The required treatment of lease agreements can seem complex, but if you
understand the key points, questions on this topic should not pose
too many problems.
EZ
technical
lessee
for lease
RELEVANT TO MODULE A
The required treatment of lease agreements can
seem complex, but if you understand the key
points, questions on this topic should not pose too
many problems.
The key points, which are considered in this
article, are:
¤ What is a lease agreement?
¤ What types of lease might an agreement give
rise to?
¤ How do we decide on the correct classification of
a lease?
¤ What is the significance of the way in which a
lease is classified?
¤ How are the values for the required
entries calculated?
¤ What is the impact of the way a lease is treated?
What is a lease agreement?
Essentially, a lease agreement is a rental agreement.
Under the agreement, the owner (lessor) receives a
series of payments which allows the lessee to have
use of an asset. Often, a lease agreement does not
include the transfer of ownership of the asset to the
lessee, although in some cases it may. In those cases
where ownership is transferred, this will occur at the
end of the agreement. What type of lease might an agreement give rise to?
There are two types of leases that might arise
from a lease agreement – a finance lease or an
operating lease.
How do we decide on the correct classification of a lease?
The key issue is related to the risks and rewards of
ownership. The relevant accounting standard (IAS
17) defines a finance lease as ‘a lease that transfers
substantially all the risks and rewards incidental to
ownership of an asset’, while an operating lease is
‘a lease other than a finance lease’.
In practice, this can sometimes difficult to tie
down, as the inclusion of the word ‘substantially’
introduces a degree of uncertainty. Moreover, the
providers of lease finance can sometimes increase
this uncertainty by drafting the agreement so that
it can be less than clear whether substantially
all the risks and rewards of ownership have
been transferred.
In an exam, however, classifying a lease should
be less problematic. If a question requires a
consideration of the classification of a lease, it will
normally include information on issues such as
whether the lessee or lessor is required to provide
insurance for the asset, and which party would
suffer monetary loss if the asset was damaged.
Responsibility for such matters can be taken to
indicate which party enjoys substantially all the
risks and rewards of ownership. Alternatively, a
lease period which is considerably shorter than
the useful life of the asset normally indicates
that substantially all of the risks and rewards of
ownership rest with the lessor.
What is the significance of the way in which a lease
is classified?
The key thing to remember is that the word
‘substantially’ is included because accounting
for a finance lease provides a specific example of
the application of the principle that accounting
practice should be based on the underlying
economic substance of the transaction, not the
legal form.
Furthermore, classification of a lease is
significant as the accounting treatment of each type
of lease is distinctly different.
This might be summarised as follows:
finance matters 08/2009
EZ
Operating lease
The rentals due under the agreement should be written off to the income statement. The normal practice is to allocate the total amount of the rentals to each accounting period on a straight line basis.
An operating lease does not lead
to either a non-current asset or a
liability for future rentals
due under the agreement being
reported on the statement of
financial position of the lessee.
Finance lease
The asset is recorded as a non‑current asset on the statement
of financial position of the lessee.
This gives rise to a charge for
depreciation, just as all other
non-current assets are depreciated.
The value of the capital element
of future payments required
under the lease agreement is
reported as liability on the
statement of financial position of
the lessee. This will be divided
into the current liability and the
non‑current liability.
Payments are split into two
elements – a capital repayment
(which reduces the liability),
and interest on the liability
(which is reported as a charge to
the income statement).
How are the values for the entries calculated?
Essentially, a lease agreement is a rental agreement. Under
the agreement, the owner (lessor) receives a series of
payments which allows the lessee to have use of an asset.
accounting
agreements
For an operating lease, this is quite straightforward.
The full value of the rentals is charged to the
income statement. Rentals are normally allocated
to an accountiing period on a straight line basis.
The application of this principle is demonstrated in
Example 2.
