ACCA P2 (INT) Corporate Reporting - Study text

Подождите немного. Документ загружается.

Chapter 12: Leases and substance over form

A lease is a finance lease if it transfers the majority of the risks and rewards relating

to the ownership of the asset to the lessee. If this is not so, then it is an operating

lease.

The distinction between a finance lease and an operating lease is based on the

substance of the transaction, and IAS 17 suggests that the following terms in a lease

agreement are indicators of a finance lease arrangement:

 Legal title to the asset transfers to the lessee at the end of the lease.

 The lessee has the option to buy the asset for less than fair value, and it seems

reasonably likely when the contract is made that the option will be taken.

 The term of the lease agreement covers most of the asset’s useful life.

 At the start of the lease, the present value of the future lease payments amounts

to at least substantially all of the fair value of the asset.

 The leased asset is highly specialised, so only the lessee can use it.

 If the lessee cancels the lease, he must compensate the lessor for his losses.

 Gains or losses from a change in the expected residual value of the leased asset

are borne by the lessee.

 After the first period of the lease term has ended, the lessee may continue the

lease for a secondary period at a very low rent.

With a finance lease, the substance of the transaction is that the lessee is the effective

owner of the asset even though legally the asset is owned by the lessor. With an

operating lease, the lessor is the effective owner as well as the legal owner.

Land and buildings

When a lease includes land and buildings, an entity must assesses the classification

of each element as a finance or an operating lease separately.

Until recently IAS 17 contained guidance that meant that on most occasions the

lease of land would be an operating lease. In some jurisdictions there are very long

leases of property, for example 999 years. Some users and preparers pointed out an

entity with a lease of this kind is in substance, in the same situation that it would

have been if it had bought the asset. The IASB has recently removed the guidance

referred to above so that long leases can now be classified as finance leases.

4.2 Accounting for a finance lease

The lessee’s accounts

At the start of the lease, the lessee should recognise the leased asset as a non-current

asset, valued at the lower of:

 the fair value of the asset, and

 the present value of the minimum lease payments under the terms of the lease

agreement.

There is a matching liability to the lessor (divided between the amount of the

liability repayable within 12 months and a long-term liability).

Paper P2: Corporate Reporting (International)

324 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP

The asset should be depreciated over the shorter of:

 the term of the lease, and

 the asset’s expected useful life.

In each financial period, the charges to the income statement relating to the finance

lease are:

 a depreciation charge, and

 a finance charge.

The lease payments each year are divided into:

 a finance charge, and

 a partial repayment of the obligation to the lessor.

The total finance charge over the term of the lease is the difference between:

 the total minimum payments under the lease agreement, and

 the ‘cost’ of the asset (the lower of fair value and the present value of the

minimum lease payments).

This total finance charge is allocated to each year of the lease in such away that there

is a constant rate of interest chargeable on the remaining obligation to the lessor.

(Two methods may be used to allocate the total finance charge between the years of

the lease: the actuarial method and the sum-of-the-digits method.)

By the end of the term of the lease, the obligation to the lessor will be reduced to

zero.



Example

ABC Company needs a new machine for its business. The fair value to buy the

machine outright is $260,000 but instead it enters into a 20-year finance lease on 1

January 20X0. Payment terms are $16,000 every six months, payable in arrears,

commencing 30 June 20X0. The interest rate implicit in the lease is 11.9% per year,

which equates to 5.4% every six months.

The company’s financial year ends on 31 December.

Required

Calculate the asset value, lease obligation and finance charge up to 31 December

20X1.



Answer

The asset is capitalised at $260,000 and a liability for a lease creditor is established

for an equal amount. The asset should be depreciated.

Chapter 12: Leases and substance over form

The total finance charge over the 20 years of the lease will be:

Totalofminimumleasepayments



(40payments×$16,000) 640,000

‘Cost’oftheasset(fairvalue)

260,000

Totalfinancechargeover20years

380,000

The interest rate in the lease is 5.4% every six months. The finance charge will be

calculated every six months at this six-monthly rate of 5.4% (since lease payments

are every six months).

The finance charge and the reduction in the obligation to the lessor, for the first two

years of the lease, are calculated as follows:



Sixmonthsto

endof:

Obligationto

thelessor:

Balanceb/f

Finance

chargeat5.4%

forsixmonths

Total

lease

payment

Reductionin

obligationto

lessor

Balance

carried

forward

June20X0 260,000

14,040

(16,000)

1,960 258,040

December20X0 258,040

13,934

(16,000)

2,066 255,974

June20X1 255,974

13,823

(16,000)

2,177 253,797

December20X1 253,797

13,705

(16,000)

2,295 251,502

The total finance charge for the year to 31 December 20X0 is $27,974 ($14,040 +

$13,934).

