Relative Resource Manager 2

Important administrative announcement

� Online Test 1� Available on DSO: 9:00 am Friday 5 August - 11:59 pm Monday 8 August

� Note: Times are AEST (Australian Eastern Standard Time)

� Marks: 3.75% (of total assessment)

� Topics covered in test: Topics 1 & 2 (Corporate Regulations and Accounting for PPE)

� Covers chapters 1, 2, 4 & 6 in the textbook

� Time allowed: 1 hour for 20 Multiple Choice Questions (one attempt is allowed)

� Please carefully read the online test instructions available in the assessment folder before you attempt the test

� Assignment� A typo error in Question 1 (The information for 31 December 2010 )

� A typo error in Question 2, part (d)(ii)

� The revised version of the assignment is uploaded on DSO

1

TOPIC 3 – PART 2

Accounting for leases

(Chapter 11)

2

Content

3

� What is a lease

� Classification of lease

� Lessee accouting for finance and operating leases

� Lessor accouting for finance and operating leases

� Leases involving land and buildings

� Lessee accounting for lease incentives under a non-cancellable operating lease

What is a lease

4

Lease defined (AASB 117, para. 4)

An agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.

AASB117 Cannot be applied to

� leases to explore for or use minerals, oil, natural gas and similar non-regenerative assets

� licensing agreements for such items as motion picture films, video recordings, plays, manuscripts and copyrights

Whether or not the leased assets and the associated commitments relating to the lease arrangement should appear in the reportingentity’s statement of financial position (balance sheet)

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A matter of ‘control’

6

As we know, in relation to assets, it is a question of ‘control’ and not ‘ownership’ that governs recognition

�A firm may recognise assets it does not own as long as it is able to control their use

�Do leases transfer control of the asset to the lessee?

� depends on the terms of the lease agreement

Classification of lease

7

Classification Of Leases

� AASB 117 recognises the following types of leases:

� Finance lease – records a leased asset and a liability

�Operating lease – record neither asset nor liability, but lease payments recognised as rental expenses

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Finance lease vs. Operating lease

� A finance lease is a lease which transfers substantially all ownership risk and rewards, with or without eventual title transfer

• Risks of ownership include possibilities of losses from obsolescence, idle capacity, uninsured damage, etc.

• Rewards of ownership include benefits from use of the asset, appreciation in value of the asset, etc.

� An operating lease is a lease other than a finance lease

9

Finance Leases (AASB 117 para. 10)

� Examples of situation that individually or in combination would normally lead to a lease being classified as a finance lease:

� The lease transfers ownership of the asset at the end of the lease term

� The lessee has the option to purchase the asset at a price substantially lower than the fair value at the date the option become exercisable, so that it is reasonably certain, at the inception of the lease, that the option will be exercised

� The lease term covers a major part of the asset’s economic life

� At the inception of the lease, the present value of minimum lease payments (MLPs) amounts to at least substantially all of the fair value of the leased asset

� The leased asset is of a specialised nature that only the lessee can use them without major modification

AASB 117 does not contain a definition or further guidance as to what “major part” and

“substantially” mean- therefore judgment required

AASB 117 does not contain a definition or further guidance as to what “major part” and

“substantially” mean- therefore judgment required

10

Finance Leases (AASB 117 para. 11)

� Indicators of situation that individually or in combination could also lead to a lease being classified as a finance lease:

� If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee

� Gains or losses from the fluctuation in the fair value of the residual accrue to the lessee

� The lessee has the ability to continue the lease for a secondaryperiod at a rental that is substantially lower than market value.

11

Minimum Lease Payments (MLPs)

MLPs =

Payments over lease term

+ Guaranteed residual value *

+ Bargain purchase option *

– Contingent rent *

– Reimbursement of costs paid by lessor

* Defined in following slides

Commonly referred to as executory costsCommonly referred to as executory costs

12

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).

