Docstoc

Accounting for Leases

Document Sample
Accounting for Leases Powered By Docstoc
					ACCOUNTING FOR LEASES

PERFORMANCE CRITERIA
On completion of the work in this chapter, you will:
 know the terminology used in relation to leases
 be aware of the advantages and disadvantages of leasing
 know how leases can be terminated
 be able to distinguish between finance leases and operating leases
 be able to prepare accounting records for finance leases in the books of the lessee.
 be able to prepare accounting records for operating leases in the books of the
   lessee.

INTRODUCTION

The leasing of assets is now a popular alternative to the outright purchase of assets.
By leasing assets businesses have less capital invested in non-current assets. Leasing
frees up capital that can be used to finance business operations or additional business
ventures.
The widespread practice of leasing assets brought new challenges to the accounting
profession as non-current assets and their associated liabilities did not appear in the
balance sheet. These transactions were termed ‘off-balance-sheet’. Meaningful
analysis and interpretation of the financial statements could not be undertaken without
these transactions being reflected in the balance sheet.
Over the years the accounting profession has developed and refined an accounting
standard for leases. This accounting standard ensures that the financial statements of a
business properly disclose leasing transactions.
This chapter examines the classification of leases, analysis of lease payments and the
associated accounting entries for the recording and disclosure of lease transactions.

The current accounting standard for leases is AASB 117. This accounting standard as
with all accounting standards has been developed to provide more meaningful
financial statements that are consistently prepared across businesses.

The accounting standard for leases is the foundation of the material in this chapter.
Terminology relating to leases, finance and operating leases, accounting for finance
and operating leases, and the disclosure requirements of leases in the accounts form
the basis of the chapter. Advantages and disadvantages of leasing and how leases may
be terminated are also considered.




                                                                                       1
LEASES
A lease is an agreement where the lessor gives the lessee the right to use an asset for
an agreed period of time. In return the lessee agrees to pay the lessor for the use of the
asset. The payment is usually made in installments.

The key elements to a lease are:
                              an asset,
                              the owner and lessor of the asset and
                              the lessee who pays for the use of the asset.

eg. a business leases a motor vehicle from a finance company for four years paying
$750 per month. The business (the lessee) pays the finance company (the lessor and
also owner) $750 per month and has the use of the motor vehicle for four years.

Examples of assets that can be leased include land & buildings, motor vehicles,
furniture, and plant & equipment.

TERMINOLOGY
The following terms are commonly used in relation to accounting for leases:

Commencement of the lease term is the date when the lessee has the right to use the
leased asset. It is also the date when the details of the lease are recorded in the
accounting records.

Economic life is the anticipated life of a leased asset.

Fair value in general terms is the market price.

Finance lease is a lease that transfers substantially the risks and rewards of ownership
without transferring ownership. The title to the asset may eventually be transferred to
the lessee. A finance lease as the name suggests is a method of financing the
acquisition of an asset. Payments under a finance lease are a payment of interest and
repayment of capital. The criteria for determining a finance lease is considered later in
the chapter.

Gross investment in the lease is the total of the minimum lease repayments and the
unguaranteed residual value of the leased asset.

Guaranteed residual value is that part of the residual value of the leased asset that is
guaranteed by the lessee under the lease agreement.

Inception of the lease relates to the commencement of the lease and is the earlier of
the date of the lease agreement and the date of commitment by the parties to the
principal provisions of the lease.

Initial direct costs are costs of negotiating and arranging a lease that have not been
incurred by manufacturer or dealer lessors.




                                                                                           2
Interest rate implicit in the lease is the discount rate that causes:
        the minimum lease payments               the fair value of the leased asset
                         +                    =                  +
        the unguaranteed residual value           any initial direct costs of the lessor

Lease is an agreement where the lessee makes a series of payments to the lessor and
in return has the right to use the asset subject to the lease.

Lease commitments are the total amount of lease payments and other expenses owing
over the remainder of the lease.

Lease term is the period of the lease plus any further terms that the lessee has options
to continue the lease, and that it is reasonably certain the lessee will exercise the
option.

Lessee under a lease agreement has the right to use an asset in return for a series of
payments to the lessor.

Lessor under a lease agreement provides an asset and receives a series of payments
from the lessee.

Minimum lease repayments. These are the payments over the lease term that the lessee
is required to make plus any amounts guaranteed by the lessee.
If the lessee has an option to purchase the asset at the end of the lease, and it is
anticipated the asset will be purchased, then the minimum lease repayments will be
the lease repayments and the amount payable to exercise the option to purchase the
asset.

Non-cancellable lease locks both parties into the lease. The lease cannot be cancelled.
It is one of the tests to determine if the lease is a financing or operating lease.

Novated lease for a motor vehicle is a tax effective method of acquiring a motor
vehicle by employees. The employee enters into a lease with a finance company to
finance a motor vehicle. The employer and the employee then enter into a sub-lease.
The employee has the use of the motor vehicle and if he assumes all the benefits, risks
and responsibilities of the original lease it is classified as an operating lease.

Operating lease is any lease that is not classified as a finance lease. Payments under
an operating lease are for the rental of the asset.

Residual value of a leased asset is the estimated amount that would be obtained from
the disposal of the asset at the end of the lease.

Sale and leaseback transaction involves the sale of an asset that is then leased back
from the purchaser.

Unearned finance income is the interest component of future lease payments under a
lease agreement.




                                                                                           3
Useful life is the estimated period over which the asset is economically usable. This
may be longer than the period of the lease.

ADVANTAGES AND DISADVANTAGES

There are many advantages in using leasing to finance the assets of the business and
these include:

Capital Conserved. Large outlays of cash are avoided allowing business funds to be
        used for operating activities and expansion.
Acquisition of assets. When new business opportunities arise new assets are readily
        acquired by leasing.
Finance. Where the business does not have the capacity to borrow large amounts of
        funds leasing may provide a viable alternative to finance new assets.
Upgrading equipment. At the end of the lease period obsolete assets can be replaced
        with assets of the latest technology eg computer equipment.
Short term needs. Leasing allows the business to use assets that are required for a
        short period of time without having to purchase them
Latest equipment. Having modern equipment creates a favourable impression for
        existing and prospective clients. Productivity also increases by having the
        latest equipment. This can be achieved by leasing assets.
Tax advantages. Leasing provides better income tax advantages over other forms of
        financing the acquisition of assets.

