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Chapter 6 HKAS 17 Leases

1. Objectives

1.1 Explain the nature and classification of leases.

1.2 Demonstrate awareness of the accounting issues concerned with expensing

versus capitalizing for leases.

1.3 Apply the required accounting treatment to operating leases and finance leases

in the financial statements of the lessee customer! and lessor seller!.

1." Descri#e the disclosure requirements under $%A& 1' for #oth lessees !

and lessors!.

1.( Account for sale and lease#ac) transactions.

A c c o u n t i n g f o r a

* i n a n c e + e a s e

A c c o u n t i n g f o r a n

, p e r a t i n g + e a s e

+ e s s e e A c c o u n t i n g

* i n a n c e

+ e a s e s

, p e r a t i n g

+ e a s e s

+ e s s o r A c c o u n t i n g & a l e s

a n d

+ e a s e # a c )

- r a n s a c t i o n s

- y p e s o f A r r a n g e m e n t

. a t u r e a n d D e f i n i t i o n s

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2. Nature and Classificatin f Leases

(A) Nature of leases

2.1 A leasing agreement is essentially ahiring agreement in which ownership of

an asset may never pass to the lessee. -he lessor retains ownership of the asset

#ut conveys the right to the use of the asset to the lessee for an agreed period

of time in return for the payment of specified rentals.

2.2 f the contract includes an option giving the lessee to purchase title to the asset

upon the fulfillment of agreed conditions the transaction is sometimes )nown

as a hire purchase contract.

2.3 +easing has #een growing rapidly as a means of financing the acquisition of

fixed assets where depreciation capital! allowance is availa#le for tax

purpose. easons for entering leasing transaction are4

a! ,ff0#alance sheet financing !

n the past under leasing the asset remains the property of the lessor

and is rented #y the lessee. -he lessee does not record the transaction

in the #alance sheet and therefore the gearing ratio of the lessee

company is not affected.

#! -ax allowances

A company is permitted to deduct some of the cost of the new assets

from the taxa#le profits of the period of acquisition and gain the

#enefit of depreciation allowance during its economic useful life thus

reducing the tax paya#le and improving cash flow.

2." 5y issuing $%A& 1' the standard is trying to4

a! standardize the accounting procedures and reporting disclosure used

where leases are involved which aids the financial statement

compara#ility.

#! prevent off0#alance sheet financing #y requiring that the su#stance oftransactions rather than legal form! is reflected in the financial

statements.

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(B) Classification of leases

(a) Classification

2.( Definitions

a! $%A& 1' defines a leaseas an agreement where#y 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.

!"#$%"#&'(

)*+"#',-./ 01 !

#! Finance lease234! 6 is a lease that transfer substantially all

the risks and rewardsincident to ownership of an asset. -itle may or

may not eventually #e transferred. 567"#&''

89:;?@&'ABCD"#ECD%

"#!

c! Operating lease6 is a lease other than a finance lease. -he lessee

pays rental for the hire of an asset for a period of time which is

normally su#stantially less than its useful economic life. -he lessor

retains most of the risks and rewards of ownership of the asset.

2./ 7nder $%A& 1' for a lease of #oth land #uildings the land and buildings

elements are considered separately for the purpose of lease classification

unlesstitle to both elementsis expected to pass to the lessee by the end of

the lease term.

2.' 8hen the land has an indefinite economic life the land element is classified

as an operating leaseunless title is expected to pass to the lessee #y the end

of the lease term. -he buildings element is classified as a finance oroperating lease in accordance with whether the risks and rewards hae

been substantially transferredto the lessee.

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(b) Risks and rewards of ownership

2.9 is)s and rewards of ownership include4

!isks !ewards

+essee carries out repairs and

maintenance

+essee insures asset

+essee runs the ris) of losses

from idle capacity

+seess runs the ris) of

technological o#solescence

+essee has right to use asset

for most or all of its useful life

:rofita#le operation over the

asset;s economic life

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provides guidance in cases where there may #e dou#t.

n the case of 7ser the lease is almost certainly a finance lease.

