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ACCOUNTING FOR LEASES AND HIRE PURCHASE CONTRACTS

UNIVERSITY OF NAIROBI SCHOOL OF BUSINESS MASTER OF BUSINESS ADMINISTRATION ADVANCED FINANCIAL ACCOUNTING DAC 601

TERM PAPER

PRESENTED TO MR. BARASA J.L BY YASIR ALI AND MARY GORRETY

ABSTRACT. The leasing of assets is now a popular alternative to the outright purchase of assets. By leasing assets businesses have less capital invested in non-current assets. Leasing frees up capital that can be used to finance business operations or additional business ventures. The widespread practice of leasing assets brought new challenges to the accounting profession as non-current assets and their associated liabilities did not appear in the balance sheet. These transactions were termed off-balance-sheet. Meaningful analysis and interpretation of the financial statements could not be undertaken without these transactions being reflected in the balance sheet. Over the years the accounting profession has developed and refined an accounting standard for leases. This accounting standard ensures that the financial statements of a business properly disclose leasing transactions. This paper examines the classification of leases, analysis of lease payments and the associated accounting entries for the recording and disclosure of lease transactions.

The current accounting standard for leases is AASB 117. This accounting standard as with all accounting standards has been developed to provide more meaningful financial statements that are consistently prepared across businesses.

The accounting standard for leases is the foundation of the material in this paper. Terminology relating to leases, finance and operating leases, accounting for finance and operating leases, and the disclosure requirements of leases in the accounts form the basis of the paper. Advantages and disadvantages of leasing and how leases may be terminated are also considered.

CHAPTER ONE INTRODUCTION The acquisition of assets - particularly expensive capital equipment - is a major commitment for many businesses. How that acquisition is funded requires careful planning. Rather than pay for the asset outright using cash, it can often make sense for businesses to look for ways of spreading the cost of acquiring an asset, to coincide with the timing of the revenue generated by the business. The most common sources of medium term finance for investment in capital assets are Hire Purchase and Leasing. Leasing and hire purchase are financial facilities which allow a business to use an asset over a fixed period, in return for regular payments. The business customer chooses the equipment it requires and the finance company buys it on behalf of the business. Many kinds of business asset are suitable for financing using hire purchase or leasing, including: Plant and machinery, land, motor vehicles etc. Lease is covered by IAS 17 and defines lease as an agreement whereby the lessor conveys to the lessee in return for a payment or series of payment the right to use the asset for an agreed period of time. Under lease purchase, the legal title is obtained when the final instalment is paid and the purchase option is exercised. Lease is a contract made between a lessor and lessee for the hire or specific asset. Under lease the legal title can never pass to the lessee. This is very common method used in practice and is very popular. It also means that one party retains ownership of an asset but conveys the right to the use of asset to another party for agreed period of time in return for an agreed amount. TERMINOLOGY The following terms are commonly used in relation to accounting for leases: Commencement of the lease term is the date when the lessee has the right to use the leased asset. It is also the date when the details of the lease are recorded in the accounting records.

Economic life is the anticipated life of a leased asset. Fair value in general terms is the market price. Finance lease is a lease that transfers substantially the risks and rewards of ownership without transferring ownership. The title to the asset may eventually be transferred to the lessee. A finance lease as the name suggests is a method of financing the acquisition of an asset. Payments under a finance lease are a payment of interest and repayment of capital. The criteria for determining a finance lease is considered later in the chapter. Gross investment in the lease is the total of the minimum lease repayments and the unguaranteed residual value of the leased asset. Guaranteed residual value is that part of the residual value of the leased asset that is guaranteed by the lessee under the lease agreement. Inception of the lease relates to the commencement of the lease and is the earlier of the date of the lease agreement and the date of commitment by the parties to the principal provisions of the lease. Initial direct costs are costs of negotiating and arranging a lease that have not been incurred by manufacturer or dealer lessors. Interest rate implicit in the lease is the discount rate that causes: the minimum lease payments + the unguaranteed residual value = the fair value of the leased asset + any initial direct costs of the lessor

Lease is an agreement where the lessee makes a series of payments to the lessor and in return has the right to use the asset subject to the lease. Lease commitments are the total amount of lease payments and other expenses owing over the remainder of the lease. Lease term is the period of the lease plus any further terms that the lessee has options to continue the lease, and that it is reasonably certain the lessee will exercise the option.

Lessee under a lease agreement has the right to use an asset in return for a series of payments to the lessor. Lessor under a lease agreement provides an asset and receives a series of payments from the lessee. Minimum lease repayments. These are the payments over the lease term that the lessee is required to make plus any amounts guaranteed by the lessee. If the lessee has an option to purchase the asset at the end of the lease, and it is anticipated the asset will be purchased, then the minimum lease repayments will be the lease repayments and the amount payable to exercise the option to purchase the asset. Novated lease for a motor vehicle is a tax effective method of acquiring a motor vehicle by employees. The employee enters into a lease with a finance company to finance a motor vehicle. The employer and the employee then enter into a sub-lease. The employee has the use of the motor vehicle and if he assumes all the benefits, risks and responsibilities of the original lease it is classified as an operating lease. Operating lease is any lease that is not classified as a finance lease. Payments under an operating lease are for the rental of the asset. Residual value of a leased asset is the estimated amount that would be obtained from the disposal of the asset at the end of the lease. Sale and leaseback transaction involves the sale of an asset that is then leased back from the purchaser. Unearned finance income is the interest component of future lease payments under a lease agreement. Useful life is the estimated period over which the asset is economically usable. This may be longer than the period of the lease. ADVANTAGES AND DISADVANTAGES There are many advantages in using leasing to finance the assets of the business and these include: 1. Capital Conserved- Large outlays of cash are avoided allowing business funds to be used for operating activities and expansion.