Disadvantages also exist with leasing arrangements:

Cost of finance. Lease finance is generally more expensive than alternative forms of
        financing.
Adverse cashflow. Lessees can over-commit themselves to a large number of leases
        with high repayments.
Lease obligations. The business may struggle to meet lease payments if it is having
        liquidity and/or profitability problems.
Guaranteed residual value. The business will have to pay the shortfall in the
        guaranteed residual value if the leased asset does not realise the amount
        guaranteed under the lease.
Capital Gains. By leasing land and buildings the business may miss out on any capital
        gain opportunities.
Ownership. Leased assets do not give the same prestige as ownership of the asset.
Credit rating. The lessee is required to have a good credit rating
Under-utilised equipment. With a downturn in demand equipment may be idle whilst
        lease payments are still required to be made.

TERMINATION OF THE LEASE

The lease may be terminated (brought to an end) in a number of ways:

Renew the lease. The lease may be renewed for a further period. The value of the
      asset is the residual value from the original lease




                                                                                        4
Purchase the leased asset. The asset subject to the lease can be purchased for its
       residual value.
Return the asset. Prior to the completion of the lease the asset may be returned to the
       lessor. The lessee is responsible for any losses and outgoings incurred by the
       lessor.
       At the end of the lease the lessee can return the asset to the lessor. The lessee
       is only liable for any shortfall in the guaranteed residual value.
Trade in. The leased asset can be traded in on a replacement item that may be
       acquired on a new lease.

FINANCE AND OPERATING LEASES

The accounting standard for leases requires the lessee and the lessor to classify each
lease as a finance lease or an operating lease at the inception of the lease.

A finance lease is a method of financing assets to be used in the business over a long
period of time. It is an alternative method to the outright purchase of an asset. As the
name suggests it is a lease to ‘finance’ the acquisition of assets.

An operating lease is usually for a shorter period of time and is a rental of the asset.

The standard sets out quite different methods for accounting for each type of lease. As
such the determination of the lease classification is vitally important.

The following example may assist in understanding the distinction between a finance
lease and an operating lease:

Discount Rent-a-car acquires motor vehicles on four-year leases and hires the vehicles
on a daily basis to the public. The acquisition of the vehicles under a four-year lease is
a finance lease. The daily rental to the public is an operating lease.

Classification of finance leases and operating leases is not always as simple as this
example. The criteria for the classification of leases are quite subjective, as the
accounting standard does not impose quantitative guidelines for the determination of
the lease classification.

Characteristics of a finance lease
A finance lease is an alternative method to outright purchase for acquiring non current
assets over an extended period of time. A finance lease substantially transfers the risks
and rewards of ownership to the lessee. The title to the asset does not have to be
transferred to the lessee.

Risks of ownership include unsatisfactory performance of the asset, the asset
becoming obsolete due to improved technology, under-use of the asset (idle capacity),
loss in value below the (guaranteed) residual value and uninsured damage to the asset
rendering it unusable.
Rewards of ownership include the benefits of using the asset and the asset being of
greater value than the residual value at the end of the lease.




                                                                                           5
Factors determining whether a lease is a finance lease are:

       1.      Is the lease non-cancelable?
       2.      Is ownership to be transferred at the end of the lease?
       3.      Is the lease term a major part of the economic life of the leased asset?
               (In the previous standard this was quantified as 75%. The current
               standard is silent as to the percentage.)
       4.      Is the present value of the minimum lease payments substantially all of
               the fair value of the leased asset?
               (In the previous standard this was quantified at 90%. The current
               standard is silent as to the percentage)
       5.      Are the risks and rewards of ownership transferred to the lessee?

If the answer to each of the above questions is ‘yes’ then each question is evidence
that the lease may be a finance lease. However the lease can be classified as a finance
lease even though some of the answers are ‘no’. If the answer to all of the above
questions is ‘no’ then it is an operating lease.

It is possible that the same lease can be classified differently by the lessor and lessee
due to individual interpretation and the subjective nature of the criteria for
determining finance leases.


Characteristics of an operating lease
An operating lease is any lease that is not a finance lease. The features of an operating
lease are:

Risks and benefits. All of the risks and benefits of ownership of the leased asset are
       retained by the lessor
Cancelled. Usually the lease can be cancelled.
Time frame. Operating leases are for a comparatively short period of time and not a
       major part of the economic life of the leased asset. Generally they are for a
       shorter period of time than finance leases
Payments. The payments under the lease are a rental of the asset and are not a
       substantial proportion of the fair value of the asset.

Examples of operating leases are the hire of equipment from a hire company eg
National Hire and Kennards. A long-term lease of office premises also is an operating
lease. A more detailed example of an operating lease is considered later in this chapter
under the heading of Accounting for operating leases.




                                                                                            6
SELF ASSESSMENT EXERCISE LEA.1 FINANCE & OPERATING LEASES

Complete the following table assuming that the lease would meet the criteria to be
classified as a finance or an operating lease.

                                                                         Finance   Operating
                                                                         Lease      Lease
Are risks and rewards of ownership incidental to
ownership transferred?                                                      Yes      No

Can the lease be cancelled?

Will ownership be transferred at the end of lease?

Is the lease term a major part of the economic life
of the leased asset?

Is the present value of the minimum lease payments
substantially all of the fair value of the leased asset?

Is the lease of a short term nature?

Do the payments amount to a rental of the asset?

REVISION

Prepare the answers to revision questions 1 to 6 (at the end of the chapter).


ACCOUNTING FOR FINANCE LEASES
The accounting for finance leases is completely different to the accounting for
operating leases. Before the development of an accounting standard for leases the
leased assets and their associated liabilities were not recorded in the balance sheet.
The financial statements did not depict the true financial position of the business and
meaningful analysis of the financial statements could not be undertaken.

Recording leased assets
The assets subject to a finance lease are now recorded in the balance sheet of the
lessee as assets along with their corresponding lease liability. They are recorded at the
lower of their fair value and the present value of the minimum lease repayments.

