Chapter 11
Accounting for leases
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-1
Objectives
• Understand the differences between operating leases
and financial leases
• Understand how lessors and lessees should account
for financial leases
• Understand how lessors and lessees should account
for operating leases
• Understand the implications that lease recognition will
have for a reporting entity’s financial statements
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-2
Introduction to accounting for leases
Accounting for leases is governed by AASB 117
• Applies to accounting for leases other than
– leases to explore for or use minerals, oil, natural gas and
similar non-regenerative assets
– licensing agreements for such items as motion picture films,
video recordings, plays, manuscripts and copyrights
Lease defined (AASB 117, par. 4)
• 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
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-3
Introduction to accounting for
leases (cont.)
Central accounting issue
• Whether or not the leased assets and the associated
commitments relating to the lease arrangement should
appear in the reporting entity’s balance sheet
• Should lack of legal ownership preclude the lessee’s
reporting of the asset and the related liability in the
balance sheet?
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-4
Introduction to accounting for
leases (cont.)
As we know in relation to assets, it is question of ‘control’
and not ‘ownership’ that governs recognition
• A firm may recognise assets it does not own as long
as it is able to control their use
• Do leases transfer control of the asset to the lessee?
– depends on the terms of the lease agreement
– it is, in fact, possible for control of the asset to be vested in the
lessee
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-5
Introduction to accounting for
leases (cont.)
Central issue concerns whether lease is
– a finance lease; or
– an operating lease
Finance leases (under AASB 117) must be disclosed
in the balance sheet
– lease asset
– corresponding lease liability
Finance lease
– a lease that transfers substantially all the risks and rewards
incidental to ownership of an asset
– title may or may not be eventually transferred
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-6
Risks and rewards of ownership
Risks and rewards of ownership central to the
application of AASB 117
– if the lessee holds the risks and rewards of ownership, the
lessee’s risk exposure is basically what it would be if the
lessee acquired the asset by way of a purchase transaction
– if the risks and benefits of ownership are transferred in
substance to the lessee, the lessee’s risk exposure in
relation to holding the asset is basically equivalent to what
it would have been if the lessee had acquired the asset for
cash or by way of a loan
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-7
Who has the risks and rewards of
ownership?
Risks and rewards of ownership (cont.)
– not always a straightforward exercise to determine whether
the risks and rewards incidental to ownership have passed
substantially to the lessee
– often requires professional judgment
– guidance offered in AASB 117 (pars 10–12) to determine
whether finance or operating lease
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-8
Is it a finance or operating lease?
AASB 117 (par. 10)
Whether a lease is a finance lease or an operating lease
depends on the substance of the transaction rather than the
form of the contract. Examples of situations that, individually
or in combination, would normally lead to a lease being
classified a finance lease are:
(a) the lease transfers ownership of the asset to the lessee by
the end of the lease term
(b) the lessee has the option to purchase the asset at a price
that is expected to be sufficiently lower than the fair value at
the date the option becomes exercisable for it to be
reasonably certain, at the inception of the lease, that the
option will be exercised
(c) The lease term is for the major part of the economic life of
the asset even if the title is not transferred
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-9
Is it a finance or operating lease?
(cont.)
AASB 117 (par. 11)
Indicators of situations that, individually or in combination,
could also lead to a lease being classified a finance lease
are:
(a) If the lessee can cancel the lease, the lessor’s losses
associated with the cancellation are borne by the lessee
(b) gains or losses from the fluctuation in the fair value of the
residual accrue to the lessee (for example, in the form of
a rent rebate equalling most of the sale proceeds at the
end of the lease); and
(c) the lessee has the ability to continue the lease for a
secondary period at a rent that is substantially lower than
the market rent
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-10
Is it a finance or operating lease?
(cont.)
Note (AASB 117, par. 12)
•
The examples and indicators in paragraphs 10 and 11 are
not always conclusive
•
If it is clear from other features of the lease that the lease
does not transfer all risks and rewards incidental to
ownership, the lease is classified as an operating lease
•
This might be the case, for example, if ownership of the asset
transfers at the end of the lease for a variable payment equal
to its then fair value or if there are contingent rents, as a
result of which the lessee does not bear substantially all such
risks and rewards
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-11
Introduction to accounting for
leases (cont.)
