F7-Financial Reporting

IAS 17 LEASES
SUBSTANCE OVER FORM The meaning of substance over form

IAS 17

In many types of transactions there is a difference between the commercial substance and the legal form: y Commercial substance reflects the financial reality of the transaction. y Legal form is the legal reality of the transaction. Accounts are generally required to reflect commercial substance rather than legal form.

APPLICATION OF SUBSTANCE OVER FORM ON LEASES When an asset is leased under a finance lease there is a difference between the legal form of that transaction and its commercial substance: Legal form: The asset remains legally owned by the party leasing it out (the lessor). Commercial Substance: The party making the lease payments (the lessee) has the use of the asset for most or all of its useful life. The lessee has effectively purchased the asset by taking out a loan (the finance lease commitments).

ACCOUNTING TREATMENT OF THE COMMERCIAL SUBSTANCE OF A LEASE As the commercial substance of finance leases is that the lessee is the effective owner of the asset the required accounting treatment is to: record the asset as a non-current asset in the lessee's statement of financial position record a liability for the lease payments payable to the lessor

FURTHER EXPLANATION WITH IASB FRAMEWORK IAS 17 is mainly concerned with regulating the accounting for finance leases. The IAS 17 treatment follows the definition of an asset in the lASB Framework for the Preparation and Presentation of Financial Statements: 'an asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity' . Ownership is not necessary, control is the essential feature.

ACCOUNTING FOR FINANCE LEASE (LESSEE ACCOUNTING) At the start of the lease, the lessee should record the transaction as follows: DEBIT Asset Account CREDIT Lessor (liability) account The amount to be recorded in this way is the lower of - The fair value OR - The present value of minimum lease payments. IAS 17 states that it is not appropriate to show liabilities as deduction from the leased assets and a distinction should be made between current and non-current leased liabilities.

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F7-Financial Reporting
DEPRECIATION The asset should be depreciated over the shorter of: - Useful life of the asset OR - The lease term

IAS 17

If there is reasonable certainty of the eventual ownership of the asset, then it should be depreciation over its useful life. The lease term is essentially the period over which the lessee has the use of the asset. It includes: - The primary (non-cancellable) period - Any secondary periods during which the lessee has the option to continue to lease the asset, provided that it is reasonably certain at the outset that this option will be exercised. PAYMENT OF RENTALS AND ALLOCATION OF FINANCE CHARGE Each individual rental payment should be split between: - Finance charge (an expense in the income statement) - Repayment of obligation to pay rentals (a reduction in the liability). The finance charge should be allocated to each accounting period so as to produce a constant periodic rate of interest on the remaining balance of the liability. QUESTION 1
st

15 mins

On 1 January 20X0 ABC Co. buys a machine from a leasing company under a finance lease. The cash price of the machine was $7,710 while the amount to be paid was 10,000. The agreement require the immediate payment of a $2,000 deposit with the balance being paid settled in four equal annual installment commencing on 31 December 20X0. The charge of $2,290 represent interest of 15% per year, calculated on the remaining balance of the liability during each accounting period. Depreciation rate of 20% per year on a straight line basis assuming a nil residual value. Required Lease Amortization Schedule. Financial statement extract for the year 20X0, 20X1 and 20X2.

QUESTION

15 mins

A company has two options. It can buy an asset for cash at a cost of $5,710 or it can lease it by way of a finance lease. The terms of the lease are as follows. y y y y y Primary period is for four years from 1 January 20X2 with a rental of $2,000 pa payable on 31 December each year. The lessee has the right to continue to lease the asset after the em of the primary period for an indefinite period, subject only to a nominal rent. The lessee is required to pay all repair, maintenance and insuranc costs as they arise. The interest rate implicit in the lease is 15%. The lessee estimates the useful life of the asset to be eight years. Depreciation is provided on a straight-line basis.

Required Lease Amortization Schedule. Financial statement extract for the year 20X2, 20X3 and 20X4.