In effect assets acquired under finance leases are recorded in the financial records and
accounts in much the same way as if the business had borrowed funds and purchased
the asset.

The following information relates to a finance lease. The first lease payment is due on
30 June 2006.




                                                                                               7
Example Lea.1

Lease term                                                           4 years

Annual payment payable in advance on 30 June each year               $24 000

Economic life of machinery                                           6 years

Estimated residual value at the end of the lease term                $13 000

Residual value guaranteed by lessee                                  $8 000

Present value of lease repayments                                    $91 731

Assets fair value June 30 2006                                       $95 406




Minimum Repayments

        June 30, 2006                                                          24000
        June 30, 2007                                                          24000
        June 30, 2008                                                          24000
        June 30, 2009                                                          24000
        June 30, 2010 Guaranteed residual                                       8000

Minimum lease payments                                                         104000

Unguaranteed residual value, June 30 2010               13000-8000               5000

                                                                               109000



Lease repayment schedule
To facilitate the recording of the lease a lease repayment schedule is prepared. The
lease payments are apportioned between the finance charge (interest) and the
reduction of the outstanding liability (principal).

Two alternative situations arise from the definition of minimum lease repayments:

        1. Where the lessee intends to return the asset at the end of the lease, the
           minimum lease repayments are the lease payments and any amount
           guaranteed by the lessee.
        2. Where the lessee intends to retain the asset at the end of the lease the
           minimum lease repayments are the lease payments and the amount of the
           payment under a purchase option.

The following schedule is prepared from the lease details in example Lea.1. The
schedule breaks down the lease payments into principal and interest in the
circumstances where the asset is returned at the end of the lease at its guaranteed
residual value. The lease repayments schedule is used to apportion lease payments



                                                                                        8
between principal and interest and facilitates the preparation of journal entries to
record lease payments. The implicit interest rate is 8%.

Lease repayment schedule



                                Lease payment schedule

               Minimum lease     Interest   Reduction in   Balance of
                 payments        expense      liability     Liability
                     $               $           $             $
June 30 2006                                                91 731*
June 30 2006       24 000                     24 000        67 731
June 30 2007       24 000         5 418       18 582        49 149
June 30 2008       24 000         3 932       20 068        29 081
June 30 2009       24 000         2 327       21 673         7 408
June 30 2010        8 000           592        7 408           0



Comments
1    (*) The opening balance of the lease liability in the table is the present value
     of the lease repayments as the asset is recorded at the lower of the present
     value of the lease repayments and the fair value of the asset. The asset is being
     returned to the lessor at its guaranteed residual value at the end of the lease.

2      The lease payment in the table for 2010 is for the guaranteed residual value.
       The asset is returned to the lessor at its guaranteed residual value.

3.     The interest component of each lease payment is calculated on the balance of
       the liability at the end of the previous year.
       eg      payment at 30 June 2007

               Interest                $67 731 * 8%            = $5 418
               Principal               $24 000 - $5 418        = $18 582
               Balance of liability    $67 731 - $18 582       = $49 149


Accounting records for financial lease – books of the lessee
Assets acquired under a finance lease are recorded as assets and liabilities in the
accounting records of the lessee. They are depreciated in the same manner as the other
depreciable assets owned by the business. The asset is depreciated over the life of the
lease or if the business is going to purchase the asset at the end of the lease, then it is
depreciated over the economic life of the asset.
Lease payments are apportioned between principal and interest. The payment of
principal reduces the liability under the lease and is debited to the liability account.
Interest is recorded as an expense and is written off against income for the period.




                                                                                          9
Example Lea.2 – accounting for finance leases

The following information is from example Lea.1 where the lessor has returned the
asset at the end of the lease. This information is used to prepare the general journal
and ledger account entries relating to the lease.

Lease term commencing 30 June 2006                                                4 years

Annual payment payable in advance on 30 June each year                            $24 000

Present value of minimum lease payments                                           $91 731

Residual value guaranteed by lessee                                               $8 000

Assets fair value 30 June 2006                                                    $95 406

Interest rate implicit in the lease                                                      8%

Lessee will return the machinery at the end of the lease


The lease payment schedule was prepared in example Lea.1.

                                 Lease payment schedule

                Minimum lease     Interest     Reduction in    Balance of
                  payments        expense        liability      liability
                      $               $             $              $
June 30 2006                                                    91 731
June 30 2006        24 000                       24 000         67 731
June 30 2007        24 000            5 418      18 582         49 149
June 30 2008        24 000            3 932      20 068         29 081
June 30 2009        24 000            2 327      21 673          7 408
June 30 2010         8 000              592       7 408            0

                   104 000            12 269     91 731



General Journal                                       Debit      Credit
                                                        $           $
30/06/2006 Leased machinery                           91 731
             Lease liability                                      91 731
           Lease of machinery

30/06/2006 Lease liability                            24 000
             Bank                                                 24 000
           Lease payment

(i)     The first journal entry records the asset and the liability resulting from the
        signing of the finance lease. The leased machinery is recorded at $91 731 that
        is the lower of the fair value of the machinery and the present value of the
        minimum lease payments at 30 June 2006.


                                                                                         10
(ii)    The second journal entry is the payment of the $24 000 payable at the
        commencement of the lease.


 30/06/2007 Lease liability                        18 582
            Interest expense                        5 418
               Bank                                           24 000
            Lease payment

30/06/2007 Depreciation                            20 933
              Accumulated depreciation                        20 933
           Depreciation of equipment
           ($91 731- $8 000)/4

30/06/2007 Profit and loss account                 26 351
             Interest expense                                  5 418
             Depreciation                                     20 933
           Closing entry

(iii)   The lease payment on the 30 June 2007 is apportioned between principal
        (reducing the lease liability) and interest expense. The apportionment comes
        from the lease payment schedule for the 30 June 2007 payment.
(iv)    The calculation of the depreciation is shown in the narration to the journal
        entry. The $91 731 is the value that the asset is recorded in the ledger. The
        $8000 is the residual value at the end of the lease. The asset is depreciated
        over four years, the life of the lease, as the lessee does not intend to purchase
        the asset at the end of the lease.
(v)     The depreciation and interest expense are transferred to the profit and loss
        account as closing entries.
(vi)    Similar entries are prepared for each of the remaining years of the lease.

