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TOPIC 3

TOPIC 3. ACCOUNTING FOR LEASES AND HIRE PURCHASE CONTRACTS. 1. Introduction. Leases and hp contracts are means by which companies obtain the right to use or purchase fixed assets. Avoids having to raise the cash up front.

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TOPIC 3

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  1. TOPIC 3 ACCOUNTING FOR LEASES AND HIRE PURCHASE CONTRACTS Copyright: Pru Marriott, University of Glamorgan

  2. 1. Introduction • Leases and hp contracts are means by which companies obtain the right to use or purchase fixed assets. • Avoids having to raise the cash up front. • The substance of the transaction is very similar to purchasing an asset through a loan. Copyright: Pru Marriott, University of Glamorgan

  3. 1.1 Leases • No legal title passes, but lessee is given the right to use the asset for a designated period of time. • Capital allowances are not available to the lessee • If a finance lease, depreciation and interest are charged against profit over the assets useful economic life. Copyright: Pru Marriott, University of Glamorgan

  4. 1.2 Hire Purchase • Hirer may acquire legal title (upon payment of agreed number of instalments). • Capital allowances are available to hirer. • If of a financing nature, depreciation (calculated over useful life) and interest are charged against profit. Copyright: Pru Marriott, University of Glamorgan

  5. 1.3 SSAP 21 • The standard requires that assets held under financing arrangements should be shown on the balance sheet. • Companies should report the substance of the transactions and not their strict legal form. STRICT LEGAL FORM Rental of assets SUBSTANCE Use of asset for most of the assets useful life with an obligation to make payments over that life. SUBSTANCE Use of asset for most of the assets useful life with an obligation to make payments over that life. STRICT LEGAL FORM Rental of ssets Copyright: Pru Marriott, University of Glamorgan

  6. Conceptually, what is capitalised in the lessees’s accounts is not the asset itself but the rights to use the asset, together with the obligation to pay rentals. • ASC’s attempt at avoiding off-balance sheet financing. Copyright: Pru Marriott, University of Glamorgan

  7. 1.4 Hire Purchase and Leasing • HP contracts and leases are treated in the same way. • Both have either operating or finance characteristics. HP- Financing Arrangement A vehicle is acquired under an HP agreement from a garage with the intention that ownership will change hands. The purchaser being responsible for taxing it, insuring it, maintaining it and servicing it. HP - Operating Arrangement Car hire for a month or two from a rental company. Finance Lease Machinery is leased from a company with the intention of keeping it for the majority of it’s useful life. The lessee is responsible for insuring it, maintaining it and servicing it. Operating Lease Machinery is rented from a company for a few months. Copyright: Pru Marriott, University of Glamorgan

  8. 2. Definition of Finance Leases(or HP contracts with financing characteristics) M A R K E T V A L U E The present value of the minimum lease payments is calculated using the interest rate implicit in the lease (more on this later). • Transfers substantially all the risk and rewards of ownership. • Presumed that such a transfer has occurred if, at the inception of the lease, the: Present value of the minimum lease payments, including any initial payment, amounts to substantially all (90% or more) of the FAIR VALUE of the asset. Copyright: Pru Marriott, University of Glamorgan

  9. 2.1 Treatment of Finance Leases In practice the FV of the asset will often be a sufficiently close approximation. Asset is treated as if it has been purchased. The value is recorded in the balance sheet as both a fixed asset and as a liability. The value is: Present value of minimum lease payments Copyright: Pru Marriott, University of Glamorgan

  10. Activity 1 Calculate the discount factor at 10% for all of years 1 to 5. Calculate the annuity factor at 10% for all of years 1 to 5. Present value of £1 1 / (1+rn) Where r = rate of interest n = number of years Present value of an Annuity (1 – ((1/1+rn)) r Where r = rate of interest n = number of years Copyright: Pru Marriott, University of Glamorgan