For a finance lease, there are three key principles
which must be used. These relate to:
¤ initial recognition of the asset
¤ depreciation
¤ dividing the payments into capital and
interest elements
Initial recognition
IAS 17 states that the value at which the asset
(and the corresponding liability) should initially
be recognised is the lower of the fair value of
the asset, and the present value of the minimum
payments due under the lease. ‘Fair value’ is the
value at which the asset could be acquired on
the open market. The interest rate implicit in the
lease is effectively the internal rate of return of the
lease, based on the fair value of the asset and the
payments which the lessee must make under the
terms of the lease.
Discounted cash flow calculations are not part of
the syllabus for Module A (they are, however, on the
syllabus for Module B). Therefore calculation of the
present value will not be required in a DipFM exam
for Module A.
This means that, more often than not, the initial
value will be the fair value of the asset, and this
value will be included in the question.
Dividing the payments into capital and interest elements is one matter in which
the approach required in a DipFM exam is likely to be much more
straightforward than most candidates might think.
EZ
technical
Depreciation
The leased asset should be depreciated on the
same basis as other assets which are owned by
the lessee.
One point to be aware of is that, if it is not
reasonably certain that ownership of the asset
will be transferred to the lessee by the end of the
lease period, the depreciation period should be
the shorter of the lease term and the useful life of
the asset.
Example 1
This matter is one in which the approach required
in a DipFM exam is likely to be much more
straightforward than most candidates might think.
The standard requires interest to be calculated
so that the interest in each period represents a
constant periodic rate of interest on the remaining
balance. In simple terms, the interest for each
period would be calculated using the interest rate
implicit in the lease. As has already been noted, the
interest rate implicit in the lease will be provided if
candidates are required to use it. This approach is
often referred to as the actuarial method, and it is
demonstrated in the example.
Helpfully, the standard allows the calculation of
the finance charge to be simplified by using ‘some
form of approximation’. In Module A, there are two
possible approximation methods which may be
used. These are:
¤ sum of digits
¤ straight line
The sum of digits method provides an allocation
of the interest to accounting periods so that the
proportion of each payment which is deemed to be
an interest payment will reduce over the term of the
lease, while the straight line method charges the
same amount of interest to each accounting period.
Therefore, the sum of digits method is a better
method, but exam questions may use the straight
line method to reduce the number of calculations
required. Both methods are illustrated in Example 1.
Impact of treatment
Clearly, the correct classification of a lease has
an impact on an entity’s financial statements as a
number of key ratios might be affected.
A finance lease gives rise to the creation of an
asset, as well as current and non-current liabilities.
Therefore, classifying a lease as a finance lease will
impact on any assessment of performance which
utilises the values for non-current assets, current
liabilities or non-current liabilities.
Examples would be:
Return on capital employed
total assets are likely to increase, and while
this will be offset to some extent by an
increase in current liabilities, the net effect
will be to increase the value of
capital employed
Return on Gross Assets
Asset turnover
Current ratio/quick assets ratio (as current
liabilities will be increased)
Profitability ratios are unlikely to be affected to any
significant extent, as the total income statement
charge under both an operating lease (rentals) and
a finance lease (depreciation + interest) are likely
to be roughly similar. The exception to this is the
interest cover ratio, which will appear to be better
under a finance lease, due to the classification of
part of the charge as interest.
EZ
Under the sum of digits method, the digits for each of the years of the
lease period are added together to obtain a total sum of digits. The interest
charge is then allocated to each year in proportion. This might seem a little
complicated, but in practice it is quite straightforward.
finance matters 08/2009
Example 1
Lessee Co entered into a lease under the
following terms:
Lease term
5 years
Payment terms: 5 annual payments of $110,690,
payable in advance, with a further
payment of $110,690 due at the
end of the lease period
Implicit
interest rate
13% per annum (approximately)
The lease does not include any right of ultimate
ownership for Lessee Co. Lessee Co is responsible
for maintaining and insuring the asset, as well as all
running costs.
If the asset had been purchased outright at
the start of the lease, the cost would have been
$500,000. The asset has an expected useful life of
seven years.
The depreciation policy of Lessee Co is to fully
depreciate non-current assets on a straight line
basis over their useful life.