General Journal                                     Debit     Credit
                                                      $         $

30/06/2008 Lease liability                         20 068
           Interest expense                         3 932
              Bank                                            24 000
           Lease payment

30/06/2008 Depreciation                            20 933
              Accumulated depreciation                        20 933
           Depreciation of equipment
           ($91 731- $8 000)/4

30/06/2008 Profit and loss account                 24 865
             Interest expense                                  3 932
             Depreciation                                     20 933
           Closing entry

30/06/2009 Lease liability                         21 673
           Interest expense                         2 327
              Bank                                            24 000
           Lease payment



                                                                                        11
30/06/2009 Depreciation                           20 933
              Accumulated depreciation                        20 933
           Depreciation of equipment
           ($91 731- $8 000)/4

30/06/2009 Profit and loss account                23 260
             Interest expense                                  2 327
             Depreciation                                     20 933
           Closing entry

30/06/2010 Depreciation                           20 932
              Accumulated depreciation                        20 932
           Depreciation of equipment
           ($91 731- $8 000)/4

30/06/2010 Lease liability                         7 408
           Interest expense                          592
              Leased machinery                                 8 000
           Return of machinery at
           guaranteed residual value

30/06/2010 Profit and loss account                21 524
             Interest expense                                    592
             Depreciation                                     20 932
           Closing entry

30/06/2010 Accumulated depreciation               83 731
             Leased machinery                                 83 731
           Leased machinery returned

(vii)  At the end of the lease the machinery is returned to the lessor at the guaranteed
       residual value of $8 000. This is shown in the second journal entry for 2010.
       The $8 000 is apportioned between interest and principal as per the lease
       payments schedule.
(viii) The accumulated depreciation written off the leased asset is transferred to the
       leased machinery account to close both accounts when the machinery has been
       returned to the lessor.

In this chapter the ledger accounts are shown in three column format. The same ledger
accounts in the traditional ‘T format’ are shown as an appendix at the end of the
chapter.

General ledger

Leased machinery
Date              Details                           Debit       Credit    Balance
30//06/2006       Lease liability                    91 731               91 731 DR
30/06/2010        Lease liability and interest                    8 000   83 731 DR
                  Accumulated Depreciation                       83 731      0




                                                                                      12
Accumulated depreciation - leased machinery
Date            Details                          Debit     Credit    Balance
30/06/2007      Depreciation                                20 933   20 933 CR
30/06/2008      Depreciation                                20 933   41 866 CR
30/06/2009      Depreciation                                20 933   62 799 CR
30/06/2010      Depreciation                                20 932   83 731 CR
                Leased machinery                  83 731                0



Lease liability
Date              Details                        Debit     Credit    Balance
30//06/2006       Leased machinery                          91 731   91 731 CR
                  Bank                            24 000             67 731 CR
30//06/2007       Bank                            18 582             49 149 CR
30//06/2008       Bank                            20 068             29 081 CR
30//06/2009       Bank                            21 673              7 408 CR
30//06/2010       Leased machinery                 7 408                0


Bank
Date              Details                        Debit     Credit    Balance
30//06/2006       Lease liability                           24 000
30//06/2007       Lease liability and interest              24 000
30//06/2008       Lease liability and interest              24 000
30//06/2009       Lease liability and interest              24 000



Depreciation
Date              Details                        Debit     Credit    Balance
30//06/2007       Depreciation                    20 933             20 933 DR
                  Profit and loss                           20 933      0
30//06/2008       Depreciation                    20 933             20 933 DR
                  Profit and loss                           20 933      0
30//06/2009       Depreciation                    20 933             20 933 DR
                  Profit and loss                           20 933      0
30//06/2010       Depreciation                    20 932             20 932 DR
                  Profit and loss                           20 932      0

Lease interest
Date              Details                        Debit     Credit    Balance
30//06/2007       Bank                             5 418              5 418 DR
                  Profit and loss                            5 418      0
30//06/2008       Bank                             3 932              3 932 DR
                  Profit and loss                            3 932      0
30//06/2009       Bank                             2 327              2 237 DR
                  Profit and loss                            2 327      0
30//06/2010       Leased mach  Chine                592                 592 DR
                  Profit and loss                              592      0




                                                                                 13
SELF ASSESSMENT QUESTION LEA.2

The following information relates to a finance lease for machinery. The first lease
payment is due on 30 June 2006. Prepare the general journal entries and general
ledger accounts for the period of the lease.

Lease term                                                                        4 years

Annual payment payable in advance on 30 June each year                            $24 000

Economic life of machinery                                                        6 years

Residual value of machinery                                                         Nil

Residual value at the end of the lease term                                       $13 000

Present value of minimum lease repayments                                         $95 406

Assets fair value 30 June 2006                                                    $95 406

The lessee has agreed to purchase the machinery at its residual value at the end of the lease.

                                     Lease payment schedule

                  Minimum lease       Interest     Reduction in      Balance of
                    payments          expense        liability        liability
                        $                 $             $                $
June 30 2006                                                          95 406
June 30 2006          24 000                          24 000          71 406
June 30 2007          24 000            5 712         18 288          53 118
June 30 2008          24 000            4 249         19 751          33 367
June 30 2009          24 000            2 669         21 331          12 036
June 30 2010          13 000              964         12 036             0

                      109 000          13 594         95 406

Note

(i)      The depreciation is calculated over six years, the economic life of the asset as
         the machine will be purchased by the lessee at the end of the lease.
(ii)     The lessee will make a cash payment of $13 000 to purchase the machine at its
         residual value at 30 June 2010

REVISION

Prepare the answers to revision questions 7 to 9 (at the end of the chapter).




                                                                                            14
Disclosure in the accounts
The accounting standard for leases requires that lessees disclose the following
information in their accounts:

(a)    the written down value (book value) for each class of asset at balance date

(b)    a reconciliation of the total of future minimum lease repayments and their
       present value at balance date. The accounts must also disclose the total of
       future minimum lease payments and their present value at balance date, for
       each of the following periods:

       (i)     not later than one year;
       (ii)    later than one year and not later than five years;
       (iii)   later than five years;

(c)    a description of the leasing arrangements.


