ACCA F7 (INT) Financial Reporting - Study text - 2010 - Emile Woolf Publishing
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Chapter 12: Leases
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Accounting for a finance lease
Substance over form
Finance leases in the financial statements of the lessee
Calculating and allocating finance charges (interest)
Lease payments made in arrears
Lease payments made in advance
Splitting the year end lease liability: current and non-current liability
Finance leases in the financial statements of the lessor
2 Accounting for a finance lease
2.1 Substance over form
Accounting for finance leases is based on the concept of ‘substance over form’. This
is the concept that transactions and items should be accounted for according to their
economic substance, rather than their legal form.
The legal form of a finance lease is that the lessor is the legal owner of the leased
asset. This might suggest that the lessor should account for the leased asset as a non-
current asset in his statement of financial position. The lessee is not the legal owner
of the asset, and rents it from the lessor. This suggests that the lease rental payments
should be treated as an expense within profit or loss each year.
This is not how finance leases are accounted for, however, because this does not
represent the economic substance of a finance lease.
The economic substance of a finance lease is that the lessee in effect has all the
benefits and costs associated with ownership of the asset. IAS17 therefore states that
an asset leased under a finance lease arrangement should be accounted for by the
lessee as a non-current asset.
The lessor has transferred the risks and rewards of ownership of the leased asset to
the lessee. Therefore the lessee records the asset in his financial statements as an
item of property, plant and equipment. This reflects the underlying substance of the
arrangement whereby, even if a legal title does not pass to the lessee, he has use of
the asset over its useful life.
For the same reason, in the case of finance leases an asset should not be accounted
for by the lessor as a non-current asset.
The effect of classifying a lease incorrectly
If a finance lease is treated as an operating lease, the financial statements do not
fairly present the financial position of the entity:
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The leased asset is not recognised in the statement of financial position, even
though the substance of the lease is that the entity owns it.
The liability for the lease payments is not recognised in the statement of financial
position.
Therefore both assets and liabilities are understated. The lease becomes a form of
‘off balance sheet finance’, hidden from the users of the financial statements. The
entity’s (lessee’s) liabilities can appear to be much lower than they actually are.
Classifying a lease incorrectly affects several key performance measures, including
return on capital employed and gearing. (These performance measures are
explained in a later chapter.) The entity appears to generate a better return on its
assets than it really does and to be a less risky investment than it really is.
2.2 Finance leases in the financial statements of the lessee
At the start of the lease
At the start of a finance lease, the lessee should record the leased asset in his
accounts as a non-current asset ‘at cost’. This is the lower of:
the fair value of the asset and
the present value of the minimum lease payments. (These are the minimum
payments that the lessee has agreed to pay, under the terms of the lease agreement.)
The fair value of the asset is the cash price had it been purchased outright. The
present value of the minimum lease payments should be given to you in an
examination question, but could be calculated using discounting techniques.
The corresponding double entry is to create a liability for the finance lease
obligation. This is the ‘capital amount’ that the lessee will have to pay back to the
lessor over the term of the lease.
Debit: Property, plant and machinery – (at cost)
Credit: Liabilities: finance lease obligations
During the term of the lease
During the term of the lease, the leased asset is accounted for as a tangible non-
current asset. It is depreciated over the shorter of:
its expected useful life, and
the term of the lease.
The leased asset is included in the statement of financial position at cost minus
accumulated depreciation, and the annual depreciation cost is an expense in profit
or loss.
The rental payments by the lessee to the lessor consist of two elements:
a finance charge (interest charge) on the liability to the lessor, and
a partial repayment of the liability (the finance lease obligation).
Chapter 12: Leases
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The finance charge is treated as a finance cost in profit or loss for the period. The
partial repayment of the lease obligation reduces the amount of the liability that
remains unpaid.
In the statement of comprehensive income of the lessee, the costs associated with an
asset held under a finance lease arrangement (and included in profit or loss each
year) are therefore a depreciation charge plus a finance charge.
Lease payments: interest charge and partial repayment of the liability
The lease payments each year are divided into a finance charge and a partial
repayment of the liability for the finance lease obligation.