  11. Activity 1 - Solution Discount factor of £1 Annuity factor (1 – (1/1.101)) / 0.10 1. 1/1.1 = 0.9091 1/1.12 = 0.8264 1/1.13 = 0.7513 1/1.14 = 0.6830 1/1.15 = 0.6209 2. 0.9091 1.7355 2.4868 3.1698 3.7907 (1 – (1/1.102)) / 0.10 (1 – (1/1.103)) / 0.10 (1 – (1/1.104)) / 0.10 (1 – (1/1.105)) / 0.10 Copyright: Pru Marriott, University of Glamorgan

  12. Activity 2 Identify whether the following are finance or operating leases, using the objective measure in SSAP 21: (a) The lease of a motor car, which normally sells at £5,000. Three annual payments of £2,500 in arrears. Interest at 10% pa. (b) The lease of machinery, fair value of which is £10,000. Five annual payments of £2,500 in advance. Interest at 14% pa. (c) Lease of warehouse, current value of £100,000. Annual rental of £15,000 in arrears for a ten-year period. Interest at 12% per annum. Copyright: Pru Marriott, University of Glamorgan

  13. Activity 1 - Solutions (a) Year Payments P.V. 10% Present Value 0 - 1 - 1 2,500 0.9091 2,272.75 2 2,500 0.8264 2,066.00 3 2,500 0.7513 1,878.25 6,217.00 OR 1-3 2,500 2.4868 6,217.00 As £6,217.00 is greater than the fair price of £5,000, this is a finance lease. Copyright: Pru Marriott, University of Glamorgan

  14. (b) Year Payments P.V. 14% Present Value 0 2,500 1.000 2,500.00 1-4 2,500 2.9137 7,284.25 9,784.25 As £9,784.25 is in excess of 90% of the fair value of £10,000 this is a finance lease. Copyright: Pru Marriott, University of Glamorgan

  15. (c) Year Payments P.V. 12% Present Value 0 - 1 - 1-10 15,000 5.650 84,750 As £84,750 is less than 90% of the fair value of £100,000 this is an operating lease. Copyright: Pru Marriott, University of Glamorgan

  16. Depreciation - the asset should be depreciated over the shorter of: Lease term AND Asset’s useful economic life • The finance charge (interest) is written off to P&L account over the life of the lease. Interest = Excess of lease payments over the cash price Copyright: Pru Marriott, University of Glamorgan

  17. 3. Definition and Treatment of Operating Leases Any lease / HP agreement falling outside the requirement of a finance arrangement is an operating lease. The asset is treated as if it is not purchased. Rental payments are charged against profit each year. DR P&L Account CR Cash / Creditor Being the lease/ hire payment for the period Copyright: Pru Marriott, University of Glamorgan

  18. 4. Accounting for Finance Leases Accounts to Open • ASSET ACCOUNT - maintained at Fair Value less accumulated depreciation • OBLIGATIONS UNDER FINANCE LEASE ACCOUNT (I.e. Creditor Account) - any capital repayments made during the accounting period reduce this account • INTEREST ACCOUNT - interest should be charged against profit each period. Copyright: Pru Marriott, University of Glamorgan

  19. 4.1 Accounting for Interest Charged to Profit Two methods available: • Defer interest until due Asset and liability accounts represent FAIR VALUEPayment split between capital and interest. • Account for total interest in a suspense a/c Asset account debited with FAIR VALUE Suspense account debited with TOTAL INTERESTLiability account credited with TOTAL LEASEVALUE Payments are debited to the liability account in full. Annual interest charges are transferred to the P&L from the suspense account. Copyright: Pru Marriott, University of Glamorgan

  20. 4.2 Calculating interest Three methods: • Level Spread Method Spreads the interest equally over the life of the lease. TOTAL INTEREST (Lease price - cash price) Number of years Copyright: Pru Marriott, University of Glamorgan