� A residual might or might not be guaranteed, i.e. guaranteed vs. unguaranteed

� Guaranteed residual value – that part of the residual value guaranteed by the lessee (the maximum amount that could become payable)

� The guarantee may range from 1% to 100% of the residual value

13

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 sufficiently lower than expected fair value – resulting in the exercising of the option becoming reasonably certain

14

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

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Present Value of MLPs

� The present value (PV) of MLPs is determined by applying an appropriate discount rate

� The discount rate is based on the interest rate implicit in the lease

� The interest rate that equates the PV of the MLPs and any unguaranteed residual value with the fair value of the leased property (and any initial direct costs of the lessor) at the inception of the lease� PV of MLP + PV of unguaranteed residual value = FV (+ initial direct costs, if any)

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Lessee accounting for finance leases

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Lessee accounting for finance leases

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� Lessee records an asset (leased) and a lease liability

Dr Leased asset

Cr Lease liability

� Asset and liability recorded at the fair value of the leased property or, where lower, at the present value of the minimum lease payments

Lessee accounting for finance leases (cont.)

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� Over the term of the lease, the rental payments to lessor constitute a payment of principal plus interest—to be apportioned by lessee

� Interest expense calculated by applying the interest rate implicit in the lease to outstanding lease liability at beginning of each lease period

� Balance of payment represents a reduction of principal of lease liability


20

� To record the lease payment, with the payment being allocated between principal and interest:

Dr Lease liability

Dr Interest expense

Cr Cash

� To record payment of executory costs:

Dr Executory expenses

Cr Cash


21

Amortisation of leased assets

� Leased assets should be amortised using the depreciation (amortisation) policies normally followed by the lessee

� Amortisation can be over useful life of asset, i.e. when reasonable assurance that lessee will obtain ownership at end of lease term(e.g. the lease contains a bargain purchase option), otherwise amortisation over lease term

� To record lease depreciation expense:

Dr Lease depreciation expense

Cr Accumulated depreciation


22

Initial direct costs (AASB 117)� Costs directly associated with negotiating and executing a lease agreement

� Include commissions, legal fees, costs of preparing and processing documentation

� Initial direct costs relating to a finance lease must be capitalised as part of the leased asset

� Where such costs are incurred the lease asset comprises the present value of the minimum lease payments and the amount of the initial direct costs incurred—total amount subject to amortisation

Worked Example 11.5 – Example of accounting for

leases by a lessee23

� Trigger Ltd enters into a non-cancellable five-year lease agreement with Brothers Ltd on 1 July 2012. The lease is for an item of machinery that, at the inception of the lease, has a fair value of $369 824.

� The machinery is expected to have an economic life of six years, after which time it will have an expected salvage value of $60 000. There is a bargain purchase option that Trigger Ltd will be able to exercise at the end of the fifth year for $80 000.

� There are to be five annual payments of $100 000, the first being made on 30 June 2013. Included within the $100 000 lease payments is an amount of $10 000 representing payment to the lessor for the insurance and maintenance of the equipment. The equipment is to be depreciated on a straight-line basis.

� The implicit interest rate is 12%

� A review of the appendices to this book shows that the present value of an annuity in arrears of $1 for five years at 12 per cent is $3.6048. Further, the present value of $1 in five years discounted at 12 per cent is $0.5674.

� Prepare journal entries fro the years ending 30 June 2013 and 2014.

