Deegan5e Sm Ch11

8/20/2019 Deegan5e Sm Ch11

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Chapter 11

Accounting for leases

11.1 Within AASB 117 a lease is defined as:

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

11.2 We should capitalise a lease transaction meaning that the leased asset and lease liability will be placed on the balance sheet! when substantially all the ris"s and rewards of ownership passto the lessee# and the lease payments are deemed to be material. AASB 117 describes theris"s and rewards of ownership as follows:

$is"s include the possibilities of losses from idle capacity or technologicalobsolescence and of variations in return because of changing economic conditions.$ewards may be represented by the e%pectation of profitable operation over the

asset&s economic life and of gain from appreciation in value or realisation of a residualvalue.

AASB 117 dedicates a number of paragraphs paragraphs 1' to 12! to assist in determiningwhether a lease is a finance lease or an operating lease. A finance lease is to be capitalised.(hese paragraphs state:

1'. Whether a lease is a finance lease or an operating lease depends on the substance ofthe transaction rather than the form of the contract. )%amples of situations thatindividually or in combination would normally lead to a lease being classified as afinance lease are:

a! the lease transfers ownership of the asset to the lessee by the end of the leaseterm*

b! the lessee has the option to purchase the asset at a price that is e%pected to besufficiently lower than the fair value at the date the option becomes e%ercisablefor it to be reasonably certain# at the inception of the lease# that the option will bee%ercised*

c! the lease term is for the ma+or part of the economic life of the asset even if title isnot transferred*

d! at the inception of the lease the present value of the minimum lease paymentsamounts to at least substantially all of the fair value of the leased asset* and

e! the leased assets are of such a specialised nature that only the lessee can use themwithout ma+or modifications.

11. ,ndicators of situations that individually or in combination could also lead to a lease being classified as a finance lease are:a! if the lessee can cancel the lease# the lessor&s losses associated with the

cancellation are borne by the lessee*b! gains or losses from the fluctuation in the fair value of the residual accrue to the

lessee for e%ample# in the form of a rent rebate e-ualling most of the sales proceeds at the end of the lease!* and

c! the lessee has the ability to continue the lease for a secondary period at a rent thatis substantially lower than mar"et rent.

Solutions anual t/a Australian Financial Accounting 0/e by raig eegan 1131


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12. (he e%amples and indicators in paragraphs 1' and 11 are not always conclusive. ,f itis clear from other features of the lease that the lease does not transfer substantially allris"s and rewards incidental to ownership# the lease is classified as an operating lease.4or e%ample# this may be the case if ownership of the asset transfers at the end of thelease for a variable payment e-ual to its then fair value# or if there are contingent

rents# as a result of which the lessee does not have substantially all such ris"s andrewards.

11.5 ,f the lease is considered to be a finance lease also referred to as a capital lease or a financiallease!# the amount to be initially capitalised by the lessee for the asset and liability is the fair value of the leased property# or if lower# the present value of the minimum lease payments asdetermined at the inception of the lease.

inimum lease payments are defined at paragraph 6 of AASB 117 as:

(he payments over the lease term that the lessee is or can be re-uired to ma"e#e%cluding contingent rent# costs for services and ta%es to be paid by and reimbursed to

the lessor# together with:a! for a lessee# any amounts guaranteed by the lessee or by a party related to the

lessee* or

b! for a lessor# any residual value guaranteed to the lessor by:

i! the lessee*

ii! a party related to the lessee* or

iii! a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee.

owever# if the lessee has an option to purchase the asset at a price that is e%pectedto be sufficiently lower than the fair value at the date the option becomes e%ercisablefor it to be reasonably certain# at the inception of the lease# that the option will bee%ercised# the minimum lease payments comprise the minimum payments payable over the lease term to the e%pected date of e%ercise of this purchase option and the

payment re-uired to e%ercise it.

As the last part of the above re-uirement indicates# for a lessee# the minimum lease paymentsinclude any bargain purchase option# even though the lessee might not be contractuallyobliged to e%ercise the option to buy the asset.

(he discount rate to be used in computing the present value of the minimum lease paymentsand hence# the amount to be included in the balance sheet for the leased asset and leaseliability if the present value of the minimum lease payments is less than the fair value of theasset at the inception of the lease! is the interest rate implicit in the lease. (he interest rateimplicit in the lease is the discount rate that# when applied to the 8minimum lease payments&and the 8unguaranteed residual value& accruing to the lessor if any!# causes the aggregate

present value to be e-ual to the fair value of the leased asset and any initial direct costs to thelessor. ,f it is not practicable to determine the interest rate implicit in the lease# the lessee&sincremental borrowing rate shall be used.

