7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
1/41
ACCOUNTING FOR LEASES AND HIRE PURCHASE CONTRACTS
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
2/41
UNIVERSITY OF NAIROBI
SCHOOL OF BUSINESS
MASTER OF BUSINESS ADMINISTRATION
ADVANCED FINANCIAL ACCOUNTING
DAC 601
TERM PAPER
PRESENTED
TO
MR. BARASA J.L
BY
YASIR ALI
AND
MARY GORRETY
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
3/41
ABSTRACT.
The leasing of assets is now a popular alternative to the outright purchase of assets. By
leasing assets businesses have less capital invested in non-current assets. Leasing frees up
capital that can be used to finance business operations or additional business ventures.
The widespread practice of leasing assets brought new challenges to the accounting
profession as non-current assets and their associated liabilities did not appear in the balance
sheet. These transactions were termed off-balance-sheet. Meaningful analysis and
interpretation of the financial statements could not be undertaken without these transactions
being reflected in the balance sheet.
Over the years the accounting profession has developed and refined an accounting standard
for leases. This accounting standard ensures that the financial statements of a businessproperly disclose leasing transactions.
This paper examines the classification of leases, analysis of lease payments and the
associated accounting entries for the recording and disclosure of lease transactions.
The current accounting standard for leases is AASB 117. This accounting standard as with all
accounting standards has been developed to provide more meaningful financial statements
that are consistently prepared across businesses.
The accounting standard for leases is the foundation of the material in this paper.
Terminology relating to leases, finance and operating leases, accounting for finance and
operating leases, and the disclosure requirements of leases in the accounts form the basis of
the paper. Advantages and disadvantages of leasing and how leases may be terminated are
also considered.
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
4/41
CHAPTER ONE
INTRODUCTION
The acquisition of assets - particularly expensive capital equipment - is a major commitment
for many businesses. How that acquisition is funded requires careful planning.
Rather than pay for the asset outright using cash, it can often make sense for businesses to
look for ways of spreading the cost of acquiring an asset, to coincide with the timing of the
revenue generated by the business. The most common sources of medium term finance for
investment in capital assets are Hire Purchase and Leasing.
Leasing and hire purchase are financial facilities which allow a business to use an asset over a
fixed period, in return for regular payments. The business customer chooses the equipment it
requires and the finance company buys it on behalf of the business.
Many kinds of business asset are suitable for financing using hire purchase or leasing,
including:
Plant and machinery, land, motor vehicles etc.
Lease is covered by IAS 17 and defines lease as an agreement whereby the lessor conveys to
the lessee in return for a payment or series of payment the right to use the asset for an agreed
period of time.
Under lease purchase, the legal title is obtained when the final instalment is paid and the
purchase option is exercised. Lease is a contract made between a lessor and lessee for the hire
or specific asset. Under lease the legal title can never pass to the lessee. This is very common
method used in practice and is very popular. It also means that one party retains ownership ofan asset but conveys the right to the use of asset to another party for agreed period of time in
return for an agreed amount.
TERMINOLOGY
The following terms are commonly used in relation to accounting for leases:
Commencement of the lease term is the date when the lessee has the right to use the leased
asset. It is also the date when the details of the lease are recorded in the accounting records.
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
5/41
Economic life is the anticipated life of a leased asset.
Fair value in general terms is the market price.
Finance lease is a lease that transfers substantially the risks and rewards of ownership
without transferring ownership. The title to the asset may eventually be transferred to the
lessee. A finance lease as the name suggests is a method of financing the acquisition of an
asset. Payments under a finance lease are a payment of interest and repayment of capital. The
criteria for determining a finance lease is considered later in the chapter.
Gross investment in the lease is the total of the minimum lease repayments and the
unguaranteed residual value of the leased asset.
Guaranteed residual value is that part of the residual value of the leased asset that is
guaranteed by the lessee under the lease agreement.
Inception of the lease relates to the commencement of the lease and is the earlier of the date
of the lease agreement and the date of commitment by the parties to the principal provisions
of the lease.
Initial direct costs are costs of negotiating and arranging a lease that have not been incurred
by manufacturer or dealer lessors.
Interest rate implicit in the lease is the discount rate that causes:
the minimum lease payments the fair value of the leased asset
+ = +
the unguaranteed residual value any initial direct costs of the lessor
Lease is an agreement where the lessee makes a series of payments to the lessor and in return
has the right to use the asset subject to the lease.
Lease commitments are the total amount of lease payments and other expenses owing over the
remainder of the lease.
Lease term is the period of the lease plus any further terms that the lessee has options to
continue the lease, and that it is reasonably certain the lessee will exercise the option.
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
6/41
Lessee under a lease agreement has the right to use an asset in return for a series of payments
to the lessor.
Lessorunder a lease agreement provides an asset and receives a series of payments from the
lessee.
Minimum lease repayments. These are the payments over the lease term that the lessee is
required to make plus any amounts guaranteed by the lessee.
If the lessee has an option to purchase the asset at the end of the lease, and it is anticipated the
asset will be purchased, then the minimum lease repayments will be the lease repayments and
the amount payable to exercise the option to purchase the asset.
Novated lease for a motor vehicle is a tax effective method of acquiring a motor vehicle by
employees. The employee enters into a lease with a finance company to finance a motor
vehicle. The employer and the employee then enter into a sub-lease. The employee has the
use of the motor vehicle and if he assumes all the benefits, risks and responsibilities of the
original lease it is classified as an operating lease.
Operating lease is any lease that is not classified as a finance lease. Payments under an
operating lease are for the rental of the asset.
Residual value of a leased asset is the estimated amount that would be obtained from the
disposal of the asset at the end of the lease.
Sale and leaseback transaction involves the sale of an asset that is then leased back from the
purchaser.
Unearned finance income is the interest component of future lease payments under a lease
agreement.
Useful life is the estimated period over which the asset is economically usable. This may be
longer than the period of the lease.