Example Lea.2 – disclosure in the accounts

The following information from example Lea.1 is used to prepare the disclosure
requirements in the accounts for 30 June 2007:

Lease payment schedule

               Minimum lease       Interest expense    Reduction in    Balance of
                 payments                                liability      Liability
                     $                    $                  $               $
June 30 2006                                                              91 731
June 30 2006       24 000                                  24 000         67 731
June 30 2007       24 000               5 418              18 582         49 149
June 30 2008       24 000               3 932              20 068         29 081
June 30 2009       24 000               2 327              21 673         7 408
June 30 2010        8 000                 592               7 408            0

                  104 000              12 269              91 731

Written down value                                            2007            2006

Leased machinery                                              91 731          91 731
Accumulated depreciation                                      20 933
                                                              70 798          91 731




                                                                                       15
Disclosure in the accounts

Finance lease liabilities
                                                  Present Value                    Present Value
                                   Lease payments of payments     Lease payments   of payments
                                      2007           2007             2006              2006

Amounts payable under finance
Leases:
         Within one year               24 000       20 068           24 000           18 582
         > 1 year, <5 years            32 000       29 181           56 000           49 149
Total minimum lease payments           56 000       49 149           80 000           67 731
Less finance charges                    6 851                        12 269
Present value of min. lease payments   49 149                        67 731


Property, plant and equipment
The written down value of leased assets included in property, plant and equipment is
$70 798 (2006, $91 731).

Accounting policies relating to leases

Leases are classified as finance leases when the lease transfers substantially all the
risks and rewards of ownership to the lessee. All other leases are classified as
operating leases.

The assets acquired under finance leases are recorded at the lower of their fair value
or the net present value of the lease payments. The amount owing under the finance
lease is disclosed as a finance lease liability in the balance sheet. Lease payments are
apportioned between repayments of principal and interest charges. Repayments of
principal reduce the lease liability and interest is written off as a financial expense.




                                                                                               16
OPERATING LEASES
A lease that is not classified as a finance lease is deemed to be an operating lease. An
operating lease is generally for a shorter period of time than a finance lease and is
treated as a rental of the asset.

Classification as an operating lease
The information contained in the following lease is used to illustrate why it was
determined to be an operating lease.

Example Lea.3 - classification as operating lease

A & M Botelho, trading as Botelho’s Café, entered into a lease for café operating
equipment. Details of the lease are as follows:


Inception date and first lease payment    30 June 2006
Lease term                                      4 years
Estimated economic life                        10 years
Lease is non-cancelable
Annual rental payment in advance                $9 800
Present value of lease payments                $35 518
Residual value at end of lease                 $38 000
Interest rate implicit in the lease                 7%
Fair value of café equipment 30 June 2006      $73 000

The lease has been classified as an operating lease. Factors taken into consideration in
making this decision were:

(a)    The term of the lease term is not a major part of the economic life of the leased
       asset.
               4 years * 100 = 40%
              10years

(b)    The present value of the minimum lease payments is not a substantial
       proportion of the fair value of the leased asset’.
              $35 518 * 100 = 48.7%
              $73 000

(c)    The lease does not provide for ownership to be transferred to the lessee at the
       end of the lease



Accounting for operating leases - the books of the lessee
Under an operating lease, lease payments are recorded as an expense. The $9 800
lease payment for 2006 in example Lea.3 is recorded in the following way:




                                                                                      17
General journal


        2006                                        $           $
      Jun-30 Lease expense                        9 800
               Bank                                            9 800
             Lease payment

      Jun-30 Profit & loss                        9 800
               Lease expense                                   9 800
             Closing entry



General ledger

Lease Expense
Date               Details                             Debit        Credit     Balance
30/06/2006       Bank                                  9 800                   9 800 DR
                 Profit and loss                                       9 800       0

Bank
Date               Details                             Debit        Credit     Balance
30/06/2006       Lease expense                                         9 800   9 800 CR

The journal entries and ledger accounts will be the same for each of the years
2007, 2008 and 2009 to record the annual lease payment.

SELF ASSESSMENT QUESTION LEA.3 – OPERATING LEASE

On 1 July, 2006 Ann enters into an operating lease arrangement with John. Ann is
to lease equipment from John for a period of three years.
Rental payments of $15,000 each are payable six-monthly with the first payment
made on 1 July 2006.

Prepare entries in the general journal and general ledger to record the lease- related
transactions in the books of Ann for the year ended 30 June, 2007.

Disclosure in accounts
The accounting standard requires the following information relating to operating
leases to be disclosed in the accounts by lessees:

(a)      future lease payments for the following periods:

         (i)     not later than one year
         (ii)    later than one year and not later than five years
         (iii)   later than five years

(b)      lease payments recorded as expenses for the period,…

(c)      description of the lessee’s leasing arrangements


                                                                                          18
The following information from Example Lea.3 would be disclosed in the accounts
of Botelho’s Café for the year ended 30 June 2007.

Accounting policies relating to leases

Leases are classified as finance leases when the lease transfers substantially all the
risks and rewards of ownership to the lessee. All other leases are classified as
operating leases.

Under operating leases, lease payments are recorded as expenses and written off
against income in the year in which it is incurred.

Operating lease liabilities
For the year ended 30 June 2007 the lease payment recorded as an expense was
$9800. (2006. $9 800).
Future minimum lease payments under non cancelable operating leases are:

                                                                 2007              2006

Within one year                                                  9 800             9 800
After one year but not more than five years                      9 800            19 600
More than five years
                                                                19 600            29 400


REVISION

Prepare the answers to revision questions 10 to 12 (at the end of the chapter).




SUMMARY
Prior to the development of an accounting standard for leases any payments made
under a lease agreement were treated as an expense. This resulted in the non-current
assets, the liabilities and the profits of the business being understated where the long-
term lease amounted to an alternative to the purchase of the assets.

The accounting standard for leases prescribes the accounting and disclosure
requirements for business leasing arrangements. The standard also sets out the factors
that should be taken into consideration in determining if a lease is to be classified as a
finance lease or an operating lease.

