Session 17

Corporate Financial Reporting

Week 9 a

IIMC-PGP-2014: Prof. Arpita Ghosh

1

Lease

• Why to use lease ?

• Identifying whether the lease is Operating or Capital ?

• Terms related to Lease

• Amortization Table for Lease

• Accounting in the books of Lessee - Operating and Capital Lease

• Financial statement implications

2

Lease – Why to use lease ?

Lease - A contractual agreement in which the owner of an asset (lessor) conveys to a counter party (known as lessee)

• the right to use an asset for an agreed period of time in return for a payment or series of payments

Advantages

• Reduced risk of obsolescence.

• Little or no immediate cash payment - can help to avoid going for debt

• Tax advantages (from depreciation and Interest expense or lease rentals)

3

Lease can be for Short term (typically operating lease) or Long Term (careful: can be structured as operating lease)

Classification based on substance at the inception :

• Operating Lease : A lease other than Finance Lease. (typically Standard Assets)

Lessor in substance, gives the leased asset to lessee on rent (usu. short term)

• Capital or Finance Lease : A lease that transfers substantially all the risks and rewards incidental to ownership of an asset (typically Customised Assets)

Lessee in substance, owns the leased asset (title may not be transferred).

Criteria - Whether Operating or Capital lease ?

Examples of situations which will normally lead lease being classified as Finance lease or

Capital lease

• The ownership of the asset is transferred to the lessee by the end of the lease term.

• The lessee has a Bargain Purchase Option

• The lease term covers major part of the economic life of the asset (≥75% US GAAP)

• At the inception of the lease,

– Present value of the minimum lease payments substantially covers all of the fair value

of the leased asset (≥ 90% US GAAP)

• The leased asset is of a specialised nature such that only the lessee can use it without

major modifications being made.

4

major modifications being made.

Suggestive : It is non-cancellable, Gain/loss from fluctuation in FV of RV accrues to lessee

• Minimum lease payments : Payments lessee is required to make over the lease term plusGuaranteed Residual Value (plus payment for BPO option if any)

• Residual Value (RV) : Estimated fair value of the asset at the end of the lease term

• Guaranteed RV (GRV) : Part of the residual value which is guaranteed to the lessor

For Lessee: by lessee/party related to lessee, For Lessor: by lessee/party related to lessee / Third

party (Financially capable of discharging obligation). So, Unguaranteed RV (UGRV) = (RV – GRV)

• Bargain Purchase Option : Option to purchase the asset at a price which is expected to be

sufficiently lower than the fair value at the date the option becomes exercisable

• Fair Value of leased asset: The amount for which an asset could be exchanged between

knowledgeable, willing parties in an arm’s length transaction.

Capital Lease: In the books of Lessee

1. At the inception, the lessee should recognise the lease

As an Asset and a Liability at lower of

• Fair value of leased asset

• Present Value of Minimum Lease Payments (MLP)

Initial direct costs: identified as directly attributable to lease (like legal fees) are added to the cost of the recognized asset

Discount rate (used to calculate PV of MLP):

• Interest rate implicit in the lease : Interest rate that the lessor has considered in deciding the lease rent (implicit interest rate)deciding the lease rent (implicit interest rate)

• If above not known to the lessee, use lessee’s incremental borrowing rate

Interest rate implicit in the lease : Discount rate which at the inception of lease, equates PV of (Lessor’s MLP +UGRV) with (FV of leased asset +Initial direct cost of lessor if any ) (IRR :Term 3)

Lessee’s incremental borrowing rate :

– Rate of interest lessee would have to pay on a similar lease. If it is not determinable, – Interest Rate that lessee would incur to borrow funds for a similar term and with a

similar security.