Operating vs finance lease
•
If lease is cancellable at limited cost to lessee, the lessee has
limited risks and the lease is considered an ‘operating’ lease
•
For the lessee to be considered to bear the risks associated with
asset ownership there should be costs for the lessee should the
lessee choose to cancel the lease
•
Thus, par. 11(a) is considered an important consideration in
determining whether a lease is a ‘finance’ lease
•
Classification of lease a matter of professional judgment, i.e.
depends on economic substance of the lease agreement
•
Leases that do not appear to satisfy any of the criteria of AASB 117
(paragraphs 10–12) will typically be classified and accounted for by
the lessee as ‘operating’ leases
•
They will not require disclosure within the balance sheet, lease
payments are typically treated as rental expenses
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-12
Key terms in accounting for leases
1. Fair value
– the amount for which an asset could be exchanged or a liability
settled between knowledgeable, willing parties in an arm’s
length transaction
– necessary for determining the amount to be included for the
leased asset in the balance sheet of the lessee
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
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11-13
Key terms (cont.)
2. Non-cancellability
A non-cancellable lease is a lease that is cancellable only:
(a) upon occurrence of some remote contingency
(b) with the permission of the lessor
(c) if the lessee enters into a new lease for the same or an
equivalent asset with the same lessor; or
(d) upon payment by the lessee of such an additional amount that
at inception of the lease, continuation of the lease is reasonably
certain
•
Important because if the lessee was able to cancel the lease
at short notice with limited penalty the lessee would not be
considered to be holding the risks and rewards associated
with asset ownership—lease would be considered an
operating lease
•
If lease cancelable—regardless of remaining terms the
lease would be considered to be an operating lease
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-14
Key terms (cont.)
3. Contingent rent (AASB 117, par. 4)
That portion of the lease payments that is not fixed in amount
but is based on the future amount of a factor that changes
other than with the passage of time (e.g. percentage of future
sales, amount of future use, future price indices, future
market rates of interest)
Why important?
•
When the amount of rent paid by the lessee is contingent
upon the amount of future sales, future use, future interest
rates, etc, there is effectively a shift of some of the risks and
rewards of ownership back to the lessor
•
‘Contingent rent’ therefore decreases the likelihood that the
lease will be a ‘finance’ lease
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-15
Key terms (cont.)
4. Transfer of ownership
•
If lease transfers ownership of the asset to the lessee at the end
of the lease term it is considered a finance lease (AASB 117,
par. 10a)
•
If the lease is also non-cancellable, the lease is really only
another type of debt agreement with title passing after last
payment is made
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-16
Key terms (cont.)
5. Bargain purchase option
Considered in AASB 117 (par. 10b)
•
A provision that allows a lessee to purchase a leased property for a
price expected to be far lower than the expected fair value of the
property at the date the option becomes exercisable
•
Difference between the option price and expected fair market value
must be large enough to make exercise of the option reasonably
assured— evaluation made at inception of lease
•
If exercise of option is likely (bargain) it is also likely that transfer of
ownership will occur—risks and rewards of ownership are assumed
to be transferred
•
Included in the calculation of minimum lease payments because the
exercise of a ‘bargain’ option is reasonably assured and it is
therefore probable that the amount will ultimately be paid by the
lessee
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
11-17
Key terms (cont.)
6. Lease term
• The non-cancellable period for which the lessee
has contracted to lease the asset, together with
any further terms for which the lessee has the
option to continue to lease the asset with or
without further payment, when at the inception of
the lease it is reasonably certain that the lessee
will exercise the option
Copyright  2007 McGraw-Hill Australia Pty Ltd
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11-18
Key terms (cont.)
