AC301: ACCOUNTING FOR LEASES
SOME BASIC TERMS LEASE is a contract between a lessor and a lessee for the hire of a specific asset. The lessor retains the ownership of the asset but conveys the right to use the asset to the lessee for an agreed period of time in return for specific rentals. LESSOR is the legal owner of the asset. Lessor rents out the asset to a lessee and receives income LESSEE pays rents in accordance with the terms of the lease; receives economic benefits associated with the asset and also incurs future obligations.
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AC301: Accounting for Leases
BACKGROUND In the UK - Leasing became popular during 1970s when profits were falling Government attempted to encourage capital investment by granting large (sometimes 100%) capital allowances to companies which purchased fixed assets Banks: large profits but few fixed assets Manufacturers: small profits and substantial fixed assets 1070s onwards: Leasing became a tool for Off Balance Sheet Financing
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Appeal of Leasing
Bank (lessor) ‘buys’ asset (and gets benefit of tax allowance) because it is awash with cash Bank post tax cash flow is improved because it receives tax allowances Bank can offer reduced interest rate (which benefits manufacturer) Bank (lessor) leases asset to manufacturer (lessee) who may not have adequate taxable profits. Thus leasing results in smaller charge against P&L compared to outright purchase Inland Revenue had no problem with these arrangements Now more sophisticated forms to improve balance sheets.
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Impact of Leasing
Leasing now covered by IAS 17 and SSAP 21 (US FAS 13) PRIOR TO SSAP 21: NO FORMAL ACCOUNTING FOR LEASES IN THE UK – Lease rental payments charged to P&L – Obligations for future lease payments not disclosed – Leasing functioned as a form of Off Balance Sheet Finance IN THE ABSENCE OF FORMAL ACOCUNTING: ASSETS/LIABILITIES UNDERSTATED ROCE DISTORTED GEARING DISTORTED FINANCIAL RISK MAY BE MIS-SPECIFIED COST OF CAPITAL MISPRICED 4 MARKETS MISLED, RESOURCES MISALLOCATED
SSAP 21
IAS17 and SSAP21 EMPHASISE SUBSTANCE OVER FORM Recognise commercial/economic substance rather than the legal form ENHANCES PREDICTIVE VALUE OF FINANCIAL STATEMENTS SEEKS TO CURB OFF BALANCE SHEET FINANCING BRINGS ASSETS AND LIABILITIES ON TO BALANCE SHEET THAT MIGHT OTHERWISE BE EXCLUDED
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Leases and Hire Purchase
Leasing Main distinction between Hire Purchase Contract and lease contract is that under a lease contract, title (ownership) does not pass to lessee. LESSOR rents asset to LESSEE asset regular cash payments
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Types of Leases
OPERATING LEASES
Relatively short term agreement: akin to hiring an asset e.g. a taxi, car for holidays Easily cancellable arrangement Risk/rewards do not usually pass to the lessee. Lessor remains responsible for repairs and maintenance. Payments by the lessee to the lessor are charged to P/L account on a straight line basis Receipts are shown as revenue in the P/L account of the lessor on a straight line basis. Note to the accounts if amounts are material
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FINANCE LEASE
Long term arrangement. Covers most of the asset life. Lessee responsible for risk of technological obsolescence Generally non-cancellable Transfers risk/reward of ownership to lessee. The lessee responsible for maintenance and insurance. Lessee pays full cost of asset plus a return on finance provided by lessor Minimum Lease Payment by the lessee = 90% of the fair value of the asset. Assets specifically manufactured may be treated as finance leases US has additional tests: e.g. The life of the lease is greater than 75% of the economic life of the asset.
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SSAP 21
Finance lease
Technically, the lessor has legal ownership of asset, but in reality the transaction is very similar to outright purchase, financed by a loan repayable in instalments Finance lease confronts issue of substance versus form Substance - reality or economic substance Form - strict legal interpretation Prior to 1984 (when SSAP 21 was issued) finance leases and operating leases were accounted for in a similar way Payments by lessee were treated as expenses in profit and loss account of lessee
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SSAP 21
However, SSAP 21 forces lessees to treat finance leases as if an asset is purchased and financed by a loan In the balance sheet of the lessee, the asset and the loan are recorded on the balance sheet In the profit and loss account of the lessee, depreciation on the asset is recorded and interest on the loan is charged
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Accounting for Finance Leases – (1)
EXAMPLE 1: AN ASSET COSTS (or has market value) £333. THE LESSEE PAYS £200 P.A. IN ARREARS FOR TWO YEARS. RESIDUAL VALUE OF THE LEASE AT THE END IS £40 AND THAT IS PASSES TO THE LESSOR. STEP 1: WHAT IS THE IMPLIED INTEREST RATE?
– Look for IRR
200 + 200+40 (1 + i) (1+i)2 BY TRIAL AND ERROR i = 20% P. V of LEASE = 200 + (1 + 0.2)
= 333
200 = 305 (1+0.2) 2
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Accounting for finance lease – continued (2)
STEP 2: What kind of a lease: DOES £305 EXCEED 90% OF THE FAIR VALUE OF THE ASSET? 90% OF £333 = £300 £305 IS GREATER THAN £300 THEREFORE IT IS A FINANCE LEASE!! ANALYSIS MINIMUM LEASE PAYMENTS £305 PV OF RESIDUAL VALUE ACCRUINGTO THE LESSOR 40/(1+0.2) 2 £ 28 £333
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Accounting Entries for Finance Lease (1)
ACCOUNTING ENTRIES FOR FINANCE LEASE If a lease is a finance lease DR Fixed Assets CR Creditors for Finance Lease When Payment made to the lessor DR Creditors for finance lease CR Cash/Bank The Asset must be depreciated DR P/L Account CR Depreciation Account At the year end make an entry for the finance charge DR P/L Account for Interest Payable CR Creditors for Finance Lease
In Balance Sheet: Split Lease liability under current and/or long-term. Show leased assets separately. Notes to accounts to explain finance charges
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Accounting for finance leases (3)
STEP 3: Establish an Asset and Liability DR Asset £305 CR Liability £305 STEP 4: Financing details: Loan Yr At start 1 305 2 166
Int Reduction 20%` Rent in Loan 61 200 34 200 95 400 STEP 5: Depreciation charge: Assuming straight line = £305-zero = £152.5
139 166
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Accounting for finance leases (4)
In Balance Sheet Time Liabs Asset Start 305 305 End Yr1 166 152.5 End Yr2 Nil Nil
In P/L Account Depn Interest Total ----------152.5 61 152.5 34 305 95 213.5 186.5 400
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Economic consequences of leasing
When a leasing standard was first proposed, the leasing industry was unhappy. But, as it turned out, SSAP 21 was not too contentious because the government had already begun to reduce tax allowances for capital investment Note that the government did not change the tax laws and transfer the capital allowances from the lessors to the lessees
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Accounting for Leases: Some Issues
Recognition of economic substance (FRS 5, Reporting the substance of transactions) 90% Test is arbitrary: Leases can be designed to bypass it. Should there be additional tests?: e.g. 75% of economic life of an asset Standard may encourage short-term leases One suggestion is to treat all leases in same way (i.e. make no distinction between operating lease and finance lease) Accounting for leases does not affect cash flows. Therefore, is it worth the managerial time? EMH: does not matter how you report markets absorb information Has accounting standard encouraged the ‘rules avoidance’ industry to look for newer pastures
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Calculation of annual payments in lease contracts
actuarial method
sum of digits method
straight line method
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