2. Upon payment of lease Rentals:

Lessee should apportion the lease payments between the finance charge and the reduction of the outstanding liability

3. The lessee should charge depreciation on the leased asset 5

Present Value Concepts

Present Value = Future Value

(1 + i )n

Interest = 10%

IF PVIFA Ord(due at the end of the period) :

Period

Lease

Rental PV of Re 1 PV of LR

1 20,000 0.909 18182

2 20,000 0.826 16529

3 20,000 0.751 15026

4 20,000 0.683 13660

PVIFA Ord (10%, 4) = (p629) 3.1699

Present value of MLP = 20,000*3.1699= 63397

IF PVIFA Due (due at the beginning of the period) :

PVIFA Ord(due at the end of the year) :

PVIFA Due (due at the beginning of the year) :

])1(1

[r

nr

−+−

CALCULATE installment payable if FV of Asset = 63,397, Interest rate = 10%, lease term=4 yrs :

Installments payable = Rs 63,397/ 3.1699= Rs 20,000

= (0.909 + 0.826+ 0.751 +.683) = 3.1699

6

IF PVIFA Due (due at the beginning of the period) :

PVIFA Due (10%, 4) 3.4869

Present value of MLP : 20,000*3.4869 = 69737

PVIFA Due (due at the beginning of the year) :

)1]()1(1

[ rr

nr

+

−+−

Implicit Interest rate Interest = 10%

If UGRV = 5000 at the end of year 4 and lease payments are due at the end of the period

PVIFA Ord (due at the end of the period) :

Period PV of Re 1 PV of LR

FV of Asset + Initial Direct Cost = 0 66,812 1 66,812

Lease Rental 1 -20,000 0.909 -18182

Lease Rental 2 -20,000 0.826 -16529

Lease Rental 3 -20,000 0.751 -15026

Lease Rental 4 -20,000 0.683 -13660

UGRV 4 -5,000 0.683 -3415

Present value of (MLP + UGRV) -66,812

IRR = 10% NPV = 0

= (1+0.909 + 0.826+ 0.751) = 3.486

Illustration

Expected Useful life of the asset = 3 years. The asset is transferred to the lessee on

expiry of lease term. Three annual lease rentals due to lessor at the end of each year

are @ Rs 20,000. The lessee's incremental borrowing rate is 10%. FV of the asset = Rs

55,000. Assume actual Residual Value of the asset at the end of year 3 is zero.

Show the Journal Entries in the books of the Lessee.

Period Lease Rental PV of Re 1 PV of LR

1 20,000 0.909 18182

2 20,000 0.826 16529

3 20,000 0.751 15026

Present value of Lease Rentals 20,000 2.487 49737

7

3 20,000 0.751 15026

Present value of MLP : 49737

Classification : The lease qualifies as Capital Lease since it meets two of the conditions -

1. Lease Term = 3 years = 100% of Expected Useful life of the asset

2. PV of MLP ( 49,737)

= 90.43% i.e. substantially all of FV of leased asset (Rs 55,000)

Lease to be recorded at lower of PV of MLP or FV of leased asset: Rs 49,737

Check with Present value tables in p629 of your book

])1(1

[r

nr

−+− =2.487

Lessee should apportion the lease payments between the finance charge (Interest Expense) and the reduction of the outstanding liability (Repayment of Principal)

– The finance charge represents a constant periodic rate of interest on remaining balance of lease obligation

1. Recording the lease at the beginning of year 1 Year 1 Year 2 Year 3

Finance (or Capital) Lease Asset Dr. 49,737

Finance (or Capital) Lease Obligations Cr. 49,737

Finance (or Capital ) Lease – In the books of Lessee

Effective interest rate method

Amortizations table for Lease

8

Amortisation Table for Lease

Beginning Bal. of

Lease Obligation Lease Payment

Finance Charge or

Interest Expense

Reduction in Lease

Obligation

Ending Bal.of

Lease Obligation

Year 1 49737 20000 4974 15026 34711

Year 2 34711 20000 3471 16529 18182

Year 3 18182 20000 1818 18182 0

2. Upon payment of lease rentals Year 1 Year 2 Year 3

Finance (or Capital) Lease Obligations Dr 15,026 16,529 18,182

Interest Expense Dr 4,974 3471 1818

Cash Cr. 20,000 20,000 20,000

A B C (= 10%* A) D (=B- C) E = (A - D)

• The lessee should charge depreciation on the leased asset

– The depreciation policy should be consistent with normal depreciation policy for other depreciable assets owned by the lessee.