$
Total lease payment in the financial period P
Minus: finance charge (interest charge) I
–
–––––
Equals: Partial repayment of the liability for the finance lease obligation (P – I)
–
–––––
The remaining liability for the finance lease obligation is calculated each year as
follows:
$
Liability for the finance lease obligation at the start of the year L
Plus: Finance charge (interest charge) I
Minus: Total lease payment in the financial period (P)
–
–––––––
Equals: Partial repayment of the liability for the finance lease obligation (L + I – P)
–
–––––––
Lease payment table
For the purpose of calculations in answering an examination question on finance
leases, you should use a lease payment table to record the change each year in the
liability for the finance lease obligation. The table has one line for each financial
period, and is used to record L + I – P. By the end of the finance lease period, the
remaining liability for the finance lease obligation should be reduced to $0 (allowing
perhaps for a rounding error in the calculations).
For example, suppose that an entity has entered into a three-year finance lease on a
machine on 1 January Year 1, and the machine has a fair value of $21,000. The
annual lease payments are $9,000, payable at the end of each year. In the lease
payment table, you should record the fair value as the initial liability in the ‘opening
balance’ column for Year 1.
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Yearended
31December
Lease
obligation:
Opening
balance
Interest
Lease
payment
Lease
obligation:
Closing
balance
$ $ $ $
Year1 21,000
Year2
Year3
During each year, the lessee makes one or more lease payments. The payment is
recorded in the ledger accounted as follows.
Debit: Liabilities: Finance lease obligations
Cr edit: Cash
In this example, the annual lease payment is $9,000 on 31 December each year. The
payment each year should be entered into the ‘lease payment’ column in the table as
a negative figure.
Yearended
31December
Lease
obligation:
Opening
balance
Interest
Lease
payment
Lease
obligation:
Closing
balance
$ $ $ $
Year1 21,000 (9,000)
Year2
Year3
At the end of each year, the lessee must:
make a charge for depreciation of the leased asset, and
calculate the finance charge in the lease rental payment.
Depreciation. The asset should be depreciated over the shorter of its useful life and
the lease term:
Debit: Income statement; depreciation expense
Credit: Property, plant and machinery – accumulated depreciation
Finance charge. The finance charge is added to the liability for the finance lease
obligation, and is also an expense in profit or loss for the year.
Debit: Income statement: interest expense
Credit: Liabilities: Finance lease obligations
The total finance charge
The total finance charge over the term of a finance lease is the difference between
the total amount of lease payments and the initial cost of the leased asset.
Chapter 12: Leases
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In the example
$ $
Total lease payments over the term of
the lease agreement
TP (3 years × $9,000) 27,000
Initial cost C (21,000)
–
–––––
–
––––––
Total finance charge over the term of
(TP – C)
6,000 the lease agreement
–
–––––––
–
––––––
This total finance charge over the term of the lease is allocated to each financial
period covered by the lease agreement.
Continuing with the example, suppose that the total finance charge of $6,000 is
allocated $3,000 to Year 1, $2,000 to Year 2 and $1,000 to Year 3.
For Year 1, the finance charge of $3,000 is entered into the ‘interest’ column of the
lease payment table.
The table now appears as follows, showing that the closing balance for the liability
(obligation for the finance lease) is $15,000 at the end of Year 1. This then becomes
the opening balance at the start of Year 2.
Year ended 31
December
Opening
balance
(OB)
Interest
(I)
Lease
payment
(P)
Closing balance
(CB = OB + I – P)
$
$
$
$
Year 1 21,000
3,000
(9,000)
15,000
Year 2 15,000
Year 3
Completing the lease payment table for the whole of the lease term, you should find
that the remaining liability at the end of the lease is $0.
Year ended 31
December
Opening
balance
(OB)
Interest
(I)
Lease
payment
(P)
Closing balance
(CB = OB + I – P)
$
$
$
$
Year 1 21,000
3,000
(9,000)
15,000
Year 2 15,000
2,000
(9,000)
8,000
Year 3 8,000
1,000
(9,000)
0
The rules about presenting the information about finance leases in the financial
statements of a lessee are described later in the chapter.