  21. Activity 3 • A lease is taken out on machinery for 10 years. The machinery could be bought for cash for £25,000 but under the lease agreement the total amount payable will be £35,000. Answer = 35,000 - 25,000 = 1,000 pa 10 Copyright: Pru Marriott, University of Glamorgan

  22. Is this a fair way of allocating interest? NO Instalments consist of capital and interest. As the amount borrowed reduces by the capital interest should also reduce as the amount borrowed becomes less. Copyright: Pru Marriott, University of Glamorgan

  23. Sum of the Digits This method (approximating to the actuarial method below) allocates more interest to the earlier years. Each installment is allocated a digit; the digits are then added together to give the sum of the digits. Interest is then allocated using the fraction: Digit of Installment Sum of the Digits Copyright: Pru Marriott, University of Glamorgan

  24. Activity 4 • A lease is taken out on machinery for 5 years. The total interest payable is £10,000. • Firstly, what is the sum of the digits. ANSWER: Sum of the digits 5 + 4 + 3 + 2 + 1 = 15 Copyright: Pru Marriott, University of Glamorgan

  25. 1 10,000 5/15 3,333 Installment Interest Fraction Interest Allocated 2 10,000 4/15 2,667 3 10,000 3/15 2,000 4 10,000 2/15 1,333 5 10,000 1/15 667 10,000 Now calculate the sum of the digits where a property is leased for 50 years. Copyright: Pru Marriott, University of Glamorgan

  26. QUICK METHOD OF SUMMING THE DIGITS: 1/2 n x (n + 1 ) where n = number of installments (1/2 x 50) x (50+1) = 1,275 (1/2 x 5) x (5+1) = 15 Copyright: Pru Marriott, University of Glamorgan

  27. Actuarial Method This method (using present value factors) finds the interest rate that gives a CONSTANT RATE OF CHARGE on the balance outstanding. The rate implicit in the lease is the IRR. The IRR is where the NPV is equal to zero. Copyright: Pru Marriott, University of Glamorgan

  28. Activity 5 On 1st January 2001 PM Ltd acquired a lorry from NM Motors Ltd, under a finance lease. The cash price of the vehicle was £15,000. The lease agreement calls for three equal payments of £6,000 to be made on 31 December each year. Depreciation is on a straight line basis. REQUIRED: Calculate the amount of interest to be charged each year using the two methods already discussed and then calculate it using the actuarial method. Copyright: Pru Marriott, University of Glamorgan

  29. SOLUTION: Interest = Lease price (6,000 x 3) 18,000 Cash price 15,0003,000 LEVEL SPREAD METHOD: 3,000 / 3 = 1,000 p.a. SUM OF THE DIGITS: (1/2 x 3) x (3+1) = 6 Year 1 3,000 x 3/6 1,500 Year 2 3,000 x 2/6 1,000 Year 3 3,000 x 1/6 5003,000 Copyright: Pru Marriott, University of Glamorgan

  30. Extract from Present Value of an Annuity Table • Year 8% 10% 12% 14% • 1 0.926 0.909 0.893 0.877 • 2 1.783 1.736 1.690 1.647 • 2.577 2.486 2.402 2.322 • 3.312 3.170 3.037 2.914 Activity 5 does not give you the rate implicit in the lease so you have to calculate it. To do this you need to refer to present value tables (PV of £1 Tables if payments are different amounts; PV of an Annuity Tables if payments are the same amounts) As the question involves the payment of £6,000 per annum then Annuity Tables are relevant. Copyright: Pru Marriott, University of Glamorgan

  31. Calculate the IRR (i.e. the rate implicit in the lease) Take the installment amount and multiply it by the factor for 3 years at each interest rate. Installment 8% 10% 12% PV NPV 6,000 2,577 15,462 462 6,000 2.487 14,922 - 78 6,000 2,402 14,412 - 588 15,462 – 15,000 = 462 14,922 – 15,000 = -78 14,412 – 15,000 = -588 Copyright: Pru Marriott, University of Glamorgan