The total finance charge for the year to 31 December 20X1 is $27,528 ($13,823 +

$13,705).

The lessor’s accounts

Accounting by the lessor should be the ‘mirror image’ of the lessee.

 The lessor should remove the asset from its statement of financial position.

 Instead, there should be a ‘lease receivable’ as an asset. The value of the lease

receivable is the sum of:

− the present value of the payments receivable under the terms of the lease,

plus

− the present value of the residual value/disposal value of the asset at the

end of the lease (on the assumption that the lessor will receive this as

income).

The payments received from the lessee are divided into:

 finance income, and

 a partial repayment of the ‘lease receivable’ by the lessee.

Paper P2: Corporate Reporting (International)

326 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP

The total finance income over the term of the lease is the difference between:

 the total receipts under the lease agreement, and

 the original value of the ‘lease receivable’.

This total finance income is allocated to each year of the lease in such a way that

there is a constant rate of return on the remaining receivable from the lessee. (Two

methods may be used to allocate the total finance income between the years of the

lease: the actuarial method and the sum-of-the-digits method.)

At the end of the lease term the lease receivable is reduced to zero.

When the lessor is also the manufacturer or dealer

A lessor is often a finance company, which buys the asset from the manufacturer

and then leases it to the lessee. Sometimes the manufacturer itself might be the

lessor. If the asset is leased by the manufacturer or supplier of the item, then

different rules apply.

The lessor has two streams of revenue if it is also the manufacturer or dealer:

 the sales revenue and profit that would have been made on an outright sale, and

 the finance income over the lease term.

The sale of the asset. The sales revenue that should be recognised is the lower of:

 the fair value of the asset; and

 the present value of the future lease receipts, discounted at a commercial rate of

interest.

(The reason for this rule about the sales price is to prevent companies from

manipulating their profit by offering a low rate of interest on the lease but

increasing the sales price of the asset.)

The cost of sale is the cost (or carrying amount) of the asset sold, minus the present

value of any residual value. The profit on the sale is recognised in the financial

period when the lease agreement begins.

Finance income. The total finance income over the period of the lease is the

difference between the total lease payments and the sale price of the asset. This is

allocated between the financial periods using the ‘normal’ rules to provide a

constant return.

4.3 Accounting for an operating lease

The lessee’s accounts

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.

IAS 17 states that the total payments made by the lessee under an operating lease

should be charged to profit or loss, and apportioned between financial periods on a

Chapter 12: Leases and substance over form

straight-line basis. (If another rational basis is more appropriate then that may be

used.)

Any difference between amounts charged to profit or loss 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.

Lease incentives offered by the lessor, such as payment ‘holidays’, should also be

spread over the life of the lease on a straight-line basis.



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 charge to profit or loss for each of the four years in the

accounts of Entity F.

(b) Calculate the balance in its 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 in profit or loss = $250,000/4 years = $62,500.

StatementoffinancialpositionatendofYear1

PaidinYear1($50,000+$50,000)

100,000

Chargedtotheincomestatement (62,500)

PrepaymentatendofYear1(assetinstatementoffinancialposition)

37,500

StatementoffinancialpositionatendofYear2

Balanceb/ffromYear1(prepayment)

37,500

PaidinYear2 50,000

87,500

Chargedtotheincomestatement (62,500)

PrepaymentatendofYear2(assetinstatementoffinancialposition)

25,000



Example

XYZ enters into an operating lease of a building on 1 January 20X1. The lease is for

20 years at a rental of $200,000 per annum with the first year being rent free.

Required

Calculate the lease expense to be recorded each year.

Paper P2: Corporate Reporting (International)

328 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP



Answer

The total lease payments will be $3.8 m (19 payments × $200,000). These are charged

evenly to profit or loss over the lease term.

This results in a charge of $190,000 per year ($3.8 m/20 years)

At the end of year 1, an accrual of $190,000 will appear in the statement of financial

position, since no payment is due until year 2.

The lessor’s accounts

Because the lessor has not transferred the risks and rewards of ownership of the

physical asset to the lessee, the lessor shows the leased asset as a non-current asset

in its statement of financial position.

