Prepare Financial Statements & Maintain Asset and Inventory Records

Transcription

1 Prepare Financial Statements & Maintain Asset and Inventory Records Gavin Dumbrell & Rex Walsh National Core Accounting Publications

2 ISBN: Second Edition Published by National Core Accounting Publications POBox 210, Bondi NSW 2026 Phone (02) This book is copyright and all rights are reserved. No part of this work is to be reproduced other than in accordance with the Copyright Act, or with the written permission of the publishers. The Copyright Act 1968 of Australia allows a maximum of one chapter or 10% of this book, whichever is the greater, to be copied by any educational institution for its educational purposes provided that that educational institution (or the body that administers it) has given a remuneration notice to Copyright Agency Limited (CAL) under the Act. For details of the CAL licence for educational institutions contact: Copyright Agency Limited, telephone: (02) , info@copyright.com.au

3 Chapter 6 Leases Learning Objectives 6.1 Define the following in Accordance with AASB 117: Lease. Finance Lease. Operating Lease. Fair Value. Inception of the Lease. Commencement of the Lease Interest Rate Implicit in the Lease. Lease Term. Minimum Lease Payments. Non-Cancellable Lease. Residual Value. Guaranteed Residual Value. Sale and Lease Back Transaction. Useful Life of the Property. 6.2 Describe a Lease. 6.3 The Advantages and Disadvantages of Leasing. 6.4 State the Options concerning the Termination of Leases.

4 4 7 0 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS 6.5 Describe the Types of Leases: Finance and Operating Leases. 6.6 Journal entries in Lessee s books - Finance Leases. 6.7 Post journal entries for a Finance Lease to Lessee s ledger. 6.8 Disclosure requirements for Finance Leases - AASB Journal entries in the Lessee s books - Operating Leases Disclosure requirements for Operating Leases - AASB 117.

5 Chapter 6 Leases Overview A lease is an agreement that grants one party, the lessee, the right to use an asset that is the property of another party, the lessor, in return for periodic payments by the lessee to the lessor. If a business requires the use of an asset, leasing provides an alternative to purchasing the asset. Under the lease, the lessee has the use and possession of the asset, whilst the lessor retains ownership. Other leasing arrangements can also enable a business to acquire an asset without the outlay of capital funds; the ownership passing to the lessee at the end of the lease term. Accounting Standard AASB 117 Leases, recognises the need in accounting to differentiate between leases that are essentially rental agreements and those that are, in effect, sources of finance for asset acquisitions. Leases are classified as either operating leases or finance leases. The Accounting Standards aim to ensure that reporting entities disclose sufficient information for users to determine the impact of leases on the business and its financial statements. In this Chapter we examine the terms relating to leases, the factors determining whether a particular lease agreement is classified as an operating lease or a finance lease and the accounting treatment appropriate to both types of leases.

6 4 7 2 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS 6.1 Definitions The following terms are defined in AASB 117 and will be used in this topic. The lessor is the person who owns the asset and grants the lease in respect of the asset. The lessee is the person who has the use of the asset and to whom the lease is granted. Lease An agreement conveying from the lessor to the lessee the right to use the property of the lessor for a stated period of time in return for a series of payments by the lessee to the lessor. Finance Lease A lease that substantially transfers all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred. Operating Lease A lease other than a finance lease. Fair Value The amount for which an asset could be exchanged or liability settled between knowledgeable, willing parties in an arm s length transaction (usually the selling price). Inception of the Lease The date of the lease agreement, or, if earlier, the date of a commitment by the parties to the principal provisions of the lease (the contract date). Commencement of the Lease The date from where the lessee is entitled to begin using the leased asset. It is the date of initial recognition of the lease (ie. the recognition of the assets, liabilities, income or expenses resulting from the lease, as appropriate).

7 Chapter 6 Leases Interest Rate Implicit in the Lease The effective rate of interest earned by the lessor on the lease contract. It is the discount rate at the beginning of the lease term, that causes the aggregate present value of: The minimum lease instalment payments, and Any unguaranteed residual value expected to accrue to the benefit of the lessor at the end of the lease term. to be equal to the sum of: the fair value of the leased property at the inception of the lease; and any initial costs of the lessor. 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. Minimum Lease Payments The total amount that a Lessee is expected to pay at particular dates over the remainder of the lease term, excluding any contingent rentals, but including any amounts guaranteed by the lessee. Non-Cancellable Lease A lease that is cancellable only: Upon occurrence of a remote contingency; With permission of the lessor; If the lessee enters into a new lease for the same or an equivalent asset with the same lessor; or Upon payment by the lessee of such an additional amount that, at inception of the lease, continuation of the lease is reasonably certain.

8 4 7 4 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS Residual Value The estimated fair value of the leased property at the end of the lease term, based on price levels and market conditions existing at the inception of the lease. Guaranteed Residual Value For a lessee, that part of the residual value that is guaranteed by the lessee or by a party related to the lessee. For a lessor, that part of the residual value guaranteed to be received from the lessee or a third party. Sale and Leaseback Transaction A transaction that involves the sale of property, with all or part of that property being leased back to the seller/lessee by the purchaser/lessor. Useful Life of the Leased Property The estimated remaining period, from the beginning of the lease term, without limitation by the lease term, over which the economic benefits embodied in the asset are expected to be consumed by the entity.

9 Chapter 6 Leases What is a Lease? A lease is an agreement by which a lessee (the person who will have the use of the asset) obtains from the lessor (the owner of the asset) the right to use the asset for a fixed period of time in return for a series of rental payments. It is a method used in business to have the use of an asset or to acquire an asset for use in the business without paying large amounts of money necessary to purchase the asset. As a lease is a contract, the terms may vary widely depending upon the nature of the property, and the requirements of the lessee and lessor and their relative bargaining power. Provisions contained in Lease agreements generally include: The period of the lease; The amount and timing of the lease payments; Whether the lease is cancellable by either party; What happens to the property at the end of the lease term; The asset s residual value; Whether the lessor or the lessee is responsible for the payment of maintenance costs associated with operating the assets.

