Thank you for downloading this extract from our ExPedite notes to accompany your free online Course in a Coffee Break. To download a free complete set of our ExPress notes please visit www.. Good luck with your F7 studies. ACCA Paper F7 Financial Reporting (INT) For exams in 2010
Chapter 9 IAS 17: Leases START The Big Picture A lease is a right to use something in return for payment. Some are very short term in nature and others can be longer-term, such that they are similar to buying an asset on hire purchase terms. Where a company has a long-term lease (eg for rental of plant for most of its useful life), the company has control of that asset, even though it may not be owned by the entity. As the plant is controlled by the lessee, it should be recognised on the lessee s SOFP. Similarly, the lessee has an obligation to pay known amounts on the lease, so the lessee has a liability, which must be recognised on its SOFP. IAS 17 categorises leases into two distinct, but somewhat arbitrary categories: Finance leases: leases which substantially transfer the risks and returns incident to ownership from the lessor to the lessee. Operating leases: leases that are not finance leases. Page 9.1
The distinction is critical. Although the characteristics of a lease may make it hard to distinguish between the two, the accounting presentation of finance leases and operating leases is very different. We ll focus on finance leases initially, as they come up far more frequently in the exam, are worth more marks and are also the future of the accounting for leases, since it s likely that the definition of finance lease will soon be widened to include virtually all longer-term leases. Accounting for finance leases Committing to a finance lease meets the Framework definition of a liability, since: It creates an obligating event The obligation results in an outflow of resources The outflows can be measured accurately. The time value of money is material, so must be discounted to present value at an appropriate discount rate. An appropriate discount rate is the rate implicit in the lease with is the IRR of the lessor s cash flows. In the exam, it s almost certain that you would be given the rate implicit in the lease, since calculating the actual implict rate is difficult to achieve. If it is impractical to determine the interest rate implicit in the lease, IAS 17 allows the lessee instead to use the lessee s incremental borrowing cost for borrowing money with a similar term and similar security. Review and self-test 1 Mickie enters into a lease as lessee on 1 January 20x3. The lease is for a minimum period of four years and requires payments to be made as follows: 31.12.x3 $8,700 31.12.x4 $8,700 31.12.x5 $8,700 31.12.x6 $8,700 Page 9.2
In addition to this, Mickie is required to guarantee the value of the asset at the end of its life. This is expected to result in a further payment on 31.12.x6 by Mickie to the lessor of $1,600. The implicit rate in the lease has been calculated at 8% and the net present value of the obligation at this rate at 1 January 20x3 is $29,991. The cash price of the asset at the inception of the lease was $34,000. Required Show how this will be reported in the financial statements of Mickie at 31 December 20x3. The only effective way to work out the split between finance costs and repayment of the lease liability principal is to work through the liability in date sequence: Working 1: Split of lease payments Finance costs (unwinding of discount) NPV of lease liability Page 9.3
At 31.12.x3, the figures in the financial statements will be: Plant and equipment held under finance leases Depreciation Finance costs Liability This total liability must then be split for disclosure Current liability Non-current liability Total Depreciation period The asset is depreciated over the shorter of its expected useful life to the lessee and the maximum lease term. Leases sometimes include a secondary period where the lease may be extended for a nominal sum. Disclosures IAS 17 requires the notes to the financial statements to show the lease liability split down further from the current and non-current distinction, thus: Liability falling due within one year Liability falling due between two and five years Liability falling due after more than five years Total liability X X X X Page 9.4