7. Economic life
Either
(a)
(b)
the period over which an asset is expected to be economically usable by
one or more users; or
the number of production or similar units expected to be obtained from
the asset by one or more users
Why important? AASB 117, par. 10(c)
•
If the non-cancellable lease term is for the major part of the
economic life of the asset the lease is generally considered a
finance lease
Note:
‘Major part’ not defined but generally accepted that if lease term is
greater than or equal to 75% of the economic life of the leased
asset risks and rewards are effectively transferred to the lessee
(finance lease)
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
11-19
Key terms (cont.)
8. Minimum lease payments
AASB 117 (par. 4)
The payments over the lease term what the lessee is or can
be required to make, excluding contingent rent, costs for
services and taxes paid by and reimbursed to the lessor
together with:
(a) for the lessee, any amounts guaranteed by the lessee or by a
party related to the lessee; or
(b) for a lessor, any residual value guaranteed to the lessor by:
(i) the lessee
(ii) a party related to the lessee; or
(iii) a third party unrelated to the lessor that is financially
capable of discharging the obligations under the guarantee
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-20
Key terms (cont.)
8. Minimum lease payments (cont.)
Why important?
•
The present value of the minimum lease payments is used to
determine whether a lease is a finance or operating lease—AASB
117, par. 10(d)
If at the inception of the lease the present value of the minimum
lease payments amounts to at lease substantially all of the fair
value of the asset—normally leads to lease classified as
‘finance’-type lease
If in a finance lease the amount to be initially recognised in the
balance sheet for the asset and liability is (par. 20) the fair value
of the leased property or, if lower, the present value of the
minimum lease payments as determined at inception of lease
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
11-21
Key terms (cont.)
8. Minimum lease payments (cont.)
•
Expressly exclude contingent rent
•
Include guaranteed residual values
(a) Guaranteed residual value defined for the lessee
•
That part of the residual value that is guaranteed by the
lessee or by a party related to the lessee (the amount of the
guarantee being the maximum amount that could in any
event become payable
(b) Guaranteed residual value defined for the lessor:
•
That part of the residual value that is guaranteed by the
lessee or by a third party unrelated to the lessor that is
financially capable of discharging the obligations under the
guarantee
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-22
Introduction to accounting for
leases (cont.)
(c) Amount of a guaranteed residual value
• The amount that the lessor has the right to require the lessee or a
related party to the lessee to pay at the end of the lease term
• Payment of this residual will often lead to the asset being legally
transferred to the lessee
Minimum lease payments
• Do not include costs for services and taxes (executory costs) that
are paid to the lessor in reimbursement
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-23
Key terms (cont.)
9. Guaranteed/Unguaranteed residual
(a) Guaranteed residual
•
The maximum amount that could become payable—
included in the minimum lease payments as its payment is
reasonably assured
(b) Unguaranteed residual
•
Not included in minimum lease payments as there is not
sufficient certainty that the amount will be paid
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-24
Interest rate for determining the present value of
minimum lease payments
AASB 117 (par. 20)
At commencement of lease term lessees are to recognise
finance leases as assets and liabilities in their balance sheets
at amounts equal to the fair value of the leased property or, if
lower, the present value of the minimum lease payments
Discount rate to be used in calculating present value:
– interest rate implicit in the lease (if this is practical to
determine); or
– if not, the lessee’s incremental borrowing rate to be used
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
11-25
Interest rate for determining the present value of
minimum lease payments (cont.)
•
Interest rate implicit in the lease (AASB 117)
The discount rate that, at the commencement of the
lease term, causes the aggregate present value of
(a) the minimum lease payments; and
(b) the unguaranteed residual value to be equal to the sum
of:
(i) the fair value of the leased asset; and
(ii) any initial direct costs of the lessor.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-26
Interest rate for determining the present value of
minimum lease payments (cont.)
Fair value of asset cannot be determined by lessee at inception of lease:
–
–
implicit interest rate cannot then be determined
lessee to discount the minimum lease payments by using incremental
borrowing rates
Incremental borrowing rate defined:
–
the rate of interest the lessee would have to pay on a similar lease or, if not
determinable, the rate that, at the inception of the lease, the lessee would
incur to borrow over a similar term, with similar security, the funds
necessary to purchase the asset
Refer to Worked Example 11.1 on page 402—Example of computing discount
rate
Refer to Worked Example 11.2 on page 403—Classification of a lease as a
finance or operating lease
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
11-27
Lessee accounting for
finance leases
Overview
• Lessee records an asset (leased) and a lease
liability
• Asset and liability recorded at the fair value of the
leased property or, where lower, at the present
value of the minimum lease payments
Copyright  2007 McGraw-Hill Australia Pty Ltd
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11-28
Lessee accounting for
finance leases (cont.)
