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47

Financial Management | October 2013

RESOURCE

STudy & tech notes/the institute/events

study
notes

In this issue:
Paper P2 Performance
Management, p50
T4 part B Test of Professional
Competence in Management
Accounting, p52

Paper F1
Financial
Operations
Operating leases are straightforward to account for compared with
finance leases, which require you to know two actuarial approaches to
allocating interest payments, as well as the sum-of-the-digits method
By Cathy Sibley

here are two classes of


lease: finance and operating. A finance lease is
one that transfers substantially to the lessee all
the risks and rewards
associated with ownership. Those that
dont do this are operating leases.
This classification, which is made at
the inception of the lease, depends on
the substance of the transaction rather
than the legal form. Circumstances that
would normally cause a lease to be filed
under finance include the following:

The lease transfers ownership of the


asset to the lessee by the end of the term.
l The lessee has the option of buying the
asset at a price thats substantially lower
than the assets fair value.
l The term of the lease covers most of
the assets useful economic life.
l At the inception of the lease, the present
value of the minimum lease payments
amounts to substantially all of the leased
assets fair value.
l The assets are of a specialised nature.
If an operating lease is deemed to
exist, the lease payments are recognised
l

as an expense on a straight-line basis


unless another systematic basis is more
appropriate. No asset or l iability is recognised, so the treatment is as follows:
l Dr Income statement.
l Cr Bank.
An accrual or prepayment may be necessary when comparing the cash flow
and the charges to the income statement.
As an example, consider the following
scenario from question 3 of September
2012s F1 paper. YZ entered into a noncancellable four-year operating lease on
1 October 2011 to acquire machinery. YZ
will pay no rent in the first year, but
$8,000 is payable for each of three years
starting on 1 October 2012. The machinerys estimated useful life is 10 years.
The charge to the income statement
is the total lease payment divided by the
term: (3 x $8,000) 4 = $6,000. The treatment is therefore:
l Dr Machinery hire (cost of sales) $6,000.
l Cr Accruals $6,000.
The fact that the machinery has an
estim ated useful economic life of 10
years supports the notion that this is an
operating lease, because its term does
not cover most of the assets useful life.

48

In situations where a finance lease is


deemed to exist, the lessee recognises
an asset and liability in the statement of
financial position as follows:
l Dr Finance lease asset.
l Cr Finance lease liability.
The amount thats initially recognised
should be the lower of the fair value of the
leased asset and the present value of
theminimum lease payments. The discount rate to use in calculating the latter
is the interest rate implicit in the lease.
As an example, lets work through the
following part of question 3 from March
2013s F1 paper. CQs trial balance at
31December 2012 is shown below:

Note $000$000
Finance lease payment (iii)
12
(iii) CQ acquired a vehicle on a finance lease
on 1 January 2012. The present value of the
minimum lease payments is $46,260 and
legal title will not pass to CQ at the end. The
terms are five annual payments of $12,000
on 1January from 1 January 2012. The rate
of interest implicit in the lease is 15 per cent.
Depreciation should be included in the cost
of sales. The only entry made for this transaction was to record the first rental payment.
We can see that we have a finance
lease and that the first payment is made
at the start of the reporting year, so the
initial recognition should be:
l Dr Finance lease asset $46,260.
l Cr Finance lease liability $46,260.
Note that we use the present value of
the minimum lease payments, since the
fair value of the asset isnt given.
In essence, CQ owns the asset, so its
recognised in the statement of financial
position as a non-current asset and dep
reciated over its useful life: five years. So
$46,260 5 = $9,252 is the depreciation
figure, giving us the following entries:
l Dr Depreciation expense $9,252.
l Cr Accumulated depreciation $9,252.
Now we need to deal with the financing part of the arrangement. This is done
either by the actuarial method, using an
implicit rate of interest, or by the sumof-the-digits method.
The actuarial approach the more
appropriate method here, as the question
provides an interest rate varies according to whether the lease payments are
made in advance or in arrears. In this case
CQ pays on the first day of the year, so its
clear that the firm is paying in advance.

Financial
Financial
Management
Management
| September
| October 2013

1. Actuarial method of allocating interest (payments in advance) for CQ


Year
Opening balance
Paid
Subtotal
Interest Closing balance

Starts with the
Amount of
Opening
Implicit
Subtotal

initial recognition
the lease
balance interest rate
+ interest

amount = payment =
paid = x subtotal =
=
31/12/12
$46,260 $12,000 $34,260
$5,139
$39,399
31/12/13
$39,399 $12,000 $27,399
$4,110
$31,509
2. Actuarial method of allocating interest (payments in arrears) for ZY
Year
Opening balance
Interest
Paid
Closing balance

Fair value of
Implicit rate x
Lease
Opening balance +

the asset = opening balance =
payment =
interest paid =
31/06/11 $120,000
$9,516 $30,000
$99,516
30/06/12
$99,516
$7,892 $30,000
$77,408
The calculation is shown in table 1.
Youll always need to find the figures up
to the year after the one you are accounting for. In this case were reporting the
year to 31 December 2012, so we must
also cover the year to 31December 2013.
Table 1 shows that the interest charge
for the income statement is $5,139 and
the total liability outstanding at the end
of the year is $39,399. Liabilities are split
into current and non-current balances in
the statement of financial position as is
the lease liability. The current liability is
the $12,000 payment, which is partly the
repayment of capital and partly the payment of the $5,139 interest outstanding.
The non-current liability is the subtotal
in the second year of $27,399, since the
interest of $4,110 has not yet accrued.
The relevant part of CQs statement
of financial position as at 31 December
2012 will therefore be as follows:
Non-current liabilities
Finance lease
Current liabilities
Finance lease 

$27,399
$12,000

Now lets try a scenario involving payments in arrears from question 3 of September 2011s P1 paper. ZY acquired new
vehicles on a five-year finance lease on
1 July 2010. The terms are as follows:
l Rental payments of $30,000 are made
annually in arrears on 30June.
l The vehicles fair value was $120,000.
l The interest rate is 7.93 per cent a year.

The initial recognition will be at fair


value this time, since the present value
of minimum lease payments is not given.
The calculation is shown in table 2.
The interest charge for the year ended
30 June 2011 will be $9,516. The liability
at the end of the year of $99,516 will be
split in ZYs statement of financial position as at 30 June 2011 as follows:
Non-current liabilities
Finance lease

$77,408

(balance at end of following year)

Current liabilities
Finance lease

$22,108

(balance at end of current year less that


of following year end: $99,516 $77,408)

Lets revisit the CQ question from the


March 2013 paper to work through the
sum-of-the-digits method of allocating
interest. You take this approach if its
required by the question or if an impli
cit interest rate is not provided. It uses
the formula (n[n + 1]) 2 where n is the
lease term. In CQs case, then, the sum
of digits will be (5 x 6) 2 = 15.
Next we find the total interest in the
financing arrangement, which is the
total lease payments less the assets fair
value: (5 x $12,000) $47,000 = $13,000.
This is apportioned by applying the sumof-the-digits fraction to the total interest each year, as shown in table 3.
Cathy Sibley is a CIMA exam marker
and freelance tutor.

3. Sum-of-the-digits method of allocating interest for CQ


Year
Total interest Sum-of-the-digits fraction Interest charge for the year
5/15$4,333
31/12/12 $13,000
4/15$3,467
31/12/13 $13,000
3/15$2,600
31/12/14 $13,000
2/15$1,733
31/12/15 $13,000
1/15
31/12/16 $13,000
$867

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