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ACC203
Financial Accounting 2
Accounting for Leases

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Lecture Outline
• Discuss the characteristics of a lease and the classification of leases
1.

• Explain the difference between a finance lease and an operating lease


2.

• Discuss the incentives to misclassify leases


3.

• Account for finance leases from the perspectives of the lessee and the
lessor
4.
• Account for operating leases from the perspective of both lessor and
the lessee
5.

• Discuss sale and leaseback transactions


6.

• Discuss possible future changes to lease accounting


7.

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Reference

Prescribed • Company Accounting 10th Edition 2015, Leo K., Knapp


Text J., McGowan S., and Sweeting J. - Chapter 10

• AASB 117 Accounting for Leases


AASB

• Tutorial 9 - Refer to the Detailed Weekly Schedule for


question numbers
Tutorial

What Is a Lease?
• An agreement where a lessor gives a lessee the
right to use an asset for an agreed period of time
1. • In return, the lessee provides a series of payments

• The lessee does not acquire an asset, merely a


right to use an asset for a period of time
2.
• A lease may result in the eventual transfer of
ownership
3. • e.g. hire purchase agreement

Classification Of Leases -
AASB117
Finance • Transfers substantially all
ownership risk and rewards, with
Lease or without eventual title transfer.

• Obsolescence, idle capacity,


Risks uninsured damage.

• Benefits from use of the asset,


Rewards appreciation in value of the asset

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Classification of Finance Leases

• The lease is a finance lease if any of the following


apply:
1.
• The lease is non-cancellable
• Certain cancellable leases can be non-cancellable
2. – refer 10.3.1 of text

• The lease transfers ownership of the asset at the


end of the lease term
• The lease contains a bargain purchase option - an
3. option to purchase the asset at a price
substantially lower than the fair value

Classification of Finance Leases


• The lease term covers a major part of the asset’s
4. economic life

• The present value of minimum lease payments


(PVMLPs) represents substantially the fair value of
5. the asset

• The leased asset is of a specialised nature that only


6. the lessee can use without major modification

• The lessee has the ability to continue the lease for a


secondary period at a rental that is substantially less
7. than market value (a lease renewal option)

Refer Figure 10.2 Guidelines for classifying a lease


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Minimum Lease Payments (MLPs)

Payments over lease term


(see next slides)
+ Guaranteed residual value
+ Bargain purchase option
(see next slides)
- Contingent rent
Commonly referred
- Reimbursement of costs paid by to as executory
lessor costs

= Minimum lease payments (MLPs)

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Minimum Lease Payments


(MLPs): Definitions
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

Under a finance lease the lessee guarantees the residual value that the
lessor will realise
The guarantee may range from 1% to 100% of the residual value

The existence of a guaranteed residual value indicates that the lessor has
transferred risks associated with movements in the residual value to the
lessee

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Minimum Lease Payments


(MLPs): Definitions
Bargain purchase option

A clause allowing the lessee to purchase the asset at the end of the lease
term for a pre-set amount

Must be less than residual value

The option price is normally sufficiently lower than the expected fair value

Resulting in the exercising of the option becoming reasonably certain

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Minimum Lease Payments


(MLPs): Definitions
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

Example
A photocopier lease may specify additional payments if the number of
photocopies exceeds a certain amount

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Minimum Lease Payments(MLPs)


Determining Present Value
• The present value (PV) of MLPs is determined by
applying an appropriate discount rate
1.
• Discounting is not necessary if the lease
agreement contains one of the following (as the
2. PV of MLP = FV of the asset in such cases):

• a bargain purchase option; or


• a 100% guaranteed residual value
3. • The discount rate is based on the interest rate
implicit in the lease

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Incentives To Misclassify
Leases
• Divergent accounting treatments provide an incentive to
misclassify leases as operating leases
• Classification as a finance lease may have the following
1. adverse impacts on a lessee’s financial statements:

• Increases non-current assets – thus reducing return on asset


ratios
• Increases non-current liabilities – adversely affecting
2. debt/equity ratios

• Depreciation and interest charges may exceed lease payment


in early years of lease – resulting in lower profits
• To avoid misclassification of leases as operating leases
3. additional guidance is contained within UIG 127 and UIG 4

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Accounting For Finance Leases


By Lessees
Initial recognition
• Initially determine and recognise a lease asset & liability
• Record at the lower of the FV of the asset and the PV of
MLP

Subsequent measurement
For assets, determine
• depreciation (over the useful life of the asset to the
entity)
• any impairment