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F7-Financial Reporting

IAS 17

QUESTION

18 mins

Bulwell Aggregates Co wish to expand their transport fleet and purchased three heavy lorries with a list price of $18,000 each. Robert Bulwell has negotiated lease finance to fund this expansion, and the company has entered into a finance lease agreement w Granby Garages Co on 1 January 20X1. ith The agreement states that Bulwell agregates will pay a deposit of $9,000 on 1 January 20X1, and two annual instalments of $24,000 on 31 December 20X1, 20X2 and a final installment of $20,391 on 31 December 20X3. Interest is to be calculated at 25% on the balance outstanding on 1 January each year and paid on 31 December each year. The depreciation policy of Bulwell Aggregates Co is to write off the vehicles over a four year period using the straight line method and assuming a scrap value of $1,333 for each vehicle at the end of its useful life Required Show the entries in the income statement and statement of financial position for the years 20X1, 20X2 & 20X3. Calculations to the nearest $ (10 marks)

ACCOUNTING FOR OPERATING LEASE (LEESEE ACCOUNTING)

Operating leases do not really pose an accounting problem. The lessee pays amounts periodically to the lessor and these are charged to the income statement. Where the lessee is offered an incentive such as a rent-free period or cash back incentive, this is effectively a discount, which will be spread over the period of the operating lease in accordance with the accruals principle. For instance, if a company entered into a 4-year operating lease but was not required to make any payments until year 2, the total payments to be made over years 2-4 should be charged evenly over years 1-4. Where a cash back incentive is received, the total amount payable over the lease term, less the cash back, should be charged evenly over the term of the lease. This can be done by crediting the cash back received to deferred income and releasing it to profit or loss over the lease term.

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F7-Financial Reporting

IAS 17

HOW TO DETERMINE THAT A LEASE AGREEMENT IS A FINANCE LEASE OR FINANCE LEASE ?

Is ownership transferred by the end of the lease term? No Does the lease contain a Bargain purchase option? No Is the lease term for a major part of the assets useful life? No Is the present value of minimum lease payments greater then or substantially equal to the assets fair value? No Operating Lease

Yes

Yes

Yes

Yes

Finance Lease

QUESTION

18mins

On 1 January 20X3 Lis Co entered into a lease agreement to rent an asset for a 6 year period, at which point it will be returned to the lessor and scrapped, with annual payments of $18,420 made in advance. The market price of the asset on the same date was $86,000. The present value of minimum lease payments amounts to $84,000, discounted at the implicit interest rate shown in the lease agreement of 12.5%. Lis Co expects to sell goods produced by the asset during the first 5 years of the lease term, but has leased the asset for 6 years as this is the requirement of the lessor, and in case this expectation changes. Required Explain how the above lease would be accounted for the year ending 31 December 20X3 including producing relevant extracts from the statement of comprehensive income and statement of financial position. You are not required to prepare the notes to the financial statements: 10 Marks

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F7-Financial Reporting

IAS 17

Explanation The lease appears to be a finance lease for the following reasons: The present value of minimum lease payments amounts to 98% ($84,000/$86,000) of the fair value of the asset at inception of the lease, which can be regarded as substantially all. The asset will be used by Lis Co for the whole of its economic life, as it will be scrapped by the lessor at the end of the lease. Consequently the asset should be capitalised in the statement of financial position. The asset should be depreciated over the shorter of its useful life (5 years) and the lease term (6 years). A lease liability will be shown in the statement of financial position reduced by lease payments made in advance and increased by interest calculated using the interest rate implicit in the lease, 12.5%. Both the asset and lease liability will initially be recognized at $84,000, the present value of minimum lease payments, as this is lower than the fair value of the asset. . QUESTION 22 mins

On 1 October 20X3 Evans entered into a non-cancellable agreement whereby Evans would lease a new rocket booster. The terms of the agreement were that Evans would pay 26 rentals of $3,000 quarterly in advance commencing on 1 October 20X3, and that after this initial period Evans cou ld continue, at its option, to use the rocket booster for a nominal rental which is not material. The cash price of this asset would have been $61,570 and the asset has a useful life of 10 years. Evans considers this lease to be a finance lease and charges a full year's depreciation in the year of purchase of an asset. The rate of interest implicit in the lease is 2% per quarter. On 1 July 20X2 Evans entered into another non-cancellable agreement to lease a Zarkov rocket for a period of 10 years at a rental of $5,000 half-yearly to be paid in advance, commencing on 1 July 20X2. Evans considers this lease to be an operating lease. Required Show how these transactions would be reflected in the financial statements for the year ended 31 December 20X3. (12 marks) QUESTION Bowtock has leased an item of plant under the following terms: Commencement of the lease was 1 January 20X2 Term of lease 5 years Annual payments in advance $12,000 Cash price and fair value of the asset $52,000 at 1 January 20X2 equivalent to the present value of the minimum lease payments. Implicit interest rate within the lease (as supplied by the lessor) 8% per annum (to be apportioned on a time basis where relevant) The company's depreciation policy for this type of plant is 20% per annum on cost (apportioned on a time basis where relevant). Required Prepare extracts of the income statement and statement of financial position for Bowtock for the year to 30 September 20X3 for the above lease. (9 marks) 15 mins