– Over Useful life (If uncertain about transfer at the end of lease term : Over shorter of the Useful life and Lease term )

Finance (or Capital ) Lease – In the books of Lessee

3. Depreciation Expense = 49737 / 3 = Rs 16579 Year 1 Year 2 Year 3

Depreciation Expense - Leased Asset Dr 16,579 16,579 16,579

Accumulated Depreciation - Leased asset Cr. 16,579 16,579 16,579

9

Accumulated Depreciation - Leased asset Cr. 16,579 16,579 16,579

4. Removal of the asset and the lease obligation on expiry of lease term

Accumulated Depreciation - Leased asset Dr 49737

Finance (or Capital) Lease Asset Cr. 49737

• Lease Payments should be recognised as an expense (as a rental of the asset).

• If rentals amounts are unequal over the lease term,

• a uniform rental cost should be recognised on a straight line basis over the lease

term (unless another systematic basis is more representative of the time pattern of

the user’s benefit)

Merely taking asset on rent:

No Asset ->No Depreciation, No Debt –>No Interest Expense

Example: Lease Rent for year 1: Rs. 18,000

year 2: Rs. 25,000

Operating Lease – In the books of Lessee

Year Lease

Payments

Expense

in IS

Asset Liability

10

Example:

Year 1 Lease Rental Expense Dr. 20,000

Cash Cr. 18,000

Accrued Lease Rental Cr. 2,000

year 2: Rs. 25,000

year 3: Rs. 17,000

Lease Rent to be expensed every year:

Rs. (18,000+25,000+17,000)/3 = Rs 20,000

Payments in IS

1 18,000 20,000 2,000

2 25,000 20,000 5,000

3 17,000 20,000 3,000

Year

Interest

Expense

Depreciation

Expense

Total

Expense

1 4974 16579 21553

2 3471 16579 20050

3 1818 16579 18397

10263 49737 60000

Finance (or Capital) Lease

Operating Lease

Year Rent Expense

1 20000

2 20000

3 20000

Year 1 2 3

Revenues 50,000 50,000 50,000

Lease Rental 20000 20000 20000

Operating Lease

Year 1 2 3

Revenues 50,000 50,000 50,000

Depreciation Expense 16579 16579 16579

Finance (or Capital) Lease

Financial Statement Implications

11

Lease Rental 20000 20000 20000

Operating Income 30,000 30,000 30,000

Interest Expense 0 0 0

EBT 30,000 30,000 30,000

Tax 40% 12000 12000 12000

PAT 18,000 18,000 18,000

Depreciation Expense 16579 16579 16579

Operating Income 33,421 33,421 33,421

Interest Expense 4974 3471 1818

EBT 28,447 29,950 31,603

Tax 40% 11379 11980 12641

PAT 17,068 17,970 18,962

• Over 3 years: Total Expense same: Operating Lease � 20,000 * 3 = Rs 60,000

Finance (or Capital) Lease � Depreciation (49,737) + Interest (10,263) = Rs. 60,000

• Year 3: Expense under Operating Lease �� Constant 20,000

Expense under Finance (or Capital) lease: Depreciation Expense is constant,

Interest expense declines (Constant Interest rate applied to declining balance).

Interest Expense lower (1818) + Depreciation constant (16579) = 18397=Total expense decreases < 20,000

Lessee – Finance (or Capital) Lease

Balance sheet Impact :

• Cash Outflow

• Finance (or Capital) lease Asset : Net of Depreciation

• Lease Obligation: Net of principal repaid

Income Statement Impact :

• Depreciation and Interest Expense

Lessee – Operating Lease

Balance sheet Impact :

• Only Cash Outflow, Nothing else

Income Statement Impact :

• Operating Expense: Lease Rentals

Financial Statement Implications

Operating Lease Finance (or Capital) Lease

Profitability Delays Expense Recognition

Operating Expense Lease Rentals > Depreciation

Operating Profit Lower Higher

12

Operating Profit Lower Higher

Total Expenses Lease Rentals Depreciation + Interest Expense

Lease Rentals lower in early years than Depreciation +Interest expense

PAT in initial years Higher Lower

ROA in initial years

( Change in PAT, Total Asset)

Higher

(PAT Higher, Lower Asset)

Lower

(PAT Lower , Leased Asset)

Solvency

Debt to Equity Ratio Lower (No Debt) Higher (Debt recorded)

Interest coverage Ratio Higher (No Interest Expense) Lower (Interest Expense recognized)