+serhas the use of the assetfor the period in which substantially all thebenefits will be deried from the asset.

-he equipment was purchased to 7ser;s detailed specification and from

7ser;s choice of supplier. t is unli)ely that once the asset transfers #ac)

to the lessor the lessor would #e easily a#le to trade it in.

+serhas also agreed tobear almost all of the risks of ownership since

it is expected to #e responsi#le for any damage to the equipment and for

any loss of use arising through #rea)downs. -his indicates that the

leasing company is acting as a finance lender to 7ser rather than as a

lender of one of its own assets.

(c) Minimum lease payments ()

2.1> Definition

a! $inimum lease paymentsis the payments over the lease term that

the lessee is or can #e required to ma)e excluding contingent rent

costs for services and taxes to #e paid #y and reim#ursed to thelessor! together with4

i! in the case of the lessee any amounts guaranteed #y the lessee@

or

ii! in the case of the lessor any residual value guaranteed to the

lessor #y the lessee.

#! Contingent rentF'! is that portion of the lease payments that

is not fixed in amount #ut is #ased on a factor other than ust the

passage of time for example percentage of sales amount of usage

price indices mar)et rates of interest!.

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2.11 -o decide whether there is a presumption of transfer of ris)s and rewards of

ownership it is necessary to consider the following4

*tep Comments1. ?alculate minimum lease

payments B+:s! inclusive of

initial payment

B+:s C minimum payment plus any

residual amounts guaranteed #y the

lessee

2. Discount 1! to determine

present value of B+:s

Discount factor is either4

i! rate of interest implicit in the lease

if )nown!@ or

ii! a commercial rate of interest for a

similar lease!3. ?alculate fair value of the asset

at #eginning of lease

*air value C arm;s length price !

". t is a finance lease if the present

value of B+:s is equal to

su#stantially all the fair value

,-. or more of (/)!

2.12 "#A$%&" 0 1 $&%A manufacturing company has #een analyzing proposals for the lease or

purchase of a maor acquisition of new equipment. -he lease proposal was

considered to #e more relia#le. -he following information is relevant4

i! -he proposed lease agreement involves an equipment that has a fair

value of />>>>>.

ii! -he lease period is for four year from 1 anuary 2>>9 with a rental of

2>>>>> per annum paya#le on the 31 Decem#er each year from 31

Decem#er 2>>9.iii! -he lessee guarantees a 2>>>> residual value on 31 Decem#er 2>11.

iv! -he lessee is required to pay all repair maintenance and insurance costs

as they arise.

v! -he interest rate implicit in the lease is 1(F per annum.

*olution

-o clarify the transaction we have4

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i! Binimum lease payments C " x 2>>>>> G 2>>>> C 92>>>>

ii! :resent value of minimum lease payments

2>>>>> x 2.9((H G 2>>>> x "F!1(11

+C (92"3(

H *rom annuity ta#les 6 present value of four annual sums at 1(F

interest rate per annum is 2.9((

iii! *air value of assets is />>>>>

At present value of the minimum lease payments (92"3(! is su#stantialequal to all the fair value of the asset />>>>>! #eing ='.1F of the fair

value the transaction is a Ifinance leaseJ since it can #e concluded that

su#stantially all the ris)s and rewards incident to ownership of the asset has

#een transferred to the lessee.

(d) Indicators

2.13 *een 2ndicators of Finance &ease

i! ownershipis transferred to the lesseeat the end of the lease@

ii! the lesseehas the option to purchase the asset at a bargain price

and it seems li)ely that at the inception of the lease this option will

#e exercised@

iii! the lease term is for the ma3or part of the useful lifeof the asset@ and

at the inception of the lease the present value of the minimum lease

payments is greater than or equal to su#stantially all of the fair value

of the leased asset@ 4G43HIJK:LMN

OK:LPQR4G4STU43HIJ

75%7!

iv! if the lessee can cancel the lease any losses associated with the

cancellation areborne by the lessee@

v! gains or lossesfrom the fluctuation in the fair alueof the residual

fall to the lesseee.g. in the form of a rent re#ate equaling most of the

sales proceeds at the end of the lease!@

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vi! the lessee has the a#ility to continue the lease for a secondary

periodat a rent which is substantially lower than market rent@ and

vii! the leased assets are of a specialised nature W X ! such thatonly the lessee can use them without maor modifications #eing made.