The aim of the standard is to ensure that leases are consistently recorded by
businesses and that the resulting financial statements provide meaningful information
that can be reliably analysed to make better informed financial decisions.




                                                                                           19
Answers to self tassessment questions.

SELF ASSESSMENT QUESTION LEA.1

                                                             Finance       Operating
                                                              Lease         Lease
Are risks and rewards of ownership incidental to
ownership transferred?                                            Yes        No

Can the lease be cancelled?                                         No      Yes

Will ownership be transferred at the end of lease?               Yes/ No     No

Is the lease term a major part of the economic life
of the leased asset?                                                Yes      No

Is the present value of the minimum lease payments
substantially all of the fair value of the leased asset?            Yes      No

Is the lease of a short term nature?                                No       Yes

Do the payments amount to a rental of the asset?                    No       Yes


SELF ASSESSMENT QUESTION LEA.2


General journal


                                                  Debit    Credit
                                                     $       $
30/06/2006 Leased machinery                       95 406
             Lease liability                               95 406
           Lease of machinery

30/06/2006 Lease liability                        24 000
             Bank                                          24 000
           Lease payment

                                                     $        $
30/06/2007 Lease liability                        18 288
           Interest expense                        5 712
              Bank                                         24 000
           Lease payment

30/06/2007 Depreciation                           15 901
              Accumulated depreciation                     15 901
           Depreciation of equipment
           95 406/6




                                                                                   20
30/06/2007 Profit and loss account       21 613
             Interest expense                      5 712
             Depreciation                         15 901
           Closing entry


30/06/2008 Lease liability               19 751
           Interest expense               4 249
              Bank                                24 000
           Lease payment

30/06/2008 Depreciation                  15 901
              Accumulated depreciation            15 901
           Depreciation of equipment
           '95 406/6

30/06/2008 Profit and loss account       20 150
             Interest expense                      4 249
             Depreciation                         15 901
           Closing entry


30/06/2009 Lease liability               21 331
           Interest expense               2 669
              Bank                                24 000
           Lease payment

30/06/2009 Depreciation                  15 901
              Accumulated depreciation            15 901
           Depreciation of equipment
           '95 406/6

30/06/2009 Profit and loss account       18 570
             Interest expense                      2 669
             Depreciation                         15 901
           Closing entry

30/06/2010 Depreciation                  15 901
              Accumulated depreciation            15 901
           Depreciation of equipment
           '95 406/6

30/06/2010 Lease liability               12 036
           Interest expense                 964
              Bank                                13 000
           Purchase of machinery at
            residual value




                                                           21
30/06/2010 Profit and loss account            16 865
             Interest expense                              964
             Depreciation                               15 901
           Closing entry

General ledger

Leased Machinery
Date        Details                             Debit     Credit      Balance
30//06/2006 Lease liability                    95 406              95 406 DR

Accumulated depreciation - leased machinery
Date       Details                              Debit    Credit       Balance
30/06/2007 Depreciation                                  15 901    15 901 CR
30/06/2008 Depreciation                                  15 901    31 802 CR
30/06/2009 Depreciation                                  15 901    47 703 CR
30/06/2010 Depreciation                                  15 901    63 604 CR

Lease liability
Date         Details                            Debit    Credit     Balance
30//06/2006 Leased machinery                             95 406    95 406 CR
             Bank                              24 000              71 406 CR
30//06/2007 Bank                               18 288              53 118 CR
30//06/2008 Bank                               19 751              33 367 CR
30//06/2009 Bank                               21 331              12 036 CR
30//06/2010 Bank                               12 036                  0

Bank
Date          Details                           Debit    Credit     Balance
30//06/2006   Lease liability                            24 000
30//06/2007   Lease liability and interest               24 000
30//06/2008   Lease liability and interest               24 000
30//06/2009   Lease liability and interest               24 000
30//06/2010   Lease liability and interest               13 000

Depreciation
Date        Details                             Debit     Credit    Balance
30//06/2007 Depreciation                       15 901              15 901 DR
            Profit and loss                              15 901        0
30//06/2008 Depreciation                       15 901              15 901 DR
            Profit and loss                              15 901        0
30//06/2009 Depreciation                       15 901              15 901 DR
            Profit and loss                              15 901        0
30//06/2010 Depreciation                       15 901              15 901 DR
            Profit and loss                              15 901        0




                                                                                22
Lease interest
Date        Details                Debit       Credit       Balance
30//06/2007 Bank                   5 712                    5 712 DR
            Profit and loss                      5 712         0
30//06/2008 Bank                   4 249                    4 249 DR
            Profit and loss                      4 249         0
30//06/2009 Bank                   2 669                    2 669 DR
            Profit and loss                      2 669         0
30//06/2010 Bank                    964                       964 DR
            Profit and loss                        964         0


SELF ASSESSMENT QUESTION LEA.3


General journal


     2006                                $              $
    July 1 Lease expense              15 000
             Bank                                  15 000
           Lease payment
     2007
    Jan 1 Lease expense               15 000
             Bank                                  15 000
           Lease payement
   Jun-30 Profit & loss               30 000
             Lease expense                         30 000
           Closing entry



General ledger

Lease Expense
Date               Details           Debit       Credit        Balance
01/07/2006       Bank                 15 000                   15 000 DR
01/01/2007       Bank                 15 000                   30 000 DR
30/06/2007       Profit and loss                  30 000            0

Bank
Date               Details           Debit       Credit        Balance
01/07/2006       Lease expense                  15 000        15 000 CR
01/01/2007       Lease expense                  15 000        30 000 CR




                                                                           23
REVISION QUESTIONS

Theory

Lea.1. What is a lease?
Lea.2. What are the advantages and disadvantages of leasing.
Lea.3. What is a finance lease?
Lea.4. What is an operating lease?
Lea.5. Explain the characteristics of a finance lease that make it
       different to an operating lease.