Step 1 – Classify the lease
As Lessee Co is responsible for maintenance,
insurance and running costs, this lease appears to
be a finance lease, notwithstanding the fact that the
lease period is a little shorter than the useful life of
the asset.
Step 2 – Obtain the value at which the asset should
initially be recognised
In this case, we have been given the fair value, so we
use that value – $500,000.
Step 3 – Calculate the depreciation charge
As ownership of the asset will not be transferred at
the end of the lease, Lessee Co should depreciate it
over the shorter of the lease period (five years) and
the useful life (seven years).
Applying the policy of fully depreciating assets
on the straight line basis, the annual depreciation
charge is:
$500,000 ÷ 5 = $100,000
Step 4 – Calculate the interest charges
The total payments due under the lease are
$664,140 (6 x $110,690).
The fair value of the asset is $500,000.
Therefore, the interest element of the total
due under the lease is $164,140 ($664,140 $500,000).
Having calculated the total interest, it must be
allocated to each year of the lease.
The most accurate method is the actuarial
method. This is demonstrated in Table 1.
Example 2
Assume that the terms of the lease are the same
as in Example 1, except that the responsibility for
maintenance and insurance of the asset remain
with the lessor, and the asset has a useful life of
ten years.
In this case, the lease is likely to be an
operating lease.
The annual charge to the income statement is
calculated as follows:
Total payments $664,140
Lease period5 years
Annual charge$132,828
The payment pattern will therefore lead to an
accrual at each year end for rentals charged, but
not yet paid, calculated as follows:
Year
Payment
1
$110,690
2
$110,690
3
$110,690
4
$110,690
5
$221,380
Total
$664,140
Income
statement
charge
$132,828
$132,828
$132,828
$132,828
$132,828
$664,140
Accrual at
year end
$22,138
$44,276
$66,414
$88,552
$
nil
EZ
technical
Sum of digits method
This is simply a different method
of allocating the total interest
of $164,140 to each year of the
lease. Under this method, the
digits for each of the years of the
lease period are added together to
obtain a total sum of digits. The
interest charge is then allocated to
each year in proportion. This might
seem a little complicated, but in
practice it is quite straightforward.
In our example, the lease runs
for five years, so we add the digits
from 1 to 5. This gives a total of
15 (1+2+3+4+5). The first year is
assigned the largest digit, and the
final year is assigned 1.Thus the
interest is allocated to each year
as follows:
Year
1
2
3
4
5
Proportion
5/15
4/15
3/15
2/15
1/15
Total
Interest
$ 54,713
$ 43,771
$ 32,828
$ 21,885
$ 10,943
$164,140
Straight line method
This is the simplest method as the
total interest of $164,140 is equally
divided across the five years of the
lease period. Thus, $32,828 will be
charged for each year.
Ronnie Paton is examiner for
Module A
1
Table 1 footnote
This adjustment arises because
the interest rate is closer to
13.001%, but 13% was used to
simplify the calculations.
TABLE 1: Calculate the interest charges – acturial Method
Actuarial method
Balance Interest
@13% pa
Year 1
Value of asset
$500,000
less: payment in advance
$110,690
thus: Capital balance at outset
$389,310
$50,610
Year 2
Balance brought forward – capital
add: Interest charge for year 1
less: Payment thus:Capital balance at start of year
$389,310
$ 50,610
$439,920
$110,690
$329,230
$42,800
Year 3
Balance brought forward – capital
add: Interest charge for year 2
less: Payment thus:Capital balance at start of year
$329,230
$ 42,800
$372,030
$110,690
$261,340
$33,974
Year 4
Balance brought forward – capital
add: Interest charge for year 3
less: Payment thus: Capital balance at start of year
$261,340
$ 33,974
$295,314
$110,690
$184,624
$24,001
Year 5
Balance brought forward – capital
add: Interest charge for year 4
less: Payment thus:Capital balance at start of year
add: Interest charge for year 5
Adjustment1
less: Final payment
Total interest
$184,624
$ 24,001
$208,625
$110,690
$ 97,935
$ 12,732
$110,667
$
23
$110,690
nil
$12,732
$
23
$164,140