11.6 4re-uently# a lessee would prefer to treat a lease as an operating lease# rather than a financelease. ,f the lease is treated as a finance lease then both the leased asset and the lease liabilitymust appear on the balance sheet at the fair value of the leased asset# or if less# at an amount

e-ual to the present value of the minimum lease payments!. (his would have the effect of adversely affecting gearing ratios# such as the debt9to9asset ratio.



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,f a lessee was sub+ect to a debt contract which had debt to asset constraints# and theseconstraints were becoming binding# then lessees may be particularly opposed to treating alease as a finance lease. (he treatment of leases in debenture trust deeds can be -uite harsh.As Whittred and immer 1;;2# p. 2f course# they may in fact be the same. =evertheless# it is the lease term# not the life of the asset# which is the basis for recognition of the gain or loss.

(here would not appear to be anything which e%plicitly prohibits )astern =itrogen fromdisclosing the unamortised balance of the deferred gain as a deduction from the gross cost of

plant and e-uipment.

11.< ,n relation to the lessor# paragraph 5< of AASB 117 states:

?essors shall recognise assets under a finance lease in their balance sheets and presentthem as a receivable at an amount e-ual to the net investment in the lease.

=et investment in the lease is defined in AASB 117 as 8the gross investment in the leasediscounted at the interest rate implicit in the lease&. @ross investment in the lease is defined asthe aggregate of:

a! the minimum lease payments receivable by the lessor under a finance lease*and

b! any unguaranteed residual value accruing to the lessor.

,n relation to the lessee# paragraph 2' of AASB 117 states:

At the commencement of the lease term# lessees shall recognise finance leases as

assets and liabilities in their balance sheets at amounts e-ual to the fair value of the



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leased property or# if lower# the present value of the minimum lease payments# eachdetermined at the inception of the lease.

inimum lease payments are defined at paragraph 6 of AASB 117 as:

(he payments over the lease term that the lessee is or can be re-uired to ma"e#

e%cluding contingent rent# costs for services and ta%es to be paid by and reimbursed tothe lessor# together with:

a! for a lessee# any amounts guaranteed by the lessee or by a party related to thelessee* or


i! the lessee*

ii! a party related to the lessee* or




inimum lease payments# from the perspective of the lessee# e%clude any unguaranteedresidual unless there is a bargain purchase option!. (herefore# where there is anunguaranteed residual# the lease receivable will be recorded at a higher amount in the boo"sof the lessor than the lease payable in the boo"s of the lessee.

11.7 inimum lease payments have been defined in the answers to some of the earlier -uestions.inimum lease payments are defined at paragraph 6 of AASB 117 as:

(he payments over the lease term that the lessee is or can be re-uired to ma"e#e%cluding contingent rent# costs for services and ta%es to be paid by and reimbursed tothe lessor# together with:

a! for a lessee# any amounts guaranteed by the lessee or by a party related to thelessee* or


i! the lessee*ii! a party related to the lessee* or






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11. a! 4irstly# to be classified as a finance lease# the lease must be such that it transfers theris"s and rewards of ownership to the lessee. As already indicated in the answers to

previous -uestions# AASB 117 dedicates a number of paragraphs paragraphs 1' to12! to assist in determining whether a lease is a finance lease or an operating lease. Aswe "now# a finance lease is to be capitalised# whereas an operating lease is not

capitalised. (hese paragraphs state:

1'. Whether a lease is a finance lease or an operating lease depends on the substanceof the transaction rather than the form of the contract. )%amples of situations thatindividually or in combination would normally lead to a lease being classified as afinance lease are:

a! the lease transfers ownership of the asset to the lessee by the end of the leaseterm*

b! the lessee has the option to purchase the asset at a price that is e%pected to besufficiently lower than the fair value at the date the option becomes e%ercisablefor it to be reasonably certain# at the inception of the lease# that the option will be

e%ercised*

c! the lease term is for the ma+or part of the economic life of the asset even if title isnot transferred*

d! at the inception of the lease the present value of the minimum lease paymentsamounts to at least substantially all of the fair value of the leased asset* and

e! the leased assets are of such a specialised nature that only the lessee can use themwithout ma+or modifications.