Other significant provisions If it is impossible to determine the rate implicit in the lease, paragraph 20 of IAS 17 allows the lessee s marginal borrowing rate to be used instead to discount the lease liability and unwind this discount. Payments in advance Sometimes, a lease will involve payments in advance of each period rather than payments in arrears. This is still calculated using the same method as REVIEW AND SELF-TEST 1, but it will mean that at the end of each period, there is likely to be an accrued finance cost not yet paid off. Review and self-test 2 Rockie enters into a lease as lessee on 1 January 20x3. The lease is for a minimum period of four years and requires payments to be made as follows: 1.1.x3: non-returnable deposit $6,635 1.1.x3: lease payment $5,000 31.12.x4 $5,000 31.12.x5 $5,000 There is no guaranteed residual value of the asset to the lessor. The implicit rate in the lease has been calculated at 6% and the net present value of the obligation at this rate at 1 January 20x3 is $25,000. The cash price of the asset at the inception of the lease was $32,000. The asset has an expected useful life to Rockie of five years. The lease comes with an optional secondary term of a further four years at an rental from years five onwards of $1 per year. Page 9.5
Required Show how this will be reported in the financial statements of Mickie at 31 December 20x3. The only effective way to work out the split between finance costs and repayment of the lease liability principal is to work through the liability in date sequence: Working 1: Split of lease payments Finance costs (unwinding of discount) NPV of lease liability Page 9.6
At 31.12.x3, the figures in the financial statements will be: Plant and equipment held under finance leases Depreciation Finance costs Liability This total liability must then be split for disclosure Current liability Non-current liability Total Operating Leases Most operating leases are short in duration and the NPV of the liability would be small relative to the value of the asset. IAS 17 uses a much simpler accounting presentation for operating leases, which is simply to show operating rentals as liabilities as they fall due for payment. The asset under an operating lease is not capitalised, nor is any obligation for future operating lease rentals recognised until the rental payment falls due. The only significant complication can be if there is an uneven pattern of rentals falling due, such as an initial rent free period. In this case, the total amounts payable over the life of the operating lease are averaged. In the exam, it s fairly likely that you would be told that a lease is a finance lease or an operating lease. IAS 17 gives five situations when a lease is likely to transfer risks and returns incident to ownership to the lessee from the lessor: 1. The lease transfers ownership of the asset to the lessee at the end of the lease term 2. The lessee has the option to purchase the asset at a price sufficiently below fair value at exercise date, that it is reasonably certain the option will be exercised 3. The lease term is for a major part of the asset s economic life even if title is not transferred 4. Present value of minimum lease payments amounts to substantially all of the asset s fair value at inception 5. The leased asset is so specialised that it could only be used by the lessee without major modifications being made. Page 9.7
In practice, the third condition is the most common one to apply. A benchmark figure not in IAS 17 but often used in practice is that if the net present value of the obligation is 90% or more of the fair value of the asset, it is a finance lease. In addition to these criteria, it s common to look at the length of the lease relative to the remaining life of the asset. If a lease is for 75% or more of the remaining life of the asset, it is likely to be classified as a finance lease. In the exam, presume a lease is a finance lease until you are satisfied that it does not meet the definition of a finance lease, so is an operating lease. Review and self-test 3 Seller Co is a retailer that on 1 April 20x4 took out a five year lease on shop premises in a new retail development. The developer offered an initial rent free year to new tenants, in the hope of filling the development quickly. The annual rentals from year 2 onwards are expected to be $400,000. Required Show how this will be presented in the financial statements of Seller Co at 31 March 20x5. Sale and leaseback transactions It is fairly common for companies in need of a cash injection to sell property belonging to them (often land and buildings) to a financial institution or investment property company. Immediately upon the sale, a lease is then signed so that the seller continues to occupy the building. Most of these transactions are likely to be operating leases. A profit or loss is likely to be made on the derecognition of the asset no longer owned/ controlled. Profit on derecognition of any asset is always the sales proceeds less previous carrying value. In some cases, some of this profit may be not genuine and thus not immediately recognised. This can be identified by looking at the apparent motives behind a transaction. Paragraph 61 of IAS 17 gives the rules for profits and losses on sale and operating leaseback transactions 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. Page 9.8