ADVANTAGES AND DISADVANTAGES
There are many advantages in using leasing to finance the assets of the business and these
include:
1.
Capital Conserved- Large outlays of cash are avoided allowing business funds to be usedfor operating activities and expansion.
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
7/41
2. Acquisition of assets. When new business opportunities arise new assets are readily
acquired by leasing.
3. Finance. Where the business does not have the capacity to borrow large amounts of funds
leasing may provide a viable alternative to finance new assets.
4. Upgrading equipment. At the end of the lease period obsolete assets can be replaced with
assets of the latest technology eg computer equipment.
5. Short term needs. Leasing allows the business to use assets that are required for a short
period of time without having to purchase them
6. Latest equipment. Having modern equipment creates a favourable impression for existing
and prospective clients. Productivity also increases by having the latest equipment. This
can be achieved by leasing assets.
7. Tax advantages. Leasing provides better income tax advantages over other forms of
financing the acquisition of assets.
Disadvantages also exist with leasing arrangements:
1. Cost of finance. Lease finance is generally more expensive than alternative forms of
financing.
2. Adverse cash flow. Lessees can over-commit themselves to a large number of leases with
high repayments.
3. Lease obligations. The business may struggle to meet lease payments if it is having
liquidity and/or profitability problems.
4. Guaranteed residual value. The business will have to pay the shortfall in the guaranteed
residual value if the leased asset does not realise the amount guaranteed under the lease.
5. Capital Gains. By leasing land and buildings the business may miss out on any capital
gain opportunities.
6. Ownership. Leased assets do not give the same prestige as ownership of the asset.
7. Credit rating. The lessee is required to have a good credit rating
8. Under-utilised equipment. With a downturn in demand equipment may be idle whilst
lease payments are still required to be made.
TERMINATION OF THE LEASE
The lease may be terminated (brought to an end) in a number of ways:
1. Renew the lease. The lease may be renewed for a further period. The value of the asset isthe residual value from the original lease
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
8/41
2. Purchase the leased asset. The asset subject to the lease can be purchased for its residual
value.
3. Return the asset. Prior to the completion of the lease the asset may be returned to the
lessor. The lessee is responsible for any losses and outgoings incurred by the lessor.
4. At the end of the lease the lessee can return the asset to the lessor. The lessee is only
liable for any shortfall in the guaranteed residual value.
5. Trade in. The leased asset can be traded in on a replacement item that may be acquired on
a new lease.
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
9/41
CHAPTER TWO
1.0 TYPES OF LEASE AGREEMENTS
1.1 FINANCE LEASE.
Long-term, non-cancellable lease contracts are known as financial leases. The essential point
of financial lease agreement is that it contains a condition whereby the lessor agrees to
transfer the title for the asset at the end of the lease period at a nominal cost. At lease it must
give an option to the lessee to purchase the asset he has used at the expiry of the lease.
Under this lease the lessor recovers 90% of the fair value of the asset as lease rentals and the
lease period is 75% of the economic life of the asset. The lease agreement is irrevocable.
Practically all the risks incidental to the asset ownership and all the benefits arising there
from are transferred to the lessee who bears the cost of maintenance, insurance and repairs.
Only title deeds remain with the lessor. Financial lease is also known as 'capital lease'. In
India, financial leases are very popular with high-cost and high technology equipment.
The finance lease or 'full pay out lease' is closest to the hire purchase alternative. The leasing
company recovers the full cost of the equipment, plus charges, over the period of the lease.
Although the business customer does not own the equipment, they have most of the 'risks and
rewards' associated with ownership. They are responsible for maintaining and insuring the
asset and must show the leased asset on their balance sheet as a capital item. Risk and
rewards associated with asset ownership include:
Risk:
1. Losses from idle capacity
2. Losses from technological obsolescence
3. The variations in return due to changing economic conditions.
Rewards:
1. Expectation of profitable operations over the assets economic life
2. Gain from appreciation in value of an asset, or realisation of a residual value.
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
10/41
When the lease period ends, the leasing company will usually agree to a secondary lease
period at significantly reduced payments. Alternatively, if the business wishes to stop using
the equipment, it may be sold second-hand to an unrelated third party. The business arranges
the sale on behalf of the leasing company and obtains the bulk of the sale proceeds.
Under the substance-over-form concept, a transaction should be accounted for according to
economic substance rather than its legal form. In finance leases, the economic substance is
that a person uses an asset as if it is his own. The legal form of finance leases is that the asset
is owned by a different person- lessor.
A financial lease is usually non-cancellable, but may be cancelled under the 3 following
conditions:
a) Upon occurrence of some remote contingency
b) With permission of the lessor
c) If the lease is extended or renewed.
1.1.1 Characteristic of finance lease
1. Lease term consist of primary (3-4 years) and secondary period2. The lease term is equal to 75% or more of the economic or useful life of the asset. 3. The payments made to the lessor during the primary period are substantial and non-
cancellable. The present value of the minimum lease payments must be 90% of the fair
value of the asset.
4. Rentals paid during the secondary period are nominal in amount and cancellable at the
option of the lessee.
5. Where the lessee wishes to terminate the lease during the secondary period, the item
is sold and substantially all of the sale proceed will be paid to the lessee as rebate of
rentals. The lease agreement contains a bargain purchase option.
6. The lessee will be responsible for insurance, repair and maintenance.
7. Lessor retains the title to the items.
8. The lessee cannot sell the asset. The lease often transfers ownership of the leased
asset to the lessee by the end of the lease term, but till then the lessor retains the title to
the asset.
9. The lessee of any claims made indemnifies the lessor.
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
11/41
1.2 OPERATING LEASE
If a business needs a piece of equipment for a shorter time, then operating leasing may be the
answer. The leasing company will lease the equipment, expecting to sell it second-hand at the
end of the lease, or to lease it again to someone else. It will, therefore, not need to recover the
full cost of the equipment through the lease rentals.
This type of leasing is common for equipment where there is a well-establishedsecond-hand
market (e.g. cars and construction equipment). The lease period will usually be for two to
three years, although it may be much longer, but is always less than the working life of the
machine.