Asset Turnover Ratios Higher (No Assets) Lower (Leased Assets)

CFO Lower (Operating Outflow) Higher

CFF Higher Lower: Interest Paid, Repayments

ROE in initial years Higher (NI higher, Equity higher) Lower

Current Ratio Higher

Lower (since CL includes Current Portion of

Lease Obligations)

Problem 9 A.6 (p421) : Operating Lease

Year Monthly Rental (Rs) Number of Months Total

1 10,000 12 120,000

2 4,000 6 24,000

18 144,000

Average Monthly Rental 8,000

Average Quarterly Rental 24,000

Date Particulars Debit (Rs) Credit (Rs)

31st March 20X1 Lease Rental Expense 24,000

Prepaid Lease Rental 6,000

Cash 30,000

30th June 20X1 Lease Rental Expense 24,000


13


Cash 30,000

Paid Lease Rental

30th Sep 20X1 Lease Rental Expense 24,000


Cash 30,000

31st Dec 20X1 Lease Rental Expense 24,000


Cash 30,000



Cash 12,000



Cash 12,000

Problem 9B.6 (p423): Accounting for Leases Part -I

1. Minimum lease payments:

• From the standpoint of the lessee: Lease rental of Rs 28,679 per year for four years.

• From the standpoint of the lessor: Lease rental of Rs 28,679 per year for four years.

2. Is this a finance lease?

This is a finance lease because at the inception of the lease the PV of MLP from the standpoint of

the lessee amounts to the FV of the leased asset = Rs 1,00,000

• PV of 4 payments of Rs 28,679 each due in the beginning at 10%:

= Rs 28,679 * 3.4869 = Rs 1,00,000 (check page 630 for PVIFA due)

Therefore, it transfers substantially all the risks and rewards incident to ownership of the asset.

Part -I

)1]()1(1

[ rr

nr

PVIFADue +

−+−

=


3. Interest rate implicit in the lease

Interest rate implicit in the lease : Discount rate which at the inception of lease, equates PV of

(MLP from lessor standpoint +UGRV) with (FV of leased asset +Initial direct cost of lessor if any)

FV of equipment is Rs 1,00,000. The MLP from lessor standpoint consists of lease rental of Rs

28,679 per year for 4 years. Equating PV of MLP, the interest rate implicit in the lease is found

to be 10%. Note that this is the same as the interest rate charged by the lessor on the lease.

4. Lessee's recording the lease

The lessee would record the asset and liability at the present value of minimum lease payments

of Rs 1,00,000, which is equal to the fair value.

14

Problem 9B.6: Accounting for Leases


• From the standpoint of the lessee: Lease rental of Rs 28, 679 per year for four years.

• From the standpoint of the lessor: Lease rental of Rs 28, 679 per year for four years.


This is a finance lease because at the inception of the lease the PV of MLP from the standpoint of the lessee amounts to a substantial portion (about 94%) of the FV of the leased asset, as shown below:

• PV of 4 payments of Rs 28,679 each due in the beginning at 10% = Rs 28,679*3.4869= Rs 1,00,000.

• PV of MLP / FV of leased asset = 1,00,000/106,830 =93.6%Therefore, it transfers substantially all the risks and rewards incident to ownership of the asset.


Part –II: FV of equipment Rs106,830 and UGRV of Rs10,000

3. Interest rate implicit in the leaseInterest rate implicit in the lease : Discount rate which at the inception of lease, equates PV of (MLP

from lessor standpoint +UGRV) with (FV of leased asset +Initial direct cost of lessor if any)

FV of equipment is Rs 106,8300. The MLP from lessor standpoint consists of lease rental of Rs 28,679 per year for 4 years. The asset has an UGRV of Rs 10,000.

Equating PV of (MLP +UGRV), the interest rate implicit in the lease is found to be 10% :


The lessee would record the asset and liability at the present value of minimum lease payments of Rs 1,00,000, rather than the fair value of Rs 106,830, since the former is the lower of the two amounts.