2.1" "#"!C2*" '

A company has entered into a four year lease for a machine with lease rentals

of 1(>>>> paya#le annually in advance and with an optional secondary

period of three years at rentals of 9>F />F and ">F of the annual rental

in the primary period. t is agreed that these rentals represent a fair

commercial rate. -he machine has a useful life of eight years and a cash

value of />>>>>.

!euired

?onsider whether this lease agreement is a finance lease or an operating leaseK

*olution

(e) Initial direct costs

2.1( +essors should include initial direct costs e.g. legal fee! incurred in

negotiating a lease in the initial measurement of finance lease receiva#les.

-hey are therefore spread oer the lease termon the same #asis as the lease

income.

2.1/ -his treatment does not apply to manufacturer or dealer lessors where such

costrecognition is as an e4pensewhen the selling profit is recognized.

2.1' Any initial direct costs of the lessee in a finance lease are added to the

amount recogni5ed as an asset.

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!. Accuntin" #reat$ent fr %inance Lease

(A) 2n lessee6s book

(a) Initial entries

3.1 $%A& 1' requires that finance leases must #e capitali5ed. A finance lease

should #e shown in the lessee;s #alance sheet #oth as an asset and as a

lia#ility. At the start of the lease4

i! the leased asset should #e included as a non0current asset su#ect to

depreciation@

ii! the o#ligation to pay rentals should #e included as a lia#ility.

3.2 At the inception of the lease the amounts will eual the lower of4

i! the fair alueof the leased property@ and

ii! the present alue of the minimum lease payments.

3.3 $owever in practice the fair alueof the asset or its cash price will usually

be the recorded amount rather than the present value of the minimum lease

payments.

(b) Depreciation

3." f there is reasona#le certainty that the lessee will o#tain ownership #y the end

of the lease term the period of expected use is the useful life of the asset.

3.( ,therwise the related non0current asset should #e depreciated oer the

shorter of4

i! the economic useful lifeof the asset@ and

ii! the lease term.

+ e a s e - e r m 7 s e f u l

E c o n o m i c + i f e

- h e & h o r t o f

3./ -he lease term is essentially the period over which the lessee is li)ely to have

use of the asset. t includes4

i! the primarynon0cancella#le! period@ plus

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ii! any secondary periodsduring which the lessee has the contractual

right to continue to use the asset provided that it is reasona#ly certain

at the outset that this right will #e exercised.

(c) Allocation of finance charge

3.' ,ver the period of the lease the total finance charge is the amount #y which

the rentals paid to the lessor exceed the initial recorded amount.

3.9 Each individual rental paymentshould #e split#etween4

i! finance charge income statement item!@ and

ii! repayment of o#ligation to pay rentals thus reducing the statement of

financial position lia#ility!.

3.= -here are two main methods to allocate the finance charges over the term of

the lease4

i! actuarial method !@

ii! sum of the digits rule of '9! method !@

,f the a#ove methods the actuarial method gives the most accurate result.

A c t u r i a l m e t h o d t h i s u s e s t h e

i n t e r e s t r a t e i m p l i c i t i n t h e l e a s e !

& u m o f t h e d i g i t s t h i s c a n # e a n

e f f e c t i v e a p p r o x i m a t i o n t o t h e

a c t u r i a l m e t h o d !

. o t e t h a t s t r a i g h t l i n e r e c o g n i t i o n

i s g e n e r a l l y n o t a c c e p t a # l e

7 s e

3.1> "#"!C2*" 0 7 AC8+A!2A& $"89OD

East +imited entered into a lease agreement with 8est +imited on 1 anuary

2>11 to lease office machinery. -he cash price for the machinery on 1 anuary

2>11 is 1>>>>. 7nder the lease agreement East +imited was required to

ma)e an initial deposit of 3==9 with the #alance #eing settled in 3 equal

installments of 2(>> paya#le on the last day of each year starting from 2>>".