11. ,ndicators of situations that individually or in combination could also lead to alease being classified as a finance lease are:

a! if the lessee can cancel the lease# the lessor&s losses associated with thecancellation are borne by the lessee*

b! gains or losses from the fluctuation in the fair value of the residual accrue to thelessee for e%ample# in the form of a rent rebate e-ualling most of the sales

proceeds at the end of the lease!* andc! the lessee has the ability to continue the lease for a secondary period at a rent that

is substantially lower than mar"et rent.

12. (he e%amples and indicators in paragraphs 1' and 11 are not always conclusive.,f it is clear from other features of the lease that the lease does not transfersubstantially all ris"s and rewards incidental to ownership# the lease is classifiedas an operating lease. 4or e%ample# this may be the case if ownership of the assettransfers at the end of the lease for a variable payment e-ual to its then fair value#or if there are contingent rents# as a result of which the lessee does not havesubstantially all such ris"s and rewards.

=ow turning our attention to part a! of the -uestion# given the guidance in paragraph1' above# the lease would not be deemed to be a finance lease. (he lease term is fiveyears and the asset has a useful life of eight years. As such# the lease would not beconsidered to cover 8the ma+or part of the economic life of the asset& as a rule of thumb# a ma+or part should constitute at least 70 per cent of the useful life of theasset!. (he period covered by the option would not be included in the lease term as

the lease rental is not low enough to give reasonable assurance of renewal that is# it is



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not below normal commercial rates!. We cannot anticipate the mar"et rentals in fiveyears time with any accuracy.

(he present value of minimum lease payments is ' per cent of the fair value of theleased property. )ighty per cent would not be construed as 8at least substantially all of the fair value of the leased asset& a rule of thumb might be that the present value of

the minimum lease payments should constitute at least ;' per cent of the fair value of the leased asset at the inception of the lease!. ence# given the lease term and the

present value of the minimum lease payments do not satisfy the guidelines provided in paragraph 1' above# the lease is not considered to transfer the ris"s and rewards of ownership. 4rom the perspective of the lessee# the term 8guaranteed residual& does notinclude amounts guaranteed by a third party unrelated to the lessee although it caninclude amounts guaranteed by related entities!. ence# from the perspective of thelessee# the lease would be an operating lease.

4rom the perspective of the lessor# the minimum lease payments include a residualguaranteed by a third party unrelated to the lessor that is financially capable of

discharging the obligations under the guarantee contrast this with the lessee whereinthe guarantee by an unrelated third party is e%cluded from minimum lease payments!.With the inclusion of the guaranteed residual in the minimum lease payments to thelessor# and given that at the time of the inception of the lease the present value of theminimum lease payments amounts to at least substantially all of the fair value of theleased asset# the lessor would classify the lease as a finance lease.

b! ,n this case# the present value of the minimum lease payments includes the lease payments plus 0' of the residual from definitions of 8minimum lease payments& and8guaranteed residual value&!.

(his amounts to 7.0 calculated as '.70 C '.0 % '.20! of the fair value of theleased asset at the beginning of the leased term. Drima facie# this would not be afinance lease as it is arguable that 7.0 would not be considered to represent8substantially all of the fair value of the leased asset&.

c! According to the guidelines in AASB 117# this would not be classified as a financelease. (he renewal period is not included in the definition of the lease term.

owever# the e%istence of the put option is probably sufficient to suggestclassification as a finance lease by both the lessee and the lessor. Assume that theresidual value e-uals the estimated mar"et value at the end of the lease term. ,n thiscase# one could argue that the lessee bears substantially all the ris"s and rewards of ownership. ,n particular# the low mar"et value that could result from obsolescenceand wear and tear.

>ne would e%pect that ownership would revert to the lessee if the mar"et value is lessthan the residual value. (his is economically e-uivalent to guaranteeing the residualvalue.

d! At two thirds of the economic life of the asset# the term of the lease is not clearly for the ma+or part of the asset&s economic life. ore convincing indicators that the leaseshould be classified as a finance lease are that it is not cancellable lessee would incur lessor&s losses if cancelling! and the lessee&s ability to renew the lease at substantiallylower than mar"et rent. (he substantial discount is evident because on renewal thelease payments would stay the same while mar"et rentals have been increased by the

effects of inflation over eight years.



