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Slide 18.1 Leasing Chapter 18
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Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Dec 27, 2015

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Page 1: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.1

Leasing

Chapter 18

Page 2: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.2

By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases by the lessee; account for leases by the lessor; critically discuss the reasons for the proposed revision of IAS 17; critically discuss the reasons for revising IAS 17.

Objectives

Page 3: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.3

What is a lease?

Leases are defined in IAS 17: Leases as: ... an agreement whereby the lessor conveys to the

lessee in return for a payment or a series of payments the right to use an asset for an agreed period of time. (para 4)

This includes contracts for the hire of an asset that contain a provision giving the hirer an option to acquire title to the asset upon the fulfilment of agreed conditions. (para 6)

It is a legal agreement whereby the lessee (the user) obtains the right to use an asset for an agreed period.

Page 4: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.4

What is a lease?

The right to use the asset is passed from the lessor (the legal owner) of the asset to another party (the lessee).

Legal ownership is retained by the lessor – the person granting the lease.

In return for the right to use the asset, the lessee pays a rental to the lessor.

Page 5: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.5

Why did leasing become popular?

In the UK, there were two major reasons: The tax advantage to the lessor (the lessor could claim

depreciation tax allowances and pass these on to the lessee in the form of a reduced rental charge) and

The commercial advantage to the lessee.

Page 6: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.6

Why did leasing become popular? (Continued)

Commercial advantage

Tax benefits gradually diminished but the benefit of spreading cash payments over the lease period instead of making a one-off lump sum payment included:• Cash flow management – more working capital is available• Conservation of capital – Lines of credit are kept open and may be

used for purposes where finance might not be available easily • Continuity – an overdraft facility may be terminated – a lease

agreement has an agreed life span• Flexibility of the asset base – non-current assets more easily

expanded and contracted• Off statement of financial position financing – leasing provides the

lessee with the possibility of off statement of financial position financing.

Page 7: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.7

Why was IAS 17 necessary?No uniformity in the treatment and disclosure of leasing

transactionsMassive growth in the leasing industry as a material

economic resourceAccounting treatment distorted financial reports – not a

true and fair viewConcern about undesirable economic consequences,

for example inclusion of the lease obligation might: affect the lessee company’s gearing adversely and cause it to exceed its legal borrowing powers

However, growth continued because of the commercially attractive reasons and lease agreements being structured to get around the standard.

Page 8: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.8

What is the main thrust of IAS 17?

IAS 17 defined two types of lease – finance and operating – and recommended different accounting treatments: Finance lease: a lease that transfers substantially all

the risks and rewards of ownership of an asset to the lessee

Operating lease: a lease other than a finance lease.

Page 9: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.9

Types of lease Finance leases Sometimes called ‘capital’ or ‘financial’ leases

because, in an economic sense, they are a form of borrowing. The lease payments contain both principal and interest portions, similar to a table mortgage.

A lease asset and liability appear on the Balance Sheet, and interest expense on the Income Statement.

IAS 17 defines this type of lease as: a lease that transfers substantially all the risks and

rewards incidental to ownership of an asset to the lessee. Title may or may not eventually be transferred. (para 4)

Page 10: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.10

Types of lease

Operating leases IAS 17 defines this type of lease as:

A lease other than a finance lease. (para 4)

An operating lease is a rental agreement. The lessee obtains the right to use the asset in

return for rental payments, but the risks and rewards of ownership are not transferred to the lessee. An example is a business renting a shop from a landlord. Nothing appears on the Balance Sheet and the full rent expense appears on the Income Statement.

Page 11: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.11

Types of lease Differences between the types of lease In a finance lease the lessee obtains practical

ownership. Legal ownership of the asset stays with the lessor. The transfer of substantially all the risks and rewards

of ownership (that come with practical ownership) means that the lessee carries losses from such things as idle capacity, technological obsolescence, or changed economic conditions.

The lessee receives any rewards expected from profitable operations over the asset’s useful life.