10 4 7 6 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS 6.3 Advantages and Disadvantages of Leasing Advantages of Leasing for the Lessee Capital is preserved as large outlays to acquire assets are avoided. Alternative uses of the funds may be more profitable, such as funding inventories, accounts receivable, or investments. The cost is spread over the life of the asset and more directly matched with the benefits to be obtained from the asset. It may be of particular advantage to growth businesses where capital is needed to fund expansion. New equipment may be easily acquired to take advantage of a short-term need. Leasing can provide flexibility to suit business needs, e.g. lease payments may be tailored to meet the seasonal nature of a business. Provided that the leased property is used to produce assessable income, lease payments can be allowable deductions for taxation purposes. Can avoid problems of asset obsolescence by being able to lease a more up-to-date model at the end of the lease term. Disadvantages of Leasing for the Lessee Leasing may be a more costly method of obtaining finance than alternative means. Lease payments must be met as they become due, irrespective of the profitability or cash flow of the business. The lessee is generally required to have a good credit rating. Lessees can over-commit themselves on high monthly or quarterly charges. If the lease has a Guaranteed Residual Value and at the end of the lease there is a shortfall between the Residual Value and the disposal proceeds, the lessee may be required to pay the shortfall. Conversely, if the asset is sold for more than the Residual Value, the lessee may not receive the excess. Leased equipment may be under-utilised if demand falls.

11 Chapter 6 Leases Termination of Leases At the end of the lease term the following options may be available to the lessee: Renew the lease for a further period for the amount of the residual value. This option is usually for a short period of one or two years. Purchase the leased asset. The asset is owned and depreciated and the value of the residual is the purchase price. Return the leased asset to the lessor. The lessor will sell it, keep any profit, and can recover any shortfall from the lessee if there is a Guaranteed Residual amount. Trade in the asset on a new item that is then subject to a further lease. The trade-in value is used to pay out the lessor. 6.5 Types of Lease Finance and Operating Leases Under AASB 117 a lease must be classified as an Operating Lease or a Finance Lease at the inception of the lease. The Standard gives guidance on this classification. Finance Lease A lease under which a lessee assumes substantially all the risks and rewards associated with ownership of the leased property without receiving legal ownership. The rewards of ownership include use of the asset, and the opportunity for gains in realisable value. Risks of ownership include obsolescence, losses in realisable value, uninsured damage and idle capacity. Operating Lease A lease other than a finance lease.

12 4 7 8 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS Classification Determinants The decision on whether a lease is a financial lease depends on the substance of the transaction. AASB 117 (para 10) gives examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease: Ownership of the property transfers to the lessee by the end of the lease term; The lease contains a bargain purchase option (or similar); The lease term is for the major part of the economic life of the leased asset even if title is not transferred; The present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset; The leased assets are of such a specialised nature that only the lessee can use them without major modifications. AASB 117 (para 11) gives indicators of situations that could lead to a lease being classified as a finance lease: If the lessee can cancel the lease, the lessor s losses associated with the cancellation are borne by the lessee; Gains or losses from the fluctuation in fair value of the residual accrue to the lessee and; The lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent. Primary Indicators Is the ownership transferred by the end of the lease term? Does the lease contain a bargain purchase option? This means that the lessee is allowed to buy the asset at the end of the lease period for a price that is significantly lower than the likely fair price. The amount that will be paid at that time will form part of the minimum lease payments. The application of these procedures will normally result in the same classification of a lease by both lessee and lessor. The following summarises the classification procedure:

13 Chapter 6 Leases Classification of a Lease by Lessees and Lessors Is the Lease Non-Cancellable? No Yes Is Ownership transferred by the end of the Lease Term? Yes No Does the Lease contain a bargain purchase option? Yes No Lease term is for a major part of the economic life of the leased property. Yes No Present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased property. Yes Operating Lease No Finance Lease

14 4 8 0 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS Self-Testing Exercise 1 Classify the following leases as Finance Leases or Operating Leases: (a) Lease of a printing machine. The lease is non-cancellable and has a term of 3 years. At the end of the lease term, the machine ownership may be transferred to the lessee, on payment of an agreed residual value. The estimated life of the printing machine is 4 years. (b) Lease of a point of sale unit for six months to take advantage of a short-term market opportunity. The useful life of the unit at inception of the lease is 4 years. The lease is cancellable. (c) Lease of a van for 5 years. The van has a useful life of 7 years. The fair value at the time of the contract was $60,000. The lease payments are $960 per month. The implicit interest rate has been estimated at 12%. There is no bargain purchase option. 6.6 Journal Entries in Lessee s Books: Finance Leases AASB 117 contains recommended procedures for accounting for Finance Leases by Lessees. If transactions involving leases are not reflected in a lessee s Statement of Financial Position, the assets and obligations of the lessee will be understated. The following accounting steps should be taken to record the lease-related transactions in the lessee s books at the commencement of the lease: Establish Lease Asset and Liability Debit Credit Leased Asset Lease Liability The initial amount of the leased asset s value and lease liability is determined by calculating the present value of the minimum lease payments, using the interest rate implicit in the lease. The minimum lease payments include rental payments plus any Guaranteed Residual Value or bargain purchase option.