Overview (cont.)
• Unguaranteed residual excluded from the amount
recognised for the lease asset and lease liability in
financial statements of lessee
• Rental payments to lessor include payment of
principal plus interest—to be apportioned by lessee
• Interest expense calculated by applying the interest
rate implicit in the lease to outstanding lease liability
at beginning of each lease period
• Balance of payment represents a reduction of
principal of lease liability
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
11-29
Lessee accounting for
finance leases (cont.)
Amortisation of leased assets
• Leased assets should be amortised using the depreciation
(amortisation) policies normally followed by the lessee
• Period of amortisation—number of accounting periods that are
expected to benefit from the asset’s use
• Amortisation can be over useful life of asset, i.e. when
reasonable assurance that lessee will obtain ownership at end
of lease term (e.g. bargain purchase option), otherwise
amortisation over lease term
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
11-30
Lessee accounting for
finance leases (cont.)
Journal entries
• To record the leased asset and lease liability (at PV of
minimum lease payments):
Dr Leased asset
Cr
Lease liability
• To record lease amortisation expense:
Dr Lease amortisation expense
Cr
Accumulated amortisation
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-31
Lessee accounting for
finance leases (cont.)
Journal entries (cont.)
• To record the lease payment, with the payment being
allocated between principal and interest:
Dr
Lease liability
Dr
Interest expense
Cr Cash
• To record payment of executory costs:
Dr
Executory expenses
Cr Cash
Copyright  2007 McGraw-Hill Australia Pty Ltd
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11-32
Lessee accounting for
finance leases (cont.)
Initial indirect costs (AASB 117)
• Costs directly associated with negotiating and executing a lease
agreement
• Include commissions, legal fees, costs of preparing and
processing documentation
• Initial direct costs relating to a finance lease must be capitalised
as part of the leased asset
• Where such costs are incurred the lease asset comprises the
present value of the minimum lease payments and the amount of
the initial direct costs incurred—total amount subject to
amortisation
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
11-33
Lessee accounting for
operating leases
• A lease that does not substantially transfer all the
risks and rewards incidental to ownership of the
asset to the lessee
• Lease payments are expensed on a basis
representative of the pattern of benefits derived from
the leased asset
• If lease payments do not represent prepayments,
they should be expensed in the period made
Copyright  2007 McGraw-Hill Australia Pty Ltd
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11-34
Lessee accounting for
operating leases (cont.)
AASB 117 (par. 33)
Lease payments under an operating lease are to be
recognised as an expense on a straight-line basis over the
lease term, unless another systematic basis is more
representative of the time pattern of the user’s benefits
• Journal entry
Dr
Rental expense
Cr
Cash
Refer to Worked Example 11.3 on page 408—Example of
accounting for an operating lease
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Slides prepared by Craig Deegan
11-35
Lessee accounting for sale and
leaseback transactions
• Occurs when the owner of a property (seller/lessee)
sells the property to another party and
simultaneously leases it back from the
purchaser/lessor (the legal owner)
• Seller does not lose control of the asset if the lease
is a finance lease
• Property often sold at a price equal to or greater
than current market value—leased back for a term
approximating useful life
Copyright  2007 McGraw-Hill Australia Pty Ltd
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11-36
Lessee accounting for sale and leaseback
transactions (cont.)
• Lease payments sufficient to repay the buyer for cash invested
plus reasonable return on investment
• Lessee typically pays all executory costs as if title remained
with lessee
• Often considered a useful way of obtaining funds while
allowing recipient of the funds to maintain control of the asset
Copyright  2007 McGraw-Hill Australia Pty Ltd
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11-37
Lessee accounting for sale and leaseback
transactions (cont.)
