Week 6: Accounting for Leases Financial Accounting BFA201 Readings and references • Deegan Chapters 10 and 11 • Ignore sections 11.6 – 11.9 (lessors) • AASB 117 also review AASB Framework and scan AASB 137 Learning Objectives • Understand when to recognise a liability • Explain the difference between finance and operating leases • Account for both finance and operating leases • Understand the implications that lease recognition will have for a reporting entity’s financial statements • Sale and leaseback transactions • Apply the requirements of AASB 117 Independent Study Tasks Tutorial questions (for workbooks) Independent study questions 4 Liabilities: An Overview • AASB 137 defines a liability as • a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits • The above is equivalent to the definition provided in the AASB Framework • Three components of the liability definition 1. There must be a future disposition of economic benefits to other entities 2. There must be a present obligation 3. A past transaction or other event must have created the obligation Liabilities: An Overview • As we can see from the definition, a central aspect of a ‘liability’ is the existence of a ‘present obligation’ • Present obligation • a duty or responsibility to act in a certain way; • might be legally enforceable, e.g. binding contracts or statutory requirements; and • might also arise from normal business practice, custom and a desire to maintain good relations or act equitably, e.g. repairing faulty goods outside of warranty periods. Liabilities: An Overview • For a liability to be recognised and disclosed in the balance sheet (the AASB Framework) • it must be probable that a sacrifice of economic benefits will be required; and • the amount of the liability must be able to be reliably measured • Where the entity retains discretion to avoid making any future sacrifice of economic benefits • a liability does not exist and is not recognised • Some professional judgment might be required to determine if a liability should be recognised • Para 12 – in a general sense all provisions are contingent liabilities because they are uncertain in timing or amount. However in AASB137 contingent means waiting on a ‘future event’ – & liabilities that do not meet the recognition criteria. Liabilities: Contingent Liabilities • Contingent liabilities are • obligations only payable contingent upon a future event; or • present obligations not currently deemed to be probable or not measurable with sufficient reliability • Examples include guarantees to cover another organisation’s debts or potential obligations from legal actions • It would be inappropriate to recognise them on the statement of financial position (balance sheet) • Disclosure of contingent liabilities is relegated to the notes to the financial statements • Appendix B to AASB 137 provides a useful decision tree for determining whether a transaction or event should be recognised as a provision and therefore included within the statement of financial position, or disclosed as a contingent liability within the notes to the financial statements. The decision tree is reproduced on the following slide. 1. Introduction to Accounting for Leases Introduction to accounting for leases Accounting for leases is governed by AASB 117 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 What is a Lease? • Leasing is a form of renting or financing • A company owns the asset and you pay for the use of the asset over a set time • Benefits: – No large upfront cash payment, so matches cash outlays more closely with the business operations – Tax deductible if used for business purposes – Easy to keep up-to-date with technology • Check out https://www.moneysmart.gov.au/borrowing-andcredit/other-types-of-credit/consumer-leases 12 http://www.flexirent.com.au/Reasons-to- 13 http://www.leaseplan.com.au/where-tostart/benefits 14 What is a Lease? • Leases are agreements which, in exchange for rental payments, convey to one party (the lessee) the right to possess and to use an asset owned by another party (the lessor) for a stated period. • In general terms, the lessee acquires the right to use the asset during the of the lease, while the lessor retains the right to use or dispose of the asset at the end of the lease term. • The lessor continues to own the asset but does not have possession of the right to use it during the term of the lease. Common terms of a Lease • The period of the lease • The amount and timing of lease payments • Whether the lease is cancellable by either party • What is to become of the asset at the end of the lease • The asset’s residual value • Whether the lessor or the lessee is responsible for payment of maintenance and repairs, insurance, taxes and other operating costs. The Nature of Leases Operating • Rental • Cancellable • Risks and benefits are with lessor