Worked Example 11.5 – Solution

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Present value of five lease payments of $90 000 discounted at 12 per cent (we eliminate the executory costs)

= $90 000 x 3.6048 = $324 432

Present value of the bargain purchase option

=$80 000 x 0.5674 = $45 392$369 824


Date Lease Payment

(exclusive of executory costs) (1)

Interest expense

(2)

Principal

reduction

(3) = (1) – (2)

Outstanding

balance

(4)

01/07/2012 369 824

30/06/2013 90 000 44 379 45 621 324 203

30/06/2014 90 000 38 904 51 096 273 107

30/06/2015 90 000 32 773 57 227 215 880

30/06/2016 90 000 25 906 64 094 151 786

30/06/2017 170 000 18 214 151 786 0

11-25

25


26

1 July 2012

DrLeased machinery 369 824

CrLease liability 369 824

(to record the leased asset and liability at the inception of the

finance lease)


27

30 June 2013

DrExecutory expenses 10 000

Dr Interest expense 44 379

DrLease liability 45 621

CrCash 100 000

(to record the lease payment of $100 000)

DrLease depreciation expense 51 637

CrAccumulated lease depreciation 51 637

(to record depreciation expense [(369 824 – 60 000) ÷ 6])

As the lessee will most probably retain the asset after the lease period as a result of the bargain purchase option, the economic life of the asset, and not the lease term, is used for amortisation purposes.


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30 June 2014

Dr Executory expenses 10 000

Dr Interest expense 38 904

Dr Lease liability 51 096

Cr Cash 100 000


Dr Lease depreciation expense 51 637

Cr Accumulated lease depreciation 51 637

To record depreciation expense)

Lessee accounting for operating leases

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Lessee accounting for operating leases (cont.)

30

AASB 117 (para. 33)

Lease payments under an operating lease are to be recognised as an expense on a straight-line basis over the lease term, unless another systematic basis is more representative of the time pattern of the user’s benefits

� Journal entry

Dr Rental expense

Cr Cash

Worked example 11.3: Lessee accounting for an

operating lease31

� On 1 July 2012 Margaret Ltd enters a lease agreement with River Ltd for the lease of a building. The length of the lease is three years and the terms require annual payments of $60 000. The lease is non-cancellable and the estimated economic life of the building is 20 years. The market value of the building is $2 million. Lease payments are made at the end of each financial year.

� REQUIRED:

Provide the journal entries that would be made in the books of Margaret Ltd to account for the lease.

Solution

32

� The lease is clearly an operating lease (do we all understand why?)

� Journal entry in the books of Margaret Ltd:

Dr Rental Expense – Building 60 000

Cr Cash 60 000

Lessor accounting for finance leases

33

Accounting by lessors

34

Lessor’s perspective

� Leases also classified either as operating leases or finance leases

� Adoption of same criteria for non-cancellable lease as for lessee

� Factors addressed in AASB 117, pars 10–12

Finance leases can be further classified into

� Direct-finance leases

� Leases involving manufacturers or dealers

Direct-financing leases

35

� A lease where the lessor provides the financial resources to acquire the asset

� Lessor typically acquires the asset, giving the lessor legal title, then enters a lease agreement to lease the asset to the lessee, who subsequently controls the asset

� No sale is recorded

� Lessor derives income through periodic interest revenue

� Where risks and rewards of ownership are held by lessee, the lessor substitutes lease receivable for the underlying asset

Lessor accounting for direct-financing leases

36

AASB 117 (para. 36)

� Lessors shall recognise assets held under a finance lease in their statements of financial position and present them as a receivable at an amount equal to the net investment in the lease

Net investment in lease (AASB 117, para. 4)

� The gross investment in the lease discounted at the interest rate implicit in the lease


37

� The gross investment in the lease includes the aggregate of

(a) the minimum lease payments receivable by the lessor under a finance lease; and

(b) any unguaranteed residual value accruing to the lessor


� Over the term of the lease, the rental payments to lessor constitute a principal plus interest revenue—to be apportioned by lessor

� Interest revenue calculated by applying the interest rate implicit in the lease to outstanding balance at beginning of each lease period

� Balance of payment represents a reduction of principal of lease liability

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Initial direct costs incurred by lessor

39

� Initial costs that are directly attributable to negotiating and arranging a lease, except for such costs incurred by manufacturer or dealer lessors

� Includes commissions, legal fees, and costs associated with processing new leases

� If material, are to be included in the lessor’s investment in the lease (refer to AASB 117, para. 38)

Recovery of executory costs

� Costs that are related specifically to the operation and maintenance of the leased property, e.g. insurance, maintenance and repairs

� Should be treated as revenue by lessor in financial years in which related costs are incurred

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Direct-financing lease: net vs gross method

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� Either net method or gross method can be used to record the lease

� Net method

� most commonly used

� For this unit, please ignore the gross method


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Net method

� To record initial acquisition of asset

Dr Asset

Cr Cash/Payables etc.

