Ch 4 - Leases Flashcards
What are the diff options for a company to obtain the use of fixed assets?
Purchase
Leasing (hiring) via a finance lease
Leasing (hiring) via an operating lease
Define a lease
A lease is an agreement whereby one party pays another to use an asset for an agreed length of time
Define a lessor
A lessor is the party who legally owns the asset and receives payment for its use
Define a lessee
The lessee is the party who makes payment to use the asset and receives payment for its use
Define a lease term
The lease term is the period for which the lessee has agreed to lease the asset
What are the 2 types of leases
Finance
Operating
Define a finance lease
is a lease that transfers substantially all the risks and rewards of ownership to the party using the asset
In some cases legal ownership is transferred at the end of the lease
Define an operating lease
any lease other than a finance lease
Why is it important to correctly classify a lease
as the acc treatment for each is v different
Give some examples of risks of ownership
Costs of insuring the asset
Costs of maintenance
Risk of obsolescence
Possibility of losses from idle capacity
Variations in return because of changing economic conditions
Give some examples of rewards of ownership
Profitable use of the asset for the majority of its useful life
Unlimited access to the asset
Gain from appreciation in value**
Realisation of a residual value**
Note, these last 2 assume the transfer of legal ownership at the end of the lease term
Give some examples of situations leading to classification of a lease as a finance leas
As the assessment of risks and rewards isn’t always conclusive, FRS 102 Section 20 suggests that if ANY of the following circs apply, a lease should be classified as a finance lease
- Ownership is transferred to the lessee at the end of the lease term
- The lessee has the option to purchase the asset for a bargain price
- The least term = the majority of the useful life of the asset
- The lessee can continue the lease for a secondary period at a below-market rate
- At the start of the lease, the PV of the min lease payments (MLPs) is substantially equal to FV of asset
- Asset is specialised so that only the lesee can use it without major modification
- If the lessee cancels the lease, they must repay the lessor for any losses associated with the cancellation
If land and buildings are leased together, what must the comp determine?
The comp should determine the classification of the land element and buildings element separately as a finance or operating lease, using the normal risks and rewards criteria
For the exam, what do you always assume a land lease is?
An operating lease
What needs to be done if the lease of L&B needs to be split?
The minimum lease payments should be allocated between L&B in proportion to the relative FV of the land and buildings at the start of the lease
What is substance over form?
Commercial substance is always accounted for over legal form
What is the legal form and commercial substance of a purchase?
Legal form: Asset legally belongs to purchasers
Commercial substance: purchaser uses the assets and therefore has the risks and rewards
Substance = legal form
What is the legal form and commercial substance of a finance lease?
Legal form: Asset legally belongs to lessor
Commercial substance: lessee bears risks and rewards, so uses it as if it was owned
Substance DOESN’T = legal form
What is the legal form and commercial substance of an operating lease?
Legal form: Asset legally belongs to lessor
Commercial substance: lessee does not bear risks and rewards, so doesn’t treat it as if it was owned
Substance = legal form
Where does an asset acquired through a finance lease appear in FS?
An asset acquired through a fin lease should be shown on the BS of the lessee as if it is owned
Where does an asset acquired through an operating lease appear in FS?
An asset acquired through an operating lease doesn’t hit the BS
The ‘rental’ is charged to P&L
What is the acc entry for a finance lease?
- Recording of asset
DR Fixed asset
CR Finance lease liability
Amount = lower of
Fair cash value of the asset and PV of the minimum lease payments (PV MLP) - Annual depr charge
DR Depr
- Cr Accumulated
- Depr over the shorter of Lease term (including any secondary periods) and UEL
- HOWEVER if the ownership transfers at the end of the lease, always use UEL - Record lease payments according to lease agreement
- DR Finance lease liability
- CR Cash - Record interest accruing on the fin lease liability
- This is reflected in the P&L
- DR Interest payable (P&L)
- CR Finance lease liability
How do you calc lease liability? and what does it show?
Using a lease liability table
Shows interest payable in P&L and ye liability on BS
What are the headings for lease liability table when interest is paid in arrears?
Along top: B/f Interest payable (P&L) Payment Cf Down side= each year/quart er
What are the headings for lease liability table when interest is paid in advance?
Along top: B/f Payment Balance Interest payable (P&L) C/f
How can you calc interest payable?
- Actuarial method
- Straight line method
- Sum of digits method
How do you calc interest payable for a lease liability using the actuarial method?
Fin charge for period - X% * bal of liability outstanding
The percentage will be given in the exam
E.f. ‘implicit rate of interest is 10%’
How do you calc the total interest payable for straight line and sum of digits method?
Total lease payments (including deposits)
Less amount ‘borrowed’ (lower of FV of asset and PV of MLP)
= Total interest payable
The total interest payable is then spread over the number of interest-bearing periods (n) using either the straight line method or the sum of digits method
What do you first need to calc for straight line and sum of digits method before you can calc interest payable for period?
Total interest payable
How do you calc the straight line method?
Total finance charge is allocated evenly to interest-bearing periods (n) of the lease where the liability is outstanding
Results in equal finance charge each year, even though the outstanding liability is gradually reducing
The straight line method does not follow the accruals principle
So is generally not allowed
Only done when the amounts involved are immaterial
What impact does the straight line method for calc interest have on subsequent FS?
Results in equal finance charge each year, even though the outstanding liability is gradually reducing
Why is the straight line method for calc interest generally not allowed?
When is it allowed?
The straight line method does not follow the accruals principle
So is generally not allowed
Only done when the amounts involved are immaterial
What is the sum of digits approach to calc interest on a lease?