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11.; a! As the lease is non9cancellable# and for the life of the asset# the lease is clearly afinance lease from both the lessor&s and lessee&s perspective. 4rom the lessee&s

perspective it is a sale and leasebac"# with any profit on sale re-uired to be amortisedover the life of the lease. 4rom the lessor&s perspective# the lease is a direct financelease.

b! (he interest rate implicit in the lease is that rate which when used to discount theminimum lease payments plus any unguaranteed residual# e-uates the discountedaggregate amounts to the fair value of the asset at the commencement of the leasefrom the perspective of the lessor the discounted aggregated amounts would bee-uated to fair value of the leased asset plus any initial direct costs of the lessorEseethe definition provided within AASB 117!. (he present value of an annuity in arrearsof 1' lease payments of F22 76 at 1' is e-ual to F22 76 %


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11.1' a! As in Kuestion 11.;# the interest rate implicit in the lease is 1' per cent and the present value of the minimum lease payments is F16' '''. ad there been any initialdirect costs to the lessor amounts that are directly attributable to negotiating andarranging a lease! then the interest rate implicit in the lease would have been greater

Ehowever# there are no initial direct costs identified in this -uestion.

b! =et method

1 Huly 2'';

r Dlant and e-uipmentEtractor 16' '''r ash 16' '''r ?ease receivable 16' '''r Dlant and e-uipmentEtractor 16' '''

5' Hune 2'1'

r ash 22 76

r ?ease receivable 76r ,nterest revenue 16 '''

c! @ross method

1 Huly 2'';

r Dlant and e-uipmentEtractor 16' '''r ash 16' '''r ?ease receivable 227 6'r Lnearned interest 7 6'

r Dlant and e-uipmentEtractor 16' '''

5' Hune 2'1'

r ash 22 76r ?ease receivable 22 76r Lnearned interest 16 '''r ,nterest revenue 16 '''



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11.11 (o underta"e this calculation students may use trial and error. (he implicit rate is 1# proven as follows:

Dresent value of initial payment: F0''' % 1.' G F0 '''

Dresent value of yearly payments: F00'' 3 F0''! % 6.6;61 G F22 67'4air value at lease inception F27 67'

Alternatively# and more easily# we can divide the liability on 1 Huly 2''; which woulde%clude the payment of F0''' at lease inception! by the periodic lease payments after deducting the e%ecutory costs! and then search for the appropriate interest rate within the

present value tables. (his is easy because of the absence of a guaranteed residual or a bargain purchase option.

27 67' 3 0'''! ÷ 0''' G 6.6;6.

A review of the present value of an annuity table shows that F6.6;61 e-uals the present valueof an annuity in arrears of F1 per year# for 1' years# discounted at 1 per cent.

11.12 a! (he implicit rate is that rate which when used to discount the minimum lease payments plus any unguaranteed residual# e-uates the discounted minimum lease payments to the fair value of the asset at the commencement of the lease. Bargain purchase options are included as part of the minimum lease payments. ,n this -uestionthe implicit rate is 12 per cent# proven as follows:

Deriodic lease payments: 510 ''' % 5.


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5' Hune 2'';

r ,nterest e%pense 15< 1


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b! i! Boo"s of Sanders using the net method

1 Huly 2'';

r ?ease receivable 251 16'

r ost of sales 2'' '''r ,nventory 2'' '''r Sales 251 16'

5' Hune 2'1'

r ash


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5' Hune 2'11

r ,nterest e%pense 26 510r ?ease liability 51 ;50r )%ecutory costs < 20'

r ash


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r ?eased buildings 1 1;2 70r ?ease liability 1 1;2 70

(o record the asset and liability at the inception of the finance lease.!

5' Hune 2'1'

r )%ecutory e%penses 20 '''r ,nterest e%pense 11; 270r ?ease liability 120 720r ?ease rental e%pense 1'0 '''r ash 570 '''

(o record the lease payment. I11; 270 G 1 1;2 70 % '.1'J!

r ?ease amortisation e%pense 17' 5;6

r Accumulated amortisation 17' 5;6

(o record depreciation e%pense I1 1;2 70 N 7J. As the lessee does not appear li"elyto retain the asset# the life of the lease is used for amortisation.!