Assets financed under operating leases are not shown as assets on the balance sheet. Instead,
the entire operating lease cost is treated as a cost in the profit and loss account.
An operating lease stands in contrast to the financial lease in almost all aspects. Thislease
agreement gives to the lessee only a limited right to use the asset. The lessor isresponsible for
the upkeep and maintenance of the asset. The lessee is not given anyuplift to purchase the
asset at the end of the lease period. Normally the lease is for ashort period and even otherwise
is revocable at a short notice. Mines, Computershardware, trucks and automobiles are found
suitable for operating lease because therate of obsolescence is very high in this kind of assets.
The lease assets are rented out to many different lessees over their useful economic lives.
The lessee pays for the hire or use of the asset. Ownership of the asset remains with the
lessor, who assumes all the risks and rewards of the asset and takes responsibility for repairs,
maintenance and insurance expenses.
According to IAS 17 rentals under operating lease should be recognized as expense and
charged on straight line method over the lease term even though the payments are not made
on such basis, unless another systematic and rational basis is more appropriate.
1.2.1 CONTRACT HIRE
Contract hire is a form of operating lease and it is often used for vehicles.
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
12/41
The leasing company undertakes some responsibility for the management and maintenance of
the vehicles. Services can include regular maintenance and repair costs, replacement of tyres
and batteries, providing replacement vehicles, roadside assistance and recovery services and
payment of the vehicle licences.
1.3 SALE AND LEASE BACK
It is a sub-part of finance lease. Under this, the owner of an asset sells the asset to a party (the
buyer), who in turn leases back the same asset to the owner in consideration of lease rentals.
However, under this arrangement, the assets are not physically exchanged but it all happens
in records only. This is nothing but a paper transaction.
Sale and lease back transactions occur when the owner sells an asset and immediately
reacquires the right to use the asset by entering into a lease with the purchaser.
Sale and lease back transaction is suitable for those assets, which are not subjected
depreciation but appreciation, say land. The advantage of this method is that the lessee can
satisfy himself completely regarding the quality of the asset and after possession of the asset
convert the sale into a lease arrangement.
The lease payment and the selling price are interdependent as they are negotiated as a
package. The accounting treatment depends on whether it results to operating lease or finance
lease.
1.3.1 Finance lease-sale and lease back
In this situation any excess of sales proceed over the carrying amount should be deferred and
amortized over the long term. An impairment loss is dealt according to IAS 36.
1.3.2 Operating lease-sale and lease back
Transaction should be established at a fair value.
a) Any excess of fair value and carrying value shall be recognized as profit or loss
immediately.
b) Where selling price is less than the fair value any profit or loss should be recognised
immediately. Unless the loss is compensated for by future lease payment at below market
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
13/41
price it should be deferred and amortized in proportion to the lease payment over the
period the asset is expected to be used.
c) Where price is more than the fair value the excess over fair value shall be deferred and
amortized over the period for which the asset is expected to be used.
d) Where the fair value at the time of sale and lease back 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 should be recognized immediately.
1.4 LEVERAGED LEASING
Under leveraged leasing arrangement, a third party is involved beside lessor andlessee. The
lessor borrows a part of the purchase cost (say 80%) of the asset from thethird party i.e.,lender and the asset so purchased is held as security against the loan.
The lender is paid off from the lease rentals directly by the lessee and the surplus
aftermeeting the claims of the lender goes to the lessor. The lessor, the owner of the assetis
entitled to depreciation allowance associated with the asset.
1.5 DIRECT LEASING
Under direct leasing, a firm acquires the right to use an asset from the manufacturer directly.
The ownership of the asset leased out remains with the manufacturer itself.
The major types of direct lessor include manufacturers, finance companies, independent lease
companies; special purpose leasing companies own your asset while spreading the cost
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
14/41
CHAPTER THREE
ACCOUNTING FOR LESSEES
CAPITALIZATION CONCEPT
It should be noted that in finance leases the lessees right and obligation are such that the
risks and rewards from the use of asset are substantially similar to those of an outright
purchaser though not completely identical.
The contentious issue is whether the leased asset should be capitalized. IAS 17 requires the
leased asset to be recognized in the balance sheet as an asset and as an obligation, in the sense
that there will be future lease payment. The amount to be recorded is the greater of fair value
of the leased asset or present value of the minimum lease payment. The applicable discount
rate for discounting the present value of minimum lease will be the interest rate explicit in the
lease. However, if it is not possible and practicable the incremental borrowing rate should be
used.
The initial direct cost incurred in securing and negotiation should be added to the recognized
amount of asset.
Operating leases:operating leases pose few problems. Amounts are payable for the use ofan
asset. From the point of view of the lessee, the amounts payable are the costs of using anasset
for particular periods and hence are charged to the profit and loss account using theaccruals
concept.
Finance leases:Accounting for finance leases is a little more complicated. Prior to the
introduction of SSAP21, finance leases were usually treated by both lessee and lessor in the
same way as operatingleases. However, it was widely recognised that such treatment, while
being justified on astrict legal interpretation of the agreement, failed to recognise the financial
reality or substanceof the transaction. The substance of the transaction was that the lessee
acquired anasset for its exclusive use with finance provided by the lessor; which in economic
terms hasfew (if any) differences from the case of an asset purchased on credit. If financial
statementsare to be realistic it is necessary to find a way of accounting for finance leases
which accordswith the reality of the transaction rather than its legal form.
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
15/41
The appropriate treatment of a finance lease, which accords with the substance of
thetransaction is, from the point of view of the lessee, to include in the lessees balance sheet
anasset representing the lease and a liability representing the obligation to make
paymentsunder the terms of the lease. At the inception of the lease the asset would be equal
to the liabilitybut this relationship does not hold thereafter. The asset would be depreciated
over theshorter of its useful economic life and the length of the lease, while the liability
would beeliminated by the payments. These payments are not, as in the case of an operating
lease,charged entirely to the profit or loss account nor are they, in general, wholly set off
againstthe liability. Instead the payments are split between that element which is regarded as
representingthe repayment of the liability and the remainder that is debited to the profit and
lossaccount as the financing (or interest) charge. This approach is referred to as the
capitalization of the lease.
