Chapter 11
Accounting for leases
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-1
Objectives of this lecture
• Understand what a lease represents
• 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  2010 McGraw-Hill Australia Pty Ltd
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11-2
Introduction to accounting for leases
•
Accounting for leases is governed by AASB 117
Leases
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
.
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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
statement of financial position (balance sheet)
• Should lack of legal ownership preclude the
lessee’s reporting of the asset and the related
liability in the statement of financial position
(balance sheet)?
.
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11-4
Introduction to accounting for
leases (cont.)
As we know in relation to assets, it is a 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
.
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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 statement of financial position
– 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
.
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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 have
been 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 acquired the asset
for cash or by way of a loan
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
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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  2010 McGraw-Hill Australia Pty Ltd
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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
.
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Is it a finance or operating lease? (cont.)
AASB 117 (par. 10) (cont.)
c) The lease term is for the major part of the economic life of
the asset even if the title is not transferred
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
.
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11-10
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 (e.g. in the form of a
rent rebate equalling most of the sale proceeds at the
end of the lease)
(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
.
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11-11
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 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
.
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11-12
Introduction to accounting for
leases (cont.)
Operating vs finance lease
•
•
•
.
If a lease is cancellable at limited cost to the 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
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11-13
Introduction to accounting for
leases (cont.)
Operating vs finance lease
•
•
•
.
Classification of a lease is a matter of professional
judgment, i.e. it depends on the economic substance of
the lease agreement
Leases that do not appear to satisfy any of the criteria of
AASB 117 (pars 10–12) will typically be classified and
accounted for by the lessee as ‘operating’ leases
They will not require disclosure within the statement of
financial position (balance sheet), and the lease
payments are typically treated as rental expenses
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11-14
Key terms used 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 statement of financial
position of the lessee
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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
.
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Key terms (cont.)
2. Non-cancellability (cont.)
(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—the lease would be considered an
operating lease
•
If a lease is cancellable—regardless of remaining
terms, the lease would be considered to be an
operating lease
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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
.
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11-18
Key terms (cont.)
4. Transfer of ownership
•
•
.
If a 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 the last payment is made
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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
.
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11-20
Key terms (cont.)
5. Bargain purchase option
Considered in AASB 117 (par. 10b) (cont.)
– If exercise of an 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
.
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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
7. 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
.
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Key terms (cont.)
7. Economic life (cont.)
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, the risks and rewards are effectively
transferred to the lessee (finance lease)
.
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11-23
Key terms (cont.)
8. Minimum lease payments
AASB 117 (par. 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 financially capable
of discharging the obligations under the guarantee
.
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11-24
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 least
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 statement of financial position 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
.
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11-25
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
.
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Key terms (cont.)
8. Minimum lease payments (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
.
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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
.
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11-28
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 is:
– interest rate implicit in the lease (if this is practical to
determine) or, if not
– the lessee’s incremental borrowing rate to be used
.
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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.
.
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Interest rate for determining the present
value of minimum lease payments (cont.)
If fair value of asset cannot be determined by lessee at
inception of lease
–
–
Then the implicit interest rate cannot be determined
The lessee is 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 367—Example of computing
discount rate
Refer to Worked Example 11.2 on page 367—Classification of a lease
as a finance or operating lease
.
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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
.
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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
.
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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
.
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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 depreciation expense:
Dr Lease depreciation expense
Cr
Accumulated depreciation
.
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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
.
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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
.
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11-37
Worked Example 11.5—Example of
accounting for leases by a lessee
• Trigger Ltd enters into a non-cancellable five-year lease
agreement with Brothers Ltd on 1 July 2012. The lease is for
an item of machinery that, at the inception of the lease, has
a fair value of $369 824
• The machinery is expected to have an economic life of six
years, after which time it will have an expected salvage
value of $60 000. There is a bargain purchase option that
Trigger Ltd will be able to exercise at the end of the fifth year
for $80 000
• There are to be five annual payments of $100 000, the first
being made on 30 June 2013. Included within the $100 000
lease payments is an amount of $10 000 representing
payment to the lessor for the insurance and maintenance of
the equipment. The equipment is to be depreciated on a
straight-line basis
.
