Financial accOUnTinG anD Tax principles

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					     >studynotes                                                                                                            PAPER P7

 Financial accOUnTinG
 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 (
 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