The lessee might also be entitled to any gains from appreciation in value or realisation of a residual value at the end of the lease.

Page 12: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.12

Types of lease The cancellation of a finance lease is only

possible: (a) upon the occurrence of some remote contingency; (b) with the permission of the lessor; (c) if the lessee enters into a new lease for the same or

an equivalent asset with the same lessor; or (d) upon payment by the lessee of such an additional

amount that, at inception of the lease, continuation of the lease is reasonably certain. (para 4)

An operating lease can be cancelled at any time by either party – usually with one month’s notice.

Page 13: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.13

Types of lease

Other differences - with a finance lease: 1 substantially all of the risks and rewards of

ownership are transferred to the lessee, and 2 the lessor can ascertain the lease costs with

reasonable certainty, and either: a the lease transfers ownership of the asset to

the lessee by the end of the lease term, or b the lessee has the option to purchase the

asset at a bargain basement price, or

Page 14: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.14

Types of lease

c the lease term is for the major part (usually considered to be 75% or more) of the economic life of the asset even if title is not transferred, or

d at the inception of the lease the present value of the minimum lease payments is substantially all (normally not less than 90%) of the fair value of the leased asset, or

e the leased assets are of a specialised nature such that only the lessee can use them without major modifications being made.

Page 15: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.15

Types of lease Legal ownership of the asset may or may not be

transferred. When legal ownership is expected to transfer, the

finance lease is another way of using debt to finance the purchase of the asset. Thus, both the asset and the liability should be shown on the lessee’s Balance Sheet – just like any other asset bought with debt is treated.

Lease term and present value of minimum lease payments.

Where these payments have determined the existence of a finance lease, IAS 17 requires the economic resources available to and the level of obligations of the lessee to be recorded as an asset and liability on the Balance Sheet (para 22).

Page 16: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.16

What is the main thrust of IAS 17? (Continued)Finance leases accounting treatment:Capitalised in the lessee’s accounts, that is,

the leased item is recorded as an asset in the statement of financial position and

the obligation for future payments should be recorded as a liability in the statement of financial position.

Operating leases accounting treatment:• Lessee is required to expense the annual

payments as a rental through the income statement.

Page 17: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.17

Why was the IAS 17 approach so controversial? The IASB Framework, para. 35 states:

If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form.

A substance over form approach to accounting treatment is completely different to the traditional approach, which has strict regard to legal owners.

Page 18: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.18

The IASB argument was that there were two separate transactions taking place: The company was borrowing funds to be repaid over a

period and It was making a payment to the supplier for the use of an

asset

The correct accounting treatment for the borrowing transaction, based on its substance, was to include in the lessee’s statement of financial position a liability

The correct accounting treatment for the asset acquisition transaction, based on its substance, was to include an asset representing the asset supplied under the lease.

Why was the IAS 17 approach so controversial? (Continued)

Page 19: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.19

IAS 17 – classification of a lease

Factors in determining transfer of risks and rewards

Ownership of the asset transferred to the lessee by the end of the lease term

The lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised.

Page 20: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.20

IAS 17 – classification of a lease (Continued)The lease term is for the major part of the

economic life of the asset even if the title is not transferred

At the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset and

The leased assets are of such a specialised nature that only the lessee can use them without major modifications.

Page 21: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.21

IAS 17 leases

• Rationale for including in accounts

– Economic substance

– Long-term commitment

– Similar to buying asset with a loan

• IASB Framework defines asset and liability

– Liability is a present obligation for outflow of resources

– Asset is a resource controlled by an enterprise.

Page 22: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.22

Recognition of an asset

• Finance lease

– Gives control of asset

– Transfers all the risks and rewards of ownership

• Asset is the benefits conferred by use

– Include at Fair Value

– Annual depreciation charge.

Page 23: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.23

Recognition of a liability

Commitment to future obligations Payments under lease

Liability measured as PV of obligations.

