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Leases

Learning Outcomes: Understand the different types of leases Understand the accounting principles related to finance lease Understand the journal entries to record finance lease Understand the disclosure requirements for finance lease. Leases. 1. Definition: FRS 117

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Leases

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  1. Learning Outcomes: Understand the different types of leases Understand the accounting principles related to finance lease Understand the journal entries to record finance lease Understand the disclosure requirements for finance lease Leases 1

  2. Definition: FRS 117 “A lease is an agreement whereby the lessor (the owner of the asset who rents out the asset) conveys to the lessee (one who get to use the asset by paying rents) in return for a payment or series of payments the right to use an asset for an agreed period of time” leases

  3. Advantages of Leasing: Financing benefits – 100% financing, no d/payment, flexible terms than the debt Risk benefits – risk is borne by the lessor e.g. risk of obsolescence Tax benefits Financial reporting benefit – Off balance sheet financing Cont.

  4. Finance lease Lease that transfers substantially, all of the risks and rewards incident to ownership of an asset. Title may or may not eventually be transferred. ( Substance over form principle) Operating lease Lease that does not transfers all of the risks and rewards incident to ownership of an asset. Types of Leases

  5. Criteria to classify lease as a finance lease: The ownership of the asset is transferred to the lessee by the end of the lease term; The lessee has the option to purchase the asset, and at the inception of the lease, it is certain that the option will be exercised The lease term is for the major part of the economic life of the asset even if title is not transferred; (as a guide, the lease should be 90% or more of the economic life of the asset) Finance Lease

  6. Criteria to classify lease as a finance lease: At the inception of the lease the present value of the minimum lease payments (MLP) amount to at least substantially all of the fair value of the leased asset The leased assets are of such a specialised nature that only the lessee can use them without major modifications. Cont.

  7. Minimum lease payment (MLP) Paymentsthat are required to be paid by the lessee to the lessor over the life of the lease. Specifically, for a lease that contains a bargain purchase option, the MLP include: The minimum periodic payments required by the lease over the lease term; and The payment required by the bargain purchased option Cont.

  8. Minimum lease payment (MLP) Otherwise: the MLP include: The minimum periodic payments plus Any guaranteed residual value Any payments on failure to renew or extend the lease. Executory costs are not included in the MLP (e.g. insurance,cost for services) Cont.

  9. Kinta SdnBhd (the lessee) entered into an equipment lease contract with Dania SdnBhd (the lessor) on January 1 of Year 1. The equipment has an estimated useful life of 20 years and has zero residual value. Using the following information decide whether the lease qualifies as an operating lease or finance lease for Kinta SdnBhd, and give an explanation using the classification criteria: The equipment reverts back to the lessor at the end of the lease, and there is no bargain purchase option. The lease term is 8 years and requires annual payments of RM10,000 at the end of each year. The fair value of the equipment at lease inception is RM100,000. Assume that the present value of MLP is RM50,000. Exercise

  10. Recognition: as asset and liabilities in the Balance Sheet Dr Asset (finance lease) Cr Liability (finance lease) WHAT VALUE: fair value of the leased asset OR present value of the minimum lease payments (if lower) WHAT RATE (for PV): interest rate implicit in the lease (if practicable to determine) OR lessee’s incremental borrowing rate Accounting Treatments

  11. Minimum lease payment (MLP) PV of the MLP: PV= ∑ lease rental + purchase option t =1 (1+ r )t (1+ r )n = lease rental (PVIFA r , n) + purchase option(PVIF r , n) Cont.

  12. Illustration 1: Manja Bhd (1 Jan); 5-year finance lease ; RM25,000 annual instalment paid every end of year ; fair value of machine = RM100,000; Manja incremental borrowing cost 10%. PV = PVIFA (10%,5) x RM25,000 = 3.791 x RM25,000 = RM94,775 Dt. (Finance) leased asset RM94,775 Cr. Liability (finance lease) RM94,775

  13. THE ASSET should be recognised as non-current asset and accounted for according to FRS 116- PPE. The lease asset should be depreciated over its useful life (if ownership is transferred); Otherwise it should be depreciated over the shorter of the leases term or its useful life Cont.

  14. Finance lease (Liability): The lease liability should be recorded at the same amount as the leased asset. The lease payment – apportioned between Finance charge Reduction of outstanding lease liability INTEREST / FINANCE CHARGE is the different between the sum of the gross lease payments and the fair value of the leases asset. Cont.

  15. Allocating Finance Charge: Three methods: Amortisation schedule using the effective/implicit interest rate Sum year digit Straight line method (only is finance charge is not material) Standard requires the 1st method to be used to produce a constant periodic rate of interest. Refer to Illustrations 117.5 (p391), 117.6 (p394) & 117.8 (p397) from NEJ, PGRSM, 2nd Edition, Cont.

  16. Disclosure: Carrying amount of each class of asset: i. Reconciliation between MLP and their fair value at the B/S date ii.Total future minimum lease payments at the B/S date and their PV for each of the following periods: not later than one year later than one year but not later than 5 years later than 5 years Contingent rent recognised Cont.

  17. Disclosure: Total future sublease payments expected to be received under non-cancellable sublease at the B/S date. General description of the lessee’s significant leasing arrangements including but not limited to: basis on which contingent rent payments are determined the existence and terms of renewal or purchase options and escalation clause restriction imposed by lease arrangements Cont.

  18. Accounting Treatment: Recognise as an expense in the income statement. Entry: Dr Leased expense Cr Bank Use a straight line basis over the lease term Operating Lease

  19. Disclosure: Total future minimum lease payments under the non-cancellable operating lease for each of the following periods: not later than one year later than one year but not later than 5 years later than 5 years General description of the lessee’s significant leasing arrangements including but not limited to: basis on which contingent rent payments are determined the existence and terms of renewal or purchase options and escalation clause restriction imposed by lease arrangements Cont.

  20. Finance vs Operating Lease

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