2. Acquisition of assets. When new business opportunities arise new assets are readily acquired by leasing. 3. Finance. Where the business does not have the capacity to borrow large amounts of funds leasing may provide a viable alternative to finance new assets. 4. Upgrading equipment. At the end of the lease period obsolete assets can be replaced with assets of the latest technology eg computer equipment. 5. Short term needs. Leasing allows the business to use assets that are required for a short period of time without having to purchase them 6. Latest equipment. Having modern equipment creates a favourable impression for existing and prospective clients. Productivity also increases by having the latest equipment. This can be achieved by leasing assets. 7. Tax advantages. Leasing provides better income tax advantages over other forms of financing the acquisition of assets. Disadvantages also exist with leasing arrangements: 1. Cost of finance. Lease finance is generally more expensive than alternative forms of financing. 2. Adverse cash flow. Lessees can over-commit themselves to a large number of leases with high repayments. 3. Lease obligations. The business may struggle to meet lease payments if it is having liquidity and/or profitability problems. 4. Guaranteed residual value. The business will have to pay the shortfall in the guaranteed residual value if the leased asset does not realise the amount guaranteed under the lease. 5. Capital Gains. By leasing land and buildings the business may miss out on any capital gain opportunities. 6. Ownership. Leased assets do not give the same prestige as ownership of the asset. 7. Credit rating. The lessee is required to have a good credit rating 8. Under-utilised equipment. With a downturn in demand equipment may be idle whilst lease payments are still required to be made. TERMINATION OF THE LEASE The lease may be terminated (brought to an end) in a number of ways: 1. Renew the lease. The lease may be renewed for a further period. The value of the asset is the residual value from the original lease

2. Purchase the leased asset. The asset subject to the lease can be purchased for its residual value. 3. Return the asset. Prior to the completion of the lease the asset may be returned to the lessor. The lessee is responsible for any losses and outgoings incurred by the lessor. 4. At the end of the lease the lessee can return the asset to the lessor. The lessee is only liable for any shortfall in the guaranteed residual value. 5. Trade in. The leased asset can be traded in on a replacement item that may be acquired on a new lease.

CHAPTER TWO 1.0 TYPES OF LEASE AGREEMENTS 1.1 FINANCE LEASE. Long-term, non-cancellable lease contracts are known as financial leases. The essential point of financial lease agreement is that it contains a condition whereby the lessor agrees to transfer the title for the asset at the end of the lease period at a nominal cost. At lease it must give an option to the lessee to purchase the asset he has used at the expiry of the lease. Under this lease the lessor recovers 90% of the fair value of the asset as lease rentals and the lease period is 75% of the economic life of the asset. The lease agreement is irrevocable. Practically all the risks incidental to the asset ownership and all the benefits arising there from are transferred to the lessee who bears the cost of maintenance, insurance and repairs. Only title deeds remain with the lessor. Financial lease is also known as 'capital lease'. In India, financial leases are very popular with high-cost and high technology equipment. The finance lease or 'full pay out lease' is closest to the hire purchase alternative. The leasing company recovers the full cost of the equipment, plus charges, over the period of the lease. Although the business customer does not own the equipment, they have most of the 'risks and rewards' associated with ownership. They are responsible for maintaining and insuring the asset and must show the leased asset on their balance sheet as a capital item. Risk and rewards associated with asset ownership include: Risk: 1. Losses from idle capacity 2. Losses from technological obsolescence 3. The variations in return due to changing economic conditions. Rewards: 1. Expectation of profitable operations over the assets economic life 2. Gain from appreciation in value of an asset, or realisation of a residual value.

When the lease period ends, the leasing company will usually agree to a secondary lease period at significantly reduced payments. Alternatively, if the business wishes to stop using the equipment, it may be sold second-hand to an unrelated third party. The business arranges the sale on behalf of the leasing company and obtains the bulk of the sale proceeds. Under the substance-over-form concept, a transaction should be accounted for according to economic substance rather than its legal form. In finance leases, the economic substance is that a person uses an asset as if it is his own. The legal form of finance leases is that the asset is owned by a different person- lessor. A financial lease is usually non-cancellable, but may be cancelled under the 3 following conditions: a) Upon occurrence of some remote contingency b) With permission of the lessor c) If the lease is extended or renewed. 1.1.1 Characteristic of finance lease 1. Lease term consist of primary (3-4 years) and secondary period 2. The lease term is equal to 75% or more of the economic or useful life of the asset. 3. The payments made to the lessor during the primary period are substantial and noncancellable. The present value of the minimum lease payments must be 90% of the fair value of the asset. 4. Rentals paid during the secondary period are nominal in amount and cancellable at the option of the lessee. 5. Where the lessee wishes to terminate the lease during the secondary period, the item is sold and substantially all of the sale proceed will be paid to the lessee as rebate of rentals. The lease agreement contains a bargain purchase option. 6. The lessee will be responsible for insurance, repair and maintenance. 7. Lessor retains the title to the items. 8. The lessee cannot sell the asset. The lease often transfers ownership of the leased asset to the lessee by the end of the lease term, but till then the lessor retains the title to the asset. 9. The lessee of any claims made indemnifies the lessor.

1.2 OPERATING LEASE If a business needs a piece of equipment for a shorter time, then operating leasing may be the answer. The leasing company will lease the equipment, expecting to sell it second-hand at the end of the lease, or to lease it again to someone else. It will, therefore, not need to recover the full cost of the equipment through the lease rentals. This type of leasing is common for equipment where there is a well-establishedsecond-hand market (e.g. cars and construction equipment). The lease period will usually be for two to three years, although it may be much longer, but is always less than the working life of the machine. Assets financed under operating leases are not shown as assets on the balance sheet. Instead, the entire operating lease cost is treated as a cost in the profit and loss account. An operating lease stands in contrast to the financial lease in almost all aspects. Thislease agreement gives to the lessee only a limited right to use the asset. The lessor isresponsible for the upkeep and maintenance of the asset. The lessee is not given anyuplift to purchase the asset at the end of the lease period. Normally the lease is for ashort period and even otherwise is revocable at a short notice. Mines, Computershardware, trucks and automobiles are found suitable for operating lease because therate of obsolescence is very high in this kind of assets. The lease assets are rented out to many different lessees over their useful economic lives. The lessee pays for the hire or use of the asset. Ownership of the asset remains with the lessor, who assumes all the risks and rewards of the asset and takes responsibility for repairs, maintenance and insurance expenses. According to IAS 17 rentals under operating lease should be recognized as expense and charged on straight line method over the lease term even though the payments are not made on such basis, unless another systematic and rational basis is more appropriate. 1.2.1 CONTRACT HIRE Contract hire is a form of operating lease and it is often used for vehicles.