-he imputed interest rate on the lease was 12F per annum. -he useful

economic life of the machinery was estimated to #e " years.

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!euired

a! Descri#e the criteria under $%A& 1' I+easesJ for classifying a lease aseither a finance lease or an operating lease. 3 mar)s!

#! +ist the indicators which would normally lead to a lease #eing classified

as a finance lease. ' mar)s!

c! &how the #rea)down #etween interest and capital throughout the lease

period using the actuarial method. ( mar)s!

d! :repare the ournal entries for the lease in East +imited;s #oo) from 2>11

to 2>12. ' mar)s!

e! :repare the statement of financial position extracts relating to the lease as

at 31 Decem#er 2>11 for East +imited. 3 mar)s!

-otal 2( mar)s!

*olution

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3.11 "#"!C2*" / 7 *+$ OF D2:28 $"89OD

,n 1 une 2>11 +emon +imited entered into a lease contract to lease

Equipment L from 5lue#erry +imited for a term of four years which is the

whole economic useful life of the equipment. -his is a non0cancela#le lease

contract and the fair value of Equipment L at the inception of lease 1 une

2>11! is 1'"3"> which equals to the present value of minimum lease

payments. -he lease term commences at 1 une 2>11.

-he implicit interest rate of the lease is 1>F per annum. Annual payment is(>>>> paya#le at 1 une of each year from 2>11 to 2>1".

!euired

a! n accordance with $%A& 1' I+easesJ determine whether the a#ove

type of lease is a finance lease or operating lease. :rovide -$EE

indicators that individually or in com#ination support your conclusion.

( mar)s!

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#! :repare the payment schedule using the actuarial methodto allocate the

finance charges. ound all figures to the nearest dollar and adust any

rounding difference in finance charges for the year ending 3> Bay 2>1".

1> mar)s!c! :repare the payment schedule using the sum1of1the1digits method to

allocate the finance charges. ound all figures to the nearest dollars.

1> mar)s!

-otal 2( mar)s!

*olution

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(d) Disclosure requirements by lessee

3.12 n the statement of financial position the transaction should #e recorded as

follows4

a! Assets6 show #y each maor class of asset the net carrying amounts of

assets held under finance leases@

#! Obligations6 the amount should #e disclosed separately from other

lia#ilities on the face of the statement of financial position or in a note

and o#ligations under finance leases should #e analysed into4

i! amount paya#le in the ne4t year@

ii! amount paya#le in the second to fifth yearsinclusive from the

statement of financial position date@ and

iii! the aggregate amounts paya#le thereafter.

3.13 n the statement of comprehensie income the total finance chargesfor the

period and depreciationfor each maor class of asset for finance leases are

reported.

3.1" "#A$%&" / 7 D2*C&O*+!"

*rom Exercise 3 extract from the financial statements would #e4

2ncome statement for the year ended /' $ay 0-'0

Depreciation 1'"3"> M "! "3(9(

*inance costs 12"3"

*tatement of financial position as at /' may 0-'0

Non1current assets

+eased equipment net #oo) value! 1'"3"> 6 "3(9(! 13>'((

Current liabilities

,#ligations under finance lease (>>>>

Non1current liabilities

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,#ligations under finance leases 9/''"

(B) 2n lessor6s book

3.1( -he accounting treatment for a finance lease in the #oo)s of a lessor is in

principle the mirror opposite of the entries for the lessee6s books . -he

finance lease since in su#stance #eing the sale of asset is recognized #y the

lessor as a lease receiva#le due from the lessee!.

3.1/ Definitions

a! :ross inestment in the leaseis the aggregate of the minimum lease

payments receiva#le #y the lessor under a finance lease and any

unguaranteed residual value accruing to the lessor.

