Leases

1. Leases Management Level – Paper F2 Advanced Financial Reporting Lecture - 010 Vidya Rajawasam ACMA CGMA MBA

2. Leases We have discussed the subject area related • Earnings per share IAS 33 in our previous lecture.

3. Leases • In this lecture we will discuss the Leases (IAS 17)

4. Leases IAS 17 - Accounting for Leases A lease is a right to use something in return for payment. Some are very short term in nature and others can be longer-term, such that they are similar to buying an asset on hire purchase terms.

5. Leases IAS 17 - Accounting for Leases Where a company has a long-term lease (e.g. for rental of plant for most of its useful life), the company has control of that asset, even though it may not be owned by the entity.

6. Leases IAS 17 - Accounting for Leases As the plant is controlled by the lessee, it should be recognized on the lessee’s SOFP. Similarly, the lessee has an obligation to pay known amounts on the lease, so the lessee has a liability, which must be recognized on its SOFP.

7. Leases IAS 17 - Accounting for Leases IAS 17 categorizes leases into two distinct, but somewhat arbitrary categories: • Finance leases: leases which substantially transfer the risks and returns incident to ownership from the lessor to the lessee. • Operating leases: leases that are not finance leases.

8. Leases IAS 17 - Accounting for Leases IAS 17 categorizes leases into two distinct, but somewhat arbitrary categories: • Finance leases: leases which substantially transfer the risks and returns incident to ownership from the lessor to the lessee. • Operating leases: leases that are not finance leases.

9. Leases IAS 17 - Accounting for Leases The distinction is critical. Although the characteristics of a lease may make it hard to distinguish between the two, the accounting presentation of finance leases and operating leases is very different.

10. Leases IAS 17 - Accounting for Leases We’ll focus on finance leases initially, as they come up far more frequently in the exam, are worth more marks and are also the “future” of the accounting for leases, since it’s likely that the definition of finance lease will soon be widened to include virtually all longer-term leases.

11. Leases IAS 17 - Accounting for Leases Committing to a finance lease meets the Framework definition of a liability, since: • It creates an obligating event • The obligation results in an outflow of resources • The outflows can be measured accurately.

12. Leases IAS 17 - Accounting for Leases The time value of money is material, so must be discounted to present value at an appropriate discount rate. An appropriate discount rate is the “rate implicit in the lease” with is the IRR of the lessor’s cash flows.

13. Leases IAS 17 - Accounting for Leases Finance leased assets are presented on the balance sheet including: • The net present value of the liability to pay future finance lease rentals (split between current and non-current liabilities), and • The carrying value of the asset, which is initially capitalized at the same value as the liability.

14. Leases IAS 17 - Accounting for Leases Most operating leases are short in duration and the NPV of the liability would be small relative to the value of the asset. IAS 17 uses a much simpler accounting presentation for operating leases, which is simply to show operating rentals as liabilities as they fall due for payment.

15. Leases IAS 17 - Accounting for Leases A Finance lease will transfer substantially all of the risk and reward of ownership of the asset to the lessee. Legal title may or may not eventually transfer. IAS 17 highlights situations that individually or in combination would normally lead to a lease being classified as a finance lease. These are; • The lease transfers ownership of the asset to the lessee by the end of the lease term • The lessee has the option to purchase the asset at a price expected to be sufficiently lower than fair value at the date the option is available and it is likely that the option will be taken up

16. Leases IAS 17 - Accounting for Leases • The lease term is for the major part of the life of the asset even if legal title isn’t transferred • At the start of the lease the present value of the minimum lease payments is substantially all of the fair value of the leased asset • The leased assets are of such a specialized nature that only the lessee can use them without major modifications

17. Leases IAS 17 - Accounting for Leases Lessee accounting Operating lease The substance of the transaction is that the legal title has not transferred and so the asset is treated as if it’s being hired and not owned. Lease payments under an operating lease shall be recognized as an expense on a straight line basis through profit or loss over the lease term unless another systematic basis is more appropriate for the way the asset is used.

18. Leases Review MCQs What statement is the true related to IAS 17, accounting for leases ? • Identification of the Purchase risks • A lease is a right to use something in return for payment. • Evaluates the Market risks related lease financing. • Non of the above.

19. Leases Review MCQs What statement is the true related to IAS 17, accounting for leases ? • Identification of the Purchase risks • A lease is a right to use something in return for payment. • Evaluates the Market risks related lease financing. • Non of the above.

20. Leases Review MCQs The true statement with regard to the leases are? • There are only finance leases • The two only two types of leases namely finance leases and operating leases. • The operating leases have lower interest rates. • Non of the above.

21. Leases Review MCQs The true statement with regard to the leases are? • There are only finance leases • The two only two types of leases namely finance leases and operating leases. • The operating leases have lower interest rates. • Non of the above.

22. Leases IAS 17 - Accounting for Leases Lessee accounting Operating lease The substance of the transaction is that the legal title has not transferred and so the asset is treated as if it’s being hired and not owned. Lease payments under an operating lease shall be recognized as an expense on a straight line basis through profit or loss over the lease term unless another systematic basis is more appropriate for the way the asset is used.