The leasing company undertakes some responsibility for the management and maintenance of the vehicles. Services can include regular maintenance and repair costs, replacement of tyres and batteries, providing replacement vehicles, roadside assistance and recovery services and payment of the vehicle licences. 1.3 SALE AND LEASE BACK It is a sub-part of finance lease. Under this, the owner of an asset sells the asset to a party (the buyer), who in turn leases back the same asset to the owner in consideration of lease rentals. However, under this arrangement, the assets are not physically exchanged but it all happens in records only. This is nothing but a paper transaction. Sale and lease back transactions occur when the owner sells an asset and immediately reacquires the right to use the asset by entering into a lease with the purchaser. Sale and lease back transaction is suitable for those assets, which are not subjected depreciation but appreciation, say land. The advantage of this method is that the lessee can satisfy himself completely regarding the quality of the asset and after possession of the asset convert the sale into a lease arrangement. The lease payment and the selling price are interdependent as they are negotiated as a package. The accounting treatment depends on whether it results to operating lease or finance lease. 1.3.1 Finance lease-sale and lease back In this situation any excess of sales proceed over the carrying amount should be deferred and amortized over the long term. An impairment loss is dealt according to IAS 36. 1.3.2 Operating lease-sale and lease back Transaction should be established at a fair value. a) Any excess of fair value and carrying value shall be recognized as profit or loss immediately. b) Where selling price is less than the fair value any profit or loss should be recognised immediately. Unless the loss is compensated for by future lease payment at below market

price it should be deferred and amortized in proportion to the lease payment over the period the asset is expected to be used. c) Where price is more than the fair value the excess over fair value shall be deferred and amortized over the period for which the asset is expected to be used. d) Where the fair value at the time of sale and lease back transaction is less than the carrying amount of the asset, a loss equal to the amount of the difference between the carrying amount and fair value should be recognized immediately. 1.4 LEVERAGED LEASING Under leveraged leasing arrangement, a third party is involved beside lessor andlessee. The lessor borrows a part of the purchase cost (say 80%) of the asset from thethird party i.e., lender and the asset so purchased is held as security against the loan. The lender is paid off from the lease rentals directly by the lessee and the surplus aftermeeting the claims of the lender goes to the lessor. The lessor, the owner of the assetis entitled to depreciation allowance associated with the asset. 1.5 DIRECT LEASING Under direct leasing, a firm acquires the right to use an asset from the manufacturer directly. The ownership of the asset leased out remains with the manufacturer itself. The major types of direct lessor include manufacturers, finance companies, independent lease companies; special purpose leasing companies own your asset while spreading the cost

CHAPTER THREE ACCOUNTING FOR LESSEES CAPITALIZATION CONCEPT It should be noted that in finance leases the lessees right and obligation are such that the risks and rewards from the use of asset are substantially similar to those of an outright purchaser though not completely identical. The contentious issue is whether the leased asset should be capitalized. IAS 17 requires the leased asset to be recognized in the balance sheet as an asset and as an obligation, in the sense that there will be future lease payment. The amount to be recorded is the greater of fair value of the leased asset or present value of the minimum lease payment. The applicable discount rate for discounting the present value of minimum lease will be the interest rate explicit in the lease. However, if it is not possible and practicable the incremental borrowing rate should be used. The initial direct cost incurred in securing and negotiation should be added to the recognized amount of asset. Operating leases:operating leases pose few problems. Amounts are payable for the use ofan asset. From the point of view of the lessee, the amounts payable are the costs of using anasset for particular periods and hence are charged to the profit and loss account using theaccruals concept. Finance leases:Accounting for finance leases is a little more complicated. Prior to the introduction of SSAP21, finance leases were usually treated by both lessee and lessor in the same way as operatingleases. However, it was widely recognised that such treatment, while being justified on astrict legal interpretation of the agreement, failed to recognise the financial reality or substanceof the transaction. The substance of the transaction was that the lessee acquired anasset for its exclusive use with finance provided by the lessor; which in economic terms hasfew (if any) differences from the case of an asset purchased on credit. If financial statementsare to be realistic it is necessary to find a way of accounting for finance leases which accordswith the reality of the transaction rather than its legal form.