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11-38
Worked Example 11.5—Example of
accounting for leases by a lessee (cont.)
• A review of the appendices to this book shows that the present
value of an annuity in arrears of $1 for five years at 12 per cent
is $3.6048, while the present value of an annuity of $1 for five
years at 14% is $3.4331. Further, the present value of $1 in five
years discounted at 12% is $0.5674, while the present value of
$1 in five years discounted at 14% is $0.5194
REQUIRED
(a)
Determine the rate of interest implicit in the lease
and calculate the present value of the minimum
lease payments
(b)
Prepare the journal entries for the years ending
30 June 2013 and 30 June 2014
.
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Worked Example 11.5—Solution
a) Present value of five lease payments of $90 000
discounted at 12% (we eliminate the executory costs)=
$90 000 x 3.6048
= $324 432
Present value of the bargain purchase option
=$80 000 x 0.5674
= $45 392
$369 824
.
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11-40
Worked Example 11.5—Solution (cont.)
Date
Lease payment
(exclusive of
executory costs)
Interest expense
Principal
reduction
01/07/2012
.
Outstanding
balance
369 824
30/06/2013
90 000
44 379
45 621
324 203
30/06/2014
90 000
38 904
51 096
273 107
30/06/2015
90 000
32 773
57 227
215 880
30/06/2016
90 000
25 906
64 094
151 786
30/06/2017
170 000
18 214
151 786
0
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Worked Example 11.5—Solution (cont.)
1 July 2012
Dr Leased machinery
369 824
Cr Lease liability
369 824
(to record the leased asset and liability at the inception
of the finance lease)
.
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Worked Example 11.5—Solution (cont.)
30 June 2013
Dr Executory expenses
10 000
Dr Interest expense
44 379
Dr Lease liability
45 621
Cr Cash
100 000
(to record the lease payment of $100 000)
Dr Lease depreciation expense
51 637
Cr Accumulated lease depreciation
51 637
(to record depreciation expense [(369 824 – 60 000) ÷ 6])
.
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Worked Example 11.5—Solution (cont.)
• As the lessee will most probably retain the asset after the lease
period as a result of the bargain purchase option, the economic
life of the asset, and not the lease term, is used for amortisation
purposes.
30 June 2014
Dr Executory expenses
10 000
Dr Interest expense
38 904
Dr Lease liability
51 096
Cr Cash
(to record the lease payment of $100 000)
Dr Lease depreciation expense
51 637
Cr Accumulated lease depreciation
($369 824 less $60 000 divided by six years)
.
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100 000
51 637
11-44
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
.
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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 372—Example of
accounting for an operating lease
.
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11-46
Worked Example 11.3—Lessee accounting
for an operating lease
On 1 July 2012 Margaret Ltd enters a lease agreement
with River Ltd for the lease of a building. The length of the
lease is three years and the terms require annual
payments of $60 000. The lease is non-cancellable and
the estimated economic life of the building is 20 years.
The market value of the building is $2 million. Lease
payments are made at the end of each financial year
REQUIRED
Provide the journal entries that would be made in the
books of Margaret Ltd to account for the lease
.
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Worked Example 11.3—Solution
The lease is clearly an operating lease (Do we all
understand why?)
Journal entry in the books of Margaret Ltd:
Dr Rental Expense—Building 60 000
Cr Cash
.
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60 000
11-48
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
.
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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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-50
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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-51
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 the 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 or 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
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-52
Lessee accounting for sale and
leaseback transactions (cont.)
Where the lease is an operating lease (cont.)
• 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
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
)
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-53
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
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-54
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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-55
Lessee accounting for sale and leaseback
transactions (cont.)