5' Hune 2'11

r )%ecutory e%penses 20 '''r ,nterest e%pense 1'< 7'0r ?ease liability 15 2;0r ?ease rental e%pense 1'0 '''

r ash 570 '''

(o record the lease payment. I1'< 7'0 G 1 1;2 70 3 120 720 % '.1'J!

r ?ease amortisation e%pense 17' 5;6r Accumulated amortisation 17' 5;6

d! 1 Huly 2'';

r ?and 0 1


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=et method

5' Hune 2'1'

r ash 570 '''

r ?ease rental income 1'0 '''r ?ease receivable 120 720r ,nterest revenue 11; 270r )%ecutory e%penses recouped 20 '''

5' Hune 2'11

r ash 570 '''r ?ease rental income 1'0 '''r ?ease receivable 15 2;0r ,nterest revenue 1'< 7'0

r )%ecutory e%penses recouped 20 '''

>D(,>=A? ,SSL)S

(he above answers have been compiled in accordance with the Accounting Standard# but a number of issues may be raised.

(he Standard re-uires that the lease payments be allocated between the land and the buildings on the basis of their relative fair values at the inception of the lease paragraph 1


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the building. (his is shown below. Adopting the method of allocation as indicated in the Standardwill not lead to this result.

DateLease receipt

for buildingInterestrevenue

Principalreduction

Closingreceivable

1 Huly 2''; 1 572 57'5' Hune 2'1' 22; 1< 157 257 ;1 ;6; 1 2' 6215' Hune 2'11 22; 1< 12 '62 1'1 166 1 17; 2775' Hune 2'12 22; 1< 117 ;2 111 20 1 '


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the lease asset should be amortised over the useful life of the asset. Amortisation e%pense per year G F20'#''' 9 F1'#'''! N G F5'#'''

b! ,f the lessee e%pects to return the asset to the lessee at the end of the lease term# andto the e%tent that the asset has a value e-ual to the guaranteed residual at the end of the lease

term meaning that the lessee can return the asset at the end of the lease term and have nofurther obligation to transfer additional money! then the amortisation would be:

Dresent value of minimum lease payments: F20'#'''?ess# present value of guaranteed residual included in minimum lease

payments! and we will assume an implicit rate of 1' percent:2'#''' % '.0152 1'#2


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amount of the difference between the carrying amount and fair value shall berecognised immediately.

11.1 a! 1 Huly 2'';

r ash 6 556 7''r Accumulated depreciation 50' '''r ?and 1 '' '''r Buildings 1 70' '''r Drofit on sale of land 5


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r ?ease payable 71


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b! 4inance ?td

1 Huly 2'';

r Dlant and machineryEaeroplane 2 62 6''

r ash 2 62 6''r ?ease receivable 2 62 6''r Dlant and machineryEaeroplane 2 62 6''r ash 5'' '''r ?ease receivable 5'' '''

c! 4lyer ?td

(o determine the entry for the final lease payment we must determine the presentvalue of one payment of F20' ''' in one year discounted at 1' per cent. (he presentvalue is F20' ''' % '.;';1 G F227 270.

r ,nterest e%pense 22 720r ?ease liability 227 270r ash 20' '''r ?ease amortisation e%pense 121 62'r Accumulated amortisation 121 62'

121 62' G 2 62 6'' ÷ 2'!

d! 4inance ?td

r ash 20' '''r ,nterest revenue 22 720r ?ease receivable 227 270

11.2' a!Dresent value of lease

payments F1'' ''' n G 6# , G 1' F51< ;;'Dresent value ofunguaranteed residual F0' ''' n G 6# , G 1' 56 10'

F501 16'

b!

Pearended

Beginningleaseinvestment

?ease payment ,nterest

?easereduction

losingliability

'


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1 Huly 2'';r ost of goods sold 1' ''' r ,nventory 1' '''r ?ease $eceivable 501 16'

r Sales 501 16'5'/'


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11.21a! fair value C nil initial direct costs G DO minimum lease payments C any unguaranteed residual

,nitial payment on 19Hul9'; payment F0' '''DO of remaining lease rental 0' '''# nG5# iG 12 00

DO of guaranteed residual 6' '''# nG6# iG 2; 6''F2' 200

b! ,nitial payment reduces the liabilityBeginning??

?ease paym&t

,ntereste%p.

Accruedint. ?ease red.

losing??

1/'7/2''; 2' 200 0' ''' 10 2005'/'


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d! opeful ?td must pay F10 '''# being the difference between the fair value of the studio andthe guaranteed residual.

1/'7/2'15r Accum. amort. 1

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Deegan5e Sm Ch11