The appropriate treatment of a finance lease, which accords with the substance of thetransaction is, from the point of view of the lessee, to include in the lessees balance sheet anasset representing the lease and a liability representing the obligation to make paymentsunder the terms of the lease. At the inception of the lease the asset would be equal to the liabilitybut this relationship does not hold thereafter. The asset would be depreciated over theshorter of its useful economic life and the length of the lease, while the liability would beeliminated by the payments. These payments are not, as in the case of an operating lease,charged entirely to the profit or loss account nor are they, in general, wholly set off againstthe liability. Instead the payments are split between that element which is regarded as representingthe repayment of the liability and the remainder that is debited to the profit and lossaccount as the financing (or interest) charge. This approach is referred to as the capitalization of the lease. The lack of a faithful representation consequent upon the failure of a lessee to capitalize financial leases is highlighted by the problems that would be experienced when comparingtwo companies, one of which leases most of its assets, with the other purchasing fixed assetsusing loans of one sort or another. The latter companys balance sheet would show the assetswhich it used to generate its revenue thus allowing users of accounts to estimate the rate ofreturn earned on those assets, whereas the former companys balance sheet would, if theleases were not capitalised, understate its assets. Similarly, the latter companys balance sheetwould indicate the liabilities that would have to be discharged if it is to continue in businesswith its existing bundle of assets, whereas the former companys balance sheet would not. Example: An illustration of the basic principles of accounting for a finance lease in the accounting records of a lessee: Lombok Limited, a company whose year end is 31 December, leases a machine from SalatLimited on 1 January 20X1. Under the terms of the lease Lombok is to make four annual payments11of 35 000 payable at the start of each year. Lombok Limited is responsible for all themaintenance and insurance costs, so these are not covered by the payments under the lease.The first step is to decide the amount at which the leased asset should be capitalised, i.e.shown as an asset and a liability in the first instance. SSAP 21 requires that: At the inception of the lease the sum to be recorded both as an asset and as a liability shouldbe the present value of the minimum lease payments, derived by discounting them at

the interestrate implicit in the lease. (Para. 32)To do that we need to know what is meant by the minimum lease payments and the interest rateimplicit in the lease. Minimum lease payments: The minimum lease payments are the minimum payments over the remaining part of the leaseterm (excluding charges for services and taxes to be paid by the lessor) and: (a) in the case of the lessee, any residual amounts guaranteed by him or by a party related tohim; or (b) in the case of the lessor, any residual amounts guaranteed by the lessee or by an independentthird party. (Para. 20)In the Lombok example we will assume that there are no residual amounts and thus the minimumlease payments at the inception of the lease are the four annual payments of 35 000 Interest rate implicit in a lease: The interest rate implicit in a lease is the discount rate that at the inception of a lease whenapplied to the amounts that the lessor expects to receive and retain produces an amount (thepresent value) equal to the fair value of the leased asset. The amounts which the lessorexpects to receive and retain comprise (a) the minimum lease payments to the lessor (asdefined above) plus (b) any unguaranteed residual value, less (c) any part of (a) and (b) forwhich the lessor will be accountable to the lessee. If the interest rate implicit in the lease is notdeterminable, it should be estimated by reference to the rate that a lessee would be expectedto pay on a similar lease. (Para.24). Fair value:Fair value is the price at which an asset could be exchanged in an arms length transaction less,where applicable, any grants receivable towards the purchase or use of the asset. (Para. 25) Note that while knowledge of the implied interest rate is required to determine the appropriateaccounting treatment in the books of the lessee, it is found by reference to the cash flows of thelessor. In practice the lessee may not know or be able to estimate the various cash flows but weassume, at this stage, that the lessee can obtain all the necessary data. If we let FV be the fair value, Lj the lease payment in year j (payable at the beginning of eachyear) and Rn the estimated residual values received at the end of year n, the last year of the lease,then using standard present value techniques the implied rate of interest r is found from the solutionof the following equation:

If we assume in the case of the Lombok/Salat lease that the fair value is 108 720 and that thereis no residual value (i.e. Rn = 0) then substituting in the above equation we get:

Inspection of tables showing the present value of an annuity shows that 3.1064 represents an interest rate of 20 per cent. Thus the interest rate implicit in the lease is 20 per cent and hencethe present value PV of the minimum lease payments can be found as follows

This is of course equal to the fair value as, in the simple case, the only cash flows that the lessorwill receive are the minimum lease payments. Later we will describe the circumstances where thetwo series of cash flows (i.e. the lessees and the lessors) might be different and the effect ofthese differences on the calculations. We can now show how the lease should be treated in the books of Lombok (the lessee). Theoriginal entry recording the lease is: Dr Leased asset 108 720 Cr Liability under lease 108 720 From this time onwards the two accounts are dealt with separately. The leased machine will bedepreciated over the shorter of the length of the lease or the assets expected life, using the companysnormal depreciation policy for assets of its type, while the liabil ity will be graduallyextinguished as payments are made during the primary period of the lease. The only problem thatremains is how to spread the total interest charge over the primary period of the lease. The total interest charge may be calculated as follows:

Theoretically, the best approach is to use the actuarial or annuity method that produces a constantannual rate of interest (in this case 20 per cent) on the outstanding balance on the liabilityaccount. This is the method specified in SSAP 21, which does, however, allow the use of anyalternative method that is a reasonable approximation to the annuity method. Assuming that all payments are made on the due dates, the liability account in the books ofLombok for the term of the lease can be summarised as follows:

This account provides us with the interest charge to the profit and loss account for each year andthe liability for inclusion in each balance sheet. The amount of interest charged to the profit andloss account declines over the life of the lease because the outstanding balance is reduced bythe annual payments. It is, of course, necessary to distinguish between the current portion of theliability, that is the amount due to be paid in the coming twelve months, and the long-term liabilityfor the purposes of balance sheet presentation. In this case, this is extremely easy as the onlypayment to be made in each of years 20X2 and 20X4 is 35000 per annum payable on the dayfollowing each balance sheet date. Hence the analysis of the liability into its current and long-termcomponents is as follows:

One commonly used alternative to the annuity method is the sum of the years digits method or Rule of 78. If the sum of the digits method were used in the above illustration the resultswould be:

The impact of residual valuesLet us now complicate matters by assuming that the asset that is the subject of the lease hasa residual value. We will assume that the manufacturer who originally supplied the asset toSalat has agreed to reacquire the asset at the end of the lease. The sum is dependent on thecondition of the machine and the market factors at the end of the lease, but the manufacturerhas guaranteed to pay 10 000 whatever the circumstances. Let us assume that at theinception of the lease it is anticipated that the manufacturer will actually pay 20 000. Letus also assume that Lombok and Salat agree that they will divide any sums realised on thedisposal of the asset in the ratio 35 : 65. Thus, at the inception of the lease it is estimatedthat Lombok will receive 7000 (of which 3500 is guaranteed) and Salat 13 000 (6500guaranteed). For the purposes of calculating the implicit interest rate, the distinction between the guaranteedand unguaranteed elements of the residual value can be ignored as both have to betaken into the calculation, but the distinction may be important when deciding whether thelease is a finance or operating lease. If we return to the equation above and substitute the estimated value on realization receivable by Salat, the equation becomes:

Use of tables or a programmable calculation on a computer shows that the above equationwill be satisfied when r is approximately 25 per cent. This is a higher rate of interest than the20 per cent that was previously calculated as Salat obviously earns a higher return due to theintroduction of the residual value as an additional cash flow.