2.3 Calculating and allocating finance charges (interest)
The total finance charge for a leased asset (finance lease) is allocated to the financial
periods over the term of the lease period. This allocation of the total charge between
accounting periods must be done in such a way as to reflect a constant rate of
interest on the amount due to the lessor. This means that as the lease liability
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decreases at each year-end, the interest charge for the next year will be lower than it
was for the previous year.
There are two acceptable methods of allocating the total finance charge between
accounting periods:
the actuarial method, or
the sum-of-the-digits method.
The actuarial method is the method that will be used in the examination.
Actuarial method
The actuarial method uses discounting arithmetic to establish the interest rate that
is implicit in the lease. This interest rate is then applied to the opening balance of the
lease liability at the start of each period, in order to calculate the finance charge.
$
Liability for the finance lease obligation at the start of the year L
Interest rate in the lease r%
Interest charge for the year L × r%
2.4 Lease payments made in arrears
The following example shows how the total finance charge for a finance lease is
allocated between the financial years using the two methods of allocation. In this
example the annual lease payments are made in arrears, at the end of each period.
Example
The fair value of an asset, leased under a finance lease commencing on 1 January
Year 1 is $12,886. The lease is for three years with payments of $5,000 annually on 31
December Year 1, Year 2 and Year 3. The interest rate implicit in the lease is 8%.
Required
(a) Calculate the finance charges for Years 1, 2 and 3 under the actuarial method.
(b) Show the closing lease liability at the end of each year.
Answer
$
Totalleasepayments(3×$5,000) 15,000
Minus:Cashpriceoftheasset (12,886)
–
–––––
Totalfinancecharge 2,114
–
–––––
Chapter 12: Leases
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The lease payment table is constructed as follows.
Yearended
31December
Opening
balance
(OB)
Interestat8%
(I=OB×8%)
Lease
payment
(P)
Closingbalance
(CB=OB+I–P)
$ $ $ $
Year1 12,886 1,031 (5,000) 8,917
Year2 8,917 713 (5,000) 4,630
Year3 4,630 370 (5,000) –
2.5 Lease payments made in advance
When the lease payments for a finance lease are made at the start of each period, the
finance lease obligation is paid in full with the final lease payment at the start of the
final period. This means that no funds are ‘borrowed’ from the lessor in the final
period, and there is no interest charge in profit or loss for that period.
For example, if the lease payments for a three-year finance lease are paid annually
in advance, at the beginning of Year 1, Year 2 and Year 3, the obligation is paid off at
the beginning of Year 3. There is an interest charge in Year 1 and Year 2, but not in
Year 3.
The opening liability for the finance lease obligation is reduced by the lease
payment at the beginning of the year, and the interest charge is applied to the
remaining balance. A lease payment table should be prepared as follows.
Year ended
Opening
balance
(OB)
Lease
payment
P
Capital
outstanding
C = OB – P
Interest
I
Closing
balance
(C + I)
$ $
$
$ $
Year 1
Year 2
Year 3
This will be illustrated with the next example.
2.6 Splitting the year-end lease liability: current and non-current liability
In the statement of financial position of the lessee, the total liability for the finance
lease obligation will consist of:
the capital balance outstanding (= the remaining liability for the finance lease
obligation), plus
any interest accrued but not yet paid at the end of the reporting period.
This total liability in the statement of financial position must be divided between:
the current liability (amount payable within the next 12 months), and
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the non-current liability.
The current liability consists of:
any interest accrued but not yet paid at the end of the reporting period (because
this will be paid within the next 12 months), plus
the amount of the ‘capital’ liability for the finance lease obligation that will be
repaid in the next 12 months.
From the lease payment table:
the non-current liability is the ‘capital balance’ outstanding in one year’s time
(which can be obtained from the figure in ‘capital outstanding’ column for the
end of the next year)
the amount of the ‘capital’ liability that is a current liability is the difference
between the figure in the ‘capital outstanding’ column for the end of the current
year and for the end of the next year.