Page 24: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.24

Categorising as finance or operating lease

Figure 18.1 IAS 17 aid to categorising operating and finance leases

Page 25: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.25

Accounting requirementsfor operating leasesTreatment conforms to the legal interpretation

and corresponds to the lease accounting practice that existed before IAS 17

No asset or obligation is shown on the statement of financial position

The operating lease rentals payable are charged to the income statement on a straight-line basis.

Page 26: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.26

Disclosure requirementsfor operating leasesDisclose:

Total of rentals charged as an expense in the income statement

Payments committed to make during the next 5 years, in the second to fifth years inclusive, and over 5 years.

Page 27: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.27

Operating lease illustration

Clifford plc negotiates a lease to begin on 1 January 20X1 with the following terms: Terms of lease – 4 years Estimated useful life of machine – 9 years Age of machine on inception of lease – 4 years Purchase price of new machine – £75,000 Annual payments – £8,000.

Page 28: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.28

Operating lease illustration (Continued)Classify as an operating lease because:

It applies only to a part of the asset’s useful life and The present value of the lease payments does not

constitute substantially all of the fair value

The amount of the annual rental paid – £8,000 p.a. – will be charged to the income statement and disclosed There will also be a disclosure of the ongoing commitment

with a note that £8,000 is payable within 1 year and £24,000 within 2 to 5 years.

Page 29: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.29

Statement of financial positionsteps for a finance leaseStep 1 The leased assets should be capitalised at

the lower of the present value of lease payments and its fair value

Step 2 The annual depreciation charge for the leased asset should be calculated by depreciating over the shorter of the estimated useful life of the asset or the lease period

Step 3 The net book value of the leased asset should be reduced by the annual depreciation charge.

Page 30: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.30

Balance Sheet steps (Continued)Step 4 The finance lease obligation is a liability At the start of the lease, the value of the leased asset and the

leased liability will be the same

Step 5 The finance charge for the finance lease should be calculated

as the difference between the total of the minimum lease payments and the fair value of the asset (or the present value of these lease paymentsif lower)

It should be allocated to the accounting periods over the term of the lease. Three methods for allocating finance charges are used in practice: Actuarial Sum of the digits Straight-line.

Page 31: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.31

Actuarial method. This applies to a constant periodic rate of charge to the balance of the leasing obligation calculated by applying present value tables to annual lease paymentsSum of digits method. This method (‘Rule of 78’) is much easier to apply than the actuarial method. The finance charge is apportioned to accounting periods on a reduced scale – method used by Elliott & ElliottStraight-line method. This spreads the finance charge equally over the period of the lease (only acceptable if immaterial).Step 6 The finance lease obligation should be reduced by the difference between the lease payment and the finance lease.

Balance Sheet steps (Continued)

Page 32: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.32

Finance charge allocation using actuarial method

Figure 18.2 Finance charge allocation using actuarial method

Page 33: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.33

Extract from the Nestlé group annual report and accounts 2008Accounting policies

Leased assets

Assets acquired under long-term finance leases are capitalised and depreciated in accordance with the Group’s policy on property, plant and equipment. The associated obligations are included in financial liabilities.

Page 34: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.34

Finance lease illustrated – similar to Clifford example pp.478-480Boonaloo Ltd entered into a lease on following

terms:

Fair value of the leased asset 20,000Term of the lease 5 yearsAnnual lease payments in arrears £4,500Expected value of asset at lease end nilImplicit rate of interest 4%

Page 35: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.35

Boonaloo Ltd - Compare FV with PV of minimum lease payment

FV of lease £ 20,000 PV of instalments: 4500/[(1.04) + (1.04)2 + (1.04)3 + (1.04)4 + 1.04)5] =

20,033 PV is very close to fair value, therefore capitalise at

fair value.