So far as Lombok is concerned the minimum lease payments are unchanged but they willnow be discounted at the higher rate of 25 per cent that will produce an initial value of theleased asset of:

The annual payments of 35 000 are the same as in the original example except that the liabilitythat is to be paid off is lower (103 320 not 108 720). Hence the finance charge in theprofit and loss account will be higher in the second example. This reflects the fact that in thefirst example the lease payments can be regarded as acquiring the whole of the productiveuse of the asset, in that a zero residual value was assumed, whereas in the second case thesame annual lease payments only acquired a proportion of the assets productive capacity. It will be noted that the estimated realisable value that Lombok expects to receive had noeffect on the calculation of the amount by which the lease should be capitalised or on theway in which the annual lease payments should be split. This is because these depend on theminimum lease payments. The recognition of the estimated realisable value does have aneffect on the amount that has to be depreciated which is the present value of the minimumlease payments less the estimated realisable value. Thus, the depreciation charges that wouldemerge from our two sets of assumptions are as follows (assuming the straight-line methodis used):

In the above examples we assumed that the lessee knows (or is able to find out from thelessor) the fair value of the asset and the estimated realisable value that the lessor expects toreceive. In practice this may well not be the case and certain estimates will have to be made.Often the fair value will be known and the interest rate estimated from a knowledge ofother leases of a similar type.

CHAPTER FOUR ACCOUNTING FOR LESSORS Operating leases: So far as the lessor is concerned the amounts receivable represent revenue from leasing the asset and are credited to the profit and loss account. The leased asset is treated as a fixed asset by the lessor and depreciated in accordance with normal policy. Accounting for finance leases by lessors general principles In the case of a finance lease the lessors balance sheet would not include the physical asset but a debtor for the amounts receivable under the lease. Thenceforth the payments received under the terms of the lease should be split between that which goes to reducing the debt and the balance being credited to the profit and loss account. Lets first describe the basic principles underlying the provisions of SSAP 21 relating tothe treatment of finance leases by lessors. Balance sheet presentation the measurement of net investment Lessors should not include in their balance sheets the assets subject to the contracts which are finance leases but instead record as a debtor the net investment in the lease after making any necessary provisions for bad and doubtful debts. In order to explain this term and describe how profit is recognised, we will need to reproduce certain definitions included in SSAP 21. Net investment: The net investment in a lease at a point in time comprises: (a) the gross investment in a lease; less (b) gross earnings allocated to future periods. Thus, we need to know what is meant by the gross investment and gross earnings. Gross investment: The gross investment in a lease at a point in time is the total of the minimum lease payments and any unguaranteed residual value accruing to the lessor. (Para. 21)

Gross earnings: Gross earnings comprise the lessors gross finance income over the lease term, representing the difference between his gross investment in the lease [see above] and the cost of the leased asset less any grants receivable towards the purchase or use of the asset. (Para. 28) In order to illustrate the effect of the above definitions assume that the details relating to a particular lease are as follows:

Let us see how one measures the net investment at the inception of the lease and at the end of the first year

Hence, at inception the net investment is equal to the cost of the asset less grants receivable by the lessor. Assume that the gross earnings recognised in the profit and loss account in the first year are 2500 .Then the net investment at the end of the first year is:

The recognition of gross earnings: The total gross earnings on any lease are reasonably easy to calculate since the minimum lease payments will be known and, generally, the residual value, if any, can be estimated. The difficulty lies in allocating the gross earnings to the different accounting periods. The

standard followed existing practice in the leasing industry by specifying that the interest should be allocated on the basis of the lessors net cash investment in the lease and not on the basis of the net investment. The meaning of net cash investment: The net cash investment in a lease at a point in time is the amount of funds invested in a lease by a lessor, and comprises the cost of the asset plus or minus the following related payments and receipts: a) government or other grants receivable towards the purchase or use of the asset; b) rentals received; c) taxation payments and receipts, including the effect of capital allowances; d) residual values, if any, at the end of the lease term; e) interest payments (where applicable); f) interest received on cash surplus; g) profit taken out of the lease.

The actuarial method after tax The guidance notes to SSAP 21 describe a number of ways of allocating the gross revenue to accounting periods based on the net cash investment. Of these the most accurate is the actuarial method after tax. This method produces a constant rate of return on the net cash investment over that period of the lease in which the lessor has a positive investment (i.e. before any cash surplus is generated). Example 9.3 The actuarial method after tax: Gasp plc, the lessor, acquired an asset for 7735 that it leased out on the following terms: Period Rental Residual value 5 years 2000 per year payable in advance on 1 January of each year Zero

Gasps year end is 31 December and tax in respect of any year is payable on 1 January of the next year but one. The tax rate is 50 per cent and capital allowances of 100 per cent are

receivable in the first year. (These rates are unrealistic but they have been chosen to simplify the figures and hence clarify the example.) The annual rate of return earned over the period when there is a net cash investment is 12 per cent while it is estimated that surplus cash can be invested at 5 per cent (both rates are before tax). The interest paid by Gasp on the funds invested in the lease will be ignored. The cash flows and the profit recognised on the lease are set out in Table 9.3

