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Revise lecture 23 • Leases What is a leasing agreement? • A leasing agreement is an agreement whereby one party, the lessee, pays lease rentals to another party, the lessor in order to gain the use of an assets over a period of time. Types of leases There are two types of lease: 1. A finance lease 2. An operating lease Finance lease • A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset to the lessee. Operating lease • An operating lease is any lease other than a finance lease Classification of leases • To decide whether a lease is finance or operating, the first step is to assess whether the risks and rewards of ownership have transferred to the lessee. Classification of leases Risks and rewards Risks and rewards of ownership include: Risks: 1. 2. 3. 4. Lessee carries out repairs and maintenance Lessee insures asset Lessee runs the risk of losses from idle capacity Lessee runs the risk of technological obsolescence Classification of leases Risks and rewards of ownership include: Rewards: 1. Lessee has right to use asset for most or all of its useful life. IAS 17 Leases - guidance • IAS 17 provides guidance as to the classification of leases as finance leases or operating leases. • It gives the following list of situations in which a lease would normally be classified as a finance lease. IAS 17 Leases - guidance 1. The lease transfers ownership of the asset to the lessee by the end of the lease term. 2. The lessee has the option to buy the asset at a price expected to be lower than the fair value at the time the option is exercised. 3. The lease term is for the major part of the economic life of the asset even if title is not transferred. IAS 17 Leases - guidance 4. At the beginning of the lease, the present value of the minimum lease payment (MLP’s) is approximately equal to the fair value of the asset. 5. The leased assets are of a specialised nature so that only the lessee can use them without major modification. IAS 17 Leases - guidance 6. If the lease gives the lessee the right to cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee. 7. Gains or losses from fluctuations in fair value are borne by the lessee. 8. The lessee has the ability to continue the lease for a secondary period at a rent below the market rent. • Substance over form Substance over form The meaning of substance over form • In many types of transactions there is a difference between the commercial substance and the legal form: Substance over form The meaning of substance over form 1. Commercial substance reflects the financial reality of the transaction 2. Legal form is the legal reality of the transaction • Accounts are generally required to reflect commercial substance rather than legal form. Substance over form with a finance lease • 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) Substance over form with a finance lease 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: 1. Record the asset as a non-current asset in the lessee’s statement of financial position. 2. Record a liability for the lease payments payable to the lessor. Lease and the definition of an asset IAS 17 is mainly concerned with regulating the accounting for finance leases. The IAS 17 treatment follows the definition of an asset in the IASB 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. Lease and the definition of an asset IAS 17 thus argues that an asset leased under a finance lease must be recorded as an asset and a corresponding liability in the lessee’s accounting records. Accounting for a finance lease There are 2 main methods of allocating the finance charge each period: 1. Actuarial method 2. Sum of the digits method • The actuarial method is used mostly in practice Accounting for a finance lease The actuarial method • The actuarial method allocates interest to each period: 1. At a constant rate on the outstanding amount. 2. Using the interest rate implicit in the lease. Recording a finance lease Initial recording At the start of the lease: • The fair value (or, if lower, the present value of the MLP’s) should be included as a non-current asset, subject to depreciation. • The same amount (being the obligation to pay rentals) should be included as a loan, i.e. a liability. Recording a finance lease Initial recording • In practice, the fair value of the asset or its cash price will often be a sufficiently close approximation to the present value of the MLPs and therefore can be used instead. Recording a finance lease Depreciation • The non-current asset should be depreciated over the shorter of: 1. The useful life of the asset 2. The lease term Recording a finance lease Depreciation The lease term is essentially the period over which the lessee has the use of the asset. It includes: • The primary (non-cancelable) 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. Accounting for operating leases Accounting treatment • Operating lease assets are very difficult in nature from finance lease assets as the risks and rewards of ownership are not transferred to the lessee. Accounting for operating leases Therefore the accounting treatment is also very different. 1. An asset is not recognised in the statement of financial position. 2. Instead, rentals under operating leases are charged to the income statement on a straight-line basis over the term of the lease, unless another systematic and rational basis is more appropriate. 3. Any difference between amounts charged and amounts paid will be prepayments or accruals. Finance or operating lease Significance: The significance of the accounting treatment of leased assets is hightened by the difference between the accounting treatment of finance leases and that of operating leases: Finance or operating lease