Finance • Lessee controls asset • Risks and benefits are with lessee • Are a means to purchase asset Central Accounting Issue • Should the leased assets and the associated commitments relating to the lease arrangements appear in the lessee’s balance sheet? • But lessee does not have legal title • Control is the issue – control does not necessarily imply legal ownership Finance Versus Operating Lease • Finance lease • where substantially all the risks and rewards of ownership pass to the lessee, the lessee records the lease as an asset and corresponding liability • Operating lease • where the risks and rewards are not transferred to the lessee no lease liability or asset recorded • lease payments effectively treated as rent expense Risks and rewards of ownership Risks and rewards of ownership central to the application of AASB 117:7 • 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 Risks and Rewards of Ownership • Risks of ownership include: • Unsatisfactory performance of the asset, obsolescence, idle capacity, decline in residual value • Benefits • those obtainable from the use of the property and gains in realisable value Risks and rewards of ownership • 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 Finance Versus Operating Lease • AASB paras 10 and 11 give examples of situations that individually or in combination could lead to an asset being classified as a finance lease: (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 Finance Versus Operating Lease (d) At the inception 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 (e) The leased assets are of such a specialised nature that only the lessee can use them without major modifications (f) If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee (e) 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 (f) the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than the market rent Finance Versus Operating Lease 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 an operating lease • If the lease is cancellable at limited cost to lessee, the lessee has limited risks and the lease is considered an ‘operating’ lease • Operating leases will not require disclosure within the balance sheet, lease payments are typically treated as rental expense. Diagram to assist in classifying leases Yes Is the lease non-cancellable? No Is ownership expected to be transferred at the end of the lease term? Yes No Is the lease term a MAJOR PART of the economic life of the lease asset? No Is the present value of the minimum lease payments SUBSTANTIALLY ALL of the fair value of the leased asset? No Is the substance of the leasing arrangement and any related arrangements such that substantially all of the risks and rewards incident to ownership are transferred to the lessee? No Operating lease Yes Yes Yes Finance lease 2. Some Important Definitions for Accounting for Leases Important Definitions When classifying leases there are three main conditions of the lease agreement to examine: • cancellability of the lease • extent of the asset’s economic life transferred to the lessee • present value of minimum lease payments Inherent in these conditions are definitions of certain terms Important Definitions – Fair value AASB 117 uses the new definition of ‘fair value’ under AASB 13 The new definition under AASB 13:9 – Price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at measurement date This is necessary for determining the amount to be included for the leased asset in the balance sheet of the lessee Important Definitions – 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 cancellable—regardless of remaining terms the lease would be considered to be an operating lease Important Definitions – 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 117:10a) • 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 Important Definitions – Bargain purchase option Considered in AASB 117:10b • 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 Important Definitions – 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 Important Definitions – Economic life Either: (a)The period over which an asset is expected to be economically usable by one or more users; or (b) the number of production or similar units expected to be obtained from the asset by one or more users Important Definitions – Economic life Why important? AASB 117:10(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) Important Definitions – Minimum lease payments AASB 117:4 The payments over the lease term that 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 Important Definitions – Minimum lease payments 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 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 Minimum lease payments • • For a finance lease, the amount to be initially recognised in the balance sheet for the asset and liability is the lower of: a) the