#! Net inestment in the lease is the gross investment in the lease

discounted at the interest rate implicit in the lease.

c! +nearned finance income is the difference #etween the gross

investment in the lease and the net investment in the lease.

3.1' "#A$%&" ;

+essor +td acquired a plant costing "">>>> on 1 anuary 2>11 which was

immediately leased under a finance lease agreement to +essee +td for a period

of five years at an annual rental of 1>>>>> receiva#le on the first day of

each year starting 1 anuary 2>11. -he residual value of the plant guaranteed

#y +essee +td at the end of the lease term is 1>>>>. -he constant periodic

rate of return on the net investment #asis is 1>F.

:resent value ta#le

Near Discount factor 1>F!

1 >.=>=1

2 >.92/"

3 >.'(13

" >./93>

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( >./2>=

>>>> x ( G 1>>>>

C (1>>>>

et investment in the lease

C 1>>>>> x 1.>>>> G >.=>=1 G >.92/" G >.'(13 G >./93>! G 1>>>> x

>./2>=

C "2319=

7nearned finance income

C (1>>>> 6 "2319=

C 9/911

-he opening and closing net investments in the lease for each of the years

2>11 to 2>1( are shown in the lease amortization schedule as follows4

Near ,pening

#alance

ental

received

&u#0total *inance

income

?losing

#alance

2>11 "2319= 1>>>>>! 32319= 3231= 3(((>9

2>12 3(((>9 1>>>>>! 2(((>9 2(((1 291>(=

2>13 291>(= 1>>>>>! 191>(= 191>/ 1==1/(

2>1" 1==1/( 1>>>>>! ==1/( ==1' 1>=>92

2>1( 1>=>92 1>>>>>! =>92 =19H 1>>>>

(>>>>>! 9/911

H 5alancing figures 1>>>> 6 =>92 C =19

ote4 -here will #e a net investment in the lease of 1>>>> at the end of the

lease which is the residual value of the plant under the lease.

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c! Any difference between amounts charged and amounts paid

should #e ad3usted to prepayments or accruals.

d! Any incentiesgiven #y the lessor should also #e recogni5ed oer

the life of the lease on a straight line basis. -ypical incentivesinclude rent1free periods or contri#utions #y the lessor to the

lessee;s relocation costs.

".2 "#A$%&" >

O8L +td is the lessor of plant which it acquired at a cost of ">>>>> on 1

anuary 2>11. -his plant which has an estimated life of 1> years with no

residual value was leased on that same day for an initial period of five years to

&- +td at an annual rental of />>>>.

*olution

O8L +td records the following ournal entries on 1 anuary 2>11 as follows4

1 anuary 2>11 Dr ! ?r !

,perating lease rental expense />>>>

?ash />>>>

-o record the payment of operating lease rentals.

Extract from statement of comprehensive income for the year ended 31

Decem#er 2>11

,perating lease rentals />>>>

".3 "#"!C2*" ;

5oro plc has moved into new premises. -he premises are on a ten0year

operating lease at a rent of 1m per annum paya#le in advance on 1 anuary

each year. -he landlord was )een to rent out the property and so 5oro has

#een given 2>>>>> up front to cover relocation costs and the first year;s rent

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has #een waived.

!euired

a! ?alculate the annual rent that will #e charged to the income statement.

#! ?alculate the accrualsMprepayments that will appear in the statement of

financial position at the end of each year of the lease.

c! :repare the disclosure notes as at the end of Near 1.

*olution

(B) 2n lessor6s book

"." =ey %oints

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a! Assets held for use in operating leases should #e treated as non1

current assets and depreciated accordingly. !entals should #e

recogni5ed on a straight line basisover the period of the lease unless

a prefera#le alternative #asis exists.#! n the statement of financial position gross assets held for operating

leases analysed #y maor class of asset together with the related

accumulated depreciation need to #e disclosed.

c! Any difference between amounts charged and amounts paid

should #e ad3usted to receiables or deferred income.

d! -he initial direct costsof the lease may #e spread oer the life of

the lease or chargedwhen incurred.

e! n the notes to the statement of financial position the future minimumlease payments under non0cancella#le operating leases analysed

among those expiring in the next year in two to five years and in

more than five years.

f! n the income statement rentals receiable from operating leases

should #e reported.