The lack of a faithful representation consequent upon the failure of a lessee to capitalize
financial leases is highlighted by the problems that would be experienced when
comparingtwo companies, one of which leases most of its assets, with the other purchasing
fixed assetsusing loans of one sort or another. The latter companys balance sheet would
show the assetswhich it used to generate its revenue thus allowing users of accounts to
estimate the rate ofreturn earned on those assets, whereas the former companys balance sheetwould, if theleases were not capitalised, understate its assets. Similarly, the latter companys
balance sheetwould indicate the liabilities that would have to be discharged if it is to continue
in businesswith its existing bundle of assets, whereas the former companys balance sheet
would not.
Example: An i ll ustration of the basic pri nciples of accounting for a finance lease in the
accounting records of a lessee:
Lombok Limited, a company whose year end is 31 December, leases a machine from
SalatLimited on 1 January 20X1. Under the terms of the lease Lombok is to make four annual
payments11of 35 000 payable at the start of each year. Lombok Limited is responsible for
all themaintenance and insurance costs, so these are not covered by the payments under the
lease.The first step is to decide the amount at which the leased asset should be capitalised,
i.e.shown as an asset and a liability in the first instance. SSAP 21 requires that:
At the inception of the lease the sum to be recorded both as an asset and as a liabilityshouldbe the present value of the minimum lease payments, derived by discounting them at
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
16/41
the interestrate implicit in the lease. (Para. 32)To do that we need to know what is meant by
the minimum lease payments and the interest rateimplicit in the lease.
Minimum lease payments: The minimum lease payments are the minimum payments over
the remaining part of the leaseterm (excluding charges for services and taxes to be paid by the
lessor) and:
(a) in the case of the lessee, any residual amounts guaranteed by him or by a party related
tohim; or
(b) in the case of the lessor, any residual amounts guaranteed by the lessee or by an
independentthird party. (Para. 20)In the Lombok example we will assume that there are no
residual amounts and thus the minimumlease payments at the inception of the lease are thefour annual payments of 35 000
Interest rate implicit in a lease: The interest rate implicit in a lease is the discount rate that
at the inception of a lease whenapplied to the amounts that the lessor expects to receive and
retain produces an amount (thepresent value) equal to the fair value of the leased asset. The
amounts which the lessorexpects to receive and retain comprise (a) the minimum lease
payments to the lessor (asdefined above) plus (b) any unguaranteed residual value, less (c)
any part of (a) and (b) forwhich the lessor will be accountable to the lessee. If the interest rate
implicit in the lease is notdeterminable, it should be estimated by reference to the rate that a
lessee would be expectedto pay on a similar lease. (Para.24).
Fair value:Fair value is the price at which an asset could be exchanged in an arms length
transaction less,where applicable, any grants receivable towards the purchase or use of the
asset. (Para. 25)
Note that while knowledge of the implied interest rate is required to determine the
appropriateaccounting treatment in the books of the lessee, it is found by reference to the cash
flows of thelessor. In practice the lessee may not know or be able to estimate the various cash
flows but weassume, at this stage, that the lessee can obtain all the necessary data.
If we let FV be the fair value, Lj the lease payment in year j (payable at the beginning of
eachyear) and Rn the estimated residual values received at the end of year n, the last year of
the lease,then using standard present value techniques the implied rate of interest r is found
from the solutionof the following equation:
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
17/41
If we assume in the case of the Lombok/Salat lease that the fair value is 108 720 and that
thereis no residual value (i.e. Rn = 0) then substituting in the above equation we get:
Inspection of tables showing the present value of an annuity shows that 3.1064 represents an
interest rate of 20 per cent. Thus the interest rate implicit in the lease is 20 per cent and
hencethe present value PV of the minimum lease payments can be found as follows
This is of course equal to the fair value as, in the simple case, the only cash flows that the
lessorwill receive are the minimum lease payments. Later we will describe the circumstances
where thetwo series of cash flows (i.e. the lessees and the lessors) might be different and the
effect ofthese differences on the calculations.
We can now show how the lease should be treated in the books of Lombok (the lessee).
Theoriginal entry recording the lease is:
Dr Leased asset 108 720
Cr Liability under lease 108 720
From this time onwards the two accounts are dealt with separately. The leased machine will
bedepreciated over the shorter of the length of the lease or the assets expected life, using the
companysnormal depreciation policy for assets of its type, while the liability will be
graduallyextinguished as payments are made during the primary period of the lease. The only
problem thatremains is how to spread the total interest charge over the primary period of the
lease.
The total interest charge may be calculated as follows:
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
18/41
Theoretically, the best approach is to use the actuarial or annuity method that produces a
constantannual rate of interest (in this case 20 per cent) on the outstanding balance on the
liabilityaccount. This is the method specified in SSAP 21, which does, however, allow the
use of anyalternative method that is a reasonable approximation to the annuity method.
Assuming that all payments are made on the due dates, the liability account in the books
ofLombok for the term of the lease can be summarised as follows:
This account provides us with the interest charge to the profit and loss account for each year
andthe liability for inclusion in each balance sheet. The amount of interest charged to theprofit andloss account declines over the life of the lease because the outstanding balance is
reduced bythe annual payments. It is, of course, necessary to distinguish between the current
portion of theliability, that is the amount due to be paid in the coming twelve months, and the
long-term liabilityfor the purposes of balance sheet presentation. In this case, this is
extremely easy as the onlypayment to be made in each of years 20X2 and 20X4 is 35000 per
annum payable on the dayfollowing each balance sheet date. Hence the analysis of the
liability into its current and long-termcomponents is as follows:
One commonly used alternative to the annuity method is the sum of the years digits
method or Rule of 78. If the sum of the digits method were used in the above illustration theresultswould be:
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
19/41
The impact of residual valuesLet us now complicate matters by assuming that the asset that is
the subject of the lease hasa residual value. We will assume that the manufacturer who
originally supplied the asset toSalat has agreed to reacquire the asset at the end of the lease.