Journal entries (cont.)
• To record depreciation of leased asset
Dr
Depreciation of leased asset
Cr
Accumulated lease depreciation
• 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 374—Example of
sale and leaseback transaction
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-56
Worked Example 11.4—Sale and leaseback
transaction
As at 1 July 2012, Winki Company owns a building that cost
$5 million and has accumulated depreciation of $3.5 million.
The building is sold on 1 July 2012 to Pop Ltd for $2 007
520, and then leased back over 10 years (the remaining
life). Lease payments are $400 000 per year, paid at the
end of the year. The lease is non-cancellable. The implicit
rate is 15%
REQUIRED
Provide the accounting entries in the books of Winki Ltd for
the year ending 30 June 2013
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-57
Worked Example 11.4—Solution
Journal entries in the books of Winki Ltd
1 July 2012
Dr Cash
2 007 520
Dr Accumulated depreciation 3 500 000
Cr Building
5 000 000
Cr Deferred gain
507 520
(to record the sale of the building to Pop Ltd)
Dr Leased building
2 007 520
Cr Lease liability
(to recognise the finance lease)
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
2 007 520
11-58
Worked Example 11.4— Solution (cont.)
30 June 2013
Dr Interest expense
301 128
Dr Lease liability
98 872
Cr Cash
400
000
(to recognise the periodic lease payment; interest =
2007520 x 15%)
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-59
Worked Example 11.4— Solution (cont.)
Date
Lease payment
(exclusive of
executory costs)
Interest expense
Principal
reduction
01/07/2009
.
Outstanding
balance
2 007 520
30/06/2010
400 000
301 128
98 872
1 908 648
30/06/2011
400 000
286 297
113 703
1 794 945
30/06/2012
400 000
269 242
130 758
1 664 187
30/06/2013
400 000
249 628
150 372
1 513 815
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-60
Worked Example 11.4— Solution (cont.)
Dr Depreciation of leased asset
200 752
Cr Accumulated lease depreciation
200
752
(to record amortisation of the leased asset assuming
the straight-line method is used)
Dr Deferred gain
50 752
Cr Profit on sale of leased asset
50 752
(to recognise the deferred gain on a straight-line basis)
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-61
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 376—Lease
commitment note—Qantas Airways Ltd
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
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11-62
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 as:
• leases involving manufacturers or dealers
• direct finance leases
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
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11-63
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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-64
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 statements of financial
position 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
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-65
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 unguaranteed residual value accruing to the lessor
• We include the unguaranteed 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
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-66
Lessor accounting for direct financing
leases (cont.)
Direct financing lease (cont.)
• Interest earned by the lessor over the lease term
– The difference between fair value of the leased asset and
the sum of the undiscounted minimum lease payments and
any unregulated residual value
• 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)
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-67
Lessor accounting for direct financing
leases (cont.)
Direct financing lease (cont.)
• 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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-68
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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-69
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 determine carrying (present) value of the
lease receivable
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-70
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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-71
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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-72
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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-73
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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-74
Worked Example 11.6 on page 383—
Accounting for leases by lessor
• To show how the entries for a lessor compare with the entries
made by the lessee, we will use the same data as that used in
Worked Example 11.5 except this time we will be doing the
exercise from the perspective of Brothers Ltd.
REQUIRED
(a) Determine the interest rate implicit in the lease, and
calculate the present value of the minimum lease
payments.
(b) Prepare the journal entries for the years ending 30 June
2013 and 30 June 2014 using the net method.
(c) Prepare the journal entries for the years ending 30 June
2013 and 30 June 2014 using the gross method.
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-75
Worked Example 11.6—Solution
Date
Lease receipt
(exclusive of
executory costs)
Interest revenue
Principal
reduction
01/07/2009
.
Outstanding
balance
369 824
30/06/2010
90 000
44 379
45 621
324 203
30/06/2011
90 000
38 904
51 096
273 107
30/06/2012
90 000
32 773
57 227
215 880
30/06/2013
90 000
25 906
64 094
151 786
30/06/2014
170 000
530 000
18 214
160 176
151 786
369 824
0
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-76
Worked Example 11.6— Solution (cont.)
• Using the net method
1 July 2012
Dr Machinery
369 824
Cr Cash
369 824
(to recognise the initial acquisition of the machinery by the lessor)
Dr Lease receivable
369 824
Cr Machinery
369 824
(to substitute the lease receivable for the asset; it would be
inappropriate to continue to show the machinery in the balance
sheet since the lessor no longer ‘controls’ it)
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
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11-77
Worked Example 11.6— Solution (cont.)
30 June 2013
DrCash
100 000
CrExecutory expense recoupment
(part of profit or loss)
CrInterest revenue
CrLease receivable
(to record the lease receipt of $100 000)
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
10 000
44 379
45 621
11-78
Worked Example 11.6— Solution (cont.)
30 June 2014
DrCash
100 000
CrExecutory expense recoupment
(part of profit or loss)
CrInterest revenue
CrLease receivable
(to record the lease payment of $100 000)
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
10 000
38 904
51 096
11-79
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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-80
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
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-81
Accounting for lessors who 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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-82
Accounting for lessors who 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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-83
Accounting for lessors who 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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-84
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—Gross method
• To record sale and lease receivable
.
Dr
Lease receivable
Dr
Cost of goods sold
Cr
Inventory
Cr
Sales
Cr
Unearned interest revenue
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-85
Accounting for lessors that are manufacturers or
dealers of the leased asset (cont.)
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
Dr
Lease receivable
Unearned interest revenue
Cr
Interest revenue
Refer to Worked Example 11.7 on page 386—Example of
lease involving a dealer or manufacturer
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-86
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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-87
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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-88
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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-89
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 388—Accounting by
the lessee for a lease involving land and buildings
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-90
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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-91
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
• Interpretation 115 Operating Leases states that
incentives are to be treated as borrowings (liability),
which will be repaid by the lessee as part of future
lease rentals
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-92
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 has negative cashflow effects on firms
• Negative cash-flow effects found to have negative
impact on security prices
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-93
Further illustration—direct finance lease—
books of lessor
Lease commences on 1 January 2011 and is non-cancellable for five
years, $1100 to be paid at the end of each year inclusive of $100
maintenance costs, guaranteed residual $1200, implicit rate of 10%,
passes ownership to lessee at end of lease term
01/01/11
Dr Lease receivable
4 536
Cr Machinery
4 536
31/12/11
Dr Cash
1 000
Cr Lease receivable
546
Cr Interest revenue
454
Dr Cash
100
Cr Maintenance costs
100
No depreciation entry
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-94
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 LESSOR’S INVENTORY WITH A COST TO LESSOR
OF $3000 (PERPETUAL INVENTORY SYSTEM IS USED)
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-95
Illustration—Net amount
NET METHOD
01/01/11
Dr Lease receivable
Dr Cost of goods sold
Cr Inventory
Cr Sales revenue
4 536
3 000
3 000
4 536
Other entries on 31/12/11 as per direct finance lease
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-96
Illustration—Gross method
Undiscounted minimum lease payments
$6 200
PV of minimum lease payments
4 536
Unearned income
$1 664
01/01/11
Dr Lease receivable
6 200
Dr COGS
3 000
Cr Inventory
3 000
Cr Sales revenue
4 536
Cr Unearned income
1 664
31/12/11
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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-97
Summary
• The lecture 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 statement of financial position of the lessee
• Leases are classified as either operating leases or
financial leases
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
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11-98
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 on the
statement of financial position of the lessee
• Where the lease is capitalised (included within the
statement of financial position) 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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-99
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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-100
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 statement of financial position 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  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
11-101