".( "#A$%&" ?

+essor +td had purchased equipment for 9>>>>> on 1 anuary 2>11 whichwas immediately leased under an operating lease agreement to +essee +td at

an annual rental of 1(>>>> receiva#le on the first day of each year starting

1 anuary 2>11. -he lease terms is for four years and the equipment is

estimated to have a useful life of eight years with no residual value.

+essor +td records the following ournal entries on 1 anuary of each of the

years 2>11 to 2>1" as follows4

Dr ! ?r !

?ash 1(>>>>

,perating lease rental income 1(>>>>

-o record the receipt of operating lease rentals.

+essor +td records the effect of the operating leasing transaction in its 2>11

financial statements as follows4

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(.1 *ale and &easeback

A sale and lease#ac) transaction ta)es place when an owner sells an asset

and immediately reacuires the right to use the asset by entering into a

lease with the purchaser. A common example is a company selling the title

to its officeM factory to a financial institution.

(.2 5efore dealing with the accounting for the sale and lease#ac) transaction

itself the carrying alue of the assetin question should #e reiewed. f the

asset has suffered an impairment in alue#elow its carrying amount it should

#e written down immediately to its fair alue.

(.3 -he subseuent stepwill depend on whether the leasebackis an operating

lease or a finance lease. f the asset is land and #uildings then it is li)ely to #e

an operating lease.

(A) Operating lease

(." *ale and &easeback 7 Operating &ease

f the leaseback is an operating lease the seller0lessee has disposed of

substantially all the risks and rewardsof ownership of the asset and so hasreali5ed a profit or loss on the disposal.

(.( :rovided that the transaction is established at fair alue the profit or loss

should #e recogni5ed immediately.

(a) Proceeds above fair value

(./ $owever it is possi#le that a sale and lease#ac) transaction can #e arranged atother than fair value. f the price is aboefair value the e4cess will not be

genuine profit #ut will arise solely #ecause the operating lease rentals

paya#le in the ensuring years will also #e at a#ove fair value.

(.' =ey %oint

$%A& 1' therefore provides that the e4cess of sale price oer fair alue

should not #e recogni5ed as profit in the year#ut should #e credited to

income oer the periodfor which the asset is e4pected to be used so as to

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reduce the rentals paya#le to a level consistent with the fair value of the

asset.

(.9 "#A$%&" @ 7 8he sale price is aboe fair alue

Ash +td sells its freehold office premises and leases them #ac) on a twenty0

year operating lease. -he sale too) place on 1 anuary 2>11 and the company

has a 31 Decem#er year end.

-he details of the scheme are as follows4

:roceeds of sale 1>>>>>>>

*air value of the asset at the time of sale =>>>>>>

et #oo) value at the time of sale 3(>>>>>

+ease payments "9>>>>

Bar)et rate for similar premises "1>>>>

n this example it is clear that the lessor is recouping the excess proceeds

through an a#ove mar)et rent. -his is common in practice. $owever the

accounting treatment set out #elow will #e followed even if the rents are at

mar)et rate.

!euired

a! ?alculate the profit on disposal that Ash +td should claim in 2>11.

#! ?alculate the annual rental that Ash +td will charge in its statement of

comprehensive income.

c! :repare all relevant extracts from Ash +td;s statement of comprehensive

income and statement of financial position for the year ended 31

Decem#er 2>11.

*olution

a! Ash +td can only claim a profit on disposal #ased upon the fair value of

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the asset. -his will give a profit on disposal of ((>>>>> =>>>>>>

fair value less 3(>>>>> 5O!

#! -he 1m difference #etween the proceeds and the fair value will #e

credited to deferred income and released over the life of the lease on astraight line #asis. -he annual release will #e (>>>> 1m M 2> years!.