Page 36: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.36

Boonaloo Ltd – step approach

Step 1 Capitalise lease at FV = £20,000

Step 2 Straight-line depreciation = £4,000

Step 3 Asset in statement of financial position Year 120,000 – 4,000 = £16,000 Year 216,000 – 4,000 = £12,000 Year 312,000 – 4,000 = £8,000 Year 48,000 – 4,000 = £4,000 Year 54,000 – 4,000 = 0

Page 37: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.37

Boonaloo Ltd – step approach

Step 4 Obligation at inception £20,000

Step 5 Finance charge (sum of digits) Sum of digits = 1 + 2 + 3 + 4 + 5 = 15 Or, by formula: n(n +1)/2 = 5(6)/2 = 15 Total to be paid £22,500 Fair value of asset £20,000 Finance charge £2,500

Allocate as follows:Year 1 5/(15) × 2,500 £(833)

Year 2 4/(15) × 2,500 £(667) Year 3 3/(15) × 2,500 £(500) Year 4 2/(15) × 2,500 £(333) Year 5 1/(15) × 2,500 £(167)

Page 38: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.38

Boonaloo Ltd – step approach

Step 6 Reduce the obligation Year 1 20,000 − 4,500 = £15,500

Add Finance charge £833 £16,333

Year 2 16,333 − 4,500 = £11,833 Add Finance charge 667

£12,500Year 3 12,500 – 4,500 = £ 8,000

Add Finance charge 500 £ 8,500

Year 4 8,500 – 4,500 = £ 4,000Add Finance charge 333

£ 4,333Year 5 4,333 – 4,500 = £ (167)

Add Finance charge 167 £ 0

Page 39: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.39

Boonaloo Ltd– income statement entries

Year 1 Year 2 Year 3 Year 4 Year 5

Depreciation 4,000 4,000 4,000 4,000 4,000

Finance charge833 667 500 333 167

Page 40: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.40

• Land and buildings are dealt with separately

• Each has to be reviewed to determine whether to classify as an operating or finance lease.

Accounting for the lease of landand buildings

Page 41: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.41

Example – the Warehouse Company

Let us assume that

• The Warehouse Company Ltd, whose borrowing rate is 10% per annum, entered into a 10-year lease, with Lessor Ltd, under which it will make payments of $106,886 annually in advance

• The present value of the land is $500,000 and of the buildings is $500,000

• The expected value of the land at the end of 10 years will be $670,000 and the expected value of the buildings will be $50,000.

Page 42: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.42

The Warehouse Company – classifying the land segment of the lease

• There is no contract to pass title at the end of the contract and the land is expected to increase in value

• The land segment of the contract does not involve the lessor transferring the risk and benefits to the lessee

• This means that the lessee has to account for the lease of the land as an operating lease.

Page 43: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.43

The Warehouse Company – classifying the building segment of the lease

• The building segment of the lease is different

• The residual value has fallen to $50,000 which has a present value of $19,275 (50,000 × 0.3855)

• 0.3855 = 10% present value discount factor [1/(1.1)10]

• This means that 96% of the benefit has been transferred (500,000 – 19,275)

• The building segment is, therefore, a finance lease.

Page 44: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.44

The Warehouse Company – how to apportion the lease payment in the income statement

• Split the payment at commencement of lease according to the fair value of components

• The present value of the land is $500,000 of which $258,285 (670,000 × 0.3855) represents the present value of the land at the end of the contract

• So, the balance of $241,715 represents the present value of the operating lease

• Similarly, the amount covered by the finance lease is $480,725 (i.e. 500,000 – 19,275)

• Split the lease payment of $106,886 in those proportions (241,715 : 480,725)

• This gives $35,763 for the land component and $71,123 for the finance lease representing the buildings leased.

Page 45: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.45

The Warehouse Company – how to report in the statement of financial position

For the finance lease covering the building:

• The lessee will have to show a $480,725 asset initially

• This will be depreciated over the 10 years of the lease according to the normal depreciation policy

• At the same time, a liability representing an obligation to the legal owner of the buildings (the lessor) for the same amount will be created

• As lease payments are made, the interest component will be treated as an expense and the balance will be used to reduce the liability – in the same way as shown in the Boonaloo example earlier.

