Week 5- Lecture 1.ppt by fdshsdhs

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									Chapter 6
 Leases
                    What Is a Lease?

•    A lease is an agreement where a lessor conveys to a
    lessee the right to use an asset for an agreed period of time
    in return for a payment or series of payments


•   The lessee does not acquire an asset, merely a right to use an
    asset for a period of time

•   May result in the eventual transfer of ownership – eg hire
    purchase agreement

•   IAS17 excludes:
      • Service agreements - as they do not involve the use of an
        asset
      • Resource exploration rights
      • Licensing agreements - eg for films, patents etc
           What is a lease?
      And how are they classified?




       Ruth Picker
   Managing Partner
Ernst & Young Melbourne
           Classification Of Leases

• AASB 117 recognises the following types of leases:
     • Finance lease
     • Operating lease
• Accounting treatment and disclosures required differ
  substantially for finance and operating leases
• A finance lease is a lease which transfers substantially all
  ownership risk and rewards, with or without eventual title
  transfer
   • Risks of ownership include obsolescence, idle capacity,
     uninsured damage etc.
   • Rewards of ownership include benefits from use of the
    asset, appreciation in value of the asset
   • An operating lease is a lease other than a finance lease
         Classification Of Finance Leases

•   The lease is a finance lease if one or a combination of the
    following apply:
     •   The lease transfers ownership of the asset at the end of
         the lease term
     •   The lessee has the option to purchase the asset at a price
         substantially lower than the fair value at the date the
         option become exercisable, so that it is reasonably
         certain that the option will be exercised
     •   The lease covers a major part of the asset’s economic life
     •   The present value of minimum lease payments (MLPs)
         represents substantially the fair value of the asset

          AASB 117 does not contain a definition or further guidance as to what “major
          part” and “substantially” mean- therefore judgment required
      Classification Of Finance Leases


•   The lease is a finance lease if one or a combination
    of the following apply (cont):
     • The leased asset is of a specialised nature that
       only the lessee can use them without major
       modification
     • The lease is non-cancellable
        AASB 117 deems certain cancellable leases to be non-cancellable – refer
        section 6.3.1 of text for further explanation


     • The lessee has the ability to continue the lease
       for a secondary period at a rental that is
       substantially less than market value.
    Minimum Lease Payments (MLPs)

                    MLPs =
            Payments over lease term
          + Guaranteed residual value *
          + Bargain purchase option *
               – Contingent rent *
     – Reimbursement of costs paid by lessor
               Commonly referred to as executory costs


* Defined on following slides
     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 (based on market
    conditions)
•   Under a finance lease the lessee guarantees that
    the lessor will realise at that amount
•   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
   Minimum Lease Payments (MLPs):
             Definitions
Bargain purchase option
• A clause in the lease agreement allowing the
  lessee to purchases the asset at the end of the
  lease term for a pre-set amount (which is less
  than the expected residual value)
• The option price is normally to be sufficiently
  lower than expected fair value – resulting in the
  exercising of the option becoming reasonably
  certain
   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
• Eg- lease of a photocopier may specify additional
  payments if the number of photocopies exceeds
  a certain amount in a month
   Minimum Lease Payments (MLPs):
      Determining Present Value

• The present value (PV) of MLPs is determined by
  applying an appropriate discount rate
• Discounting is not necessary if the lease
  agreement contains one of the following (as the
  PV of MLP = FV of the asset in such cases):
   • a bargain purchase option; or
   • a 100% guaranteed residual value
• The discount rate is based on the interest rate
  implicit in the lease
      Classification Of Lease: Example

•   On 30 June 2008 E Ltd leased a vehicle to C 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.
•   The annual lease payments (payable in advance on 30 June each
    year) are $23,900. This includes $1,900, representing a
    reimbursement of insurance and maintenance costs paid by the
    lessor. Referred to as “executory costs”
•   The lease is cancellable, but will incur a penalty equal to 2 years
    lease payments.
•   The PV of MLP has been calculated to be $85,457.
•   The estimated residual value of the asset at the end of the lease
    term is $15,000 and the guaranteed residual value is $7,500.
•   C Ltd intends on returning the asset to E Ltd at the end of the lease
    term.
•   The interest rate implicit in the lease is 7%.