The sum is dependent on thecondition of the machine and the market factors at the end of the
lease, but the manufacturerhas guaranteed to pay 10 000 whatever the circumstances. Let us
assume that at theinception of the lease it is anticipated that the manufacturer will actually
pay 20 000. Letus also assume that Lombok and Salat agree that they will divide any sums
realised on thedisposal of the asset in the ratio 35 : 65. Thus, at the inception of the lease it is
estimatedthat Lombok will receive 7000 (of which 3500 is guaranteed) and Salat 13 000
(6500guaranteed).
For the purposes of calculating the implicit interest rate, the distinction between the
guaranteedand unguaranteed elements of the residual value can be ignored as both have to
betaken into the calculation, but the distinction may be important when deciding whether
thelease is a finance or operating lease.
If we return to the equation above and substitute the estimated value on realization receivable
by Salat, the equation becomes:
Use of tables or a programmable calculation on a computer shows that the above equationwill
be satisfied when r is approximately 25 per cent. This is a higher rate of interest than the20
per cent that was previously calculated as Salat obviously earns a higher return due to
theintroduction of the residual value as an additional cash flow.
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
20/41
So far as Lombok is concerned the minimum lease payments are unchanged but they willnow
be discounted at the higher rate of 25 per cent that will produce an initial value of theleased
asset of:
The annual payments of 35 000 are the same as in the original example except that the
liabilitythat is to be paid off is lower (103 320 not 108 720). Hence the finance charge in
theprofit and loss account will be higher in the second example. This reflects the fact that in
thefirst example the lease payments can be regarded as acquiring the whole of the
productiveuse of the asset, in that a zero residual value was assumed, whereas in the second
case thesame annual lease payments only acquired a proportion of the assets productive
capacity.
It will be noted that the estimated realisable value that Lombok expects to receive had
noeffect on the calculation of the amount by which the lease should be capitalised or on
theway in which the annual lease payments should be split. This is because these depend on
theminimum lease payments. The recognition of the estimated realisable value does have
aneffect on the amount that has to be depreciated which is the present value of the
minimumlease payments less the estimated realisable value. Thus, the depreciation charges
that wouldemerge from our two sets of assumptions are as follows (assuming the straight-line
methodis used):
In the above examples we assumed that the lessee knows (or is able to find out from
thelessor) the fair value of the asset and the estimated realisable value that the lessor expects
toreceive. In practice this may well not be the case and certain estimates will have to be
made.Often the fair value will be known and the interest rate estimated from a knowledge
ofother leases of a similar type.
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
21/41
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
22/41
Gross earnings: Gross earnings comprise the lessors gross finance income over the lease
term, representing the difference between his gross investment in the lease [see above] and
the cost of the leased asset less any grants receivable towards the purchase or use of the asset.
(Para. 28)
In order to illustrate the effect of the above definitions assume that the details relating to a
particular lease are as follows:
Let us see how one measures the net investment at the inception of the lease and at the end of
the first year
Hence, at inception the net investment is equal to the cost of the asset less grants receivable
by the lessor. Assume that the gross earnings recognised in the profit and loss account in the
first year are 2500 .Then the net investment at the end of the first year is:
The recognition of gross earnings:
The total gross earnings on any lease are reasonably easy to calculate since the minimum
lease payments will be known and, generally, the residual value, if any, can be estimated. Thedifficulty lies in allocating the gross earnings to the different accounting periods. The
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
23/41
standard followed existing practice in the leasing industry by specifying that the interest
should be allocated on the basis of the lessors net cash investment in the lease and not on the
basis of the net investment.
The meaning of net cash investment:
The net cash investment in a lease at a point in time is the amount of funds invested in a lease
by a lessor, and comprises the cost of the asset plus or minus the following related payments
and receipts:
a) government or other grants receivable towards the purchase or use of the asset;
b) rentals received;
c) taxation payments and receipts, including the effect of capital allowances;d) residual values, if any, at the end of the lease term;
e) interest payments (where applicable);
f) interest received on cash surplus;
g) profit taken out of the lease.
The actuarial method after tax
The guidance notes to SSAP 21 describe a number of ways of allocating the gross revenue to
accounting periods based on the net cash investment. Of these the most accurate is the
actuarial method after tax. This method produces a constant rate of return on the net cash
investment over that period of the lease in which the lessor has a positive investment (i.e.
before any cash surplus is generated).
Example 9.3 The actuarial method after tax:
Gasp plc, the lessor, acquired an asset for 7735 that it leased out on the following terms:
Period 5 years
Rental 2000 per year payable in advance on 1 January of each year
Residual value Zero
Gasps year end is 31 December and tax in respect of any year is payable on 1 January of thenext year but one. The tax rate is 50 per cent and capital allowances of 100 per cent are
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
24/41
receivable in the first year. (These rates are unrealistic but they have been chosen to simplify
the figures and hence clarify the example.)
The annual rate of return earned over the period when there is a net cash investment is 12 per
cent while it is estimated that surplus cash can be invested at 5 per cent (both rates are before
tax).
The interest paid by Gasp on the funds invested in the lease will be ignored. The cash flows
and the profit recognised on the lease are set out in Table 9.3
Notes:
(a) The profit taken on the lease has been calculated at 12 per cent of the net cash investment
at the start of each year (e.g. 688 = 0.12 5735) while the interest on the cash surplus has
been calculated at 5 per cent of the opening balance (e.g. 45 = 0.05 903). Interest on the
cash surplus in 20X6 has been ignored (otherwise the calculation would never end).
(b) The tax computation for 20X0 (tax payable on 1 January 20X2) is as follows:
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
25/41
In subsequent years the tax payment is 50 per cent of the sum of the rental income and the
interest earned on the cash surplus.