Page 46: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.46

The Warehouse Company – how to report in the income statement The income statement would show a finance charge for each year of: Step 5 Finance charge (sum of digits) Sum of digits = n(n + 1)/2 = 10(11)/2 = 55 Total to be paid (71,123 x 10) £711,230 Fair value of asset £480,725 Finance charge £230,505 Year 1 (10/55 x 230,505) £ 41,910 Year 2 (9/55 x 230,505) £ 37,719 Year 3 (8/55 x 230,505) £ 33,528 Year 4 (7/55 x 230,505) £ 29,337 Year 5 (6/55 x 230,505) £ 25,146 Year 6 (5/55 x 230,505) £ 20,955 Year 7 (4/55 x 230,505) £ 16,764 Year 8 (3/55 x 230,505) £ 12,573 Year 9 (2/55 x 230,505) £ 8,382 Year 10 (1/55 x 230,505) £ 4,191

Page 47: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.47

Accounting for Leases - Lessor In the books of the lessor In accounting for a finance lease the lessor has

an additional issue to deal with. NZ IAS 17 recognises two types of finance lease: • a direct finance lease such as would be

provided by a bank or finance company • a manufacturer’s or dealer’s lease, also known

as a sales-type lease. A direct finance lease is one where the lessor

provides the finance to the lessee to buy the asset

Page 48: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.48

Accounting for Leases - Lessor A sales-type lease is one where the cost of the asset to the

lessor is different from the asset’s fair value and, as a consequence, the lessor receives two types of income.

One is the difference between the asset’s cost and sale prices (the treatment for which is the same as any sales and cost of sales transactions).

The other is the finance income over the term of the lease. In these situations, the cost to the lessor is the cost of

manufacturing the asset, or the cost charged by the manufacturer to the lessor as an importer or wholesaler.

The fair value in these cases is the fair retail price of the asset.

Consequently, the lessor is required to account for the normal surplus on the transaction with the lessee.

Page 49: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.49

Warehouse example – Lessor Accounting assuming a direct finance lease For a direct finance lease, Lessor Ltd will show, in

effect, a mirror image record of what The Warehouse Company shows in its accounts for the leased building;

Finance lease receivable (Building) £480,725 Each year as the lease rental is received, this amount

will be written down – just as other fixed assets are written down by the depreciation charge. The journal entries are (for year 1): Bank £ 71,123 Finance lease receivable £ 29,213 Interest earned £ 41,910

Page 50: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.50

Warehouse example – Lessor AccountingAt the end of the lease, the finance lease

receivable will be written down to zero, and the total interest earned will equal ₤230,505

Page 51: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.51

IASB and FASB proposal

Non-cancellable operating leases to be treated the same way as finance leases Rationale: rights and benefits meet definition of asset

and liability Prevents current practice of formulating lease contracts

so as to technically fall within operating classification Prevents this form of off statement of financial position

financing.

Page 52: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.52

Off-Balance Sheet Financing

Kallend Tiepins plc – p.484 Machine cost: 100,000. Profit increase: 10%pa Current Buy Lease Operating profit 40,000 44,000 44,000 Equity capital200,000 200,000 200,000 Long-term debt 100,000 200,000 100,000 Capital employed 300,000 400,000 300,000 Gearing ratio 0.5:1 1:1 0.5:1 ROCE 13.33% 11% 14.66%

Page 53: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.53

Do you agree or disagree with the following?All leases should be treated as assets with

accompanying liability in the statement of financial position

Including operating leases in the statement of financial position will distort inter-company ratio comparisons

Investors will be misled if operating leases are capitalised.

Page 54: Slide 18.1 Leasing Chapter 18. Slide 18.2 By the end of this chapter, you should be able to: critically discuss the reasons for IAS 17; account for leases.

Slide 18.54

Review questions

2. (a) Consider the importance of the categorisation of lease transactions into operating lease or finance lease decisions when carrying out financial ratio analysis. What ratios might be affected if a finance lease is structured to fit the operating lease classification?

3. State the factors that indicate that a lease is a finance lease under IAS 17.