fair value of the leased property or, b) the present value of the MLP … (para.20) Any initial direct costs for the lessee such as legal fees and for preparing documents are added to the value of the asset. Important Definitions – Minimum lease payments Minimum lease payments • Expressly exclude contingent rent • Include guaranteed residual values Important Definitions – Minimum lease payments (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 (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 (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 Important Definitions – Minimum lease payments • Do not include costs for services and taxes (executory costs) that are paid to the lessor in reimbursement Unguaranteed residual • • No certainty that this residual will be paid Not included in minimum lease payments as there is not sufficient certainty that the amount will be paid Important Definitions – Minimum lease payments Minimum lease payments Payments over the lease term Guaranteed residual value Bargain purchase option Contingent rent Reimbursement of costs paid to lessor = + + - 43 Minimum lease payments Include Do not include • Guaranteed residual • Bargain purchase option • Unguranteed residual • Executory costs (e.g. Maintenance, rent, insurance, taxes • Contingent rents 44 3. Interest rate for determining the present value of minimum lease payments Discount rate Discount rate used in calculating present value: The interest rate implicit in the lease is the interest rate that makes the: PV of MLP + unguaranteed residual = Fair value (if this is practical to determine); OR if not, the lessee’s incremental borrowing rate Interest rate for determining the present value of minimum lease payments Why interest in 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 Interest rate for determining the present value of minimum lease payments 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. Lecture Example 1: Leases (Case a) • An asset with a fair value of $170 is leased for 4 years. The asset has no expected value at the end of the lease. An initial payment of $50 is required then 3 further $50 payments at the end of each year. Year Minimum lease payments 0 $50 1 to 3 $50 x 2.4018 Present value 50 120 170 • The leased asset and liability will be recorded initally at $170 Solution 1 a) Yr 0 Yr 1 Yr 2 Yr 3 50 + 50 + 50 + 50 = 170 (1+k) (1+k)2 (1+k)3 This is the same as an annuity for 3 periods plus $50 upfront. 50 + 50 x PVA3 = 170 120/50 = PVA3 PVA3 = 2.4 Look up annuity tables p. 1276 Deegan to find interest rate is 12%. 50 Solution 1 a) cont. The interest rate implicit in this lease is 12%: Minimum lease payments Present value $50 50 $50 x 2.4018 120 170 Dr Leased asset Cr 170 Lease liability 170 To record the leased asset and lease liability (at PV of minimum lease payments at inception) 51 Example: Leases (Case b) • Exactly the same facts as Case a except the asset has an expected value at the end of the lease of $9. • The interest rate implicit in this lease is 15% Year 0 1 to 3 3 Minimum lease payments $50 Present value 50 $50 x 2.2832 114 (Initial recognition) 164 Unguaranteed residual $9 x 0.6575 6 170 Example: Leases (Case c) • Exactly the same facts as Case 2 except the lessee pays $2 to the lessor for maintenance each year so only $48 relates to the lease (not $50). • The interest rate implicit in this lease is 12% Year 0 1 to 3 3 Minimum lease payments $48 Present value 48 $48 x 2.4018 115 (initial recognition) 163 Unguaranteed residual $9 x 0.7118 7 170 4. Lessee Accounting for Leases Lessee accounting for finance leases Overview • Essentially the same as acquiring the asset by way of a long- term loan • 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 • Consideration to be given to present value of future cash flows Lessee accounting for finance leases • 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 Lessee accounting for finance leases 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 Lessee accounting for finance leases Depreciation of leased assets • Depreciate in accordance with AASB 116 and AASB 138 • If no reasonable certainty lessee will obtain ownership at end of term, depreciation over the shorter of the lease term and the useful life, otherwise the useful life • Deduct guaranteed residual from initial value of leased asset in the calculation of depreciation. Lessee accounting for finance leases 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 59 Lessee accounting for finance leases • To record lease depreciation expense Dr Lease depreciation expense Cr Accumulated depreciation • 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 Lecture Example 2 • Apple Ltd sells apple-picking machines for $263 948. The machines have a useful life of 8 years. • AJ Ltd decides to lease a machine from Apple Ltd for a period of 7 years by way of a non-cancellable lease. • • The lease commenced on 1 July 2011. • The lease payments, including reimbursement of Apple Ltd’s executory costs of $5 000 per annum, are made at the end of each year and amount to $55 000. • There is an unguaranteed residual at the end of the lease term of $40 000. Lecture Example 2 According to the requirements of AASB 117: 1. Determine whether the lease is an operating lease or a finance lease and list the reasons for your decision. 