For liabilities, lease payment to be allocated


between If the lessee intends on returning the asset at
the end of the lease period the useful life will
• reduction of the lease liability be the term of the lease. Where the lessee
• interest expense incurred intends on purchasing the asset at the end of
the lease term, the useful life will be the
• reimbursement of lessor costs economic life of the asset
• contingent rent
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Accounting for a Finance Lease


 On 30 June 2015 Lessor Ltd leased a vehicle to Lessee
Ltd.
 The FV of the vehicle at the inception of the lease was
$89,721.
 Lease establishment costs incurred by E Ltd totalled
$1,457.
 The lease agreement is for 4 years and the economic life
of the vehicle is 6 years.
 Annual lease payments (payable in advance on 30 June
each year) are $23,900. This includes $1,900
reimbursement of insurance and maintenance costs paid
by the lessor.
 The lease is cancellable, but will incur a penalty equal to 2
years lease payments.
 The estimated residual value at the end of the lease term
is $15,000 and the guaranteed residual value is $7,500.
 Lessee Ltd intends on returning the asset to Lessor Ltd at
the end of the lease term.
 The interest rate implicit in the lease is 7%.

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Calculating the PV of MLP


Year 0 1 2 3 4

Annual payment 23,900 23,900 23,900 23,900 -

Guaranteed residual value - - - - 7,500

Bargain purchase option - - - - -

Contingent rent - - - - -

Cost reimbursements (1,900) (1,900) (1,900) (1,900) -

Minimum lease payments 22,000 22,000 22,000 22,000 7,500

Discount rate 1.000 0.9346 0.8734 0.8163 0.7629

PVMLP 22,000 20,561 19,215 17,959 5,722

Total PVMLP 85,457

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Classification of the lease


• Is the lease non-cancellable?
• The lease is cancellable, but a significant monetary

1.
penalty will apply – therefore the lease is deemed to be
non-cancellable

• Is ownership to be transferred at end of the lease


term?
• No – Lessee Ltd expects to return the asset
2. • Is there a bargain purchase option in the lease? No

• Does the term of the lease cover a major part of the


asset’s economic life?
• The lease term is for 67% of the economic life of the
3. asset (4/6 years).Unlikely that this would be considered
to be a major part of the asset’s life

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Classification of the lease


• Does the PV of MLP represent substantially the FV
of the asset? (85,457/(89,721 + 1,457)) = 93.7%
• This represents substantially all the FV of the lease
4. asset.

• As soon as one of the tests is passed the asset is a


finance lease. In spite of the mixed signals above, the
lease should be classified as a finance lease as
5. substantially all the risks and rewards of ownership
pass to the lessee

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Accounting for Finance


Leases - Lessees: Example
• Using the facts provided earlier
prepare a schedule summarising the
lease payments to be made over the
1. term of the lease

• Prepare the journal entries in Lessee


Ltd.'s books for the years ended 30
June 2015 and 2016 in relation to the
2. lease

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Accounting for finance


leases - Lessees: Example
MLP Interest Reduction in Balance of
expense liability liability

30/06/15 * Lower of FV ($89,721) and PV of MLP ($85,457) 85,457 *

30/06/15
22,000 -** 22,000 63,457
** Paid annually in advance therefore no interest expense on 30/06/15
30/06/16 22,000 4,442*** 17,558**** 45,899
*** Based on interest rate implicit in lease of 7% ($63,457 x 7%)
30/06/17 22,000 3,213 18,787 27,112

30/06/18
22,000 1,898 20,102 7,010
30/06/19
7,500***** 491 7,010 -
**** $22,000 - $4,442 = $17,558
***** Guaranteed residual paid on last day of lease 23

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Accounting for finance leases


- Lessees: Example
Journal entries for year ended 30 June 2015
Dr Lease Asset 85,457
Cr Lease Liability 85,457
Recognition of the leased asset at lower of FV and PV
of MLP

Dr Lease Liability 22,000


Dr Prepaid executory costs 1,900
Cr Cash 23,900
Payment in advance of first annual lease payment

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Accounting for finance leases -


Lessees: Example
Journal entries for year ended 30 June 2016
Dr Executory costs 1,900
Cr Prepaid executory costs 1,900
Prior year prepayment of executory costs
Dr Lease liability 17,558
Dr Interest expense 4,442 Taken from lease
Dr Prepaid executory costs 1,900 payment schedule

Cr Cash 23,900
Payment of second annual lease payment
Dr Depreciation expense 19,489
Cr Accumulated depreciation 19,489
($85,457 - $7,500 g’teed
Annual depreciation charge rv) = $77,957 / 4 yrs =
$19,489.
Depreciated over lease term as Lessee Ltd intends
on returning the asset at the end of lease

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Accounting for Finance


Leases - Lessors
• Initial Recognition:
• Lessor needs to ‘derecognise’ the asset and record a
lease receivable at an amount equal to the net
1. investment in the lease

• The net investment is calculated as follows:


• (MLP payable by the lessee + any unguaranteed
residual value) discounted using the interest rate implicit
2. in the lease

• Normally equal to the fair value of the asset at inception


of the lease
3.