Although the lease will generate an annual rental of 2000 for each of the five years after tax,
profit recognised in respect of the lease is 688 in year 1, 531 in year 2 and 11 in year 3.
It may be thought that this is a very imprudent way of recognising profit in that most of the
profit is taken in the first two years of the lease. However, it must be recognised that theprofit reported is that which is generated by the lessors financing activities and is calculated
by reference to the amount that the lessor has invested in the lease. As Table 9.3 shows, the
investment falls to zero, to be replaced by a cash surplus by 1 January 20X3.
Arithmetically all the figures in Table 9.3 can be found if you know the cash flows, which
will be specified in the agreement, and either the profit on the lease (12 per cent) or the re-
investment rate (5 per cent). Thus, if one of the two rates is known the other can be
calculated, with the aid of a computer or a lot of patient trial and error. In practice, of course,
the lessor will have made the calculations of these rates when agreeing the terms of the rental
with the lessee. Thus the lessor would start by deciding, on the basis of market conditions and
competitive forces, the return required on the lease (taking into account the return on any
surplus cash invested and hence work out the rent that would need to be charged.
The next step is to calculate the proportion of the annual receipts of 2000, which is deemed
to represent the reduction in the amount due from the lessee. The calculation is based on the
figures in Table 9.4. This table also shows the necessary transfers to and from the deferred
taxation account if it is judged necessary to establish such an account.
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
26/41
Table 9.4 is constructed from the bottom up. The figures in line 9 are taken from Table 9.3.
The net profit is then grossed up at the appropriate tax rate (50 per cent) to give line 5. Line 6,
which shows the actual tax payments, is also taken from Table 9.3 which means that line 8
(deferred tax) can be derived. Line 4 is taken from Table 9.3 and hence the gross earnings
(line 3) and capital repayments (line 2) can be deduced. If, taking into consideration the
affairs of the company as
a whole, it is decided that it is not necessary to account for deferred tax, one could start Table
9.4 at line 5 and work up from there.
It must be emphasised that Table 9.4 is used only to calculate the capital repayment and, if
appropriate, the deferred taxation transfers. For the purposes of the balance sheet presentation
SSAP 21 requires that the amount due from the lessee should be the net investment (not the
net cash investment) in the lease. Thus in the instance of Gasp plc the asset would be
recorded as follows:
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
27/41
The gross earnings allocated to future periods are found from line 3 of Table 9.4. Thus, for
example, the figure at 31 December 20X0 is (1062 + 22459852) = 889 and so on.
The method produces the apparently absurd result that the net investment at certain dates is
greater than the remaining lease payments, the extreme case being that at 31 December 20X4
when a net investment of 52 is produced notwithstanding the fact that the lease has
terminated. This odd result derives from the fact that a larger profit is taken in the early years
of the lease in consequence of the anticipated return on the surplus cash invested; thus, for
example, the net investment at 31 December 20X3 of 2150 can be regarded as representing
the final lease payment of 2000 plus the anticipated interest receipts of 150 (98 in 20X4
and 52 in 20X5).
Beyond SSAP 21
Accounting for Leases: A New Approach (1996)
A movement to treat all non-cancellable leases as finance leases has been under way for some
time. The opening shot of the international campaign was the publication of a G4+1
Discussion Paper Accounting for Leases: A New Approach by the Financial AccountingStandards Board, in 1996. Although the author of the report is stated to be Warren McGregor,
the paper is a report of a working party of the G4+1 group of standard setters, made up of
representatives of the IASC and groups from five countries.21 It confirms that leasing
continues to be a major source of financing and suggests that it may become even more
important in the future.
The authors of the paper, drawing largely on research carried out in Australia and the USA,
conclude that there have been many examples of lease agreements for what are, in all
material respects, finance leases that were drawn up in such a way to ensure that they
qualified for treatment as operating leases and hence appear off the balance sheet. The
authors were skeptical of the ability of standard setters to produce criteria that would
overcome this problem. They took a different approach and examined the issue from first
principles, largely relying on the definitions of assets and liabilities contained in the IASCs
Framework.
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
28/41
The report argues that, in respect of any non-cancellable lease, the lessee possesses both an
asset and a liability and these should be reflected on its balance sheet. Hence, the report
recommends that all non-cancellable leases should be capitalised. This recommendation is
advanced on the grounds of both theory and pragmatism. This is normally a powerful
combination but it appears to be working slowly in this particular case.
Leases: Implementation of a New Approach (1999)
While SSAP 21 remains in force, the battle continues. In 1999 the ASB published another
discussion paper produced by the G4+1 group, Leases: Implementation of a New Approach.
The 1999 report adopts the same position as its 1996 predecessor but advances the argument
in a number of ways.
The cash flows on which the capitalisation is based:
The 1999 paper addresses a range of practical issues concerned with the identification of the
cash flows that should be capitalised to provide the measure of the initial asset and liability in
the books of the lessee, and covers such issues as possible variations in residual values, the
question of contingent rentals and the treatment of long-term property leases.
One of the reasons why SSAP 21 is thought to be inadequate is the rich variety of types ofleases that have been developed by the financial community. Many leases are far removed
from the simple notion of a predetermined regular flow of resource from lessee to lessor over
the life of the agreement. Much of the 1999 paper is concerned with examining the different
types of leasing agreement that exist and discussing the basis on which they should be
capitalised. We do not have the space to deal with the whole variety of leases discussed in the
paper but it would be helpful to quote one as an example, both to provide a flavour of the
document and to illustrate the thinking that underpins it.
The example we have selected is of a lease where the rent payable varies according to the
revenue generated by the use of the asset. Specifically the example, example 4 in the paper, is
of an agreement where a lessee enters a three-year lease on a retail store. The annual rent
comprises a minimum base rental of 10 000 plus 1/2 per cent of the stores turnover during
that year.