The asset will be shown in an appropriate category of property, plant and

equipment at its carrying value (cost/valuation minus accumulated depreciation).

The lessor’s annual statement of comprehensive income (profit or loss) should

include, in respect of the leased asset:

 depreciation on the asset as a charge, and

 rental income (as for the lessee, this is usually calculated on a straight-line basis).

Any differences between income recognised and amounts received should be

recorded as deferred or accrued income.

Lease incentives provided by the lessor should also be spread over the life of the

lease on a straight line basis.

Operating leases: incentives

When a new operating lease is negotiated or an existing operating lease is re-

negotiated, the lessor may offer incentives t the lessee to persuade the lessee to enter

into the lease agreement. An example is an up-front cash payment to the lessee.

Another (mentioned earlier) might be a ‘payment holiday’ in which the lessee is not

required to make the first one or two lease payments.

SIC Interpretation 15 (‘Operating Leases: Incentives’) states that all such incentives

should be recognised as part of the net consideration agreed for the use of the asset

by the lessee.

 The lessor should recognise the incentives as a reduction of rental income over

the term of the lease, normally on a straight-line basis.

 The lessee should recognise the incentives as a reduction of rental expense over

the term of the lease, normally on a straight-line basis.

4.4 Sale and leaseback transactions

Sale and leaseback transactions involve one entity selling an asset, normally to a

bank or finance company, and then immediately leasing it back. The main purpose

is to allow the entity to release cash that is ‘tied up’ in the asset, whilst retaining use

of the asset.

Chapter 12: Leases and substance over form

For example, a company may own an office building that it uses for its

administrative operations. It may decide to sell and lease back the building, to raise

cash. By selling the building, it raises cash. By leasing back the building, it retains

the use of the building for its operational activities.

The leaseback could be arranged either as a finance lease or an operating lease, and

this will affect the accounting treatment of the transaction.

Sale and finance leaseback (finance lease)

There are two stages, the disposal (sale) and the finance leaseback.

 The sale. On disposal, the asset should be removed from the seller’s statement of

financial position.

 Any surplus from the sale in excess of the carrying amount should be deferred

and amortised over the life of the lease.

 The leaseback. The normal finance lease rules are then applied, to reintroduce

the asset to the statement of financial position of the lessee at its fair value, and

to establish a leasing obligation.

It could be argued that by accounting for a sale and finance leaseback in this way,

the substance of the transaction has not been shown correctly. The asset was sold

and then immediately leased back under a finance lease, which means that the

owner never lost the risks and rewards from holding the asset. Is it therefore

appropriate to remove the asset from the statement of financial position (step 1

above) and then reintroduce it immediately at a different value (fair value)?

This accounting treatment (in IAS 17) leads to the value of the asset being increased

in the statement of financial position, because its carrying value is removed and

replaced by its fair value, which is likely to be higher. Would another treatment

better reflect the substance of the transaction?

An alternative accounting treatment might be to consider the lease as a finance

arrangement, providing a loan that is secured on the asset. As there is no ‘sale’,

there should be no profit or loss on disposal, and the asset should stay at its carrying

value.



Example

In 20X6 a company sold an asset and leased it back under a finance lease. The asset

had a carrying value of $70,000 and was sold for its market value of $120,000. At the

date of sale it had a remaining life of five years and was leased back for the whole of

this period at a rental of $28,000 per annum in arrears.

Option 1: Treat as a genuine sale (IAS 17)

Debit Credit

Thesale

$ $

DRCash 120,000

CRAsset

70,000

CRDeferredincome

50,000

Paper P2: Corporate Reporting (International)

Debit Credit

Theleaseback

DRAsset 120,000

CRLeaseobligation

120,000

Option 2: Treat as a secured loan (a potential alternative)

No sale is recorded.

$ $

DRCash 120,000

CRLeaseobligation

120,000

Both methods would show the same calculation of the repayment of the lease

obligation, but each method gives a different asset value. In option 1 the asset is re-

stated to its fair value (which will lead to higher depreciation charges). The higher

depreciation charges will be offset by the release of the deferred income over the

lease term.

Sale and operating leaseback (operating lease)

Again, there are two stages to the transaction, the sale and the operating leaseback.

The substance and the legal form of the transaction are the same. The asset has been

sold and the risks and rewards have been permanently transferred as the leaseback

is an operating lease in nature.

On sale, the asset should be removed from the seller’s statement of financial

position.

 The gain or loss on disposal should be recognised in profit or loss. (See below for

details of how the gain is calculated.)