Required:
• Determine whether the lease is an operating or finance lease per
  AASB 117.
     Classification Of Lease: Example

1.   Is the lease non-cancellable?
         The lease is cancellable, but a significant monetary
          penalty will apply – therefore the lease is deemed to be
          non-cancellable
         As per section 12.4.1 of text

2.   Is ownership to be transferred at end of the lease term?
        No – C Ltd expects to return the asset to the lessor
3.   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
         asset (4/6 years) Text book uses > 75% as a benchmark
        Unlikely that this would be considered to be a major
         part of the asset’s life
      Classification Of Lease: Example

4.   Does the PV of MLP represent substantially the FV of the
     asset?    Textbook uses > 90% as a benchmark
       (85,457/(89,721 + 1,457)) = 93.7%
       This represents substantially all the FV of the lease asset.
5.   Does the lessee bear substantially all ownership risks and
     rewards?
       It appears so, as the costs of insurance, maintenance etc
        lie with the lessee.
Conclusion:
   In spite of the mixed signals above, the lease should be
   classified as a finance lease as substantially all the risks and
   rewards of ownership pass to the lessee
    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 adverse impacts on a lessee’s financial
  statements:
   • Increases non-current assets – thus reducing
     return on asset ratios
   • Increases non-current liabilities – adversely
     affecting debt/equity ratios
   • Depreciation and interest charges may exceed
     lease payment in early years of lease – resulting
     in lower profits
    Incentives To Misclassify Leases

• In an attempt to avoid misclassification of leases as
  operating leases additional guidance is contained
  within the following:

   • UIG 127 Evaluating the Substance of
     Transactions Involving the Legal Form of a Lease

   • UIG 4 Determining Whether an Arrangement
     Contains a Lease
Whilst AASB 117 has been effective in reducing the amount
 of off-balance-sheet financing of assets, why are some
          leases written to avoid the accounting
              requirements of the standard?




        Ruth Picker
    Managing Partner
 Ernst & Young Melbourne
      Accounting For Finance Leases
               By Lessees


Initial recognition

• Initially determine and recognise a lease asset &
  liability
• Recorded at the lower of the FV of the asset and
  the PV of MLP
     Accounting For Finance Leases By
                 Lessees
Subsequent measurement

• For assets, determine
   • depreciation (over the useful life of the asset to
     the entity)      If the lessee intends on returning the asset at the
   • any impairment end of the lease period the useful life will be on
                      term of the lease. Where the lessee intends
                                                                    the

                               purchasing the asset at the end of the lease term,
                               the useful life will be the economic life of the asset


• For liabilities, lease payment to be allocated
  between
   • reduction of the lease liability
   • interest expense incurred
   • reimbursement of lessor costs
   • contingent rent
     Accounting For Finance Leases By
            Lessees: Example

Required:

a)    Using the facts provided in the example on slide 12
      prepare a schedule summarising the lease payments
      to be made over the term of the lease

b)    Prepare the journal entries in C Ltd’s books for the
      years ended 30 June 2008 and 2009 in relation to the
      lease
 Accounting For Finance Leases By Lessees:
                  Example

                    MLP                Interest             Red’n in        Balance of
                                       expense              liability        liability
30/06/08                                                                     85,457 *
30/06/08        22,000**                        -***          22,000         63,457
30/06/09 22,000                        4,442****              17,558*****    45,899
30/06/10 22,000                        3,213                  18,787         27,112
30/06/11 22,000                          1,898                 20,102         7,010
30/06/12 7,500******                       491                  7,010              -
* Lower of FV ($89,721) and PV of MLP ($85,457)

** Excludes $1,900 executory costs

*** Paid annually in advance therefore no interest expense on 30/06/06

**** Based on interest rate implicit in lease of 7% ($63,457 x 7%)

***** $22,000 - $4,442 = $17,558
****** Guaranteed residual paid on last day of lease
Accounting For Finance Leases By Lessees:
                 Example

Journal entries for year ended 30 June 2008 – C Ltd

  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
Accounting For Finance Leases By Lessees:
                 Example
Journal entries for year ended 30 June 2009 – C Ltd
  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
  Annual depreciation charge
  ($$85,457 - $7,500 guaranteed residual value) = $77,957 depreciable amount.
  $77,957/ 4 yrs = $19,489. N.B Depreciated over the lease term as C Ltd intends on
  returning the asset to E Ltd at the end of the lease term
   Accounting For Finance Leases By
               Lessors