       Multiple Choice

Lea 6
(a)    P.Roberts instructed his agent, P.Lam, to gain a client for the lease of his
property and an agreement was made with J.Knowles. Who is the lessor?
             (i)   P.Roberts
             (ii)  P.Lam
             (iii) Knowles

(b)    A finance lease is one in which:
            (i)       Legal ownership is transferred to the lessee
            (ii)      Legal ownership is not transferred to the lessee.
            (iii)     Possession remains with the lessor.
            (iv)      None of the above

 (c) The Accounting Standard for leases was introduced primarily for:
            (i)     Operating leases.
            (ii)    Finance leases.
            (iii)   Real Estate leases

  (d) Residual value is:
            (i)        The scrap value at the end of the lease.
             (ii)      The amount to be deducted from the lease before depreciation
                      is calculated.
            (iii)      The estimated fair value of the property at the end of the
                       lease term.

 (e) Fair value is:
             (i)      The acceptable price between knowledgeable buyer and seller
                      of non-current assets, in an arms length transaction.
             (ii)     The unguaranteed residual value.
             (iii)    The value of the lease including legal costs.




                                                                                      24
(f) An operating lease is one in which the risks and benefits are retained by the:
           (i)       Lessor.
           (ii)      Lessee.
          (iii)      Agent preparing the lease.

(g) The principal owing to the lessor on a finance lease is reduced by:
            (i)     The amount of the yearly payments.
            (ii)    The yearly depreciation.
            (iii)   The yearly payment minus the interest component.

(h) T. Ryan leased a vehicle for three weeks while his car was being repaired. Is this a:
          (i)      Finance lease.
          (ii)     Operating lease.
          (iii)    Sales - type lease.




                                                                                     25
Accounting for finance leases

Lea.7. J. Craig entered into a finance lease on 1 July, 2008. The details contained in
       the lease contract are:

    Start lease term 1 July, 2008
    Present value of lease repayments at 1 July 2008 is $100,000.
    Fair value of the asset at 1 July 2008is $110 000.
    Lease term 5 years
    Useful life of asset (no scrap value) 8 years
    Lease payments $20,000 p.a. commencing 1 July, 2008 and each 30 June
     afterwards
    Lease implicit interest rate is 9%
    The lessee intends to return the asset at the end of the lease term at a guaranteed
     residual value of $23 396

Prepare:
      In the books of J Craig the lessee, prepare the general journal entries and
      general ledger accounts for the period of the lease.


                                   Lease repayment schedule

    Period Ended       Minimum                                 Reduction in          Balance
                     Lease Payment            Interest        Lease Liability       Outstanding
                            $                    $                 $                    $
                                                                                      100,000
      1-7-2008            20,000                                  20,000               80,000
     30-6-2009            20,000               7 200              12 800              67 200
     30-6-2010            20,000               6 048              13 952              53 248
     30-6-2011            20,000               4 792              15 208              38 040
     30-6-2012            20,000               3 424              16 576              21 464
     30-6-2013            23,396               1 932              21 464                 -




                                                                                           26
Lea.8. A.Wade signed a lease for new bread making equipment. The lease
    contract had the following terms:

       Inception date of lease                                    1 July 2005
       Fair Value of lease asset at 1 July 2005                     $55 271
       Lessee guarantee residual value at end of lease term         $18 500
       Lease payments payable at 30 June of each year.
         1st payment on 1/7/2005                                     $10,500
       Lease implicit interest rate                                    10%
       Useful life of leased asset                                   7 years
       Scrap value at end of useful life                             $4,871
       Lease Term (ends 30 June 2010).                                5 years

   The lessee intends to make an offer to purchase the asset on 30 June
   2010 for the guaranteed residual value.

                              Lease repayment schedule

   Period ended        Lease Payment         Interest       Reduction in          Balance
                                                           Lease Liability       Outstanding
                              $                 $                $                    $

                                                                                   55,271
       01/7/2005           10,500               -              10,500              44,771
       30/6/2006           10,500             4,477             6,023              38,748
       30/6/2007           10,500             3,875             6,625              32,123
       30/6/2008           10,500             3,212             7,288              24,835
       30/6/2009           10,500             2,483             8,017              16,818
       30/6/2010           18,500             1,682            16,818                 -


    Prepare general journal entries and general ledger accounts to record the lease
       transactions in the books of A.Wade for the period of the lease.




                                                                                      27
Lea.9. D.Finch leased machinery from B.Hogles. The lease contract had the
following terms:

              Inception of lease                                            1 July 2006
              Fair value of lease asset at 1 July 2006                        $84 000
              Lease guarantee residual value at end of lease                  $27 640
              Lease payments payable on 30 June each year                     $19 200
              An initial payment to be made on 1 July 2006                    $10 000
              Lease implicit interest rate                                      12%
              Useful life of leased asset                                     10 years
              Scrap value at end of useful life                                $4 000
              Lease term (ends 30 June 2011)                                   5 years


  D.Finch intends to make an offer to purchase the asset on 30 June 2011 for the
     guaranteed residual value.
                              Lease payment Schedule:

  Period              Lease             Interest      Reduction in Balance
  Ended               Payment           Expense       Lease liability Outstanding

                         $                   $                  $         $
                                                                       84 000
1 July 2006          10 000                              10 000        74,000
30 June 2007         19 200                8 880         10 320        63 680
30 June 2008         19 200                7 642         11 558        52 122
30 June 2009         19 200                6 254         12 946        39 176
30 June 2010         19 200                4 702         14 498        24 678
30 June 2011         27 640                2 962         24 678         —
                    114 440               30 440         84.000

   Prepare the general journal entries and general ledger accounts to
   record the lease transactions in the books of D.Finch for the period of
   the lease.




                                                                                     28
Operating leases

Lea 10. On 1 October 2006, Alex Ltd entered into an operating lease
     agreement with Beryl Ltd for the lease of equipment for a period of 3
     years. Lease rental payments are $15,000 each, payable half-yearly
     with the first payment on 1 October 2006.

     Prepare entries in the general journal and general ledger to record the
     lease-related transactions in the books of Alex Ltd for the year ended
     30 June, 2007.


      Note: The question has prepaid rental payments and requires adjustments for
     prepaid expenses and reversal entries.

Lea 11 Croker Ltd entered into an operating lease for equipment for a period of 3
     years. Rental payments of $6,000 are made, in advance, on 1 March and 1
     September. The first payment was due on 1 March 2007.

     Prepare entries in the general journal and general ledger to record the
     lease-related transactions in the books of Croker Ltd for the year
     ended 30 June, 2008.
      Note: The question has prepaid rental payments and requires adjustments for
     prepaid expenses and reversal entries.