15

PV of 4 payments of Rs 28,679 each due in the beginning at 10% =Rs28,679 * 3.4869 100,000

PV of RV receivable at the end of 4 years of Rs 10,000 at 10%: = Rs 10,000 * 0.6830 6,830

PV of (MLP + UGRV) Total 106,830



• From the standpoint of the lessee: Lease rental of Rs 28, 679 per year for four years + lessee guaranteed RV of Rs5000 at the end of 4 years

• From the standpoint of the lessor: Lease rental of Rs 28, 679 per year for four years + lessee guaranteed RV of Rs5000 at the end of 4 years.


This is a finance lease because at the inception of the lease the PV of MLP from the standpoint of the lessee amounts to the FV of the leased asset, as shown below:



Interest rate implicit in the lease : Discount rate which at the inception of lease, equates PV of (MLP

Part –III: FV of equipment Rs103,415 and + lessee guaranteed RV of Rs5,000


from lessor standpoint +UGRV) with (FV of leased asset +Initial direct cost of lessor if any )

FV of equipment is Rs103,415. The MLP from lessor standpoint consists of a) lease rental of Rs 28,679

per year for four years b) lessee guaranteed RV of Rs 5,000

Equating PV of MLP, the interest rate implicit in the lease is found to be 10% :


The lessee would record the asset and liability at the present value of minimum lease payments of Rs Rs103,415 , which is equal to the fair value.

16


PV of GRV receivable at the end of 4 years of Rs 5,000 at 10%: = Rs 5,000 * 0.6830 3,415

PV of MLP for Lessor Total 103,415



• From the standpoint of the lessee: Lease rental of Rs 28, 679 per year for four years

• From the standpoint of the lessor: Lease rental of Rs 28, 679 per year for four years Third Party guaranteed RV of Rs5000 at the end of 4 years.


This is a finance lease because at the inception of the lease the PV of MLP from the standpoint of the lessee amounts to a substantial portion (about 97 percent) of the FV of the leased asset, as shown below:

PV of MLP / FV of leased asset = 1,00,000/103,415 =96.69%




Part –IV: FV of equipment Rs103,415 and + Third Party guaranteed RV of Rs5,000



from lessor standpoint +UGRV) with (FV of leased asset +Initial direct cost of lessor if any )

FV of equipment is Rs103,415. The MLP from lessor standpoint consists of a) lease rental of Rs 28,679

per year for four years b) Third Party guaranteed RV of Rs 5,000

Equating PV of MLP, the interest rate implicit in the lease is found to be 10% :


The lessee would record the asset and liability at the present value of minimum lease payments of Rs 1,00,000, rather than the fair value of Rs 103,415, since the former is the lower of the two amounts.

17


PV of GRV receivable at the end of 4 years of Rs 5,000 at 10%: = Rs 5,000 * 0.6830 3,415

PV of MLP for Lessor Total 103,415






This is not a finance lease because at the inception of the lease the PV of MLP from the standpoint of the lessee amounts to less than 90 percent (about 88 percent) of the FV of the leased asset.


• PV of MLP / FV of leased asset = 1,00,000/113,660 =87.98%Of course, it is possible that it may be a finance lease under any of the other criteria specified in the

accounting period.


Part –V: FV of equipment Rs113,660 and UGRV of Rs20,000




FV of equipment is Rs 113,660. The MLP from lessor standpoint consists of lease rental of Rs 28,679 per

year for 4 years. The asset has an UGRV of Rs 20,000.



If the lease is not a finance lease under any of the other criteria specified, the lessee would treat it as an operating lease.

18


PV of UGRV receivable at the end of 4 years of Rs 20,000 at 10%: = Rs 20,000 * 0.6830 13,660







At the inception of the lease the PV of MLP from the standpoint of the lessee amounts to less than 90

percent (about 88 percent) of the FV of the leased asset.


• PV of MLP / FV of leased asset = 1,00,000/113,660 =87.98% (< 90%)

But the lease term is for the major part of the economic life of the asset (4 of the 5 years of useful life

i.e. 80 percent >75%). So, under this criteria this is a finance lease.

Part –VI: FV of equipment Rs113,660 and UGRV of Rs20,000, Useful life= 5 years




FV of equipment is Rs 113,660. The MLP from lessor standpoint consists of lease rental of Rs 28,679 per

year for 4 years. The asset has an UGRV of Rs 20,000.