15 Chapter 6 Leases Periodic Instalment Payments Periodic instalment payments made by a lessee will have an interest component and an amount representing repayment of principal. Each payment needs to be dissected. Debit Debit Credit Lease Liability Lease Interest Expense Bank Accounting Standard AASB 117 requires the actuarial method to be used in dissecting the lease payment. Interest expense is calculated by applying the rate of interest implicit in the lease to the outstanding lease liability at the beginning of each lease instalment period. The calculation is shown in later examples. Depreciation of the Leased Asset AASB 117 stipulates that leased assets must be depreciated in accordance with AASB 116 and AASB 138. AASB 117 states If there is reasonable certainty that the lessee will obtain ownership by the end of the lease term, the period of expected use is the useful life of the asset; otherwise the asset is depreciated over the shorter of the lease term and its useful life. Debit Credit Depreciation Expense Accumulated Depreciation Leased Asset Lease Expenses transfer Lease related expense account balances will be transferred to Profit & Loss, along with other operating expenses, as part of the end-of-period closing entries. Debit Credit Credit Profit & Loss Lease Interest Expense Depreciation Expense

16 4 8 2 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS 6.7 Post Journal Entries for Finance Lease to the Lessee s Ledger The following example demonstrates: Calculation of the components of Lease Payments. Journal entries for lease-related transactions. Posting to the lessee s ledger. Example Debden Company Ltd contracts to lease equipment from ABC Finance Ltd and the following details are provided. Commencement of the lease 1 July 2009 Lease term 5 years Fair value of asset at 1 July 2009 $36,050 Useful life of asset (no scrap value) 5 years Annual rental payment at the end of each year $10,000 Lease implicit interest rate 12% This lease in non-cancellable and, at the end of the lease term, ownership will transfer to Debden Company Ltd. Required: (a) Prepare general journal entries to record the finance lease transactions for the year ended 30 June (b) Post the entries to the ledger of Debden Company Ltd.

17 Chapter 6 Leases Solution Workings The Lease is classified as a finance lease, as the lease is non-cancellable and the lease term is for a major part of the useful life of the asset. Periodic Instalment Payments To establish the interest component of periodic rental payments it is necessary to prepare a schedule of lease payments. Date Schedule of Lease Payments to ABC Finance Ltd Lease Payment Interest 12% Principal Reduction Balance Outstanding 01/07/09 36,050 30/06/10 10,000 4,326 5,674 30,376 30/06/11 10,000 3,645 6,355 24,021 30/06/12 10,000 2,882 7,118 16,903 30/06/13 10,000 2,028 7,972 8,931 30/06/14 10,000 1,069 8, ,000 13,950 36,050 Note: Interest component = Balance outstanding x Interest rate x Instalment period e.g. 30/06/2010 instalment = $36,050 x 12% x 1 year = $4,326

18 4 8 4 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS (a) General Journal of Debden Company Ltd Date Debit Credit 01/07/09 Leased Asset Equipment 36,050 Lease Liability ABC Finance Ltd 36,050 Value of leased asset and liability under finance lease 30/06/10 Lease Liability ABC Finance Ltd 5,674 Lease Interest Expense 4,326 Bank 10,000 Lease instalment payment 30/06/10 Depreciation Expense 7,210 Accumulated Depreciation Leased Asset 7,210 Depreciation charge as per Depreciation Schedule: $36,050/ 5 years on a straight-line basis. 30/06/10 Profit & Loss Account 11,536 Lease Interest Expense 4,326 Depreciation Expense 7,210 Transfer of balances

19 Chapter 6 Leases (b) General Ledger of Debden Company Ltd Lease Asset Equipment 01/07/09 Lease Liability 36,050 Accumulated Depreciation Leased Asset 30/06/10 Depreciation 7,210 Lease Liability ABC Finance Ltd 30/06/10 Bank 5,674 01/07/09 Lease Asset 36,050 30/06/10 Balance c/d 30,376 36,050 36,050 01/07/10 Balance b/d 30,376 Bank 30/06/10 Lease Liability 10,000 Lease Interest Expense 30/06/10 Bank 4,326 30/06/10 Profit & Loss 4,326 4,326 4,326 Depreciation Expense 30/06/10 Acc. Depreciation 7,210 30/06/10 Profit & Loss 7,210 7,210 7,210 Profit & Loss Account Extract 30/06/10 Lease Interest Expense 4,326 30/06/10 Depreciation Expense 7,210 11,536

20 4 8 6 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS Lease Asset Equipment Date Details Debit Credit Balance 01/07/09 Lease Liability 36,050 36,050 Dr Accumulated Depreciation Leased Asset Date Details Debit Credit Balance 30/06/10 Depreciation 7,210 7,210 Cr Lease Liability ABC Finance Ltd Date Details Debit Credit Balance 01/07/09 Lease Asset 36,050 36,050 Cr 30/06/10 Bank 5,674 30,376 Cr Bank Date Details Debit Credit Balance 30/06/10 Lease Liability 10,000 10,000 Cr Depreciation Expense Date Details Debit Credit Balance 30/06/10 Profit & Loss 7,210 7,210 Cr 30/06/10 Acc. Depreciation 7,210 0 Profit & Loss Account Extract Date Details Debit Credit Balance 30/06/10 Lease Interest Expense 4,326 4,326 Dr 30/06/10 Depreciation Expense 7,210 11,536 Dr

21 Chapter 6 Leases Disclosure Requirements for Finance Leases: AASB 117 AASB 117 paragraph 31 requires the following to be disclosed for finance leases in the financial statements of lessees: For each major class of asset, the net carrying amount at the reporting date. Future minimum lease payments, as at balance date, reconciled to their present value and each classified into the following periods: 1. Not later than one year. 2. Later than one year and not later than five years. 3. Later than five years. The total of future minimum sublease payments expected to be received under non-cancellable subleases at the reporting date. Contingent rents recognised as an expense in the period. A general description of the lessee s material leasing arrangements.