 The normal operating lease rules are then applied to account for the rental

payments.

IAS 17 outlines three treatments for accounting for the profit on the sale of the asset,

depending on whether the asset was sold for its fair value, for less than fair value or

for more than fair value.

 Sale at fair value. If the asset is sold at fair value, the gain or loss on disposal is

recognised immediately in profit or loss.

 Sale at less than fair value. Similarly, if the asset is sold at less than fair value, the

gain or loss on disposal is recognised immediately in profit or loss.

 However, if the sale is at less than fair value but in addition the lease rental

payments are at below the fair market cost, the loss on disposal should not be

recognised immediately, but deferred and then released to profit or loss over the

expected period of use (the lease period).

 Sale at more than fair value. If the asset is sold at more than fair value, the

normal gain or loss on disposal (based on fair value) is recognised immediately

in profit or loss. The excess profit however should be deferred and released to

profit or loss over the expected period of use (the lease period).

Chapter 12: Leases and substance over form



Example

In early 20X7 a company sold an asset for $1.5 million and leased it back under a

five-year operating lease. The asset had a carrying value of $1 million and a

remaining useful life of ten years.



Answer

If the asset was sold at fair value

$ $

DRCash

1,500,000

CRAsset

1,000,000

CRIncomestatement

500,000

If the fair value at the date of sale was $1.2 million

$ $

DRCash

1,500,000 

CRAsset

1,000,000

CRIncomestatement

(Normalprofit:thisis$1.2m–$1m)

200,000

CRDeferredincome

(Excessprofit:thisis$1.5m–$1.2m)

300,000

Note: The deferred income will be released to profit or loss over the lease term of 5

years.

4.5 Termination of a lease

A lease agreement is a contract to lease an asset for a fixed term. Some leases allow

the lessee the option to extend the lease for a secondary period at a reduced rent as

the lessor may find it difficult to find another lessee for the second-hand asset.

But what if the lessee decides to terminate the lease agreement?

 Termination might take place at the end of the main lease term, and the asset

returned to the lessor.

 Alternatively, the lessee may decide to terminate the main lease early.

Finance leases – the lessee

Termination at the end of the lease

The lessee may be required to guarantee the residual value of the asset at the end of

the lease. So if it is in poor condition and the residual value is less than originally

expected, the lessor will demand an additional payment for the shortfall.

Paper P2: Corporate Reporting (International)

Early termination

If the lessee decides to terminate the lease before the end of the agreed lease term

the lessor will normally charge a termination fee to compensate for the lost rentals.

Once the asset has been returned it will be removed from the lessee’s statement of

financial position. Any difference between the outstanding lease obligation

(liability) in the statement of financial position and the termination payment will be

treated as a loss on the asset disposal.

Finance leases – the lessor

The lease receivable will be removed from the lessor’s statement of financial

position when the asset is returned. Any difference between the lease receivable and

the termination payment will be treated as a gain on the lease termination, and

credited to profit or loss.

Operating leases

The termination payment is treated as an expense in the income statement (profit or

loss) of the lessee. The termination receipt is treated as income in the accounts of the

lessor.

4.6 Tax variation clauses

The rentals charged by a lessor will take account of several factors, in order to

generate a target profit. The factors to consider are the lease period, the expected

residual value of the asset, the tax charged on the income and the capital allowances

(tax-allowable depreciation) that the lessor will receive on the asset.

The estimates of tax payments and tax benefits (capital allowances) will be based on

the tax rates in force at the start of the lease. If the tax rates change, the lessor may

find that he does not achieve the expected return. Therefore he may insert a tax

variation clause into the lease contract. The effect of this is to adjust the rental

payments over the remainder of the lease so that the lessor is protected against any

changes in tax rules or tax rates.

Whilst the lessor’s profit is unaffected (because the lessor will simply be covering

his extra costs), the lessee’s finance charge will increase. This increase in the finance

charge should be spread over the remaining life of the lease.

4.7 Evaluating the substance of transactions involving a lease

Some transactions involving leases can be quite complex. There might well be a

series of structured transactions, one or more of which involves a lease. A problem

is to decide how to account for these linked transactions.

SIC Interpretation 27 states that when there is a series of linked structured

transactions involving a lease and the overall economic effect (the substance of the

transactions) cannot be understood without reference to the series of transactions as

a whole, it should be accounted for as a single transaction.

ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)

Подождите немного. Документ загружается.