2. Confirm the interest rate implicit in the lease is 10% and show your calculations. 3. Prepare the lease payment schedule for the life of the lease. 4. Record entries in general form to record the lease transactions at 1 July 2011 and at 30 June 2012 for AJ Ltd (the lessee) 5. Show what would be reported in the statement of financial position for AJ Ltd at 30 June 2012. Lecture Example 2 Solution 1. Determining type of lease • The lease is a finance lease because: – It is non-cancellable – The lease term is for a major part of the economic life of the asset – The present value of the minimum lease payments is substantially all of the fair value of the leased asset (see b below) Lecture Example 2 Solution a. Checking whether the minimum lease payments is substantially all of the fair value of the leased asset: • Minimum lease payments $50 000 x 4.8684 = $243 420 • Fair value = $263 948 • Therefore $243 420/263 948 x 100 = 92% Lecture Example 2 Solution b. Confirming the implicit interest rate • The implicit interest rate is that rate which causes the combined present value of the minimum lease payments and the unguaranteed residual to equal the fair value of the asset at the inception of the lease. • If a 10% discount rate is used, the PV of the two amounts over 7 years is: Minimum lease payments $50 000 x 4.8684 = $243 420 Unguaranteed residual $40 000 x 0.5132 = 20 528 $263 948 • As the discounted value equals the fair value of the asset at inception of the leased, 10% must be the rate of interest implicit in the lease. c. Prepare the lease payment schedule for the life of the lease. Date ofpayment Lease payment Interest expense Principal repayment 1/07/11 Balance of liability 243420 30/06/12 50000 24342 25658 217762 30/06/13 50000 21776 28224 189538 30/06/14 50000 18954 31046 158492 30/06/15 50000 15849 34151 124341 30/06/16 50000 12434 37566 86775 30/06/17 50000 8678 41322 45453 30/06/18 50000 4545 45453 0 c. Example of calculations 30/06/12 243 420 x 0.10 = 24 342 (interest) 50 000 – 24 342 = 25 658 (principal repay) 243 420 – 25 658 = 217 762 (balance) 30/06/13 217 762 x 0.10 = 21 776 (interest) 50 000 – 21 776 = 28 224 (principal repay) 217 762 – 28 224 = 189 538 (balance) d. Journal Entries 1/07/11 Leased machinery 243420 Lease liability To record lease asset and lease liability at lower of PVof MLP & fair value 30/06/12 Lease liability Interest expense Cash at bank To record lease payment 25658 24342 30/06/12 Lease depreciation expense Accumulated depreciation (leased asset) Depreciate over useful life 243420/7 34774 30/06/12 Executory expenses Cash at bank Payment of executory costs not considered to be part of minimum lease payments 243420 50000 34774 5000 5000 68 e. Statement of financial position extract AJ Ltd Extract from the Statement of Financial Position As at 30 June 2012 ASSETS Leased asset less accumulated depreciation CURRENT LIABILITIES Lease liability (current portion) NON CURRENT LIABILITIES Lease liability 243420 34774 208646 28224 189538 217762 69 Leases - land & buildings Land: • indefinite life • risks & benefits cannot be transferred unless ownership transferred at end • Unless transfer is likely, a lease of land will be treated as an operating lease. Land and buildings: • May need to split the MLP between the land and buildings in proportion to their relative fair values • land - operating lease; • building - finance lease (if criteria are met) 70 Operating leases An operating lease is not a finance lease (para 4) • NOT in the balance sheet – recognised as expense on straight-line basis over term (para 33) Indicators of an operating lease: • Can cancel at short notice with limited penalty • if ownership transfers at the end of the lease for a variable payment equal to its then fair value • if there are contingent rents (eg. if lease payments are variable and depend partly on sales or how much the asset is used). 71 Accounting for Operating leases In each of these cases the lessee does not bear all the risks and rewards of ownership. Lease payments are treated like rent expense: Dr Rental expense Cr Cash (May need to use accruals or prepayments for lease payments) 72 Lessee accounting for operating leases 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 Lecture Example 3 • On 1 June 2012 AJ Ltd enters a 5-year lease agreement with Ground Ltd for land. The lease is non-cancellable. The land has a value of $1 million and the annual lease payments are $30,000 per year in arrears. • Prepare the journal entries for AJ Ltd to account for the lease. 