Upon completing this chapter readers should: LO1 understand what a lease represents;
LO2 understand the differences between operating leases and financial leases; LO3 understand how lessors and lessees should account for financial leases; LO4 understand how lessors and lessees should account for operating leases;
LO5 understand the implications of lease recognition for a reporting entity’s financial statements; and LO6 be aware of joint efforts currently being undertaken by the IASB and the FASB to develop a revised
accounting standard that will lead to significant changes in how leases are to be accounted for.
10.1 Introduction to accounting for leases
The international accounting standard pertaining to leases is IAS 17 Leases. This stand-ard applies to all leases except for ‘leases to explore for or use minerals, oil, natural gas and similar non-generative resources; and licensing agreements for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights’ (IAS 17, para-graph 2 ). It also does not apply to items that are covered by another standard such as leases on investment property (covered by IAS 40 Investment Property) or biological assets (covered by IAS 41 Agriculture). According to paragraph 4 of IAS 17, a lease is:
an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.
Lessees may have access to a large and diverse array of assets by means of leases. The central accounting issue is whether or not the leased assets and the associated commitments relating to the lease arrangement should appear in the reporting entity’s statement of financial position. A lessee does not have legal title to the leased asset during the lease term. However, should lack of legal ownership preclude the lessee’s reporting of the asset, and related liability, in the statement of financial position?
As the discussion in Chapter 4 indicated, it is control of an asset that is relevant, not legal ownership. As the IASB Conceptual Framework indicates, assets are future economic benefits controlled by the entity as a result of past transactions or other past events. Hence a firm will recognise assets it does not own, as long as it is able to control the use of those assets. But do leases transfer control of assets to the lessee? As we will see, depending upon the terms of the lease agreement, control of the asset can in fact be vested in the lessee.
lease An agreement conveying the right from a lessor to a lessee to use property for a stated period in return for a series of payments.
If a firm has entered into a long-term lease, disclosure of the lease obligation as a liability in the statement of financial position of the lessee would also be appropriate (subject to certain requirements, to be discussed below). The economic substance of acquiring an asset by way of a lease can, depending upon the terms of the lease, be essentially the same as ‘acquiring’ an asset by borrowing funds, even though legal title does not pass to the lessee upon signing the lease. For certain types of leases, failure to disclose the leased asset, and the related lease obligation, may cause the financial statements to be misleading. As paragraph 21 of IAS 17 states:
Transactions and other events are accounted for and presented in accordance with their substance and financial reality and not merely with legal form. Although the legal form of a lease agreement is that the lessee may acquire no legal title to the leased asset, in the case of finance leases the substance and financial reality are that the lessee acquires the economic benefits of the use of the leased asset for the major part of its economic life in return for entering into an obligation to pay for that right an amount approximating, at the inception of the lease, the fair value of the asset and the related finance charge.
According to IAS 17, certain leases must be disclosed in the statement of financial position (as a leased asset and a lease liability), while others will not appear in the statement of financial position. Specifically, leases that are classified as finance leases must be disclosed in the statement of financial position, whereas leases that are con-sidered to be operating leases will not appear in the financial statements.
At this point it needs to be emphasised that the following discussion relates to the accounting requirements in place at the time of writing this chapter. That is, we will be discussing the accounting requirements incorpo-rated within IAS 17. There is much discussion about the accounting for leases and a revised accounting standard is expected to be released in 2013 or 2014 with an application date expected to be in 2015, or later. We will discuss the probable contents of the new accounting standard towards the end of this chapter, but one of the key likely changes is that the requirement to differentiate between operating and financial leases—as is required under IAS 17 and described below—will ultimately be removed, and there will be a requirement that all leases (other than short-term leases of 12 months or less) be shown on the statement of financial position both as a lease liability and as an asset, which will be referred to as a ‘right-of-use asset’. The consequence will be that, when the new accounting standard is finally released, more leased assets and associated liabilities will appear in the statement of financial position than is currently the case. We will defer further discussion on the likely new accounting standard and will now return to our discussion of IAS 17.
IAS 17 defines a finance lease as a lease that ‘transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred.’ Finance leases are also sometimes referred to as capital or financial leases. A lease that is not a finance lease is an operating lease. Indeed, IAS 17 defines an operating lease as ‘a lease other than a finance lease’. An operating lease does not transfer substantially all the risks and rewards incidental to ownership of the asset to the lessee.