These points will be illustrated with an example.
Example
The fair value of an asset, leased under a finance lease commencing on 1 January
Year 1 is $10,000. The lease is for three years with payments of $4,021 annually on 1
January Year 1, Year 2 and Year 3. The interest rate implicit in the lease is 22.25%.
Required
Complete the lease payment table for all three years 1 to 3, and calculate the current
liability and the non-current liability at 31 December Year 1 under the actuarial
method.
Answer
$
Totalleasepayments(3×$4,021) 12,063
Minus:Cashpriceoftheasset (10,000)
–
–––––
Totalfinancecharge 2,063
–
–––––
Actuarial method
Yearended
31December
Opening
balance
(OB)
Lease
payment
(P)
Capital
outstanding
(C=OB–P)
Interestat
22.25%
I=C×22.5%
Closing
balance
CB=C+I
$ $ $ $ $
Year1 10,000 (4,021) 5,979 1,330 7,309
Year2 7,309 (4,021) 3,288 733(rounded) 4,021
Year3 4,021 (4,021) – – –
Chapter 12: Leases
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The year-end liability at the end of Year 1 is $7,309 in total.
The non-current liability is the capital liability that will be outstanding at the
end of Year 2, which is $3,288.
The current liability is the capital liability that will be paid during Year 2 (=
$5,979 – $3,288 = $2,691) plus the $1,330 interest accrued at the end of Year 1 (but
not payable until the start of Year 2). $2,691 + $1,330 = $4,021.
$
Currentliability,endofYear1 4,021
Non‐currentliability,endofYear1 3,288
–
––
–
–
–
Totalliability,endofYear1 7,309
–
–––––
2.7 Finance leases in the financial statements of the lessor
Because the lessor has transferred the risks and rewards of ownership of the
physical leased asset to the lessee, the lessor does not record the leased asset in his
own financial statements. Instead he records the amount due to him under the terms
of the finance lease as a receivable. The entries to be made in the ledger accounts of
the lessor are a ‘mirror image’ of those made by the lessee in respect of his lease
liability.
At the start of the lease
The lessor records a receivable for the capital amount owed by the lessee. This
should be stated at the amount of the ‘net investment in the lease’. The net
investment in the lease is the fair value of the asset.
During the term of the lease
The rental payments by the lessee to the lessor consist of two elements:
finance income (interest on the capital amount receivable from the lessee), and
a partial repayment of the capital amount receivable.
The finance income is treated as income in profit or loss for the period. The partial
repayment of the capital receivable reduces the amount of the remaining capital
receivable from the lessee.
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Accounting for an operating lease
Operating leases in the financial statements of the lessee
Operating leases in the financial statements of the lessor
3 Accounting for an operating lease
3.1 Operating leases in the financial statements of the lessee
An operating lease is accounted for in a different way from a finance lease. The
leased asset is not owned ‘in substance’ by the lessee. The lease arrangement is
similar to a rental agreement for the hire of the asset.
IAS17 Leases states that the total payments made by the lessee under an operating
lease should be recognised as an expense, and apportioned between financial
periods on a straight-line basis. (If another rational basis is more appropriate then
that may be used.)
Any difference between amounts charged as an expense for a financial period and
amounts of lease rental actually paid during the period will result in an accrual or
prepayment in the statement of financial position.
Example
Under a four-year operating lease agreement, Entity F pays a non-returnable deposit
of $50,000 and then four years’ rental of $50,000 per annum on the first day of each
year.
Required
(a) Calculate the annual expense for the operating lease for each of the four years.
(b) Calculate the asset or liability in the statement of financial position at the end
of Year 1 and at the end of Year 2.
Answer
(a) Total lease payments = $50,000 + ($50,000 × 4 years) = $250,000
Annual charge for the lease (annual expense) = $250,000 ÷ 4 years = $62,500.
StatementoffinancialpositionatendofYear1
$
LeasepaymentsinYear1($50,000+$50,000) 100,000
ChargedasanexpenseinYear1 (62,500)
–
–––––––
Prepayment:assetatendofYear1 37,500
–
–––––––