22 4 8 8 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS Using the information from the previous example, the following disclosure would be made in the financial statements of Debden Company Ltd: Debden Company Limited Statement of Financial Position (extract) as at 30 June 2010 Non-Current Assets Note Equipment under Lease 1 36,050 Less: Accumulated Depreciation 7,210 Current Liabilities 28,840 Lease Liability ABC Finance Ltd 2 6,355 Non-Current Liabilities 6,355 Lease Liability ABC Finance Ltd 2 24,021 Note 1 Operating Profit Debden Company Limited Notes to and forming part of the Financial Statements (extract) Operating profit is arrived at after charging the following specific items: 24,021 Finance charges relating to finance leases $ 4,326 Depreciation equipment under finance leases 7,210 Note 2 Future Minimum Lease Payments Future minimum lease payments in relation to finance leases are payable as follows: Not later than one year 10,000 Later than one year but not later than 5 years 30,000 Minimum payments/ total commitments 40,000 Less: Unexpired charges ($13,950 $ 4,326) 9,624 Total lease liability ($6,355 + $24,021) $ 30,376

23 Chapter 6 Leases Self-Testing Exercise 2 A lease of plant and equipment has the following characteristics: Inception and Commencement of Lease: 01/01/2009. Fair value of leased asset at 01/01/2009: $30,000. Lease term (terminates 31/12/2016): 8 years. Useful life of asset (nil scrap value): 10 years. Lessee guaranteed value at end of lease: $12,841. Instalment payments (payable on 01/01/2009 and thereafter on 31 December each year): $5,000. Lease implicit interest rate:15%. The lessee intends to make an offer to purchase the asset on 31/12/2016 for the guaranteed residual value. Past experience with the same lessor indicates that there is no reason to believe the offer will be refused. Schedule of Lease Payments Date Lease Payment 15% Principal Reduction Balance Outstanding 01/01/2009 5,000 5,000 25,000 31/12/2009 5,000 3,750 1,250 23,750 31/12/2010 5,000 3,562 1,438 22,312 31/12/2011 5,000 3,347 1,653 20,659 31/12/2012 5,000 3,099 1,901 18,758 31/12/2013 5,000 2,814 2,186 16,572 31/12/2014 5,000 2,486 2,514 14,058 31/12/2015 5,000 2,109 2,891 11,167 31/12/ ,841 1,674 11,167 Nil 52,841 22,841 30,000 Required: (a) Classify the lease. (b) Prepare journal entries for the lease-related transactions for the year ended 31 December (c) Post the journal entries to the General Ledger. (d) Prepare disclosure notes to satisfy AASB 117.

24 4 9 0 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS Self-Testing Exercise 3 On 1 July 2009, Hope Island Ltd. entered into a finance lease with Golf Finance Ltd for the lease of a turf cutter on the following terms: Commencement: 1 July Period of Lease: 4 years (also the expected useful life). Lease Payments: 5 payments of $ 15,000, with the first payable on 1 July 2009, and thereafter on 30 June each year. Residual Value: Nil. Interest Rate: 12%. The fair value at the inception of the lease is $ 60,560. Schedule of Lease Payments Date Lease Payments 12% Principal Reduction Balance Outstanding 01/07/09 15,000 15,000 45,560 30/06/10 15,000 5,467 9,533 36,027 30/06/11 15,000 4,323 10,677 25,350 30/06/12 15,000 3,042 11,958 13,392 30/06/13 15,000 1,608 13,392 75,000 14,440 60,560 Required: (a) Prepare general journal entries in the lessee s books to record the lease-related transactions for the year ended 30 June (b) Prepare a Statement of Financial Position extract and appropriate notes to the financial statements at 30 June 2010 in accordance with AASB 117.

25 Chapter 6 Leases Journal Entries in Lessee s Books: Operating Leases Accounting Standard AASB 117 contains recommended procedures for accounting for operating leases. As a close relationship usually exists between the benefits derived by the lessee and the period of time the property is available for use, the rental payments are brought to account as an expense (lease rental) over the duration of the lease. Adjustment at balance date for prepayment or accrual may be necessary according to the timing of payments. Periodic lease rental payments: Debit Credit Lease Rental Expense Bank Balance day adjustment: Prepayment Debit Credit Prepaid Expenses Lease Rental Expense Accrual Debit Credit Lease Rental Expense Accrued Expenses Expenses transfer: Debit Credit Profit & Loss Lease Rental Expense

26 4 9 2 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS 6.10 Disclosure Requirements for Operating Leases: AASB 117 Paragraph 35 requires the following to be shown in the financial statements of lessees for operating leases: The total of future minimum sublease payments expected to be received under noncancellable subleases at the reporting date. A general description of the lessee s significant leasing arrangements. Lease and sublease payments recognised as an expense in the period, with separate amounts for minimum lease payments, contingent rents and sublease payments. The total of future minimum lease payments under non-cancellable operating leases for each of the following: 1. Not later than one year. 2. Later than one year and not later than five years. 3. Later than five years. Example Extract from Notes to Financial Statements Note 1 Operating profit Operating profit is arrived at after charging the following specific items: Lease Rental Expense relating to Operating Leases Note 2 Future minimum lease payments Lease expenditure contracted for at balance date, but not provided for in the accounts, payable: Not later than one year Later than one year but not later than 5 years Later than 5 years Minimum payments/ Total Commitments xxx xxx xxx xxx xxx

27 Chapter 6 Leases Example On 1 October 2009, N entered into an operating lease agreement with O for the lease of equipment for a period of 3 years. Lease rental payments are $ 5,000 each, payable half-yearly, with the first payment on 1 October Required: (a) Prepare general journal entries for the lease-related transactions for the year ended 30 June (b) Post the entries to the ledger of N. (c) Show (extract of ) notes to financial statements of N for the year ended 30 June 2010, to satisfy the disclosure requirements. Solution (a) General Journal of N 01/10/09 Lease Rental Expense 5,000 Bank 5,000 Lease rental payment 01/04/10 Lease Rental Expense 5,000 Bank 5,000 Lease rental payment 30/06/10 Prepaid Expenses 2,500 Lease Rental Expense 2,500 Balance day adjustment Profit & Loss 7,500 Lease Rental Expense 7,500 Balance transfer