Where the lease is a finance lease
• Where substantially all risks and rewards incidental
to ownership remain with lessee—represents
refinancing of an asset
• Any profit or loss on sale deferred in the balance
sheet and amortised to the profit and loss over the
term of the lease (AASB 117, par. 59)
• Asset considered not to have been ‘sold’ to lessor,
therefore inappropriate to recognise profit or loss
(AASB 117, par. 60)
Copyright  2007 McGraw-Hill Australia Pty Ltd
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11-38
Lessee accounting for sale and leaseback
transactions (cont.)
Where the lease is an operating lease
• Where substantially all risks and rewards incidental to ownership effectively
pass to lessor
AASB 117 (par. 61)
• If a sale and leaseback transaction results in an operating lease, and it is clear
that the transaction is established at fair value, any profit and loss shall be
recognised immediately
• If the sale price is below fair value, any profit or loss shall be recognised
immediately, except that, if the loss is compensated for by future lease
payments at below market price, it shall be deferred and amortised in
proportion to the lease payments over the period for which the asset is
expected to be used
• If the sale price is above fair value, the excess over fair value shall be deferred
and amortised over the period for which the asset is expected to be used
Copyright  2007 McGraw-Hill Australia Pty Ltd
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11-39
Lessee accounting for sale and leaseback
transactions (cont.)
Operating lease (cont.)
AASB 117 (par. 63)
• For operating leases, if the fair value at the time of the sale
and leaseback transaction is less than the carrying amount of
the asset, a loss equal to the amount of the difference between
the carrying amount and fair value is to be recognised
immediately
)
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11-40
Lessee accounting for sale and leaseback
transactions (cont.)
Journal entries
• To record the sale of an asset (any profit on sale is
deferred and recognised throughout lease term)
Dr
Cash
Dr
Accumulated depreciation
Cr Asset
Cr Deferred gain
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11-41
Lessee accounting for sale and leaseback
transactions (cont.)
Journal entries (cont.)
• To record finance lease
Dr
Leased asset
Cr Lease liability
• To recognise periodic lease repayment
Dr
Interest expense
Dr
Lease liability
Cr Cash
Copyright  2007 McGraw-Hill Australia Pty Ltd
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11-42
Lessee accounting for sale and leaseback
transactions (cont.)
Journal entries (cont.)
• To record amortisation of leased asset
Dr
Amortisation of leased asset
Cr
Accumulated lease amortisation
• Recognition of deferred gain (on straight-line basis)
Dr
Deferred gain
Cr
Profit on sale of leased asset
Refer to Worked Example 11.4 on page 410—Example of sale
and leaseback transaction
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11-43
Lessee disclosure requirements
Finance lease
• Numerous disclosures required—Refer to AASB 117, par. 31
Operating lease
• Numerous disclosures required—Refer to AASB 117, par. 35
Refer to Exhibit 11.2 on page 399—Lease commitment note
Qantas Airways Ltd
Refer to Worked Example 11.5 on page 415—Comprehensive
example of accounting for leases by a lessee
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11-44
Accounting by lessors
Lessor’s perspective
• Leases also classified either as operating leases or finance
leases
• Adoption of same criteria for non-cancellable lease as for
lessee
• Factors addressed in AASB 117, pars 10–12
Finance leases can be further classified into
• Leases involving manufacturers or dealers
• Direct finance leases
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11-45
Lessor accounting for
direct financing leases
Direct financing lease
• A lease where the lessor provides the financial resources to
acquire the asset
• Lessor typically acquires the asset, giving the lessor legal title,
then enters a lease agreement to lease the asset to the lessee,
who subsequently controls the asset
• No sale is recorded
• Lessor derives income through periodic interest revenue
• Where risks and rewards of ownership are held by lessee, the
lessor substitutes lease receivable for the underlying asset
Copyright  2007 McGraw-Hill Australia Pty Ltd
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11-46
Lessor accounting for direct-financing
leases (cont.)
Direct financing lease (cont.)