The lessee would record the asset and liablity at the present value of minimum lease payments of Rs

1,00,000, rather than the fair value of 113,660, since the former is the lower of the two amounts.19


PV of UGRV receivable at the end of 4 years of Rs 20,000 at 10%: = Rs 20,000 * 0.6830 13,660


Installment Number

Beginning

Principal Balance

Semi - annual

Installment

Semi - annual

Interest

Reduction in

Principal

Ending Principal

Balance

(Col. 2 * 10%) (Col. 3 - Col. 4) (Col.2 - Col. 5)

1,000,000

1 1,000,000 229,605 100000 129,605 870,395

2 870,395 229,605 87040 142,566 727,830

3 727,830 229,605 72783 156,822 571,008

4 571,007 229,605 57101 172,504 398,503

5 398,504 229,605 39850 189,755 208,749

6 208,749 229,605 20875 208,730 19

BDC 9.2 (p429): SOFTSCAPE CORPORATION

1. The repayment schedule is the same for borrowing as well as leasing.

20

6 208,749 229,605 20875 208,730 19

Period Interest Depreciation Total

1 100,000 150,000 250,000

2 87,040 150,000 237,040

3 72,783 150,000 222,783

4 57,101 150,000 207,101

5 39,851 150,000 189,851

6 20,875 150,000 170,875

In addition, under the borrowing alternative, the company gets the estimated residual value of the asset

at the end of period 6; the present value of the amount is Rs 56,450 (Rs 1,00,000 * 0.5645)

Under the lease capitalization alternative, the total expense is the same for borrowing and leasing. The

expense consists of periodic interest and depreciation charge. The amount for each period would be as

follows:

Period No Capitalization Capitalization Difference

Lease Rental Interest + Depreciation

1 229,605 250,000 -20,395

2 229,605 237,040 -7,435

3 229,605 222,783 6,822

4 229,605 207,101 22,504

5 229,605 189,851 39,754

6 229,605 170,875 58,730

Total 1,377,630 1,277,650 99,980

In the no capitalization case, the entire lease rental would be expensed in each period.

The Comparative position would be as follows:

BDC 9.2 (p429): SOFTSCAPE CORPORATION continued

21

Total 1,377,630 1,277,650 99,980

Finance Lease Equipment 1,000,000

Finance Lease Obligation 1,000,000

(To record capital lease obligation)

3. From the table in 1, the two alternatives are financially equivalent. This is because both carry the

same interest rate and involve equal installment amounts.

• However, under the borrowing alternative the company gets a residual value of Rs 1,00,000, the

present value of which is Rs 56,450. This is the net financial difference and it tilts the balance in favor

of borrowing.

• The total expense to be recognized in each semi- annual period is identical under the two alternatives

if the lease is capitalized.

• If the lease is not capitalized, the Charge to the profit and loss account would differ as shown earlier.

4. A lease would be an "Off - balance sheet" if it is not required to be shown on the balance sheet.

There are other considerations in selecting between the two alternatives such as the following :

1.Taxation (availability of taxable income to claim depreciation allowance).

2. Equipment obsolescence (leasing ensures that the company is not stuck with the obsolete

equipment after the lease term);

3. Equipment selection services from the lessor;

4. Additional cost of lease finance;

5. Availability of borrowing capacity; and 6. Off -Balance sheet benefit, in some cases.

BDC 9.2 (p429): SOFTSCAPE CORPORATION continued

22

4. A lease would be an "Off - balance sheet" if it is not required to be shown on the balance sheet.

The claim of the marketing manager of Expro Finance that the proposed lease would be off -

balance sheet is not borne by the requirements of AS 19. In accordance with AS 19, it is a finance

lease. This is because the lease term is equal to the economic life of the asset.

If the lease term is equal to 75% or more of the asset's life, the lease must be capitalized. It would

be a different matter if the marketing manager indicated that the proposed lease can be

structured so as to become an operating lease under AS 19.

In that case, the lease would be an off- balance sheet item. Based on the information

given in the case, it is not possible to classify the lease as an operating lease.

Significant Accounting Policy : Lease

INFOSYS

23

HINDALCO

Thank YouThank You

24

Session 17

Documents

finance lease

lease accounting

lease rentals3lease

lessee minimum lease

lease amortization table

payments lessee

asset lessor

books of lessee