Notes: (a) The profit taken on the lease has been calculated at 12 per cent of the net cash investment at the start of each year (e.g. 688 = 0.12 5735) while the interest on the cash surplus has been calculated at 5 per cent of the opening balance (e.g. 45 = 0.05 903). Interest on the cash surplus in 20X6 has been ignored (otherwise the calculation would never end). (b) The tax computation for 20X0 (tax payable on 1 January 20X2) is as follows:

In subsequent years the tax payment is 50 per cent of the sum of the rental income and the interest earned on the cash surplus. Although the lease will generate an annual rental of 2000 for each of the five years after tax, profit recognised in respect of the lease is 688 in year 1, 531 in year 2 and 11 in year 3. It may be thought that this is a very imprudent way of recognising profit in that most of the profit is taken in the first two years of the lease. However, it must be recognised that the profit reported is that which is generated by the lessors financing activities and is calculated by reference to the amount that the lessor has invested in the lease. As Table 9.3 shows, the investment falls to zero, to be replaced by a cash surplus by 1 January 20X3. Arithmetically all the figures in Table 9.3 can be found if you know the cash flows, which will be specified in the agreement, and either the profit on the lease (12 per cent) or the reinvestment rate (5 per cent). Thus, if one of the two rates is known the other can be calculated, with the aid of a computer or a lot of patient trial and error. In practice, of course, the lessor will have made the calculations of these rates when agreeing the terms of the rental with the lessee. Thus the lessor would start by deciding, on the basis of market conditions and competitive forces, the return required on the lease (taking into account the return on any surplus cash invested and hence work out the rent that would need to be charged. The next step is to calculate the proportion of the annual receipts of 2000, which is deemed to represent the reduction in the amount due from the lessee. The calculation is based on the figures in Table 9.4. This table also shows the necessary transfers to and from the deferred taxation account if it is judged necessary to establish such an account.

Table 9.4 is constructed from the bottom up. The figures in line 9 are taken from Table 9.3. The net profit is then grossed up at the appropriate tax rate (50 per cent) to give line 5. Line 6, which shows the actual tax payments, is also taken from Table 9.3 which means that line 8 (deferred tax) can be derived. Line 4 is taken from Table 9.3 and hence the gross earnings (line 3) and capital repayments (line 2) can be deduced. If, taking into consideration the affairs of the company as a whole, it is decided that it is not necessary to account for deferred tax, one could start Table 9.4 at line 5 and work up from there. It must be emphasised that Table 9.4 is used only to calculate the capital repayment and, if appropriate, the deferred taxation transfers. For the purposes of the balance sheet presentation SSAP 21 requires that the amount due from the lessee should be the net investment (not the net cash investment) in the lease. Thus in the instance of Gasp plc the asset would be recorded as follows:

The gross earnings allocated to future periods are found from line 3 of Table 9.4. Thus, for example, the figure at 31 December 20X0 is (1062 + 22 45 98 52) = 889 and so on.

The method produces the apparently absurd result that the net investment at certain dates is greater than the remaining lease payments, the extreme case being that at 31 December 20X4 when a net investment of 52 is produced notwithstanding the fact that the lease has terminated. This odd result derives from the fact that a larger profit is taken in the early years of the lease in consequence of the anticipated return on the surplus cash invested; thus, for example, the net investment at 31 December 20X3 of 2150 can be regarded as representing the final lease payment of 2000 plus the anticipated interest receipts of 150 (98 in 20X4 and 52 in 20X5). Beyond SSAP 21 Accounting for Leases: A New Approach (1996) A movement to treat all non-cancellable leases as finance leases has been under way for some time. The opening shot of the international campaign was the publication of a G4+1 Discussion Paper Accounting for Leases: A New Approach by the Financial Accounting Standards Board, in 1996. Although the author of the report is stated to be Warren McGregor, the paper is a report of a working party of the G4+1 group of standard setters, made up of representatives of the IASC and groups from five countries.21 It confirms that leasing continues to be a major source of financing and suggests that it may become even more important in the future. The authors of the paper, drawing largely on research carried out in Australia and the USA, conclude that there have been many examples of lease agreements for what are, in all material respects, finance leases that were drawn up in such a way to ensure that they qualified for treatment as operating leases and hence appear off the balance sheet. The authors were skeptical of the ability of standard setters to produce criteria that would overcome this problem. They took a different approach and examined the issue from first principles, largely relying on the definitions of assets and liabilities contained in the IASCs Framework.

The report argues that, in respect of any non-cancellable lease, the lessee possesses both an asset and a liability and these should be reflected on its balance sheet. Hence, the report recommends that all non-cancellable leases should be capitalised. This recommendation is advanced on the grounds of both theory and pragmatism. This is normally a powerful combination but it appears to be working slowly in this particular case. Leases: Implementation of a New Approach (1999) While SSAP 21 remains in force, the battle continues. In 1999 the ASB published another discussion paper produced by the G4+1 group, Leases: Implementation of a New Approach. The 1999 report adopts the same position as its 1996 predecessor but advances the argument in a number of ways. The cash flows on which the capitalisation is based: The 1999 paper addresses a range of practical issues concerned with the identification of the cash flows that should be capitalised to provide the measure of the initial asset and liability in the books of the lessee, and covers such issues as possible variations in residual values, the question of contingent rentals and the treatment of long-term property leases. One of the reasons why SSAP 21 is thought to be inadequate is the rich variety of types of leases that have been developed by the financial community. Many leases are far removed from the simple notion of a predetermined regular flow of resource from lessee to lessor over the life of the agreement. Much of the 1999 paper is concerned with examining the different types of leasing agreement that exist and discussing the basis on which they should be capitalised. We do not have the space to deal with the whole variety of leases discussed in the paper but it would be helpful to quote one as an example, both to provide a flavour of the document and to illustrate the thinking that underpins it. The example we have selected is of a lease where the rent payable varies according to the revenue generated by the use of the asset. Specifically the example, example 4 in the paper, is of an agreement where a lessee enters a three-year lease on a retail store. The annual rent comprises a minimum base rental of 10 000 plus 1/2 per cent of the stores turnover during that year. In this example, the authors came to the view that a fair value approach should be used and an estimate is made of what the rental payments would have been had there not been the