The sum of digits in an approximation to the actuarial method, whereby the finance charge decreases per year as the liability reduces
A SOD fraction is calculated for each interest-bearing period and that proportion of the total finance charge is allocated to that period
The SOD fraction is calculated as n(n+1)/2
n = number of interest-bearing periods
So need to be careful to spot if it is in advance or in arrears
How is sum of digits method for calc interest for a lease calculated?
A SOD fraction is calculated for each interest-bearing period and that proportion of the total finance charge is allocated to that period
The SOD fraction is calculated as n(n+1)/2
n = number of interest-bearing periods
So need to be careful to spot if it is in advance or in arrears
What must be done if payments aren’t annual?
Some lease agreement require 2 half-yearly, 4 quarterly or even monthly repayments
In this case, each lease period (period for which there is a repayment) is given a line in the lease liability table
MUST remember to reduce interest payable into the MONTHS, so wouldn’t be divided by years, would be divided by months/quarters
How is a deposit treated at the start of a finance lease?
This should be accounted for as an immediate reduction of the liability
DR Fin lease liability
CR Cash
First entry in the lease liability table = net lease liability after the deposit has been deducted
But remember to include deposits as part of the total payment for calculating the total finance charge
What is important to remember re deposits when calculating interest payable? (2)
First entry in the lease liability table = net lease liability after the deposit has been deducted
But remember to include deposits as part of the total payment for calculating the total finance charge
What must be disclosed for finance leases in FS?
The acc policy
Y/e lease liability split between Creditors falling due within 12 months and after 12 months
The NBV of assets held under a finance lease
[It is common to disclose the NBV of assets held under fin lease in a sentence included within the tangible fixed assets note
‘Of the total NBV of £x, £x relates to assets held under a finance lease’]
Future finance lease payments on a gross and net basis
How is the y/e lease liability shown in FS? and how would you do this?
For inclusion in the BS, this must be split between creditors falling due
- Within 12 months
- After 12 months
The easiest way to split the liability is
Complete 2 years of the lease liability table
In the lease liability table, find the last repayment of the second year
The figure to the RHS of this is the creditor due after 12 months at the end of the period
The total liability at this period end less the creditor due after 12 months gives the creditor due within 12 months (i.e. balancing figure)
What must be done with NBV of assets held under finance lease?
It is common to disclose the NBV of assets held under fin lease in a sentence included within the tangible fixed assets note
‘Of the total NBV of £x, £x relates to assets held under a finance lease’
What is the sentence used when disclosing NBV of assets held under finance lease?
‘Of the total NBV of £x, £x relates to assets held under a finance lease’
What must be disclosed relating to future lease payments?
Payments should be disclosed according to when the future payment is to be made
Within 1 year
In the next 2-5 years
Over 5 years
The disclosure must be made either
On the gross basis
i.e. showing payments including interest payable
On the net basis
i.e. showing payments less interest payable
How are operating leases recognised?
Rentals under op lease are charged to P&L over straight-line basis over the term of the lease
P&L charge = total payments made / lease term
Any diff between charged and amounts paid will be prepayments/accruals
This often occurs with
Deposits paid upfront (creates prepayments)
Rent-free periods (creates accruals)
Why is operating lease not recognised in BS?
As the risks and rewards of ownership of an asset aren’t transferred in the case of an operating lease
What should be disclosed for operating leases?
The following should be disclosed for an operating lease
- Accountancy policy
- Operating lease payments charged as an expense in the year
- The amount that a lessee is committed to pay in the future on non-cancellable leases
What is a sale and lease back?
An entity sells one of its own assets and immediately leases the asset back
What is a sale and lease back a common thing to help with?
Common way of raising finance whilst retaining the use of the related assets
The buyer/lessor is normally a bank
What is a sale and leaseback classified as?
Finance or operating in accordance with the usual FRS 102 Section 20 criteria
What are the steps to a sale and leaseback classified as when payments are in arrears?
1. record sale DR Cash CR Asset (NBV) CR Deferred profit (or if loss = DR and recog immediately) 2. Record finance lease DR Fixed asset CR Lease liability During the year (Note; have to consider if in arrears or in advance to when do lease repayment and interest accruing- may need to switch these round) 3. Interest accruing Implicit interest rate * Lease liability DR Interest payable CR lease liability Year end 4. Lease repayment DR Lease liability CR Cash 5. Depreciate asset Lease liability/lease length DR Depr expense CR Accumulated depr 6. Release deferred payment Profit made / UEL DR Deferred profit CR P&L
How does FRS 102 Section 20 suggest treatment of sale and lease back?
Recognise sale and lease
- Record sale of asset in normal way except profit is deferred and amortised over the lease term
- Any loss should be recognised immediately
- Separately, record the finance lease in accordance with FRS 102 Section 20 rules
What happens to the asset in a sale and leaseback
It is de-recognised in BS and operating lease rental is then recognised in PL
How is the profit/loss dealt with in the P&L account for a sale and leaseback?
If NBV exceeds FV, recog as impairment loss in P&L acc first then
If Sale proceeds < FV - recog any prof immediately, and recog a loss immediately if future lease toenails are at market rate (but defer loss over period of assets use if future lease rentals are < market rate)
If sales = FV - recog profit immediately
If sales proceeds > FV - take profit based on FV immediately , and defer excess profit over period for which the asset is used
What should you do if Sales proceeds < fair value when recognising prof/loss on sale and operating lease back?
If Sale proceeds < FV - recog any prof immediately, and recog a loss immediately if future lease toenails are at market rate (but defer loss over period of assets use if future lease rentals are < market rate)
What should you do if Sales proceeds = fair value when recognising prof/loss on sale and operating lease back?
If sales = FV - recog profit immediately
What should you do if Sales proceeds > fair value when recognising prof/loss on sale and operating lease back?
If sales proceeds > FV - take profit based on FV immediately , and defer excess profit over period for which the asset is used