� To record lease receivable at inception

Dr Lease receivable

Cr Asset

� To record receipt of lease payment

Dr Cash

Cr Lease receivable

Cr Interest revenue

Worked Example 11.6

43

To show how the entries for a lessor compare with the entries made by the lessee, we will use the same data as that used in Worked Example 11.5 except this time we will be doing the exercise from the perspective of Brothers Ltd.

REQUIRED

Prepare the journal entries for the years ending 30 June 2013 and 30 June 2014 using the net method.


Date Lease Receipt

(exclusive of executorycosts)

Interest

revenue

Principal

reduction

Outstanding

balance

01/07/2009 369 824

30/06/2010 90 000 44 379 45 621 324 203

30/06/2011 90 000 38 904 51 096 273 107

30/06/2012 90 000 32 773 57 227 215 880

30/06/2013 90 000 25 906 64 094 151 786

30/06/2014 170 000

530 000

18 214

160 176

151 786

369 824

0

11-44

44


45

1 July 2012

DrMachinery 369 824

CrCash 369 824

(to recognise the initial acquisition of the machinery by the lessor)

DrLease receivable 369 824

CrMachinery 369 824

(to substitute the lease receivable for the asset; it would be

inappropriate to continue to show the machinery in the balance

sheet since the lessor no longer ‘controls’ it)


46

30 June 2013

Dr Cash 100 000

Cr Executory expense recoupment

(part of profit or loss) 10 000

Cr Interest revenue 44 379

Cr Lease receivable 45 621

(to record the lease receipt of $100 000)

30 June 2014

Dr Cash 100 000

Cr Executory expense recoupment

(part of profit or loss) 10 000

Cr Interest revenue 38 904

Cr Lease receivable 51 096


Accounting for lessors that are manufacturers or

dealers of the leased asset47

� Where fair value of the property at the inception of the lease differs from its cost to the lessor (e.g. car dealer)

� Represents a finance lease

� Two parts of the transaction

1. a sale with a resulting gain (the difference between fair value and cost to dealer/manufacturer)

2. a lease transaction that will provide interest revenue over the period of the lease

Accounting for lessors that are manufacturers or

dealers of the leased asset (cont.)48

Lessor’s investment in lease accounted for in same manner

as direct-financing lease

� value of sale recorded as fair value of asset at date of sale (equal to present value of minimum lease payments)

� direct costs (e.g. commissions, legal fees, etc.) accounted for by lessor as a cost of sales in year in which transaction occurs—not as part of net investment in lease receivable (AASB 117, para. 38)

� lease rentals representing a recovery of executory costs (if material) to be treated by lessor as revenue in year in which costs incurred

Lessor’s journal entries for a lease involving a

dealer or manufacturer (Net method)

49

� To record sale and lease receivable:

Dr Lease receivable

Dr Cost of goods sold

Cr Inventory

Cr Sales

Cost of sales will represent the cost of the asset to the lessor—assumed that asset being sold was part of the inventory of the lessor

� To record receipt of lease payment:

Dr Cash

Cr Lease receivable

Cr Interest revenue

� Lessor accounting for operating leases

50

Lessor accounting for operating leases

51

� Leased property accounted for as a non-current asset

� Required to depreciate if it is a depreciable asset

� Lease receipts treated as rental revenue

AASB 117 (para. 53)