28 4 9 4 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS (b) Ledger of N Lease Rental Expense 01/10/09 Bank 5,000 30/06/10 Prepaid Expenses 2,500 01/04/10 Bank 5,000 Profit & Loss 7,500 10,000 10,000 Prepaid Expenses 30/06/10 Lease Rental Expense 2,500 Profit & Loss(Extract) 30/06/10 Lease Rental Expense 7,500 Lease Rental Expense Date Details Debit Credit Balance 01/10/09 Bank 5,000 5,000 Dr 01/04/10 Bank 5,000 10,000 Dr 30/06/10 Prepaid Expenses 2,500 7,500 Dr Profit & Loss 7,500 0 Prepaid Expenses Date Details Debit Credit Balance 30/06/10 Lease Rental Expense 2,500 2,500 Dr Profit & Loss(Extract) Date Details Debit Credit Balance 30/06/10 Lease Rental Expense 7,500 7,500 Dr

29 Chapter 6 Leases (c) Notes to Financial Statements of N for the year ended 30 June 2010 Note 1 Operating Profit Operating Profit is arrived at after charging the following specific items: Lease rental expense 7,500 Note 2 Future minimum lease payments Lease expenditure contracted for at balance date but not provided for in the accounts payable: Not later than one year 10,000 Later than one year but not later than 5 years 10,000 Later than 5 years Minimum payments/total lease commitments 20,000 Self-Testing Exercise 4 On 1 April 2010, P entered into an operating lease agreement with Q for the lease of a stamping machine for a period of 4 years. Rental payments of $4,000 each are payable half-yearly, with the first payment on 1 April Required: (a) Prepare general journal entries for the lease-related transactions for the year ended 30 June (b) Post the entries to the ledger of P. (c) Show (extract of ) notes to financial statements of P for the year ended 30 June 2010 to satisfy the disclosure requirements of AASB 117.

30 4 9 6 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS Self-Testing Exercise Solutions Solution 1 (a) Finance lease as it is non-cancellable and the lease term is greater than, or for the major part of, the useful life of the property. (b) Operating lease as the lease term is less than a major part of the estimated useful life of the property. (c) Operating lease as the present value of minimum lease payments at beginning of lease term is not substantially all of the fair value of lease property to the lessor at inception of the lease. The present value of the payments is $960 x = $43,156. Solution 2 (a) The lease is non-cancellable and the lease term is for a major part of the useful life of the property. It would be classified as a finance lease. (b)) General Journal 01/01/09 Leased Asset Equipment 30,000 Lease Liability 30,000 Lease asset and liability under finance lease. 01/01/09 Lease Liability 5,000 Bank 5,000 Initial lease instalment payment 31/12/09 Lease Liability 1,250 Lease Interest Expense 3,750 Bank 5,000 Lease instalment payment Depreciation Expense 3,000 Accumulated Depreciation - Leased Equipment 3,000 Depreciation expense as per Depreciation Schedule on straight-line basis $30,000/10years Profit & Loss 6,750 Lease Interest Expense 3,750 Depreciation Expense 3,000 Balances transfer

31 Chapter 6 Leases (c) General Ledger Leased Asset Equipment 01/01/09 Lease Liability 30,000 Lease Liability 01/01/09 Bank 5,000 01/01/09 Leased Asset 30,000 31/12/09 Bank 1,250 31/12/09 Balance c/d 23,750 30,000 30,000 01/01/10 Balance b/d 23,750 Bank 01/01/09 Lease Liability 5,000 31/12/09 Lease Liability 5,000 10,000 Lease Interest Expense 31/12/09 Cash at Bank 3,750 31/12/09 Profit & Loss 3,750 3,750 3,750 Depreciation Expense 31/12/09 Acc. Depreciation 3,000 31/12/09 Profit & Loss 3,000 3,000 3,000 Accumulated Depreciation 31/12/09 Depreciation Exp. 3,000 Profit & Loss ( Extract) 31/12/09 Lease Interest Expense 3,750 Depreciation Expense 3,000 6,750

32 4 9 8 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS Leased Asset Equipment Date Details Debit Credit Balance 01/01/09 Lease Liability 30,000 30,000 Dr Lease Liability Date Details Debit Credit Balance 01/01/09 Leased Asset 30,000 30,000 Cr 01/01/09 Bank 5,000 25,000 Cr 31/12/09 Bank 1,250 23,750 Cr Bank Date Details Debit Credit Balance 01/01/09 Lease Liability 5,000 5,000 Cr 31/12/09 Lease Liability 5,000 10,000 Cr Lease Interest Expense Date Details Debit Credit Balance 31/12/09 Profit & Loss 3,750 3,750 Cr 31/12/09 Cash at Bank 3,750 0 Depreciation Expense Date Details Debit Credit Balance 31/12/09 Profit & Loss 3,000 3,000 Cr 31/12/09 Acc. Depreciation 3,000 0 Accumulated Depreciation Date Details Debit Credit Balance 31/12/09 Depreciation Exp. 3,000 3,000 Dr Profit & Loss ( Extract) Date Details Debit Credit Balance 31/12/09 Lease Interest Expense 3,750 3,750 Dr Depreciation Expense 3,000 6,750 Dr

33 Chapter 6 Leases (d) Disclosure Notes (Extract of) Statement of Financial Position as at 31 December 2009 Note $ Non-Current Assets Equipment under Lease 30,000 Less: Accumulated Depreciation 1 3,000 27,000 Current Liabilities Lease Liability 2 1,438 Non-Current Liabilities Lease Liability 2 22,312 Notes to the Financial Statements for the year ended 31 December 2009 Note 1: Operating Profit Operating profit is arrived at after charging the following specific items: Finance charges relating to finance leases 3,750 Depreciation Equipment under finance leases 3,000 Note 2: Future minimum lease payments Future minimum lease payments in relation to finance leases are payable as follows: Not later than one year 5,000 Later than one year but not later than 5 years 20,000 Later than 5 years 17,841 Minimum payments 42,841 Less: Unexpired charges ( 22,841-3,750 ) 19,091 Total Lease Liability $ 23,750

