12 Leasing

Question 1

Define Lease; finance lease: operating elase

Answer 1

Lease. An agreement whereby the lessor conveys to the lessee in return for rent the right to use an asset for an agreed period of time. Finance lease. A lease that transfers substantially all the risks and rewards incident to ownership of an asset. Title may or may not eventually be transferred. Operating lease. A lease other than a finance lease.

Question 2

What is a lease transaction?

Answer 2

In a leasing transaction there is a contract between the lessor and the lessee for the hire of an asset. The lessor retains legal ownership but conveys to the lessee the right to use the asset for an agreed period of time in return for specified rentals.

Question 3

Define Minimum lease payments

Answer 3

The payments over the lease term that the lessee is or can be required to make.

Question 4

Define Interest rate implicit in the lease

Answer 4

The discount rate that, at the inception of the lease, causes the aggregate present value of: (a) The minimum lease payments, and (b) The unguaranteed residual value to be equal to the sum of: (a) The fair value of the leased asset, and (b) Any initial direct costs.

Question 5

Define Lease term

Answer 5

The non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option

Question 6

What are the following questions which if the lease answers yes to make it a finance lease

Answer 6

Is ownership transferred by the end of the lease term?
Does the lease contain a bargain purchase option?
Is the lease term for a major part of the asset’s useful life?
Is the present value of minimum lease payments substantially equal to the asset’s fair value?

Question 7

IF the company answers no to the following questions what does it make the type of lease
Is ownership transferred by the end of the lease term?
Does the lease contain a bargain purchase option?
Is the lease term for a major part of the asset’s useful life?
Is the present value of minimum lease payments substantially equal to the asset’s fair value?

Answer 7

Operating lease

Question 8

Can a lease of land be treated as a finance lease if it meets certain criteria?

Answer 8

Yes it can if the risks and rewards of ownership can be considered to have been transferred

Question 9

Under finance leases what is the two points to remember:

Answer 9

 Assets acquired should be capitalised  The interest element of instalments should be charged against profit Operating leases are rental agreements and all instalments are charged against profit.

Question 10

IAS 17 requires that, when an asset changes hands under a finance lease, lessor and lessee should account for the transaction as though it were a credit sale. In the lessee’s books therefore:

Answer 10

DEBIT Asset account CREDIT Lessor (liability) account

Question 11

The amount to be recorded in this way is the lower of the fair value and the present value of the minimum lease payments. IAS 17 states that it is not appropriate to show liabilities for leased assets as deductions from the leased assets. A distinction should be made between current and non-current lease liabilities, if the entity makes this distinction for other liabilities. The asset should be depreciated (on the bases set out in IASs 16 and 38) over the shorter of:

Answer 11

 The lease term  The asset’s useful life If there is reasonable certainty of eventual ownership of the asset, then it should be depreciated over its useful life

Question 12

When the lessee makes a rental payment it will comprise two elements.

Answer 12

(a) An interest charge on the finance provided by the lessor. This proportion of each payment is interest payable in the statement of profit or loss of the lessee. (b) A repayment of part of the capital cost of the asset. In the lessee’s books this proportion of each rental payment must be debited to the lessor’s account to reduce the outstanding liability.

Question 13

The accounting problem is to decide what proportion of each instalment paid by the lessee represents interest, and what proportion represents a repayment of the capital advanced by the lessor. There are two usual apportionment methods:

Answer 13

 The actuarial method  The sum-of-the-digits method

Question 14

The actuarial method is the best and most scientific method. It derives from the common-sense assumption that the interest charged by a lessor company will equal the rate of return desired by the company, multiplied by the amount of capital it has invested:

Answer 14

(a) At the beginning of the lease the capital invested is equal to the fair value of the asset (less any initial deposit paid by the lessee). (b) This amount reduces as each instalment is paid. It follows that the interest accruing is greatest in the early part of the lease term, and gradually reduces as capital is repaid. In this section, we will look at a simple example of the actuarial method.

Question 15

Disclosure requirements for lessees IAS 17 (revised) requires the following disclosures by lessees in respect of finance leases:

Answer 15

 The net carrying amount at the end of the reporting period for each class of asset  A reconciliation between the total of minimum lease payments at the end of the reporting period, and their present value. In addition, an entity should disclose the total of minimum lease payments at the end of the reporting period, and their present value, for each of the following periods: – Not later than one year – Later than one year and not later than five years – Later than five years

Question 16

For operating leases the disclosures are as follows. The total of future minimum lease payments under non-cancellable operating leases for each of the following periods:

Answer 16

(a) Not later than one year (b) Later than one year and not later than five years (c) Later than five years

Question 17

What does sale and leaseback involve

Answer 17

A sale and leaseback transaction involves the sale of an asset and the leasing back of the same asset. The lease payment and the sale price are usually negotiated as a package. The accounting treatment depends upon the type of lease involved. If the transaction results in a finance lease, then it is in substance a loan from the lessor to the lessee (the lessee has sold the asset and then leased it back), with the asset as security. In this case, any ‘profit’ on the sale should not be recognised as such, but should be deferred and amortised over the lease term.

Question 18

If the transaction results in an operating lease and the transaction has been conducted at fair value, then it can be regarded as a normal sale transaction. The asset is derecognised and any profit on the sale is recognised. The operating lease instalments are treated as lease payments, rather than repayments of capital plus interest. True/ False

Answer 18

True
If the transaction results in an operating lease and the transaction has been conducted at fair value, then it can be regarded as a normal sale transaction. The asset is derecognised and any profit on the sale is recognised. The operating lease instalments are treated as lease payments, rather than repayments of capital plus interest

Question 19

If the result is an operating lease and the sale price was below fair value, this may be being compensated for by lower rentals in the future. If this is the case, any loss on sale should be amortised over the period for which the asset is expected to be used. If the sale price was above fair value any excess is deferred and amortised over the period for which the asset is expected to be used. True/ False

Answer 19

True
If the result is an operating lease and the sale price was below fair value, this may be being compensated for by lower rentals in the future. If this is the case, any loss on sale should be amortised over the period for which the asset is expected to be used. If the sale price was above fair value any excess is deferred and amortised over the period for which the asset is expected to be used

Question 20

A business acquires an asset under a finance lease. What is the double entry?

Answer 20

DEBIT Asset account CREDIT Lessor account

Question 21

A lorry has an expected useful life of six years. It is acquired under a four year finance lease. Over which period should it be depreciated?

Answer 21

The four year term, being the shorter of the lease term and the useful life

Question 22

A company leases a photocopier under an operating lease which expires in June 20X2. Its office is leased under an operating lease due to expire in January 20X3. How should past and future operating leases be disclosed in its 31 December 20X1 accounts?

Answer 22

The total operating lease rentals charged though profit or loss should be disclosed. The payments committed to should be disclosed analysing them between those falling due in the next year and the second to fifth years.