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 • Asset A resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise • Liability A 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 = 12,500 10,000 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
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 = 8,445 Non-current = 5,945 Current = 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?