74 Solution 3 Must determine whether operating or finance lease. As land has indefinite life, period of lease is too short to be finance lease. Dr Rental expense – land Cr Cash $30,000 $30,000 To record operating lease payments for land 75 Sale and leaseback transactions • Owner (seller/lessee) sells asset to another party and simultaneously leases it back from the purchaser/lessor (the legal owner )(para. 58) • Seller does not lose control of the asset - Finance Lease: Profit or loss on the sale is deferred in the balance sheet of the seller/lessee and is amortised over the term of the lease (para.59) • Operating lease: any profit or loss can be recognised at the point of sale as long as the exchange is at the fair value of the asset (para.61) 76 Lessee accounting for sale and leaseback transactions 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) Lessee accounting for sale and leaseback transactions 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 Lessee accounting for sale and leaseback transactions 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 Lessee accounting for sale and leaseback transactions 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 Lecture Example 4 • In an attempt to alleviate its liquidity problems, Banff Ltd entered into an agreement on 1 July 2007 to sell its processing plant to Lethbridge Ltd for $3.5m (which is the fair value of the plant). At the date of sale, the plant had a carrying amount of $2.75m. Lethbridge Ltd immediately leased the processing plant back to Banff Ltd. The terms of the lease agreement were: Lease term 6 years Economic life of plant 8 years Annual rental payment, in arrears (commencing 30/6/08) $700 000 Residual value of plant at end of lease term (fully guaranteed) $500 000 Interest rate implicit in lease 10% 81 Example 4 The lease is non-cancellable. The annual rental payment included $35,000 to reimburse the lessor for maintenance costs. Ownership will transfer to Banff Ltd at the end of the lease. Required a) Classify the lease b) Record the sale and leaseback transaction in the books of Banff Ltd on 1 July 2007, as well as the entries required on 30 June 2008. 82 Solution 4 a) • • • • • Finance lease? Non-cancellable Ownership is expected to be transferred at the end of term Lease term is a major part of the economic life PV of MLP is substantially all of the fair value. It is calculated as follows: PV of MLP = $665 000 x 4.3553 + $500 000 x 0.5645 = $2 896 275 + $282 250 = $3 178 525 PV/FV = $3 178 525/$3 500 000 = 90.8% 83 Solution 4 b) Date of payment Lease payment Interest expense 1/07/2007 30/06/2008 665000 317853 30/06/2009 665000 283138 30/06/2010 665000 244952 30/06/2011 665000 202947 30/06/2012 665000 156741 30/06/2013 1165000 105915 Principal repayment 347148 381862 420048 462053 508259 1059085 Balance of liability 3178525 2831378 2449515 2029467 1567413 1059155 70 84 Solution 4 b) cont. 1/07/2007Cash at bank Accumulated depreciation Plant Deferred gain To record the sale of the plant. 30/06/2008Leased asset Lease liability To record the finance lease 30/06/2008Interest expense Lease liability Executory costs Cash at bank To record lease payment 3,500,000 2,750,000 750,000 3,178,525 3,178,525 317,853 347,148 35,000 700,001 Depreciation expense: leased machine Accumulated depreciation: leased machine Depreciation over useful life (3178525 – 500000)/8 334,816 Deferred gain Profit on sale of leased asset Amortisation of the deferred gain on a straight line basis 750000/6 125,000 334,816 125,000 The nature of the accounting problem created by leases: incentives and effects • Operating leases (off-balance sheet): – No lease assets or liabilities are recognised • Finance leases (on-balance sheet): – ↑NCA…Entity’s return on assets ratio is reduced – ↑NCL…debt/equity ratio adversely affected – Performance measures will be reduced eg. Depreciation & interest charges (lower profits) • Incentives for managers to favour operating leases • IASB agenda - http://go.ifrs.org/leases (with FASB) may lead to treating operating leases similarly to financial leases 86 Disclosure requirements lessees Finance lease para 31 Operating lease para 35 Disclose amounts owing: i. Not later than 1 yr ii. Between 1 and 5 yrs iii. Later than 5 yrs 87 Next Week Test in Lecture Time (No Tutorial) © Copyright University of Tasmania, School of Accounting & Corporate Governance All rights reserved. Commonwealth of Australia Copyright Regulations 1969 - WARNING This material has been reproduced and communicated to you by or on behalf of the University of Tasmania pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further reproduction or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice.