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Important administrative announcement

Online Test 1
Available on DSO: 9:00 am Friday 5 August - 11:59 pm Monday 8 August

Note: Times are AEST (Australian Eastern Standard Time) Marks: 3.75% (of total assessment) Topics covered in test: Topics 1 & 2 (Corporate Regulations and Accounting for PPE) Covers chapters 1, 2, 4 & 6 in the textbook Time allowed: 1 hour for 20 Multiple Choice Questions (one attempt is allowed) Please carefully read the online test instructions available in the assessment folder before you attempt the test

Assignment
A typo error in Question 1 (The information for 31 December 2010 ) A typo error in Question 2, part (d)(ii) The revised version of the assignment is uploaded on DSO

TOPIC 3 PART 2
Accounting for leases (Chapter 11)

Content
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What is a lease Classification of lease Lessee accouting for finance and operating leases Lessor accouting for finance and operating leases Leases involving land and buildings Lessee accounting for lease incentives under a noncancellable operating lease

What is a lease

Lease defined (AASB 117, para. 4)

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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.
AASB117 Cannot be applied to leases to explore for or use minerals, oil, natural gas and similar nonregenerative assets licensing agreements for such items as motion picture films, video recordings, plays, manuscripts and copyrights

Whether or not the leased assets and the associated commitments relating to the lease arrangement should appear in the reporting entitys statement of financial position (balance sheet)

A matter of control
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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

Classification of lease

Classification Of Leases
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AASB 117 recognises the following types of leases:

Finance lease records a leased asset and a liability Operating lease record neither asset nor liability, but lease payments recognised as rental expenses

Finance lease vs. Operating lease

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A finance lease is a lease which transfers substantially all ownership risk and rewards, with or without eventual title transfer

Risks of ownership include possibilities of losses from obsolescence, idle capacity, uninsured damage, etc. Rewards of ownership include benefits from use of the asset, appreciation in value of the asset, etc.

An operating lease is a lease other than a finance lease

Finance Leases (AASB 117 para. 10)

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Examples of situation that individually or in combination would normally lead to a lease being classified as a finance lease: The lease transfers ownership of the asset at the end of the lease term The lessee has the option to purchase the asset at a price substantially lower than the fair value at the date the option become exercisable, so that it is reasonably certain, at the inception of the lease, that the option will be exercised The lease term covers a major part of the assets economic life At the inception of the lease, the present value of minimum lease payments (MLPs) amounts to at least substantially all of the fair value of the leased asset The leased asset is of a specialised nature that only the lessee can use them without major modification
AASB 117 does not contain aadefinition or further guidance as to what major part and AASB 117 does not contain definition or further guidance as to what major part and substantially mean- therefore judgment required substantially mean- therefore judgment required

Finance Leases (AASB 117 para. 11)

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Indicators of situation that individually or in combination could also lead to a lease being classified as a finance lease:
If the lessee can cancel the lease, the lessors losses associated with the cancellation are borne by the lessee Gains or losses from the fluctuation in the fair value of the residual accrue to the lessee The lessee has the ability to continue the lease for a secondary period at a rental that is substantially lower than market value.

Minimum Lease Payments (MLPs)

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MLPs = Payments over lease term + Guaranteed residual value * + Bargain purchase option * Contingent rent * Reimbursement of costs paid by lessor
Commonly referred to as executory costs Commonly referred to as executory costs

* Defined in following slides

Guaranteed residual value

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At the commencement of the lease, the lessor estimates the residual value of the asset at the end of the lease term (based on market conditions). A residual might or might not be guaranteed, i.e. guaranteed vs. unguaranteed Guaranteed residual value that part of the residual value guaranteed by the lessee (the maximum amount that could become payable) The guarantee may range from 1% to 100% of the residual value

Bargain purchase option

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A clause in the lease agreement allowing the lessee to purchase the asset at the end of the lease term for a preset amount (which is less than the expected residual value) The option price is normally sufficiently lower than expected fair value resulting in the exercising of the option becoming reasonably certain

Contingent rent
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Additional payments arising from increases/decreases in the schedule lease payments due to the occurrence of particular events specified in the lease agreement Eg- lease of a photocopier may specify additional payments if the number of photocopies exceeds a certain amount in a month

Present Value of MLPs

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The present value (PV) of MLPs is determined by applying an appropriate discount rate The discount rate is based on the interest rate implicit in the lease The interest rate that equates the PV of the MLPs and any unguaranteed residual value with the fair value of the leased property (and any initial direct costs of the lessor) at the inception of the lease
PV of MLP + PV of unguaranteed residual value = FV (+ initial direct costs, if any)

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Lessee accounting for finance leases

Lessee accounting for finance leases

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Lessee records an asset (leased) and a lease liability Dr Leased asset Cr 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

Lessee accounting for finance leases (cont.)

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Over the term of the lease, the rental payments to lessor constitute a 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 (cont.)

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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

Lessee accounting for finance leases (cont.)

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Amortisation of leased assets Leased assets should be amortised using the depreciation (amortisation) policies normally followed by the lessee 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. the lease contains a bargain purchase option), otherwise amortisation over lease term

To record lease depreciation expense: Dr Lease depreciation expense Cr Accumulated depreciation

Lessee accounting for finance leases (cont.)

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Initial direct 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 incurredtotal amount subject to amortisation

Worked Example 11.5 Example of accounting for leases by a lessee

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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. The implicit interest rate is 12% 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. Further, the present value of $1 in five years discounted at 12 per cent is $0.5674. Prepare journal entries fro the years ending 30 June 2013 and 2014.

Worked Example 11.5 Solution

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Present value of five lease payments of $90 000 discounted at 12 per cent (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

Worked Example 11.5 Solution

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Date

Lease Payment (exclusive of executory costs) (1)

Interest expense (2)

Principal reduction (3) = (1) (2)

Outstanding balance (4) 369 824

01/07/2012

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

11-25

Worked Example 11.5 Solution

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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)

Worked Example 11.5 Solution

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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])
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.

Worked Example 11.5 Solution

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30 June 2014 Dr Executory expenses Dr Interest expense Dr Lease liability Cr Cash (to record the lease payment of $100 000) Dr Lease depreciation expense Cr Accumulated lease depreciation To record depreciation expense) 51 637 51 637 10 000 38 904 51 096 100 000

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Lessee accounting for operating leases

Lessee accounting for operating leases (cont.)

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AASB 117 (para. 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 users benefits Journal entry Dr Rental expense Cr Cash

Worked example 11.3: Lessee accounting for an operating lease

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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.

Solution
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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 60 000

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Lessor accounting for finance leases

Accounting by lessors
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Lessors 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 1012 Finance leases can be further classified into Direct-finance leases Leases involving manufacturers or dealers

Direct-financing leases
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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

Lessor accounting for direct-financing leases

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AASB 117 (para. 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, para. 4) The gross investment in the lease discounted at the interest rate implicit in the lease

Lessor accounting for direct-financing leases

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The gross investment in the lease includes 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

Lessor accounting for direct-financing leases

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Over the term of the lease, the rental payments to lessor constitute a principal plus interest revenueto be apportioned by lessor Interest revenue calculated by applying the interest rate implicit in the lease to outstanding balance at beginning of each lease period Balance of payment represents a reduction of principal of lease liability

Initial direct costs incurred by lessor

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Initial 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 lessors investment in the lease (refer to AASB 117, para. 38)

Recovery of executory costs

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Costs that are related specifically to the operation and maintenance of the leased property, e.g. insurance, maintenance and repairs Should be treated as revenue by lessor in financial years in which related costs are incurred

Direct-financing lease: net vs gross method

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Either net method or gross method can be used to record the lease Net method
most commonly used

For this unit, please ignore the gross method

Lessor accounting for direct-financing leases

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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 To record receipt of lease payment Dr Cash Cr Lease receivable Cr Interest revenue

Worked Example 11.6

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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 Prepare the journal entries for the years ending 30 June 2013 and 30 June 2014 using the net method.

Worked Example 11.6 Solution

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Date

Lease Receipt (exclusive of executory costs)

Interest revenue

Principal reduction

Outstanding balance

01/07/2009 30/06/2010 30/06/2011 30/06/2012 30/06/2013 30/06/2014 90 000 90 000 90 000 90 000 170 000 530 000 44 379 38 904 32 773 25 906 18 214 160 176 45 621 51 096 57 227 64 094 151 786 369 824

369 824 324 203 273 107 215 880 151 786 0
11-44

Worked Example 11.6 Solution

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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)

Worked Example 11.6 Solution

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30 June 2013 Dr Cash Cr Executory expense recoupment (part of profit or loss) Cr Interest revenue Cr Lease receivable (to record the lease receipt of $100 000) 30 June 2014 Dr Cash Cr Executory expense recoupment (part of profit or loss) Cr Interest revenue Cr Lease receivable (to record the lease payment of $100 000) 38 904 51 096 10 000 100 000 44 379 45 621 10 000 100 000

Accounting for lessors that are manufacturers or dealers of the leased asset
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Where fair value of the property at the inception of the lease differs from its cost to the lessor (e.g. car dealer) Represents a finance lease Two parts of the transaction
1.

2.

a sale with a resulting gain (the difference between fair value and cost to dealer/manufacturer) a lease transaction that will provide interest revenue over the period of the lease

Accounting for lessors that are manufacturers or dealers of the leased asset (cont.)
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Lessors 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) direct costs (e.g. commissions, legal fees, etc.) accounted for by lessor as a cost of sales in year in which transaction occursnot as part of net investment in lease receivable (AASB 117, para. 38) lease rentals representing a recovery of executory costs (if material) to be treated by lessor as revenue in year in which costs incurred

Lessors journal entries for a lease involving a dealer or manufacturer (Net method)
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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

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Lessor accounting for operating leases

Lessor accounting for operating leases

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Leased property accounted for as a non-current asset Required to depreciate if it is a depreciable asset Lease receipts treated as rental revenue AASB 117 (para. 53) The depreciation policy for depreciable leased assets is to be consistent with the lessors normal depreciation policy for similar assets, and depreciation is to be calculated in accordance with AASB 116 and AASB 138

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Leases involving land and buildings

Leases involving land and buildings

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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 (para. 14)

Leases involving land and buildings (cont.)

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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)

Leases involving land and buildings (cont.)

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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, para. 17) You can refer to Worked Example 11.8 on page 388

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Lessee accounting for lease incentives under a noncancellable operating lease

Lessee accounting for lease incentives under a non-cancellable operating lease

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Lessor may offer incentives for entering 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

Lessee accounting for lease incentives under a noncancellable operating lease (cont.)
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Up-front incentives are typically not free to the lessee, but, instead, are paid for by the lessee over the term of the lease.
e.g. a 6-year agreement to lease a property, with the first year being rent free.

Interpretation 115 Operating Leases Incentives*

The lessor shall recognise the aggregate cost of incentives as a reduction of rental income over the lease term The lessee shall recognise the aggregate benefit of incentives as a reduction of rental expense over the lease term Based on straight-line basis (unless another systematic basis is representative of the time pattern of use)
* An Interpretation is released when there appears to be significantly divergent interpretations of particular accounting requirements

Multiple choice question 1

An operating lease is one in which:
A.

B. C.

D.

E.

The lessee agrees to maintain the operating capability of the asset to a level specified by the lessor The risks and benefits of ownership reside with the lessor The lessee is required to maintain the leased asset according to an agreed maintenance schedule The risks and benefits of ownership reside with the lessor and the lessee is required to maintain the leased asset according to an agreed maintenance schedule None of the given answers

Multiple choice question 2

In determining if the risks and rewards of ownership have been transferred, AASB 117 states the following would indicate a finance lease is in effect: Ownership of the assets transfers at the end of the lease term for a variable payment equal to its then fair value B. Contingent rents exist C. The lease is non-cancellable by the lessor D. The lease term is for a major part of the economic life of the asset E. All of the given answers
A.

Multiple choice question 3

Johnson Ltd enters into a lease agreement with Pete Ltd under the following terms: Duration of lease 10 years Life of leased asset 12 years Unguaranteed residual $8,000 Lease payment $6,500 at lease inception Annual lease payments (in arrears) $7,000 per year (10 payments) The lease may be cancelled only with the permission of the lessor. If the rate of interest implicit in the lease is 10 per cent, what is the fair value of the asset at the inception of the lease, and is the lease a finance or operating lease?
A. B. C. D. E.

$56,745, finance lease $52,596, operating lease $56,745, operating lease $52,596, finance lease None of the given answers