Initial recognition
• Lessor needs to ‘derecognise’ the asset and
  record a lease receivable at an amount equal to
  the net 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 in the lease
• Normally equal to the fair value of the asset at
  inception of the lease
  Accounting For Finance Leases By
              Lessors

Subsequent measurement
• Receipts need to be allocated between:
   • Reduction of the lease receivable
   • Interest revenue earned
   • Reimbursement of costs paid on behalf of the
     lessee
   • Receipt of contingent rent
 Accounting For Finance Leases By
        Lessors: Example

Required:

a)   Using the facts provided in the example on
     slide 12 prepare a schedule summarising the
     minimum lease receipts over the term of the
     lease.
b)   Prepare the journal entries in E Ltd’s books for
     the years ended 30 June 2008 and 2009 in
     relation to the lease.
Accounting For Finance Leases By Lessors:
                 Example

                 Minimum              Interest             Red’n in         Balance of
                   lease              revenue             receivable        receivable
                 receipts
30/06/08                                                                    91,178*
30/06/08 22,000**                             -***             22,000       69,178
30/06/09 22,000                           4,842****                17,158    52,020
30/06/10         22,000                   3,641                18,359       13,661
30/06/11          22,000                   2,356               19,644       14,017
30/06/12           15,000*****               983                   14,017        -
* FV ($89,721) less Initial cost ($1,457) = $91,178 Equal to PV of MLP + PV of
unguaranteed residual of $7,500
** Excludes executory costs
*** Received annually in advance therefore no income at 30/06/06

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

***** Total residual value at end of lease (50% guaranteed)
Accounting For Finance Leases By Lessors:
                 Example

Journal entries for year ended 30 June 2008 – E Ltd
  Dr Lease receivable           91,178 FV of asset
      Cr    Motor vehicle                      89,721
      Cr    Cash                                 1,457
  Lease of vehicle to C 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
 Accounting For Finance Leases By Lessors:
                  Example

Journal entries for year ended 30 June 2009 – E Ltd

  Dr Reimbursement in advance 1,900
     Cr    Cash                            1,900
  Payment of costs on behalf of lessee

  Dr Cash                     23,900
     Cr     Lease receivable            17,158
     Cr     Interest revenue             4,842
     Cr     Reimbursement in advance     1,900
  Receipt of second annual lease payment Taken from
                                             lease receipts
                                             schedule
   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 two types of income:
   • profit/(loss) equalling outright asset sale
     (based on sale at FV)
   • 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
• Refer example 6.4 in text
    Accounting For Operating Leases

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

Lessors
• Lease receipts are recognised as revenue on a
  straight line basis over the term of the lease
• Initial direct costs relating to the lease are
  capitalised as part of the carrying amount of the
  asset being leased and are expenses over the
  lease term on the same basis as the lease income
  is recognised (ie straight line basis)
• The asset is depreciated by the lessee on the
  same basis as for similar assets held by the lessee
     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 of the asset
• Used to generate immediate cash flow while
  retaining asset use
• 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 whether it is classified as a finance
  or operating lease
     Sale & Leaseback Transactions

• Under a finance lease the lessee’s gain/(loss) from
  the sale of the asset is deferred and amortised
  over the term of the lease

• Under an operating lease the lessee’s gain/(loss)
  is:
   • recognised immediately if ‘sale’ is calculated at
      fair value
   • excess/reduced gains/(losses) are deferred and
      amortised over the term of the lease
       Likely future developments

• A G4+1 1996 report identified areas of concern in
  relation to the current lease accounting
  requirements
• In 1999, IASC issued a discussion paper raising
  additional concerns about the current
  requirements
• Complete overhaul needed and anticipated for a
  more conceptually based standard for leases
What are the developments with the joint project
on lease accounting between IASB and FASB?




          Ruth Picker
       Managing Partner
   Ernst & Young Melbourne
Will this project overcome the criticism level at
    current lease accounting standards and
      differences in accounting outcomes?




        Ruth Picker
     Managing Partner
 Ernst & Young Melbourne

								
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