AASB 117 (par. 36)
• Lessors shall recognise assets held under a finance
lease in their balance sheets and present them as a
receivable at an amount equal to the net investment
in the lease
Net investment in lease (AASB 117, par. 4)
• The gross investment in the lease discounted at the
interest rate implicit in the lease
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11-47
Lessor accounting for direct financing
leases (cont.)
Direct financing lease (cont.)
Gross investment in the lease
• The aggregate of
(a) the minimum lease payments receivable by the lessor under a finance
lease; and
(b) any unregulated residual value accruing to the lessor
• We include the un-guaranteed residual as part of the lease receivable
as apart from the payments of cash that the lessee is obliged to make
(the minimum lease payments) the lessor also expects to receive
back an asset that has an expected (but un-guaranteed) value at the
end of the lease term
• Interest earned by lessor over lease term
- difference between fair value of leased asset and sum of the
undiscounted minimum lease payments and any unregulated residual
value
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-48
Lessor accounting for direct financing leases
(cont.)
Direct financing lease (cont.)
• Initial indirect costs incurred by lessor
– incremental costs that are directly attributable to negotiating and
arranging a lease, except for such costs incurred by
manufacturer or dealer lessors
– includes commissions, legal fees, and costs associated with
processing new leases
– if material, are to be included in the lessor’s investment in the
lease (refer to AASB 117, par. 38)
• Recovery of executory costs
– should be treated as revenue by lessor in financial years in
which related costs are incurred
– Costs that are related specifically to the operation and
maintenance of the leased property, e.g. insurance,
maintenance and repairs
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-49
Lessor accounting for direct financing
leases (cont.)
Direct financing lease—Net vs gross method
• Either net method or gross method can be used to
record the lease
• Net method
– most commonly used
– lease receivable recorded at its present value and does not
use contra account (unearned interest revenue)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-50
Lessor accounting for direct financing
leases (cont.)
Direct financing lease—Net vs gross method (cont.)
• Gross method
– lease receivable recorded at the sum of the undiscounted
minimum lease payments and the unguaranteed residual
– unearned interest revenue also recorded (contra account)
and amortised to interest revenue over the lease term
– unearned interest revenue is subtracted from lease
receivable to determined carrying (present value) of the
lease receivable
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-51
Lessor accounting for direct financing
leases (cont.)
Net method
• To record initial acquisition of asset
Dr
Asset
Cr Cash/Payables etc.
• To record lease receivable at inception
Dr
Lease receivable
Cr Asset
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-52
Lessor accounting for direct financing
leases (cont.)
Net method (cont.)
• To record receipt of lease payment
Dr
Cash
Cr Lease receivable
Cr Interest revenue
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-53
Lessor accounting for direct financing
leases (cont.)
Gross method
• To record initial acquisition of asset
Dr
Asset
Cr Cash/Payables etc
• To record lease receivable
Dr
Lease receivable
Cr Asset
Cr Unearned interest revenue
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-54
Lessor accounting for direct financing
leases (cont.)
Gross method (cont.)
• To record receipt of lease payment
Dr
Cash
Cr Lease receivable
Dr
Unearned interest revenue
Cr Interest revenue
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-55
Lessor accounting for direct financing
leases (cont.)
Lessor disclosure requirements for finance lease
AASB 117, par. 47
•
Lessors, in addition to meeting the requirements in AASB
132, disclose the following for finance leases
(a) A reconciliation between the gross investment in the lease at the
balance sheet date, and present value of minimum lease
payments receivable at the balance sheet date. In addition, an
entity shall disclose the gross investment in the lease and the
present value of minimum lease payments receivable at the
balance sheet date, for each of the following periods:
(i) not later than one year
(ii) later than one year and not later than five years
(iii) later than five years
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-56
Lessor accounting for direct financing leases
(cont.)
Lessor disclosure requirements for finance lease
(cont.)
