the lease term as Tauranga Ltd intends on returning the asset to Gisborne Ltd at the end of the lease term

20. 20 Disclosures - Lessees Carrying amount of each class of leased asset as at balance date Reconciliation between total future MLP at balance sheet date and present value Total MLP at balance date and future value for periods under 1 year, 1–5 years and over 5 years Contingent rents expensed Sublease details Material leasing arrangements (para 31)

21. 21 Operating leases All ownership risks/rewards to lessor Treated as rental agreements so that: Lessees Lease payments are expensed on a straight line basis over the term of the lease (para 33). Disclosures See para 35 for lessee disclosures

22. 22 Sale & leaseback transactions Involves the sale of an asset that is then leased back from the purchaser for all or part of the remaining economic life of the asset. (para 58) Used to generate immediate cash flow while retaining asset use. Lease component of the transaction is accounted for in the same way as normal lease transactions. The ‘sale’ component transaction differs, depending on whether it is classified as a finance or operating lease. Under a finance lease the lessee’s gain/(loss) from the sale of the asset is deferred and amortised over the term of the lease. Under an operating lease the lessee’s gain/(loss) is: recognised immediately if ‘sale’ is calculated at fair value excess/reduced gains/(losses) are deferred and amortised over the term of the lease