In this example, the authors came to the view that a fair value approach should be used and
an estimate is made of what the rental payments would have been had there not been the
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
29/41
turnover element. Suppose that this is 10 500 per annum, then the initial carrying value of the
lease should be based on three payments of 10500 and the differences between those amounts
and the amounts actually paid should be credited or debited to the profit and loss account for
the relevant year.
In general the approach taken in the paper is to capitalise on the basis of the minimum lease
payments and to deal with variations on a year-by-year basis unless, as in the above example,
the amount so derived would not provide a reasonable estimate of the fair value of the lease.
The discount rate to be used by the lessee:
As we pointed out earlier, SSAP 21 requires the lessee to use the discount rate that it is
implied in the leasing agreement and which is set by the lessor, which is not something thatthe lessee can always readily determine. The 1999 paper takes a much more sensible
approach and argues that the discount rate to be applied by lessees should be an estimate of
the lessees incremental borrowing rate for a loan of a similar term and with the same security
as is provided by the lease. This proposal underscores the point that a lease is a form of
finance and should be treated as far as possible in a comparable way to other sources of
finance that the entity might employ.
The recognition of lease-related assets in the books of the lessor:
The 1999 paper, unlike the 1996 version, deals with lessors as well as leases. The paper
argues that, in the context of a lease agreement, a lessor possesses two distinct assets:
the right to receive payments from the lessee; and
the right to the return of the asset at the end of the agreement.
The paper argues that these are distinct assets, one financial and one non-financial, and that
they should be reported separately. The paper discusses a number of different ways by which
the necessary measurements might be made
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
30/41
CHAPTER FIVE
4.1 HIRE PURCHASE ACCOUNTING
With a hire purchase agreement, after all the payments have been made, the business
customer becomes the owner of the equipment. This ownership transfer either automatically
or on payment of an option to purchase fee.
For tax purposes, from the beginning of the agreement the business customer is treated as the
owner of the equipment and so can claim capital allowances. Capital allowances can be a
significant tax incentive for businesses to invest in new plant and machinery or to upgrade
information systems.
Under a hire purchase agreement, the business customer is normally responsible for
maintenance of the equipment.
Hire purchase - otherwise known as lease purchase - is a simple repayment facility, where
you eventually own the asset at the end of your agreement with Lombard.
Hire purchase benefits
Total control - the asset is yours at the end of the agreement
Flexibility in your repayments - makes for easy budgeting
Fixed or variable interest options - it's your decision which is best for you
Tax advantages - normally you can claim writing-down allowances and perhaps
capital grants, while repayment interest may be offset against profits and VAT is
usually reclaimable (special rules apply to cars)
There is great flexibility with this type of asset finance. We can structure it in various ways,
with a flexible deposit, fixed payments and perhaps a balloon final lump sum.
Hire purchase transactions are initially classified into two
1) Books of purchaser
2) Books of the vendor.
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
31/41
4.1.1 PUCHASERS BOOKS
For any hire purchase transaction it is important to realise that the hire purchase price is more
than cash price such that the difference between the two is hire purchase interest.
Cash price + H.P Interest =H.P price
Cash price- record as an asset
H.P Interest-record as interest in P&L accounts
H.P Price-record as liability to be paid off
The hire purchase contract may last for several years, thus the purchaser should record the
interest expense in the P&Ls of all the years over which the contract lasted. Apportionment of
interest to the various P&Ls is done by any of the following methods.
1. Straight line method
2. Actuarial method
3. Sum-of digits method.
EXAMPLE ONE
Nairobi school acquired 2 new buses on 1 Jan. 1990 for $ 129,150. The cash prices of the
bases were $90,000. The deal was financed by TSPP LTD, and the terms of the hire purchase
contract required a deposit of $30,000 on delivery, followed by 3 instalments on 31 st Dec.
1990, 1991 and 1992 of $33,000, $33,000 and $33,150 respectively. The true interest rate
was 30% per annum.
Required-Prepare the appropriate accounts in the books of Nairobi school to record the above
transaction, accounts after the end of 1992 need to be prepared. Depreciation is to be charged
on vehicle at 20% per annum, using straight line method.
Solution
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
32/41
Vehicle
$ $
Jan-01
H.P
Supplier 90,000 Dec-31
Balance
c/d 90,000
1990 1990
Jan-01
Balance
b/d 90,000 Dec-31
Balance
c/d 90,000
1991 1991
Jan-01
Balance
b/d 90,000 Dec-31
Balance
c/d 90,000
1992 1992
Jan-01
1993
Balance
b/d 90,000 1993
H.P Suppliers (TSPP LTD)
1990 $
1 Jan. Cashbook 30,000
31 Dec. Cashbook 33,000
31 Dec. Balance c/d 45,000
108,000
1991
1990 $
1 Jan. Motor Vehicle 90,000
31 Dec. H.P Interest 18,000
108,000
1991
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
33/41
31 Dec. Cashbook 33,000
31 Dec. Balance c/d 25,500
58,500
1992
31 Dec. Cashbook 33,150
33,150
1 Jan. Balance b/d 45,000
31 Dec. H.P Interest 13,500
58,500
1992
1 Jan Balance b/d 25,500
31 Dec. H.P Interest 7,650
33,150
HIRE PURCHASE
INTEREST (EXP.)
$ $
Dec 31 H.P Supplier 18,000 Dec-31 P & L 18,000
1990 1990
Dec 31 H.P Supplier 13,500 Dec-31 P & L 13,500
1991 1991
Dec 31 H.P Supplier 7,650 Dec-31 P & L 7,650
1992 1992
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
34/41
PROVISION FOR DEPRECIATION
1990 $
31 Dec. Balance c/d 18,000
1991
31 Dec. Balance c/d 36,000
36,000
1992
31 Dec. Balance c/d 54,000
54,000
1990 $
31 Dec. P & L 18,000
1991
1 Jan. Balance b/d 18,000
31 Dec. P & L 18,000
36,000
1992
1 Jan Balance b/d 36,000
31 Dec. P & L 18,000
54,000
The above solution is on the basis of the actuarial method, where the true rate of interest is
given. If the straight line method is to be used the interest is apportioned as follows:
Cash price + H.P Interest = H.P Price
90,000 + 39,050 = 129,050
39,050/3=13,050 for each of the 3 years.