  32. Choose the two rates with a PV closest to the cash price of £15,000 or with an NPV closest to zero (one will be positive and the other negative). Installment 8% 10% 12% PV NPV 6,000 2,577 15,462 462 6,000 2,577 15,462 462 6,000 2.487 14,922 - 78 6,000 2.487 14,922 - 78 6,000 2,402 14,412 - 588 Take the interest rates of 8% and 10% Copyright: Pru Marriott, University of Glamorgan

  33. To find the IRR use the following formula: Int A + ((Int B - Int A) x NPV A . NPV A - NPV B where: INT A = lower interest rate INT B = higher interest rate NPV A = NPV using rate A NPV B = NPV using rate B Copyright: Pru Marriott, University of Glamorgan

  34. 8% + (( 10% - 8% ) x (462/(462- -78))) = 9.7% Quick way of knowing which interest rate to start with? Cash Price15,000 = 2.5 Installment 6,000 2.5 falls between 8% and 10% so interpolate in the above manner. Copyright: Pru Marriott, University of Glamorgan

  35. +NPV x A AB = BE AC CD B E 0 % r1 r2 -NPV y C D Copyright: Pru Marriott, University of Glamorgan

  36. AB = BE AC CD 462 = BE 540 2 462= BE 540 CD 462 = BE 540 CD 462= BE540CD Re-arrange equation BE = 462 x 2 = 1.7 540 NPV So, required interest rate 8% + 1.7% = 9.7% 462 x A B E 8% 1.7% % 0 8 10 -78 y C D Copyright: Pru Marriott, University of Glamorgan

  37. Interest would therefore be charged at a constant rate of 9.7% on the balance outstanding. Year Opening Interest Payment Closing Balance (@ 9.7) Balance 1 15,000 1,455 (6,000) 10,455 2 10,455 1,014 (6,000) 5,469 3 5,469 531 (6,000) nil Copyright: Pru Marriott, University of Glamorgan

  38. 4.3 Accounting for Interest • Using the information in Activity 5 and the interest figures calculated under the actuarial method: (a) Prepare the ledger accounts not using a suspense account and then using a suspense account. (b) Prepare extracts from the profit and loss account and balance for PM Ltd. Copyright: Pru Marriott, University of Glamorgan

  39. NO SUSPENSE ACCOUNT Fixed Asset Interest Jan 1 15,000 Dec 1 1,455 P&L 1,455 Dec 2 1,014 P&L 1,014 Dec 3 531 P&L 531 Obligations under Finance Lease Depreciation Dec 1 6,000 Jan 1 15,000 Dec 1 5,000 P&L 5,000 Bal 10,455 Dec 1 1,455 Dec 2 5,000 P&L 5,000 16,455 16,455 Dec 3 5,000 P&L 5,000 Dec 2 6,000 Bal 10,455 Bal 5,469 Dec 2 1,014 Accum Depreciation 11,469 11,469 Dec 3 6,000 Bal 5,469 Dec 3 531 Dec 1 5,000 6,000 6,000 Dec 2 5,000 Copyright: Pru Marriott, University of Glamorgan Dec 3 5,000

  40. Interest Suspense Account USE OF SUSPENSE ACCOUNT: Asset and Depreciation A/cs the same Jan 1 3,000 P&L 1,455 Bal 1,545 3,000 3,000 Jan 2 1,545 P&L 1,014 Obligations under Finance Lease Bal 531 1,545 1,545 Dec 1 6,000 Jan 1 15,000 Jan 3 531 P&L 531 Bal 12,000 Jan 1 3,000 18,000 18,000 531 531 Dec 2 6,000 Bal 12,000 Bal 6,000 12,000 12,000 Dec 3 6,000 Bal 6,000 Copyright: Pru Marriott, University of Glamorgan

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