LIABILITIES & LEASE
Deegan: Chapter 10 & 11
Learning Objectives
1. Determine whether an item meets the definition & recognition criteria for liabilities 2. Define contingent Liability 3. Discuss the rationale for lease financing 4. Distinguish between operating & financing leases 5. Record accounting entries for an operating lease in the books of the lessor & lessee 6. Record accounting entries for a financing lease in the books of the lessor & lessee
DEFINITION & RECOGNITION CRITERIA
Taken from Conceptual Framework
Definition
a. Present Obligation Legal e.g. contractual Constructive or equitable b. Future sacrifice of economic benefits Payment Exchange of assets c. Based on past event or transaction Related to purchase of goods or services
Example 1
Liability Present Obligation Accounts Payable To pay the supplier according to terms of the purchase √
Future Sacrifice of Economic Benefit Past Event
Payment i.e. outflow of cash
√
Taking delivery of the inventory
√
Example 2
Liability
Present Obligation
Future Sacrifice of Economic Benefit Past Event
Student loan money from colleague (cinema, book etc) To pay colleague according to √ terms of the loan Payment i.e. outflow of cash √
Taking delivery of the money
√
Recognition Criteria
a. Reliability of Measurement
b. Probability that economic benefits will be sacrificed
Example
Reliability Valued at cost, based on supplier invoices √ √
Probability Almost 100% (50% and above) Otherwise, company will face difficulty in continuing to operate
Contingent Liability
Definition a. A possible obligation, b. that arises from past events c. will be confirmed only by the occurrence or non-occurrence of 1 or more uncertain future events not wholly within the control of the enterprise
Example
Contingent Liability Possible Obligation Past Event Uncertain Future Event Bank Guarantee
To pay the bank if the loan client defaults
Agreeing to guarantee the loan i.e. signing the contract Will the client default? This is beyond the control of the guarantor
√
√ √
Contingent Liability Disclosure
Provide a disclosure note, which should include a. Brief description of the nature of the contingent liability b. Estimate of its financial effect c. Indication of the uncertainties relating to the amount or timing of any outflow
Refer to financial statements
LEASE FINANCING
Financing Non-current Assets
Example Air Pacific requires a new aircraft for its fleet. What are some of the ways to finance the aircraft?
Financing Non-current Assets
Some alternatives
1. Purchase the aircraft, using existing cash 2. Purchase the aircraft, using a loan 3. Purchase the aircraft by depositing some existing cash and taking a loan for the balance 4. Lease the aircraft
Advantages of Leasing
1. Easier to pay in smaller installments 2. Spread re-payments over a longer period of time 3. May be able to swap the asset for a different one e.g. newer model, larger or smaller aircraft
Advantages of Leasing
4. Asset may not appear on the balance sheet. Hence debt/equity ratio is unaffected does not affect company’s ability to borrow funds
OPERATING LEASES & FINANCING LEASES
Refer to your set of financial statements
Accounting Treatment
An asset is classified as operating or financing depending on who bears the risks & rewards relating to it
Risks & Rewards
Risks include possibility of 1. Losses from idle capacity 2. Technological obsolescence 3. Variations in return caused by changing economic conditions Rewards may include 1. Expectation of profitable operations 2. Gain from appreciation in asset value
Differences
Type of Lease Operating Financing
Reported in
P&L Statement Balance Sheet
Asset & Liability Transferred to the Lessee More or less same as owning the asset
Classification Expense Risks & Rewards Economic Substance Remain with the Lessor
First Indicator of Financing Lease
Non-cancellable If the lease is cancelled, the lessee incurs heavy costs or penalties If a lease is cancellable, the lessee does not bear the risks associated with the asset Classified as an operating lease
Other Indicators of Financing Lease
1. Asset ownership is transferred to lessee by the end of the lease term 2. Lessee has an option to purchase asset for a bargain price at the end of the lease term 3. Lease term covers majority of the assets economic life
Other Indicators of Financing Lease
4. At inception, Present Value of minimum lease payments is substantially equal to Fair Value 5. Asset has a specialised nature. Only lessee can use it without major alterations
ACCOUNTING ENTRIES FOR OPERATING LEASES
Books of Lessee
Event/Transaction Inception Payment Journal Entry None Dr Lease Expense Cr Cash
Books of Lessor
Event/Transaction Journal Entry Inception Payment None Dr Cash Cr Lease Revenue
The asset will appear in the Balance Sheet of the lessor, who will also depreciate it.
END