(b) unearned finance income
(c) the unguaranteed residual values accruing to the benefit
of the lessor
(d) the accumulated allowance for uncollectible minimum
lease payments receivable
(e) contingent rents recognised as income in the period
(f) a general description of the lessor’s material leasing
arrangements
Refer to Worked Example 11.6 on page 421—
Accounting for leases by lessor
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-57
Accounting for lessors that are manufacturers or
dealers of the leased asset
•
•
Where fair value of the property at the inception of
the lease differs from its cost to the lessor (dealer
or manufacturer)
Represents a finance lease
•
Two parts of the transaction
1. a sale with a resulting gain (fair value vs cost to
dealer/manufacturer)
2. a lease transaction that will provide interest revenue over
the period of the lease
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-58
Accounting for lessors that are manufacturers or
dealers of the leased asset (cont.)
Lessor’s investment in lease accounted for in same
manner as direct financing lease
– value of sale recorded as fair value of asset at date of sale
(equal to present value of minimum lease payments)
– indirect costs (e.g. commissions, legal fees, etc.)
accounted for by lessor as a cost of sales in year in which
transaction occurs—not as part of net investment in lease
receivable (AASB 117, par. 38)
– lease rentals representing a recovery of executory costs (if
material) to be treated by lessor as revenue in year in
which costs incurred
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-59
Accounting for lessors that are manufacturers or
dealers of the leased asset (cont.)
Lessor’s journal entries for a lease involving a dealer or
manufacturer Net method
• To record sale and lease receivable:
Dr Lease receivable
Dr Cost of goods sold
Cr
Inventory
Cr
Sales
Cost of sales will represent the cost of the asset to the
lessor—assumed that asset being sold was part of the
inventory of the lessor
• To record receipt of lease payment:
Dr Cash
Cr
Lease receivable
Cr
Interest revenue
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-60
Accounting for lessors that are manufacturers or
dealers of the leased asset (cont.)
Lessor’s journal entries for a lease involving a dealer or manufacture –
Gross method
• To record sale and lease receivable:
Dr
Lease receivable
Dr
Cost of goods sold
Cr
Inventory
Cr
Sales
Cr
Unearned interest revenue
Cost of sales represents the cost of the asset to the lessor—unearned interest
revenue represents the gross amount of interest to be earned throughout the term
of the lease
•
To record receipt of lease payment:
Dr
Cash
Cr
Lease receivable
Dr
Unearned interest revenue
Cr
Interest revenue
Refer to Worked Example 11.7 on page 409—Example of lease involving
a dealer or manufacturer
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-61
Lessor accounting for
operating leases
• Leased property accounted for as a non-current asset
• Required to depreciate if a depreciable asset
• Lease receipts treated as rental revenue
AASB 117 (par. 53)
• The depreciation policy for depreciable leased assets is to be
consistent with the lessor’s normal depreciation policy for
similar assets, and depreciation is to be calculated in
accordance with AASB 116 and AASB 138
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-62
Leases involving land
and buildings
• Land is an asset with usually an indefinite life
• Risks and benefits of land typically cannot be
transferred to lessee unless the lease will, at
completion, transfer ownership or has a bargain
purchase option
• Leases of land (as well as the land component of a
lease relating to land and buildings) is treated as
operating lease unless reasonably assured of
transferring ownership
• Refer to AASB 117 (par. 14)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-63
Leases involving land
and buildings (cont.)
• Minimum lease payments must be allocated
between land and buildings in proportion to their
relative fair values at lease inception
• If lease not assured of transferring ownership of
land and buildings at end of lease, lease payments
allocated to land to be treated as operating lease
• Payments allocated to building (operating or finance
lease) will depend on whether lease transfers risks
and benefits of ownership to lessee (normal tests
apply)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-64
Leases involving land
and buildings (cont.)
• Exception: Where fair value of land is immaterial in relation to
the fair value of total property, it may be treated as a unit for
classification purposes and so land component may be ignored
• If lease then appears to transfer risks and benefits of
ownership the total lease for land and buildings may be treated
as a finance lease otherwise operating (refer to AASB 117, par.
17)
Refer to Worked Example 11.8 on page 427—Accounting by
the lessee for a lease involving land and buildings
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-65
Lessee accounting for lease incentives under a
non-cancellable operating lease
Incentives by lessor
• May offer incentives to enter non-cancellable
operating leases (particularly for buildings)
–
–
–
–
initial rent-free periods
financial assistance for fitting out offices
up-front cash incentives
financial assistance to terminate existing lease agreements
• Lease incentives not specifically dealt with under
AASB 117
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-66
Lessee accounting for lease incentives under a
non-cancellable operating lease (cont.)