-his reduces the rent charged to "3>>>>.

c! &tatement of comprehensive income for 2>11

:rofit on disposal ((>>>>> ?r

,perating lease rentals "9>>>> Dr

+ess4 release of deferred income (>>>> ?r "3>>>> Dr

d! &tatement of financial position as at 31 Decem#er 2>11

:rovision for deferred income 5rought forward 0

Arising during the year 1>>>>>>

eleased to the income

statement

(>>>>!

?arried down =(>>>>

=>>>>> of this provision is non0current.

(b) Proceeds below fair value

(.= =ey %oint

f a loss on disposal arises #ecause the proceeds are less than the fair value of

the asset then the loss can only be deferredif the future operating lease

rentals are also at below the market rate. -his is #ecause deferring a lossgives rise to an asset in the statement of financial position and assets can

only #e recognized if there are future economic #enefits. -he economic

#enefits that will ustify deferring this loss are reduced rentals.

(.1> "#A$%&" , 7 8he sale price is below fair alue

,n 1 anuary 2>11 ?rash +td sold its freehold office premises and leased them

#ac) on a 2>0year operating lease. -he details of the scheme are as follows4

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:roceeds of sale 9>>>>>>

*air value of the asset at the time of sale 1(>>>>>>

et #oo) value at the time of sale 12>>>>>>

Annual operating lease rentals on a 2>0year lease! /(>>>>

!euired

:repare all relevant extracts from ?rash +td;s statement of comprehensive

income and statement of financial position for the year ended 31 Decem#er

2>11 assuming4

a! the future rentals are at mar)et rate@ and

#! the future rentals are at #elow mar)et rate and that the reduced rate will

fully compensate ?rash for the loss suffered on disposal.

*olution

a! *uture rentals at mar)et rate

f the rentals are at mar)et rate or a#ove! then there are no future

#enefits to offset the loss on disposal and so the loss must #e recognized

immediately.

&tatement of comprehensive income for the year ending 31 Decem#er

2>11

+oss on disposal 9m proceeds less 12m

5O

">>>>>> Dr

,perating lease rentals Amount paid /(>>>> Dr

-here will #e no asset carried forward in the statement of financial

position.

#! *uture rentals at #elow mar)et rate

f the rentals are #elow mar)et rate then the loss on disposal will give

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rise to the future #enefits of cheap #enefits. n this case the loss can #e

deferred and amortised over the life of the lease.

&tatement of comprehensive income for the year ending 31 Decem#er 2>11

+oss on disposal 6 Deferred il

,perating lease rentals

Amount paid /(>>>>

:lus4 amortisation of deferred loss

"mM2> years! 2>>>>>

Amount charged to the income statement 9(>>>>

&tatement of financial position as at 31 Decem#er 2>>9

Assets

Deferred loss on disposal

5rought forward 0

Arising during the year ">>>>>>

Amortised 2>>>>>!

?arried down 39>>>>>

(.11 t would #e wise to do regular impairment reviews on such assets #ecause

changes in mar)et rentals andMor interest rates could easily impair the #enefit

of the reduced rent.

(.12 f the proceeds are less than the fair alue and the fair alue is less than

the net book alue then only the difference between the proceeds and the

fair alue can be deferred. -he difference between the fair alue and the

net book alue must be recogni5ed as a loss immediately.(.13 *or example if a #uilding with a carrying value of =m and a fair value of

'm was sold for "m then a loss of 2m would #e recognized on disposal

and the 3m difference #etween the proceeds and the fair value would #e

deferred.

(B) Finance lease

(.1" =ey %oint

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years.

-here are five annual lease payments of 2''">= each commencing on 31

Decem#er 2>11. -he implicit rate of interest is 12F.

!euired

a! :repare relevant extracts from +ash +td;s statement of financial position

immediately after the sale on 1 anuary 2>11.

#! :repare relevant extracts from +ash +td;s statement of comprehensive

income and closing statement of financial position for the year ending 31

Decem#er 2>11.

*olution

a! -he statement of financial position on 1 anuary 2>11 will show the

original asset at its net #oo) value. -here will also #e the asset on 1m

cash and its related lia#ility.