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Accounting for Finance


Leases - Lessors
• Subsequent measurement:
• Receipts need to be allocated between:
1.

• Reduction of the lease receivable


• Interest revenue earned
2.
• Reimbursement of costs paid on behalf of the
lessee
3. • Receipt of contingent rent

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Accounting for Finance


Leases - Lessors
• Using the facts provided earlier prepare
a schedule summarising the minimum
1. lease receipts over the term of the lease.

• Prepare the journal entries in Lessor


Ltd.'s books for the years ended 30 June
2. 2015 and 2016 in relation to the lease.

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Accounting for Finance Leases


- Lessors
Minimum Interest Reduction in Balance of
lease revenue receivable receivable
receipts
30/06/15 91,178*
30/06/15 22,000** -*** 22,000 69,178
30/06/16 22,000 4,842**** 17,158 52,020
30/06/17 22,000 3,641 18,359 13,661
30/06/18 22,000 2,356 19,644 14,017
30/06/19 15,000***** 983 14,017 -
* FV ($89,721) add IDC ($1,457) = $91,178 Equal to PV of MLP + PV of unguaranteed RV $7,500
** Excludes executory costs
*** Received annually in advance therefore no income at 30/06/11

**** Based on interest rate implicit in lease of 7% ($69,178 x 7%)


***** Total residual value at end of lease (50% guaranteed + 50% unguaranteed)

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Accounting for Finance


Leases - Lessors
Journal entries for year ended 30 June 2015
FV of asset
Dr Lease receivable 91,178
Cr Motor vehicle 89,721
Cr Cash 1,457
Lease of vehicle to Lessee Ltd, including costs of
establishing lease

Dr Cash 23,900
Cr Lease receivable 22,000
Cr Reimbursement in advance 1,900
Receipt of first annual lease payment
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Accounting for Finance Leases -


Lessors
Journal entries for year ended 30 June 2016
Dr Reimbursement in advance 1,900
Cr Cash 1,900
Payment of costs on behalf of lessee
Dr Cash 23,900
Taken
Cr Lease receivable 17,158 from lease
receipts
Cr Interest revenue 4,842 schedule

Cr Reimbursement in advance 1,900


Receipt of second annual lease payment

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Accounting For Finance Leases By


Lessors: Manufacturers Or Dealers
• When manufacturers or dealers offer customers the choice
of either buying or leasing an asset, the lease gives rise to
1. two types of income:

• profit/(loss) equalling outright asset sale (based on sale at


FV)
2. • finance income over lease term

• As well as recording the lease receivable a profit/(loss) on


sale is also recorded at the commencement of the lease
3. • Refer example 10.5 in text

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Accounting For Operating


Leases
• Lessees:
• Lease payments are expensed on a straight line basis
1. over the term of the lease

• Lessors
• Lease receipts are recognised as revenue on a straight
2. line basis over the term of the lease

• Initial direct costs relating to the lease are capitalised as


part of the asset being leased and are expensed over the
lease term
3. • The asset is depreciated by the lessor on the same basis
as for similar assets held by the lessor

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Accounting For Lease


Incentives
• Lessors may offer lease incentives to encourage
lessees to enter into non-cancellable operating
1. leases.

• For example rent-free periods, upfront cash


payments or contributions towards lessee expenses
2. such as fit-out costs

• They are rarely truly free as rental payments are


normally higher than for leases that do not offer
3. incentives.

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Sale & Leaseback Transactions


• Involves the sale of an asset that is then leased back from
the purchaser for all or part of the remaining economic life
1. of the asset

• Used to generate immediate cash flow while retaining asset


use
2. • Creates accounting problems for lessees

• Lease component of the transaction is accounted for in the


same way as normal lease transactions
• The ‘sale’ component transaction differs, depending on
3. whether it is classified as a finance or operating lease

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Future Developments
• IASB and FASB have released an ED on leases
• Converged standard will result in significant
1. changes to current accounting methods

• Key objective is to ensure asset and liabilities


arising from lease contracts are recognised on
2. the balance sheet

• Proposed model will eliminate off balance sheet


accounting and remove the distinction between
3. operating and finance leases

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Lecture 10 Activity

Chapter 10 of the prescribed text:


Question 10.4

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