turnover element. Suppose that this is 10 500 per annum, then the initial carrying value of the lease should be based on three payments of 10500 and the differences between those amounts and the amounts actually paid should be credited or debited to the profit and loss account for the relevant year. In general the approach taken in the paper is to capitalise on the basis of the minimum lease payments and to deal with variations on a year-by-year basis unless, as in the above example, the amount so derived would not provide a reasonable estimate of the fair value of the lease. The discount rate to be used by the lessee: As we pointed out earlier, SSAP 21 requires the lessee to use the discount rate that it is implied in the leasing agreement and which is set by the lessor, which is not something that the lessee can always readily determine. The 1999 paper takes a much more sensible approach and argues that the discount rate to be applied by lessees should be an estimate of the lessees incremental borrowing rate for a loan of a similar term and with the same security as is provided by the lease. This proposal underscores the point that a lease is a form of finance and should be treated as far as possible in a comparable way to other sources of finance that the entity might employ. The recognition of lease-related assets in the books of the lessor: The 1999 paper, unlike the 1996 version, deals with lessors as well as leases. The paper argues that, in the context of a lease agreement, a lessor possesses two distinct assets: the right to receive payments from the lessee; and the right to the return of the asset at the end of the agreement. The paper argues that these are distinct assets, one financial and one non-financial, and that they should be reported separately. The paper discusses a number of different ways by which the necessary measurements might be made

CHAPTER FIVE 4.1 HIRE PURCHASE ACCOUNTING With a hire purchase agreement, after all the payments have been made, the business customer becomes the owner of the equipment. This ownership transfer either automatically or on payment of an option to purchase fee. For tax purposes, from the beginning of the agreement the business customer is treated as the owner of the equipment and so can claim capital allowances. Capital allowances can be a significant tax incentive for businesses to invest in new plant and machinery or to upgrade information systems. Under a hire purchase agreement, the business customer is normally responsible for maintenance of the equipment. Hire purchase - otherwise known as lease purchase - is a simple repayment facility, where you eventually own the asset at the end of your agreement with Lombard. Hire purchase benefits

Total control - the asset is yours at the end of the agreement Flexibility in your repayments - makes for easy budgeting Fixed or variable interest options - it's your decision which is best for you Tax advantages - normally you can claim writing-down allowances and perhaps capital grants, while repayment interest may be offset against profits and VAT is usually reclaimable (special rules apply to cars)

There is great flexibility with this type of asset finance. We can structure it in various ways, with a flexible deposit, fixed payments and perhaps a balloon final lump sum. Hire purchase transactions are initially classified into two 1) Books of purchaser 2) Books of the vendor.

4.1.1 PUCHASERS BOOKS For any hire purchase transaction it is important to realise that the hire purchase price is more than cash price such that the difference between the two is hire purchase interest. Cash price + H.P Interest =H.P price Cash price- record as an asset H.P Interest-record as interest in P&L accounts H.P Price-record as liability to be paid off The hire purchase contract may last for several years, thus the purchaser should record the interest expense in the P&Ls of all the years over which the contract lasted. Apportionment of interest to the various P&Ls is done by any of the following methods. 1. Straight line method 2. Actuarial method 3. Sum-of digits method. EXAMPLE ONE Nairobi school acquired 2 new buses on 1 Jan. 1990 for $ 129,150. The cash prices of the bases were $90,000. The deal was financed by TSPP LTD, and the terms of the hire purchase contract required a deposit of $30,000 on delivery, followed by 3 instalments on 31st Dec. 1990, 1991 and 1992 of $33,000, $33,000 and $33,150 respectively. The true interest rate was 30% per annum. Required-Prepare the appropriate accounts in the books of Nairobi school to record the above transaction, accounts after the end of 1992 need to be prepared. Depreciation is to be charged on vehicle at 20% per annum, using straight line method. Solution

Vehicle
$ $

Jan-01 1990

H.P Supplier

90,000

Dec-31 1990

Balance c/d

90,000

Balance Jan-01 b/d 1991 Balance Jan-01 b/d 1992 Jan-01 1993 Balance b/d

90,000

Dec-31 1991

Balance c/d

90,000

90,000

Balance Dec-31 c/d 1992

90,000

90,000

1993

H.P Suppliers (TSPP LTD) 1990 1 Jan. Cashbook 31 Dec. Cashbook 31 Dec. Balance c/d 108,000 1991 $ 30,000 33,000 45,000 108,000 1991 1990 1 Jan. Motor Vehicle 31 Dec. H.P Interest $ 90,000 18,000

31 Dec. Cashbook 31 Dec. Balance c/d 58,500 1992

33,000 25,500

1 Jan. Balance b/d 31 Dec. H.P Interest 58,500 1992 1 Jan Balance b/d

45,000 13,500

25,500 7,650

31 Dec. Cashbook 33,150

33,150

31 Dec. H.P Interest 33,150

HIRE PURCHASE INTEREST (EXP.)


