Accounting Standards

Leasing

What is a lease?

• An agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time

IAS 17

Why lease an asset?

• Tax advantages• Commercial advantages

– Cash flow management– Conservation of capital– Continuity– Flexibility– Off balance sheet financing

Off balance sheet financing

• P buys a machine for £500,000. • Q leases the same machine. • P will show a non-current asset and a loan in

the SFP. They will show depreciation and interest in the SCI

• Q will just show rental as part of operating profit.

Substance over form

• To be reliable, information must represent faithfully the transactions and other events that it purports to represent.

• To be reliable, financial information must represent the substance and economic reality of transactions and other events, not merely their legal form

IASB Framework - Melville

Elements – key definitions

• AssetA resource controlled by the enterprise as a result of

past events and from which future economic benefits are expected to flow to the enterprise

• LiabilityA present obligation of the enterprise arising from

past events, the settlement of which is expected to result in an outflow from the enterprise of resources

IAS 17

• Originally issued 1982

• Distinguishes between two types of leases and recommends different accounting treatment for each

Definitions

• Finance lease:A lease that transfers substantially all the risks and rewards of ownership of an asset. Title may or may not eventually be transferred.

• Operating lease:A lease other than a finance lease

Risks and rewards?• Ownership transferred by end of lease term• Lease contains a bargain purchase option• Lease term for major part of asset’s useful

economic life• At the start of the lease the present value of

the minimum lease payments amounts to at least substantially all of the fair value of the leased asset

Example

• Machine costs £800,000. Life of 3 years.• Could borrow £800,000 for 3 years at 10%pa• Could rent for £1,000 a day, terminable at any

time by either party • Could sign a non-cancellable 3 year rental

agreement with payments of £300,000pa in advance.

Accounting treatment for finance leases

• Statement of Financial Position– Non current asset– Liability (current and non current)

• Statement of Comprehensive Income– Depreciation– Interest/finance charge– NOT lease rental

Example

• Machine has a fair value of £10,000 and a residual value of £nil at the end of a 5 year life.

• Lease terms: 5 payments of £2,500 pa in advance commencing 1 Jan X1.

• The interest rate implicit in the lease is 12.6%

Example: Asset side

• Depreciation is 10,000/5 years = £2,000pa• Net book value is :

– Year 1 8,000– Year 2 6,000– Year 3 4,000– Year 4 2,000– Year 5 nil

Example: Liability side• Calculate total interest

5 x 2,500 = 12,50010,000

interest 2,500• Split interest across life of lease

– Actuarial method – we will use only this method– Other possible methods are straight line and sum

of the digits

Example: Actuarial calculations

b/f payment o/s interest c/f

X1 10,000 (2,500) 7,500 945 8,445

X2 8,445 (2,500) 5,945 749 6,694

X3 6,694 (2,500) 4,194 528 4,722

X4 4,722 (2,500) 2,222 280 2,502

X5 2,502 (2,500) 2 (ignore)

Disclosure

• Asset: either separate column in ppe table or note below

• Liability: either separate on face of statement of financial position or note disclosure.

• Split liability into current and non-current• Statement of comprehensive income:

depreciation and finance cost

Example: Liability side

At 31Dec X1:Total liability = 8,445Non-current = 5,945Current = interest accrual of £945 and obligation

under the lease of (2,500 – 945) = £1,555

Operating leases

• Remember this was anything that failed the finance lease test

• No asset or obligation in the statement of financial position

• Operating lease rentals charged to statement of comprehensive income on a straight line basis

Good points

• It avoids some of the problems of off-balance sheet financing which tends to understate liabilities.

• It attempts to make more consistency of treatment for leases which are in substance purchases of assets with a loan

Problems

• The definition of a finance lease refers to risks and rewards of ownership, rather than to definitions of asset and liability.

• There are some leases which can be classified as operating, but which are for a substantial period of time and are non-cancellable. These can currently be kept off-balance sheet.

The future?

• There is a proposal to bring all non-cancellable leases onto the statement of financial position as finance leases.

• BUT how to measure the asset/liability?