Lea 12 Moore Ltd entered into a 3 year operating lease for equipment. Rental
     payments of $9,000 are made, in advance, on 1 March and 1 September each
     year. The first payment was due on 1 March 2007.

     In the books of the lessee prepare the journal entries relating to the lease for the
     year ending 30 June 2008. Cash entries are to be entered in the general journal.
     In the general ledger prepare the Lease expense account and Bank account for
     the year ended 30 June 2008.

     Note: The question has prepaid rental payments and requires adjustments for
     prepaid expenses and reversal entries.




                                                                                        29
APPENDIX

General ledger accounts in ‘T account format’

Example 1

General
ledger
                              Leased machinery
   2006                          $        2010                     $
                                           Jun-   Lease liab. &
  Jun-30    Lease liability     91731        30   interest         8000
                                                                  83731
                               91731                              91731

                   Accumulated depreciation - leased machinery
   2010                         $         2007                     $
            Leased                         Jun-
  Jun-30    machinery         83731           30 Depreciation     20933
                                          2008
                                           Jun-
                                              30 Depreciation     20933
                                          2009
                                           Jun-
                                              30 Depreciation     20933
                                          2010
                                           Jun-
                                              30 Depreciation     20932
                              83731                               83731




                                                                          30
                       Lease liability
 2006                  $          2006                         $

                                   Jun-
Jun-30   Bank          24000         30    Leased machinery   91731
         Balance c/d   67731
                       91731                                  91731
 2007                              2007
                                    Jul-
Jun-30   Bank          18582         01    Balance b/d        67731
         Balance c/d   49149
                       67731                                  67731
 2008                              2008
                                    Jul-
Jun-30   Bank          20068         01    Balance b/d        49149
         Balance c/d   29081
                       49149                                  49149
 2009                              2009
                                    Jul-
Jun-30   Bank          21673         01    Balance b/d        29081
         Balance c/d    7408
                       29081                                  29081
 2010                              2010
         Leased                     Jul-
Jun-30   machinery      7408         01    Balance b/d         7408

                        7408                                   7408

                            Bank
                        $          2006                        $
                                    Jun-   Lease liab. &
                                      30   interest           24000
                                   2007
                                    Jun-   Lease liab. &
                                      30   interest           24000
                                   2008
                                    Jun-   Lease liab. &
                                      30   interest           24000
                                   2009
                                    Jun-   Lease liab. &
                                      30   interest           24000




                                                                      31
                               Depreciation
   2007                        $         2007                      $
                                          Jun-
 Jun-30   Depreciation        20933         30    Profit & loss   20933
   2008                                  2008
                                          Jun-
 Jun-30   Depreciation        20933         30    Profit & loss   20933
   2009                                  2009
                                          Jun-
 Jun-30   Depreciation        20933         30    Profit & loss   20933
   2010                                  2010
                                          Jun-
 Jun-30   Depreciation        20932         30    Profit & loss   20932



                                Lease interest
   2007                        $          2007                     $
                                           Jun-
 Jun-30   Bank                 5418          30   Profit & loss    5418
   2008                                  2008
                                          Jun-
 Jun-30   Bank                 3932         30    Profit & loss    3932
   2008                                  2008
                                          Jun-
 Jun-30   Bank                 2327         30    Profit & loss    2327
   2009                                  2009
                                          Jun-
 Jun-30   Bank                  592         30    Profit & loss       592




SELF ASSESSMENT LEA.1



General ledger
                            Leased machinery
   2006                        $                                  $
 Jun-30   Lease liability     95406




                                                                            32
                Accumulated depreciation - leased machinery
                             $         2007                         $
                                        Jun-
                                          30 Depreciation          15901
                                       2008
                                        Jun-
                                          30 Depreciation          15901
                                       2009
                                        Jun-
                                          30 Depreciation          15901
                                       2010
                                        Jun-
                                          30 Depreciation          15901
                                                                   63604

                             Lease liability
 2006                        $         2006                         $
                                        Jun-
Jun-30   Bank               24000          30   Leased machinery   95406
         Balance c/d        71406
                            95406                                  95406
 2007                                  2007
                                        Jul-
Jun-30   Bank               18288        01     Balance b/d        71406
         Balance c/d        53118
                            71406                                  71406
 2008                                  2008
                                        Jul-
Jun-30   Bank               19751        01     Balance b/d        53118
         Balance c/d        33367
                            53118                                  53118
 2009                                  2009
                                        Jul-
Jun-30   Bank               21331        01     Balance b/d        33367
         Balance c/d        12036
                            33367                                  33367
 2010                                  2010
                                        Jul-
Jun-30   Bank               12036        01     Balance b/d        12036

                            12036                                  12036




                                                                           33
                             Bank
                         $          2006                     $
                                     Jun-   Lease liab. &
                                       30   interest        24000
                                    2007
                                     Jun-   Lease liab. &
                                       30   interest        24000
                                    2008
                                     Jun-   Lease liab. &
                                       30   interest        24000
                                    2009
                                     Jun-   Lease liab. &
                                       30   interest        24000
                                    2010
                                     Jun-   Lease liab. &
                                       30   interest        13000

                         Depreciation
 2007                    $         2007                      $
                                    Jun-
Jun-30   Depreciation   15901         30    Profit & loss   15901
 2008                               2008
                                     Jun-
Jun-30   Depreciation   15901          30   Profit & loss   15901
 2009                               2009
                                     Jun-
Jun-30   Depreciation   15901          30   Profit & loss   15901
 2010                               2010
                                     Jun-
Jun-30   Depreciation   15901          30   Profit & loss   15901



                          Lease interest
 2007                    $         2007                      $
                                    Jun-
Jun-30   Bank            5712         30    Profit & loss    5712
 2008                               2008
                                     Jun-
Jun-30   Bank            4249          30   Profit & loss    4249
 2008                               2008
                                     Jun-
Jun-30   Bank            2669          30   Profit & loss    2669
 2009                               2009
                                     Jun-
Jun-30   Bank             964          30   Profit & loss     964




                                                                    34

				
DOCUMENT INFO