$ $

Dec 31 H.P Supplier 1990 Dec 31 H.P Supplier 1991 Dec 31 H.P Supplier 1992

18,000

Dec-31 1990

P&L

18,000

13,500

Dec-31 1991

P&L

13,500

7,650

Dec-31 P & L 1992

7,650

PROVISION FOR DEPRECIATION 1990 31 Dec. Balance c/d 1991 $ 18,000 1990 31 Dec. P & L 1991 1 Jan. Balance b/d 31 Dec. Balance c/d 36,000 1992 36,000 31 Dec. P & L 36,000 1992 1 Jan Balance b/d 31 Dec. Balance c/d 54,000 54,000 31 Dec. P & L 54,000 36,000 18,000 18,000 18,000 $ 18,000

The above solution is on the basis of the actuarial method, where the true rate of interest is given. If the straight line method is to be used the interest is apportioned as follows: Cash price + H.P Interest = H.P Price 90,000 + 39,050 = 129,050 39,050/3=13,050 for each of the 3 years. If the sum of digits methods were used, the interest will be apportioned as follows: YEAR 1990 = 39,150*(3/6) =19,575 YEAR 1991 = 39,150*(2/6) = 13,050 YEAR 1992 = 39,150*(1/6) = 6,525

4.1.2 THE VENDORS BOOKS From the sellers perspective, there are two sets of income Cost-cash selling price-H.P selling price Pure gross profit= Cash selling price-Cost Interest income= H.P Price- Cash selling price If the items are large and transactions few, a distinction may be made between pure gross profit and interest, and each recorded individually and independently. However, if the transactions are many and each of relatively low value, there is no need to make a distinction between pure gross profit and interest, and the total of these may be recorded and accounted for together. The books are a mirror image of the purchasers books. EXAMPLE ONE TSPP finances ltd supplied bases to Nairobi school at H.P Price of $129,150.The terms of the contract required a deposit of $30,000 on delivery, followed by 3 instalments on 31st Dec. 1990, 1991 and 1992 of $33,000, $33,000 and $33,150 respectively. The true interest rate was 30% per annum. The cost of the vehicle to the supplier was $ 60,000 and the cash selling price was $ 90,000. Required-Prepare the appropriate accounts in the books of TSPP LTDto record the above transaction, accounts after the end of 1992 need to be prepared. Depreciation is to be charged on vehicle at 20% per annum, using straight line method. Solution H.P Sales 1990 31 Dec. H.P Trading A/C $ 90,000 1990 1 Jan. H.P Debtor $ 90,000

H.P Purchases 1990 1 Jan. Bank//Creditor60,000 $ 1990 31 Dec. H.P Trading a/c60,000 H.P Trading A/C -1990 $ Purchases ( cost of sales) Provision for unrealised profit P & L pure gross profit interest 108,000 60,000 15,000 33,000 108,000 P & L (EXTRACT) 1991 $ H.P Interest Provision for unrealised profit P & L (EXTRACT) 1992 $ H.P Interest Provision for unrealised profit H.P Debtors A/C 1990 $ 1990 $ $ 7,650 5,000 $ 13,500 10,000 Sales90,000 H.P Interest income 18,000 $ $

1 Jan. Cashbook 1 Jan. Sales 31 Dec. H.P Interest income 108,000 1991 1 Jan. Balance b/d45,000 31 Dec. H.P Interest income 58,500 1992 1 Jan Balance b/d 31 Dec. Cashbook 33,150 25,500 7,650 31 Dec. Cashbook33,150 33,150 13,500 90,000 18,000 31 Dec. Cashbook 31 Dec. Balance c/d 108,000 1991 31 Dec. Cashbook 33,000

30,000 33,000 45,000

31 Dec. Balance c/d25,500 58,500 1992

H.P Interest Income 1990 1 Jan. H.P TP & L 1991 31 Dec. H.P P & L 1992 31 Dec. H.P P & L 7,650 13,500 $ 18,000 1990 1 Jan. H.P Debtor 1991 31 Dec. H.P Debtor 1992 31 Dec. H.P Debtor 7,650 13,500 $ 18,000

Provision for unrealised profit 1990 31 Dec. Balance c/d15,000 1991 31 Dec. P & L (1991)10,000 31 Dec. Balance c/d5,000 15,000 1992 31 Dec. P& L (1992)5000 15,000 1992 1 Jan. Balance b/d 5,000 $ 1990 31 Dec. H.P T P & L 1991 1 Jan. Balance b/d 15,000 15,000 $

CHAPTER SIX 5.1 EMERGING ISSUES Capitalization of leased assets has been one of the emerging issues. There has been case for and against capitalization.

5.1.1 ARGUMENT FOR CAPITALIZATION IAS 17 recognises that lessee acquires the economic benefit of the leased asset for the major part of its economic life in return for entering into the obligation to pay the right almost equal at the inception of the lease to the fair value of the asset and the related finance charge. The lessee enjoys these benefits without the legal title, which is the legal form of the agreement. 5.1.1.1GROUNDS FOR ARGUMENT OF CAPITALIZATION A) SUBSTANCE OVER FORM The substance over form recognizes that lessees right are similar to those of an outright purchaser. As these results represent an economic benefit arising from the use, then leased asset should be capitalized. B) FINANCIAL RATIOS If leased transactions are not reflected in the balance sheet of the lessee, the economic resources and the level of obligations of an enterprise are understated and hence distort financial ratios. 5.1.2 ARGUMENTAGAINST CAPITALIZATION The following are the main arguments against capitalization. 1. Legal form- legal form should not be ignored on the grounds that the benefits arising from the lease to a lessee is form of an intangible asset. Therefore, it could be misleading if the obligation under lease is similar to those of a loan stock when an asset is purchased outright. 2. Differentiation. The difficulty of differentiating between finance leases and operating lease remain.

3. Capitalization amount. It is not very clear whether to capitalize the whole amount of the lease or the principle. 4. Complexity. Capitalization computations are very complex for small business to carry out. 5. Consistency. The capitalization process is arbitrary to a lesser extent and therefore lack consistency. 6. Presentation in financial statement by a note is more understandable than the mere computation. Standard committee has rejected the argument against capitalization and they have recommended for its adoption.

References: Richard Lewis andDavid Pendrill, Advanced financial accounting, 7th edition, financial times prentice hall,2004 Imea P. KamenchuAdvanced applied accounting, 2008 IASB, international accounting standards, IFRS latest publication

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