If the sum of digits methods were used, the interest will be apportioned as follows:
YEAR 1990 = 39,150*(3/6) =19,575
YEAR 1991 = 39,150*(2/6) = 13,050
YEAR 1992 = 39,150*(1/6) = 6,525
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
35/41
4.1.2 THE VENDORS BOOKS
From the sellers perspective, there are two sets of income
Cost-cash selling price-H.P selling price
Pure gross profit= Cash selling price-Cost
Interest income= H.P Price- Cash selling price
If the items are large and transactions few, a distinction may be made between pure gross
profit and interest, and each recorded individually and independently. However, if the
transactions are many and each of relatively low value, there is no need to make a distinctionbetween pure gross profit and interest, and the total of these may be recorded and accounted
for together.
The books are a mirror image of the purchasers books.
EXAMPLE ONE
TSPP finances ltd supplied bases to Nairobi school at H.P Price of $129,150.The terms of the
contract required a deposit of $30,000 on delivery, followed by 3 instalments on 31 st Dec.
1990, 1991 and 1992 of $33,000, $33,000 and $33,150 respectively. The true interest rate
was 30% per annum. The cost of the vehicle to the supplier was $ 60,000 and the cash selling
price was $ 90,000.
Required-Prepare the appropriate accounts in the books of TSPP LTDto record the above
transaction, accounts after the end of 1992 need to be prepared. Depreciation is to be charged
on vehicle at 20% per annum, using straight line method.
Solution
H.P Sales
1990 $
31 Dec. H.P Trading A/C 90,000
1990 $
1 Jan. H.P Debtor 90,000
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
36/41
H.P Purchases
1990 $
1 Jan. Bank//Creditor60,000
1990 $
31 Dec. H.P Trading a/c60,000
H.P Trading A/C -1990
$
Purchases ( cost of sales) 60,000
Provision for unrealised profit 15,000
P & L pure gross profit interest 33,000
108,000
$
Sales90,000
H.P Interest income 18,000
108,000
P & L (EXTRACT) 1991
$ $
H.P Interest 13,500
Provision for unrealised profit 10,000
P & L (EXTRACT) 1992
$ $
H.P Interest 7,650
Provision for unrealised profit 5,000
H.P Debtors A/C
1990 $ 1990 $
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
37/41
1 Jan. Sales 90,000
31 Dec. H.P Interest income 18,000
108,000
1991
1 Jan. Balance b/d45,000
31 Dec. H.P Interest income 13,500
58,500
1992
1 Jan Balance b/d 25,500
31 Dec. Cashbook 7,650
33,150
1 Jan. Cashbook 30,000
31 Dec. Cashbook 33,000
31 Dec. Balance c/d 45,000
108,000
1991
31 Dec. Cashbook 33,000
31 Dec. Balance c/d25,500
58,500
1992
31 Dec. Cashbook33,150
33,150
H.P Interest Income
1990 $
1 Jan. H.P TP & L 18,000
1991
31 Dec. H.P P & L 13,500
1992
31 Dec. H.P P & L 7,650
1990 $
1 Jan. H.P Debtor 18,000
1991
31 Dec. H.P Debtor 13,500
1992
31 Dec. H.P Debtor 7,650
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
38/41
Provision for unrealised profit
1990 $
31 Dec. Balance c/d15,000
1991
31 Dec. P & L (1991)10,000
31 Dec. Balance c/d5,000
15,000
1992
31 Dec. P& L (1992)5000
1990 $
31 Dec. H.P T P & L 15,000
1991
1 Jan. Balance b/d 15,000
15,000
1992
1 Jan. Balance b/d 5,000
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
39/41
CHAPTER SIX
5.1EMERGING ISSUESCapitalization of leased assets has been one of the emerging issues. There has been case for and
against capitalization.
5.1.1 ARGUMENT FOR CAPITALIZATIONIAS 17 recognises that lessee acquires the economic benefit of the leased asset for the major part of
its economic life in return for entering into the obligation to pay the right almost equal at the
inception of the lease to the fair value of the asset and the related finance charge. The lessee enjoys
these benefits without the legal title, which is the legal form of the agreement.
5.1.1.1GROUNDS FOR ARGUMENT OF CAPITALIZATION
A) SUBSTANCE OVER FORMThe substance over form recognizes that lessees right are similarto those of an outright purchaser.
As these results represent an economic benefit arising from the use, then leased asset should be
capitalized.
B) FINANCIAL RATIOSIf leased transactions are not reflected in the balance sheet of the lessee, the economic resources and
the level of obligations of an enterprise are understated and hence distort financial ratios.
5.1.2 ARGUMENTAGAINST CAPITALIZATIONThe following are the main arguments against capitalization.
1. Legal form- legal form should not be ignored on the grounds that the benefits arising from
the lease to a lessee is form of an intangible asset. Therefore, it could be misleading if the
obligation under lease is similar to those of a loan stock when an asset is purchased outright.
2. Differentiation. The difficulty of differentiating between finance leases and operating lease
remain.
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
40/41
3. Capitalization amount. It is not very clear whether to capitalize the whole amount of the
lease or the principle.
4. Complexity. Capitalization computations are very complex for small business to carry out.
5. Consistency. The capitalization process is arbitrary to a lesser extent and therefore lack
consistency.
6. Presentation in financial statement by a note is more understandable than the mere
computation.
Standard committee has rejected the argument against capitalization and they have recommended
for its adoption.
7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary
41/41
References:
Richard Lewis andDavid Pendrill, Advanced financial accounting, 7th edition, financial
times prentice hall,2004
Imea P. KamenchuAdvanced applied accounting, 2008
IASB, international accounting standards, IFRS latest publication