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F7-Financial Reporting
Explanation

IAS 17

The first task is to decide what sort of lease the asset is held under. This is a finance lease because it transfers substantially all the risks and rewards of ownership to the lessee, as shown by the length of the lease and its cost: y The asset's useful life is five years (as shown by the 20% straight line depreciation policy) and the lease is also for five years. Therefore the asset is being held for the whole of its useful life The minimum lease payments are $60,000, spread over four years as payments are made in advance. The present value of these payments at an 8% discount rate is $51,745, which is almost the same as the asset's fair value.

The asset is capitalised and depreciated over its five year useful life, and the obligation to make lease payments is recognised as a liability.

QUESTION

18 mins

(A) An important requirement of the lASB's Framework for the Preparation and Presentation of Financial Statements {Framework) is that in order to be reliable, an entity's financial statements should represent faithfully the transactions and events that it has undertaken. Required Explain what is meant by faithful representation and how it enhances reliability. (5 marks)

(B) On 1 April 2007, Fino increased the operating capacity of its plant. Due to a lack of liquid funds it was unable to buy the required plant which had a cost of $350,000. On the recommendation of the finance director, Fino entered into an agreement to lease the plant from the manufacturer. The lease required four annual payments in advance of $100,000 each commencing on 1 April 2007. The plant would have a useful life of four years and would be scrapped at the end of this period. The finance director, believing the lease to be an operating lease, commented that the agreement would improve the company's return on capital employed (compared to outright purchase of the plant). o Discuss the validity of the finance director's comment and describe how IAS 17 Leases . Ensures that leases such as the above are faithfully represented in an entity's financial statements. (4 marks) Prepare extracts of Fino's income statement and statement of financial position for the year ended 30 September 2007 in respect of the rental agreement assuming: (1) It is an operating lease (2 marks) (2) It is a finance lease (use an implicit interest rate of 10% per annum). (4 marks)

(Total = 15 marks)

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F7-Financial Reporting
Explanation

IAS 17

(a) The concept of faithful representation requires that the financial statements give a true picture of the nature and effect of financial transactions. If users can be confident that this is the case, then the financial statements can be considered to be reliable This means that assets and liabilities as shown in the statement of financial position exist, are assets or liabilities of the entity and are shown at the correct amount, in accordance with the stated accounting policies of the entity. For instance, it may seem that a property shown at original cost when its market value is twice that amount is not faithfully represented, but if the disclosed accounting policy of the entity is not to revalue its properties, users will know what they are looking at and can adjust accordingly. The most obvious examples of faithful representation not being adhered to involve off balance sheet finance transactions, such as sale and leaseback, where secured loans are disguised as the sale of assets. This keeps borrowing out of the statement of financial position and avoids any consequent impact on gearing. The accounting scandals of the past decade revealed numerous off-balance-sheet schemes and underlined the importance of faithful representation.

(b)(i) The finance director is correct in that, if the plant is regarded as being held under an operating lease, it will not be capitalised. In this case the cost of the plant will not be included in capital employed and so will not have an adverse effect on ROCE. However, the finance director's comments betray an ignorance of IAS 17. Under IAS 17 leases are classified according to the substance of the transaction, on the basis of whether or not the risks and rewards of ownership have been transferred. The standard gives examples of situations where a lease would normally be classified as a finance lease, including: y where the lease transfers ownership to the lessee at the end of the lease term y Where an option to purchase exists on terms which makes it reasonably certain that the option will be exercised. y Where the lease term is for the major part of the assets economic life. y Where the present value of minimum lease payments amounts to at least substantially all of the fair value of the asset. In this case lease term is for the whole of the assets economic life and the present value of the minimum lease payments (four payments of $ 100,000 over the years) amounts to substantially all of the fair value of the plant this must therefore be regarded as a finance lease and consequently will impact the ROCE.

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