34 5 0 0 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS Solution 3: Schedule of Lease Payments (a) General Journal of Hope Island Ltd Date Debit Credit 01/07/09 Leased Asset Turf Cutter 60,560 Lease Liability 60,560 Leased asset and liability under finance lease 01/07/09 Lease Liability 15,000 Bank 15,000 Initial lease payment 30/06/10 Lease Liability 9,533 Lease Interest Expense 5,467 Bank 15,000 Lease instalment payment 30/06/10 Depreciation Expense 15,140 Accumulated Depreciation Turf Cutter 15,140 Depreciation as per Depreciation Schedule $60,560/ 4 years 30/06/10 Profit & Loss 20,607 Lease Interest Expense 5,467 Depreciation Expense 15,140 Balances transfer

35 Chapter 6 Leases (b) (Extract of) Statement of Financial Position as at 30 June 2010 Non-Current Assets Note Equipment under lease 60,560 Less: Accumulated Depreciation 15, ,420 Current Liabilities Lease Liability 10, ,677 Non-Current Liabilities Lease Liability 25, ,350 Notes to Financial Statements for the year ended 30 June 2010 Note 1 Operating Profit Operating Profit arrived at after charging the following specific items: Finance charges relating to finance leases 5,467 Depreciation - equipment under finance leases 15,140 Note 2 Future minimum lease payments Commitments in relation to finance leases are payable as follows: Not later than one year 15,000 Later than one year not later than 5 years 30,000 Minimum payments / total lease commitments 45,000 Less: Unexpired charges ( 14,440-5,467 ) 8,973 Total Lease Liability 36,027

36 5 0 2 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS Solution 4 (a) General Journal of P Debit Credit 01/04/10 Lease Rental Expense 4,000 Bank 4,000 Lease rental payment 30/06/10 Prepaid Expenses 2,000 Lease Rental Expense 2,000 Balance day adjustment 30/06/10 Profit & Loss 2,000 Balance transfer Lease Rental Expense 2,000 (b) Ledger of P Lease Rental Expense 01/04/10 Bank 4,000 30/06/10 Prepaid Expenses 2,000 30/06/10 Profit & Loss 2,000 4,000 4,000 Prepaid Expenses 30/06/10 Lease Rental Expense 2,000 Profit & Loss(Extract) 30/06/10 Lease Rental Expense 2,000

37 Chapter 6 Leases Lease Rental Expense Date Details Debit Credit Balance 01/04/10 Bank 4,000 4,000 Dr 30/06/10 Prepaid Expenses 2,000 2,000 Dr 30/06/10 Profit & Loss 2,000 0 Prepaid Expenses Date Details Debit Credit Balance 30/06/10 Lease Rental Expense 2,000 2,000 Dr Profit & Loss(Extract) Date Details Debit Credit Balance 30/06/10 Lease Rental Expense 2,000 2,000 Dr (c) Notes to Financial Statements of P for the year ended 30 June 2010 Note 1 Operating Profit Operating Profit is arrived at after charging the following specific items: Lease rental expense 2,000 Note 2 Lease Commitments Lease expenditure contracted for at balance date but not provided for in the accounts payable: Not later than one year 8,000 Later than one year but not later than 5 years 20,000 Later than 5 years Minimum payments/total lease commitments 28,000

38 5 0 4 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS Chapter Review Questions 1. Define the following terms: (a) Lease. (b) Finance Lease. (c) Operating Lease. (d) Fair Value. (e) Useful life of the leased property. 2. Prepare brief answers to the following: (a) What are the advantages and disadvantages of leasing compared to the outright purchase of an asset? (b) What options are available to a lessee on termination of a lease? (c) What is a finance lease and how does it differ from an operating lease? (d) Show diagrammatically how to determine whether a lease is a finance lease in accordance with AASB Classify the following leases as finance or operating: (a) The hire of a washing machine by a laundry for 2 days to meet an unexpected weekend demand. (b) The lease of a van for 2 years at $ 750 per month. The van usually has a value of $ 26,000 and a useful life of 8 years. (c) The lease of a car in which the lease provides that the lessee guarantees to purchase the vehicle at the end of the lease term. (d) An airline company leases an aircraft for 5 years with an annual lease payment of $ 150,000. The aircraft has a useful life of 7 years and a fair value at the inception of the lease of $ 600,000. The present value of minimum lease payments is $ 540,720. (e) A textile company leases a knitting machine for 4 years. The useful life of the machine is 10 years. The quarterly lease payment is $ 800 and the fair value of the machine at inception is $ 13,000. The interest rate implicit in the lease is estimated at 12%. There is no bargain purchase option.

39 Chapter 6 Leases Dr Hope leased a motor vehicle for 1 month while working interstate. The cost of the lease was $ 1,050. Prepare journal entries to record the lease payment in the books of Dr Hope. 5. (a) Global Building Company wishes to acquire a new excavator for use in the business. The excavator costs $ 40,000 to purchase. Your advice is sought xin the following matters: Required: (i) What is a Finance Lease? (ii) How does a finance lease differ from an outright purchase? (iii) How does a finance lease differ from an operating lease? (b) Global enters into a finance lease arrangement with Countrybank on 1 May 2010 (also the commencement date) under the following terms. Term: 48 Months Interest Rate: 12% p.a. (1% p.m.) Payments: $792 per month, with the first payment at 31/05/10 and thereafter at the end of each month. Lease Residual: $ 16,000. Required: (i) Show the allocation of the payments for the year ended 30 June 2010 and the allocation to interest (lease finance charges) and loan reduction if all payments are made on time (use whole dollars). (ii) What is the balance due at 30 June Minmetal Company leased an extraction machine to use at an exploration site for two years. The lease is classified as an operating lease. The monthly rental payment is $13,500. The lease commencement date was 1 June 2010 with all payments at the end of the month. Required: (a) Prepare general journal entry to record the rental payment in the lessee s books on the 30 June (b) Prepare notes to the financial statements for the year ended 30 June 2010 in accordance with AASB 117 disclosure requirements in respect of the lease of the extraction machine.