&tatement of financial position as at 1 anuary 2>11

Bachinery ?ost 1(>>>>>

Depreciation '(>>>>!

et #oo) value '(>>>>

?urrent assets ?ash 1>>>>>>

+ia#ilities ,#ligations under finance leases?urrent 1('">=

on0current 9"2(=1

1>>>>>>

#! -he income statement will show the annual depreciation charge #ased

upon original cost and the finance charge on the lease. -here will no

recognition of the sale or of its related profit.

&tatement of comprehensive income for the year ending 31 Decem#er 2>11

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Depreciation charge 1(>>>>> M 1> years 1(>>>>

*inance charge 1>>>>>> P 12F 12>>>>

&tatement of financial position as at 31 Decem#er 2>11

Bachinery ?ost 1(>>>>>

Depreciation =>>>>>!

5O />>>>>

+ia#ilities ,#ligations under finance leases

?urrent 1'/2=9

on0current ///2=3

9"2(=1

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uestion /

5owtoc) has leased an item of plant under the following terms4

1. ?ommencement of the lease was 1 anuary 2>11

2. -erm of lease ( years

3. Annual payments in advance 12>>>

". ?ash price and fair value of the asset 6 (2>>> at 1 anuary 2>11 6 equivalent

to the present value of the minimum lease payments.

(. mplicit interest rate within the lease as supplied #y the lessor! 9F per annum

to #e apportioned on a time #asis where relevant!.

/. -he companyQs depreciation policy for this type of plant is 2>F per annum on

cost apportioned on a time #asis where relevant!.

!euired

:repare extracts of the income statement and statement of financial position for

5owtoc) for the year to 3> &eptem#er 2>12 for the a#ove lease. ( mar)s!

A??A 2.( *inancial eporting Decem#er 2>>3 S(#!

uestion ;

Bass +td. leased #rand new equipment to Bachinery +td. on 1 anuary 2>>9.

Bachinery +td. has to pay annual rental of 1"(>>> commencing 1 anuary 2>>9.

-his is a four year lease with the last rental payment falling on 1 anuary 2>11. At the

end of the lease term Bachinery +td. has the option of purchasing the leased

equipment for 1>>>> and it is most pro#a#le that Bachinery +td. will exercise this

option.

Bachinery +td. will guarantee Bass +td. a residual value of 9>>>>. *urther

Bachinery +td. is required to pay all repair and maintenance expenses as well as the

insurance cost of the equipment.

-he equipment has an expected useful life of ( years. f machinery +td. were to #uy

the equipment directly from the mar)et the cash price is (9>>>>.

-he mar)et #orrowing rate at the inception of the lease is 12F.

:resent value ta#le4

Nears Discount factor

12F

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1 >.9=2=

2 >.'='2

3 >.'119

" >./3((

!euired

a! IA lease is classified as a finance lease if it transfers su#stantially all the ris)s

and rewards incidental to ownership. A lease is classified as an operating lease

if it does not transfer su#stantially all the ris)s and rewards incidental to

ownership.J

Explain the nature of Iris)sJ and IrewardsJ in the a#ove context. " mar)s!

#! Explain and determine whether the a#ove lease is a finance lease or an

operating lease. " mar)s!

c! Assume that the lease is a finance lease prepare ournal entries including

narratives! that are required to #e entered into the #oo)s of Bachinery +td. for

the financial year ended 31 Decem#er 2>>9. ' mar)s!

d! :repare extracts of statements of comprehensive income and statements of

financial position to report the a#ove lease for Bachinery +td. and Bass +td.

respectively for financial year ended 31 Decem#er 2>>9. ' mar)s!

e! ,ne of the main o#ectives of $%A& 1' I+easesJ is to for#id a company from

reporting a finance lease as an operating lease in the financial statement.

Explain why a company might wish to report a finance lease as an operating

leaseK 3 mar)s!

-otal 2( mar)s!

$%AA- :aper ' *inancial Accounting Decem#er 2>>= ?2!

uestion