>studynotes PAPER P7
anD Tax principles
Any section of paper P7 can test you on leasing agreements and how
to treat them. Sally Vernon offers her guide to accounting for leases.
Imagine that you’ve just passed your finals the financial statements should
and want to celebrate by buying a new car. be reliable. A factor that
You might have received a big bonus for contributes to reliability is that
completing the exams, so you could use this the accounts should show the
cash to buy the car. Alternatively, you may substance (commercial reality) of a
need to borrow part or all of the money. transaction over and above its legal form.
There is also a third option: hire-purchase For most transactions the substance and
(HP), where you sign a contract committing the form are the same, but the two differ n It’s a finance lease with a
you to making a set number of payments for in the case of arrangements such as five-year term.
perhaps three or four years. If you take this finance leases. n The lease payments are made in advance
option, the total you end up paying will Because the risks and rewards of – ie, at the start of each year.
undoubtedly be more than the car’s cash ownership are passed to you when you sign n Interest should be charged to the income
price. The difference is interest, which the finance lease agreement, the asset in statement using the actuarial method, since
accrues over the duration of the HP contract. essence becomes yours at that instant. But a rate of 13.44 per cent has been given.
Three main financing options also apply to from a legal standpoint the asset may never n You need to calculate the finance charge
a company when it is acquiring a non-current belong to you or, if legal title does pass, it will and the current and non-current liability for
asset: buy the asset outright with cash; not occur until the final payment. The asset the second year of the lease.
borrow to fund the purchase; or lease the should, therefore, be capitalised in the Only when you have extracted this key
asset. The only leasing option that individuals balance sheet and a corresponding finance information should you then try answering the
have is HP, but companies have two types to lease liability created, because it has not yet question. I will provide a model answer in the
choose from: a finance lease (which is in been paid for. October issue of Velocity, the new student
essence the same as HP) and an operating The interest incurred on the amount owed e-magazine (www.cimaglobal.com/velocity).
lease. Their accounting treatments, governed over the term of the lease must be recorded
by IAS17, are very different. as a finance charge in the income statement. Sally Vernon is education team specialist for
Both types of lease are examinable in P7 There are two main methods of allocating the paper P7 at BPP Professional Education.
and could be tested in all three sections of interest: actuarial and sum of digits. If a
the paper. Questions are more likely to require question gives you an interest rate, the
you to perform calculations such as the examiner wants you to use the actuarial
Question 2(b) from May 2007
finance charge, the net book value of the method. Otherwise, you should allocate the On April 1, 2005 DX acquired plant and
asset or the value of the current and non- interest using the sum-of-digits method. machinery with a fair value of $900,000
current finance lease liability, but they could When answering questions on this topic on a finance lease. The lease is for five
also ask you to discuss the rationale behind you first need to establish whether the lease years, with the annual lease payments of
the accounting treatment of leases. is finance or operating. Sometimes you’ll $228,000 being paid in advance on April
Under a finance lease, you as the holder need to look at the scenario to determine 1 each year. The interest rate implicit in
of the asset are responsible for it – the “risks where the risks and rewards of ownership lie, the lease is 13.44 per cent. The first
and rewards of ownership” are yours. This but usually the examiner will state which type payment was made on April 1, 2005.
means that you are responsible for its of lease it is. If it’s an operating lease, you You are required to:
safekeeping and maintenance and that you simply need to ensure that the rental costs n Calculate the finance charge in
also enjoy unrestricted use of it. Leases are charged to the income statement evenly respect of the lease that will be
without this distinction are operating leases. over the lease term. It it’s a finance lease, shown in DX’s income statement for
How you account for a finance lease all there are extra considerations. the year ended March 31, 2007.
comes down to the substance of the Let’s look at question 2(b) from the May n Calculate the amount to be shown
transaction. The International Accounting 2007 exam in the panel to consider the detail as a current liability and a non-current
Standards Board’s framework lists four that you need to extract. Take a minute to liability in DX’s balance sheet at
qualitative characteristics of information. highlight the key details given in the scenario March 31, 2007.
One of these is that the information shown in and the requirement. They are as follows:
58 financial management