40 5 0 6 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS 7. Magic Photos leased a developing machine to improve service. The following details related to the lease contract. Commencement of the lease: 1 January 2010 Lease term: 4 years Fair value of leased property: $30,000 Lease payments on 31 December each year: $ 0,721 Interest rate implicit in the lease: 16% Useful life of asset: 6 years It is expected Magic Photos will obtain ownership of the property at the end of the lease term. Period Ended Magic Photos Schedule of Lease Payments Minimum Lease Payment Interest 16% Principal Reduction Balance Outstanding 01/01/10 30,000 31/12/10 10,721 4,800 5,921 24,079 31/12/11 10,721 3,852 6,869 17,210 31/12/12 10,721 2,753 7,968 9,242 31/12/13 10,721 1,479 9,242 42,884 12,884 30,000 Required: Prepare journal entries to record the lease in the lessee s books for the year ended 31 December For Magic Photos in Question 7, prepare a Statement of Financial Position extract and notes to the accounts for the year ended 31 December 2010 to meet AASB 117 disclosure requirements.

41 Chapter 6 Leases On 1 January 2010 Moonriver Ltd entered into a lease with Tiffany Finance Ltd for the lease of photocopiers on the following terms. Commencement: 1 January 2010 Period of Lease: 4 years Lease Payments: 5 payments of $12,000, with the first payment on 1 January 2010 and thereafter at 31 December each year. Residual Value: Nil Interest Rate: 10% Useful Life: 5 years The Fair Value at the inception of the Lease is $ 50,039. Schedule of Lease Payments Period ended Min. Lease Payment Interest Principal Reduction Balance Outstanding 01/01/ ,000 12,000 38,039 31/12/ ,000 3,804 8,196 29,843 31/12/ ,000 2,984 9,016 20,827 31/12/ ,000 2,083 9,917 10,910 31/12/ ,000 1,090 10,910 60,000 9,961 50,039 Required: (a) Prepare journal entries in the lessee s books to record the lease transactions for the year ended 31 December (b) Prepare an extract of the Statement of Financial Position and appropriate notes at 31 December 2010 in accordance with AASB 117.

42 5 0 8 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS 10. On 1 July 2009 Mr Jones acquired a machine on lease on the following terms. Period of lease: Fair value of lease asset: $34,869 Implicit rate of interest: 10% Residual value: 3 years (also the expected useful life) Nil Rental payments: Four of $10,000 each with the first due 1 July 2009 and thereafter each year on June 30. Schedule of Lease Payments Period ended Lease Payment 10% Principal Reduction Balance Outstanding 34,869 01/7/09 10,000 10,000 24,869 30/6/10 10,000 2,487 7,513 17,356 30/6/11 10,000 1,736 8,264 9,092 30/6/12 10, ,092 40,000 5,131 34,869 Nil The lease is a finance lease and Mr Jones capitalised it in his accounting records as per AASB 117, providing depreciation on a straight-line basis. Required: Prepare in the books of Mr Jones: (a) Journal entries at the end of each year in respect of the lease agreement, including depreciation. (b) Extract of the Statement of Financial Position showing how the relevant lease balance would appear at 30 June 2010.

43 Chapter 6 Leases XYZ Building Company leased a cement mixer. The lease contract had the following terms. Commencement of lease: 1 July 2009 Fair value of leased asset at 1 July 2009: $55,000 Lessee guarantee residual value at end of lease term: $5,580 Rental payments payable at 30 June of each year. First payment on 01/07/09: 12,000 Lease implicit interest rate: 15% Useful life of leased asset: 7 years Scrap value at end of useful life: 4,500 Lease term (ends 30 June 2014): 5 years The lessee intends to make an offer to purchase the asset on 30 June 2014 for the guaranteed residual value. XYZ Building Company Schedule of Lease Payments Period ended Lease Payment Interest Principal Reduction Balance Outstanding 01/7/09 12,000 12,000 43,000 30/6/10 12,000 6,450 5,550 37,450 30/6/11 12,000 5,618 6,382 31,068 30/6/12 12,000 4,660 7,340 23,728 30/6/13 12,000 3,559 8,441 15,287 30/6/14 17,580 2,293 15,287 77,580 22,580 55,000 Required: (a) Prepare journal entries to record the lease transactions in the books of XYZ for the year ended 30 June (b) Prepare a Statement of Financial Position extract and notes to the financial statements for the year ended 30 June 2010, in accordance with AASB 117 disclosure requirements.

44 5 1 0 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS 12. On 1 January 2010 Dandar Ltd entered into a lease with Nifty Finance Ltd for the lease of a computer on the following terms. Commencement: 1 January 2010 Period of lease: Lease payments: Residual value: 5 years (also the expected useful life) 5 payments of $ 18,000, with the first due on 1 January 2010 a nd thereafter at 31 December each year. Nil Interest rate: 15% The fair value at the inception of the lease is $69,390. Period Ended Dandar Ltd Schedule of Lease Payments Minimum Lease Payment Interest 15% Principal Reduction Balance Outstanding 01/01/10 18,000 18,000 51,390 31/12/10 18,000 7,708 10,292 41,098 31/12/11 18,000 6,165 11,835 29,263 31/12/12 18,000 4,389 13,611 15,652 31/12/13 18,000 2,348 15,652 90,000 20,610 69,390 Required: (a) Prepare entries in general journal form in the lessee s books to record the lease transactions for the year ended 31 December (b) Prepare an extract of the Statement of Financial Position and appropriate notes to financial statements at 31 December 2010 in accordance with AASB 117. ( Note: There are only four accounting periods ).