23. Leases Example, operating leases Example – David David has taken out an operating lease on its photocopier at the start of the financial year paying a nonrefundable deposit of $2,000. The lease is for two years with annual payments of $3,000 after which the photocopier goes back to the lessor. The photocopier has a useful economic life of five years. Show how the photocopier will be accounted for in the statement of financial position and statement of profit or loss for the first year of the lease.

24. Leases Answer– David Year 1 Statement of financial position Statement of profit or loss $ $ Accrual 1,000 Operating lease expense 4,000 Workings Annual expense = (2 x $3,000) + $2,000 / 2 years = $4,000 p.a CR Bank $5,000 DR P/L $4,000 DR Accruals $1,000

25. Leases Lease Accounting Finance leases The substance of the transaction it that even though legal title does not initially pass to the lessee, the asset is treated as if it’s owned the lessee as they have the significant risk and reward of ownership. 1. The leased asset is initially recognized at its fair value (cash price) or if lower the present value of the minimum lease payments along with a corresponding lease liability Dr Non-current assets – leased assets Cr Finance lease liability

26. Leases Lease Accounting Finance leases 2. The asset is then depreciated using a systematic basis. If it is likely that the lessee will obtain legal title at the end of the lease the useful life of the asset would be used. Otherwise the asset would be depreciated over the shorter of the lease term and the useful life. Dr Depreciation expense (SPL) Cr Accumulated depreciation (SFP)

27. Leases Lease Accounting Finance leases 3. Interest is charged on the outstanding liability using either the sum of digits method or actuarial method. Dr Finance cost (SPL) Cr Finance lease liability (SFP) 4. The lease payment is recorded, reducing the value of the outstanding liability Dr Finance lease liability Cr Bank

28. Leases Lease Accounting Finance leases Example - 2 Peter enters into a four year finance lease for a piece of machinery paying $5,000 at the end of each year. The present value of minimum lease payments is $14,275, which is equivalent to its fair value. The rate of interest implicit in the lease arrangement is 15% per annum and the machinery has a useful life of five years. Prepare extracts from the statement of profit or loss and the statement of financial position for the end of the first year in respect of the finance lease.

29. Leases Lease Accounting Answer- 2 Statement of financial position Statement of profit or loss $ $ PPE 10,706 Depreciation 3,569 (14,275 – 3,569) (14,275/4) FL payable 10,703 Interest 1,428 (14,275 + 1,428 – 5,000) (14,275 x 10%)

30. Leases Lease Accounting Allocating interest Interest should be allocated to each period during the lease term so as to produce a constant periodic rate of interest on the remaining balance of the liability. Two methods of allocating the interest are: • Sum of digits • Actuarial method

31. Leases Lease Accounting Sum of the digits If an interest rate is not given to allocate the interest then the sum of digits method is used. Step 1 Use the following formula to initially work out the sum of the digits. n(n + 1) / 2 where n is the number of installments paid.

32. Leases Lease Accounting Sum of the digits If an interest rate is not given to allocate the interest then the sum of digits method is used. Step 2 The total interest needs to be calculated $ Total payments X Cash price/fair value (X) Total interest X

33. Leases Lease Accounting Sum of the digits If an interest rate is not given to allocate the interest then the sum of digits method is used. Step 3 The total interest is then systematically allocated using the sum of the digits figure calculated in step 1 and total interest in step 2

34. Leases Lease Accounting Actuarial method This method applies an implicit rate of interest, applicable specifically to the lease, to the value of the outstanding liability.

35. Leases Lease Accounting Example – Finance lease 2 Danny commences a finance lease on 1 January 20X4 acquiring a specialist camera which has a fair value of $10,000. The lease requires a deposit of $575 followed by seven annual installments of $2,000 payable in arrears. The implicit interest rate in the lease is 11%. Calculate the total finance lease liability in the statement of financial position as at 31 December 20X4 using sum of digits method to allocate the interest.

36. Leases Answer – Finance lease 2 Step 1 – Calculate the sum of digits figure Related Formula - n(n + 1) / 2 7 x (7 + 1) / 2 = 28 Step 2 – Total interest $ Total payments 14,575 Cash price/fair value (10,000) Total interest 4,575

37. Leases Answer – Finance lease 2 Step 3 - Interest Year 1 = 7/28 x 4,575 = $1,144

38. Leases Answer – Finance lease 2 Sum of digits method Statement of financial position Statement of profit or loss $ $ PPE 8,571 Depreciation 1,429 (10,000 – 1,429) (10,000/7) FL payable 8,569 Interest (W) 1,144 ((10,000 – 575) + 1,144 – 2,000)

39. Leases Review MCQs What are the methods of calculating lease interest ? • Disclosure method. • Sum of the digits method • Average interest rates. • Non of the above

40. Leases Review MCQs What are the methods of calculating lease interest ? • Disclosure method. • Sum of the digits method • Average interest rates. • Non of the above

41. Leases Review MCQs What is the true statement with regard to finance leases? • Finance leases are similar to operating leases. • The leased asset is initially recognized at its fair value. • The asset is not deprecated • Non of the above

42. Leases Review MCQs What is the true statement with regard to finance leases? • Finance leases are similar to operating leases. • The leased asset is initially recognized at its fair value. • The asset is not deprecated • Non of the above

43. Leases Lecture Summary • Leases

44. Leases Management Level – Paper F2 Advanced Financial Reporting Lecture - 010 Vidya Rajawasam ACMA CGMA MBA