� The depreciation policy for depreciable leased assets is to be consistent with the lessor’s normal depreciation policy for similar assets, and depreciation is to be calculated in accordance with AASB 116 and AASB 138

Leases involving land and buildings

53

Leases involving land and buildings

52

� Land is an asset with usually an indefinite life

� Risks and benefits of land typically cannot be transferred to lessee unless the lease will, at completion, transfer ownership or has a bargain purchase option

� Leases of land (as well as the land component of a lease relating to land and buildings) is treated as operating lease unless reasonably assured of transferring ownership

� Refer to AASB 117 (para. 14)

Leases involving land and buildings (cont.)54

� Minimum lease payments must be allocated between land and buildings in proportion to their relative fair values at lease inception

� If lease not assured of transferring ownership of land and buildings at end of lease, lease payments allocated to land to be treated as operating lease

� Payments allocated to building (operating or finance lease) will depend on whether lease transfers risks and benefits of ownership to lessee (normal tests apply)

Leases involving land and buildings (cont.)

55

� Exception: Where fair value of land is immaterial in relation tothe fair value of total property, it may be treated as a unit for classification purposes and so land component may be ignored

� If lease then appears to transfer risks and benefits of ownership, the total lease for land and buildings may be treated as a finance lease, otherwise operating (refer to AASB 117, para. 17)

� You can refer to Worked Example 11.8 on page 388

Lessee accounting for lease incentives under a non-

cancellable operating lease

56

Lessee accounting for lease incentives under a

non-cancellable operating lease57

� Lessor may offer incentives for entering non-cancellable operating leases (particularly for buildings)

� initial rent-free periods

� financial assistance for fitting out offices

� up-front cash incentives

� financial assistance to terminate existing lease agreements

� Lease incentives not specifically dealt with under AASB 117

Lessee accounting for lease incentives under a non-

cancellable operating lease (cont.)58

� Up-front incentives are typically not ‘free’ to the lessee, but, instead, are paid for by the lessee over the term of the lease.

� e.g. a 6-year agreement to lease a property, with the first year being rent free.

� Interpretation 115 Operating Leases – Incentives*

� The lessor shall recognise the aggregate cost of incentives as a reduction of rental income over the lease term

� The lessee shall recognise the aggregate benefit of incentives as a reduction of rental expense over the lease term

� Based on straight-line basis (unless another systematic basis is representative of the time pattern of use)

* An Interpretation is released when there appears to be significantly divergent

interpretations of particular accounting requirements

*

Multiple choice question 1

An operating lease is one in which:

A. The lessee agrees to maintain the operating capability of the asset to a level specified by the lessor

B. The risks and benefits of ownership reside with the lessor

C. The lessee is required to maintain the leased asset according to an agreed maintenance schedule

D. The risks and benefits of ownership reside with the lessorand the lessee is required to maintain the leased asset according to an agreed maintenance schedule

E. None of the given answers


In determining if the risks and rewards of ownership have been transferred, AASB 117 states the following would indicate a finance lease is in effect:

A. Ownership of the assets transfers at the end of the lease term for a variable payment equal to its then fair value

B. Contingent rents exist

C. The lease is non-cancellable by the lessor

D. The lease term is for a major part of the economic life of theasset

E. All of the given answers


Johnson Ltd enters into a lease agreement with Pete Ltd under the following terms:

Duration of lease 10 years

Life of leased asset 12 years

Unguaranteed residual $8,000

Lease payment $6,500 at lease inception

Annual lease payments (in arrears) $7,000 per year (10 payments)

The lease may be cancelled only with the permission of the lessor. If the rate of interest implicit in the lease is 10 per cent, what is the fair value of the asset at the inception of the lease, and is the lease a finance or operating lease?

A. $56,745, finance lease

B. $52,596, operating lease

C. $56,745, operating lease

D. $52,596, finance lease

E. None of the given answers

Relative Resource Manager 2

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