45 Chapter 6 Leases On 1 July 2009 L entered into a finance lease agreement with M. Commencement of the lease: 1 July 2009 Duration of lease: 3 years Useful life of leased equipment with no residual value: 5 years Fair value of lease equipment: 1 July 2009 $29,545 Lease payments, payable: 1 July 2009 $10, June 2010 $10, June 2011 $10,000 Guarantee residual value: 30 June 2012 $ 5,000 Lease implicit interest rate 15%. Depreciation is charged on a straight-line basis. Schedule of Lease Payments Date Lease Payment Interest Principal Reduction Balance 01/7/09 $29,545 $ 10,000 $ 10,000 $19,545 30/6/10 $ 10,000 $ 2,932 $ 7,068 $12,477 30/6/11 $ 10,000 $ 1,872 $ 8,128 $ 4,349 30/6/12 $ 5,000 $ 651 $ 4,349 Required: (a) Prepare general journal entries to record the lease related transactions in the books of L for the year ended 30 June (b) Prepare a Statement of Financial Position extract and appropriate notes to financial statements at 30 June 2010 in accordance with AASB 117.

46 5 1 2 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS 14. Waterfall Ltd leased plant and equipment from Helpful Leasing Ltd. Details of this lease appear below: Inception of lease and commencement of lease term: 31 December 2009 Lessor s carrying amount of assets at 31 December 2009: $ 25,000 Fair value of asset at 31 December 2009: $ 30,000 Lease term (terminates 31 December 2017): 8 years Useful life of Asset (no salvage value): 14 years Lessee guaranteed residual value at end of lease: $ 12,841 Initial direct costs of lease (legal fees): $ 1,250 Rental payments payable 31 Dec each year commencing 31 Dec 2009: $ 5,000 Schedule of Lease Payments Period Ended Minimum Lease 15% Principal Reduction Balance Outstanding 31/12/09 5, ,000 25,000 31/12/10 5,000 3,750 1,250 23,750 31/12/11 5,000 3,562 1,438 22,312 31/12/12 5,000 3,347 1,653 20,659 31/12/13 5,000 3,099 1,901 18,758 31/12/14 5,000 2,814 2,186 16,572 31/12/15 5,000 2,486 2,514 14,058 31/12/16 5,000 2,109 2,891 11,167 31/12/17 12,841 1,674 11, ,841 22,841 30,000 0 Additional Information: The lease implicit interest rate that is known to Waterfall Ltd is 15%. The lease is non-cancellable. Waterfall Ltd intends to make an offer to purchase the asset on 31 December 2017 for the guaranteed residual value. Past experience with Helpful Leasing Ltd indicates there is no reason to believe the offer will be refused. Required: (a) Prepare journal entries to record the lease transactions in the books of Waterfall Ltd for the year ended 31 December (b) Prepare a Balance Sheet extract and notes to the financial statements for the year ended 31 December 2010 in accordance with AASB 117 disclosure requirements.

47 Chapter 6 Leases Imation Company leased a computer system. The lease contract had the following terms: Inception of lease and commencement of lease term: 1 July 2009 Fair Value of lease asset at 1 July 2009: $55,271 Lessee guarantee residual value at end of lease term: $8,000 Rental payments payable at 30 June of each year. 1st payment on 01/07/2009: $10,500 Lease implicit interest rate: 10% Useful life of leased asset: 7 years Scrap value at end of useful life: 4,871 Lease term ( ends 30 June 2014 ): 5 years The lessee intends to make an offer to purchase the asset on 30 June 2014 for the guaranteed residual value. Depreciation is to be accounted for on a straight-line basis over the useful life of the asset. Schedule of Lease Payments Period ended Lease Payment Interest 10% Principal Reduction Balance Outstanding 01/07/09 10,500 10,500 44,771 30/06/10 10,500 4,477 6,023 38,748 30/06/11 10,500 3,875 6,625 32,123 30/06/12 10,500 3,212 7,288 24,835 30/06/13 10,500 2,483 8,017 16,818 30/06/14 18,500 1,682 16,818 71,000 15,729 55,271 Required: (a) Prepare general journal entries to record the lease transactions in the books of Imation Company for the year end 30 June (b) Prepare a Statement of Financial Position extract and notes to the financial statements in accordance with AASB 117 disclosure requirements for the year ended 30 June 2010.

48 5 1 4 PREPARE FINANCIAL STATEMENTS & MAINTAIN ASSET AND INVENTORY RECORDS 16. On 28 June 2009 A.B.C. Manufacturing Co. entered into a leasing agreement with D. E. Finance Ltd for the lease of a processing machine. It is the intention of the lessee to acquire the asset at the end of the lease term. Processing Machine Commencement date: 1 July 2009 Lease Term: 5 years Lease implicit interest rate: 15% Fair value of leased asset at 1 July 2009: $ 110,000 Lease payments payable on 30 June each year. First payment on 1 July 2009: $ 24,000 Lease guarantee residual value at end of lease term on 30 June 2014: $11,160 Useful life of leased asset with an estimated scrap value of $10,000: 8 years Schedule of Lease Payments Date Lease Payment 15% Principal Reduction Balance Outstanding 01/07/ ,000 01/07/ ,000 24,000 86,000 30/06/ ,000 12,900 11,100 74,900 30/06/ ,000 11,235 12,765 62,135 30/06/ ,000 9,320 14,680 47,455 30/06/ ,000 7,118 16,882 30,573 30/06/ ,000 4,587 19,413 11,160 11,160 11, ,160 45, ,000 0 Required: (a) Prepare general journal entries to record the lease related transactions for the year ended 30 June (b) Prepare extract of Statement of Financial Position of A.B.C. Manufacturing Co as at 30 June 2010 and appropriate notes to the financial statements for the year ended 30 June 2010.