If the sale price is below fair value, any profit or loss shall be recognised immediately except that, if the loss is compensated for by future lease payments at below market price, it shall be deferred and amortised in proportion to the lease payments over the period for which the asset is expected to be used. If the sale price is above fair value, the excess over fair value shall be deferred and amortised over the period for which the asset is expected to be used. In other words, look at the motive behind the transaction. If the sales proceeds were very high, it is likely that the buyer will recover this excess payment by future high rentals. The excess gain (proceeds fair value) will then be deferred over the life of the operating lease and credited to the cost of actual payments made. If a sale results in a loss, but subsequent below market rental payments, this loss will be deferred and matched to the subsequent lower rentals. Review and self-test 4 Determine an appropriate accounting treatment for the transactions below. All figures in $ million. 1 2 3 4 Fair value 100 120 120 80 Carrying value prior to sale 80 80 100 80 Sales proceeds 108 130 90 60 Operating lease rentals (10 year lease) At market rate Above market rate At market rate Below market rate Page 9.9
SOLUTIONS TO Review and self-test assessments Review and self-test 1 Working 1: Split of lease payments Finance costs (unwinding of discount) NPV of lease liability 1 Jan x3: Inception of lease 0 29,991 31.12.x3: Finance cost: 8% x 29,991 2,399 0 31.12.x3: Lease payment (2,399) (6,301) 31.12.x3: Year-end liability 0 23,690 31.12.x4: Finance cost: 8% x 23,690 1,895 0 31.12.x4: Lease payment (1,895) (6,805) 31.12.x4: Year-end liability 0 16,885 31.12.x5: Finance cost: 8% x 16,885 1,351 0 31.12.x5: Lease payment (1,351) (7,349) 31.12.x5: Year-end liability 0 9,536 31.12.x6: Finance cost: 8% x 29,991 763 0 31.12.x6: Lease payment (763) (9,536) 31.12.x6: Year-end liability 0 0 At 31.12.x3, the figures in the financial statements will be: Plant and equipment held under finance leases 17,993 (29,991 x ¾) Depreciation (29,991 x ¼) 7,498 Finance costs 2,399 Liability 23,690 This total liability must then be split for disclosure Page 9.10
Current liability 6,805 Non-current liability (23,690 6,805) 16,885 Total 23,690 Review and self-test 2 The only effective way to work out the split between finance costs and repayment of the lease liability principal is to work through the liability in date sequence: Working 1: Split of lease payments Finance costs (unwinding of discount) NPV of lease liability 1 Jan x3: Inception of lease 0 25,000 1 Jan x3: Initial payments (0) (11,635) 1 Jan x3: Net initial liability 0 13,365 31.12.x3: Finance cost: 6% x 13,365 802 0 31.12.x3: Year-end liability 802 13,365 1.1.x4: Lease payment (802) (4,198) 1.1.x4: Net liability 0 9,167 31.12.x4: Finance cost: 6% x 9,167 550 0 31.12.x4: Year-end liability 550 9,167 1.1.x5: Lease payment (550) (4,450) 1.1.x5: Net liability 0 4,717 31.12.x5: Finance cost: 6% x 4,717 283 0 31.12.x5: Year-end liability 283 4,717 1.1.x4: Lease payment (283) (4,717) 1.1.x4: Net liability 0 0 Page 9.11
At 31.12.x3, the figures in the financial statements will be: Plant and equipment held under finance leases 20,000 (25,000 x 4/5) Depreciation (25,000 x 1/5) 5,000 Finance costs 802 Liability (802 + 13,365) 14,167 This total liability must then be split for disclosure Current liability (802 + 4,198) 5,000 Non-current liability (14,167 5,000) 9,167 Total 14,167 Solution to Review and self-test 3 Total amounts expected to be paid ($400,000 x 4) Expected period of benefit $1.6m 5 years Averaged annual cost $320,000 At 31 March 20x5, an expense and liability of $320,000 will be recognised. This liability will progressively be repaid over the five year life of the operating lease. Solution to review and self-test 4 1 2 3 4 Recognise profit of Recognise loss of 40 now. Defer 10 in full now excess profit of 10 over 10 year operating lease. Recognise profit of 28 in full now Defer loss of 20 over 10 year operating lease Page 9.12