Incentives by lessee
• Generally in exchange for benefits, lessee pays higher lease
payments than if no lease incentive were provided
• UIG Abstract 3 states that incentives are to be treated as
borrowings (liability), which will be repaid by the lessee as part
of future lease rentals
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-67
Implications for
accounting-based contracts
• Classification as finance rather than operating lease
will affect debt–asset constraints
• Introduction of accounting standards requiring
capitalisation of finance leases have negative cashflow effects on firms
• Negative cash-flow effects found to have negative
impact on security prices
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-68
Illustration – direct finance lease – books of
lessor
Lease is non-cancellable for 5 years, $1,100 to be paid at the end
of each year inclusive of $100 maintenance costs, guaranteed
residual $1,200, implicit rate of 10%, passes ownership to lessee
at end of lease term
1/1/08
Dr Lease receivable
4,536
Cr Machinery
4,536
31/12/08
Dr Cash
1,000
Cr Lease receivable
546
Cr Interest revenue
454
Dr Cash
100
• Cr Maintenance costs
• No depreciation entry
100
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-69
Illustration –lease involving a manufacturer
A finance lease in which the fair value of the property
at the inception of the lease differs from its cost to the
lessor
2 METHODS - NET METHOD
- GROSS METHOD
ILLUSTRATION: ASSUME SAME DATA AS LAST
ILLUSTRATION AND THAT MACHINE HAD BEEN PART OF
LESSORS INVENTORY WITH A COST TO LESSOR OF $3,000
(PERPETUAL INVENTORY SYSTEM IS USED)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-70
Illustration – net amount
NET METHOD
1/1/08
Dr Lease receivable
Dr Cost of goods sold
Cr Inventory
Cr Sales revenue
4,536
3,000
3,000
4,536
Other entries on 31/12/08 as per Direct Finance Lease
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-71
Illustration – gross method
Undiscounted minimum lease payments
$6,200
PV of minimum lease payments
4,536
Unearned income
$1,664
1/1/08
Dr Lease receivable
6,200
Dr COGS
3,000
Cr Inventory
3,000
Cr Sales revenue
4,536
Cr Unearned income
1,664
31/12/08
Dr Cash
1,000
Dr Unearned income
454
Cr Lease receivable
1,000
Cr Interest revenue
454
(Assume $100 annual maintenance charge no longer made)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-72
Summary
• The chapter has addressed the treatment of
accounting for leases
• A major issue in accounting for leases is whether the
leased asset-related liability should appear on the
balance sheet of the lessee
• Leases are classified as either operating leases or
financial leases
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-73
Summary (cont.)
• Finance lease
• Transfers the risks and rewards of ownership from the lessor
to the lessee
• The leased asset and lease liability must appear in the
balance sheet of the lessee
• Where the lease is capitalised (on balance sheet) the amount
to be capitalised is the present value of the minimum lease
payments or the fair value of the leased asset, whichever is
the lower
• Where the lessee has capitalised a lease, the lease payments
are to be apportioned between interest expense and the
repayment of the lease liability, and the lessee must amortise
the leased asset over its expected useful life to the lessee
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-74
Summary (cont.)
• Operating lease
– does not transfer the risks and rewards of ownership to the
lessee
– no asset or liability is recognised in the accounts of the
lessee (unless periodic lease payments are made in
advance or in arrears)
– periodic lease payments are treated as an expense in the
accounts of a lessee and as revenue in the accounts of the
lessor
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-75
Summary (cont.)
• From the perspective of the lessor
- leases must be classified as either operating or financing
- finance leases can be further broken down into leases
involving dealers or manufacturers or direct finance leases
- if a finance lease, the underlying asset is removed from
the balance sheet and the asset is replaced with a lease
receivable
- periodic lease receipts from the lessee will be apportioned
between interest revenue and the recoupment of the lease
receivable
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
11-76