Where substantially all the risks and rewards of ownership pass to the lessee (a finance lease) and if the financial effects of the lease are material, paragraph 20 of IAS 17 requires the lessee to record, as at the beginning of the lease term, an initial asset and liability equal to the fair value of the leased property or, if lower, the present value of the mini-mum lease payments (we will define ‘minimini-mum lease payments’ shortly).
For a finance lease, the lease payments paid by the lessee to the lessor will comprise both the payment of principal and the payment of interest. As paragraph 25 of IAS 17 states:
Minimum lease payments shall be apportioned between the finance charge and the reduction of the outstanding liability. The finance charge shall be allocated to each period during the lease term so as to produce a constant periodic rate of interest on the remaining balance of the liability. Contingent rents shall be charged as expenses in the periods in which they are incurred.
Contingent rents are defined in IAS 17 as, ‘that portion of the lease payments that is not fixed in amount but is based on the future amount of a factor that changes other than with the passage of time (e.g. percentage of future sales, amount of future use, future price indices, future market rates of interest)’. As already indicated, if the risks and rewards of ownership are not transferred, the lease is referred to as an operating lease. For an oper-ating lease, no lease liability or asset should be shown in the statement of financial position of the lessee (although some disclosures will be required in the notes to the financial statements). In effect, the lease pay-ments relating to an operating lease are simply treated as rental expenses, which go through the statement of profit and loss.
finance lease A lease in which the terms of the lease agreement transfer the risks and benefits of ownership from the lessor to the lessee.
operating lease Lease in which the risks and rewards of ownership stay with the lessor.
To determine whether a lease is a finance lease or an operating lease, we need to deter-mine the risks and rewards of ownership. Again, the central rule is that, if the risks and rewards (or benefits) of ownership transfer to the lessee, the leased asset, and the associ-ated liabilities for the minimum lease payments, are recognised and disclosed in the statement of financial position of the lessee (the lease would be a finance lease). If we are to recognise the lease for statement of financial position purposes (that is, capitalise the lease), we need to be able to calculate the minimum lease payments (given that assets and liabilities are recognised at the fair value of the asset or the present value of the minimum lease payments, whichever is the lower). This and other important terms are defined in what follows.
10.2 Key terms used in accounting for leases
10.2.1 Risks and rewards of ownership
From the preceding discussion it should be clear that consideration of the risks and rewards of ownership is central to the application of IAS 17. Paragraph 7 of IAS 17 addresses the risks and rewards of ownership. It states:
Risks include the possibilities of losses from idle capacity or technological obsolescence and of variations in return because of changing economic conditions. Rewards may be represented by the expectation of profitable operation over the asset’s economic life and of gain from appreciation in value or realisation of a residual value.
If the lessee holds the risks and rewards of ownership, the lessee’s risk exposure is basically what it would be if the lessee acquired the asset by way of a purchase transaction. Therefore, if the risks and rewards of ownership are transferred in substance to the lessee, the lessee’s risk exposure in relation to holding the asset is basically equivalent to what it would have been if the lessee had acquired the asset for cash or by way of a loan.
It is not always a straightforward exercise to determine whether the risks and rewards incidental to owner-ship have passed substantially to the lessee. Professional judgement might be required. As a result, IAS 17 dedi-cates paragraphs 10 to 12 to assisting determination of whether a lease is a finance lease or an operating lease. These paragraphs explain:
10. Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract. Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease are:
(a) the lease transfers ownership of the asset to the lessee by the end of the lease term;
(b) the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised;
(c) the lease term is for the major part of the economic life of the asset even if title is not transferred; (d) at the inception of the lease the present value of the minimum lease payments amounts to at least
sub-stantially all of the fair value of the leased asset; and
(e) the leased assets are of such a specialised nature that only the lessee can use them without major modifications.
11. Indicators of situations that individually or in combination could also lead to a lease being classified as a finance lease are:
(a) if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee;
(b) gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (for example, in the form of a rent rebate equalling most of the sales proceeds at the end of the lease); and
(c) the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent.
12. The examples and indicators in paragraphs 10 and 11 are not always conclusive. If it is clear from other features of the lease that the lease does not transfer substantially all risks and rewards incidental to owner-ship, the lease is classified as an operating lease. For example, this may be the case if ownership of the asset transfers at the end of the lease for a variable payment equal to its then fair value, or if there are contingent rents, as a result of which the lessee does not have substantially all such risks and rewards.
risks and rewards of ownership
Risks include those associated with idle capacity and obsolescence and benefits include gains in realisable value.
minimum lease payments Rental payments over the lease term including the amount of any bargain purchase option, premium and any guaranteed residual value and excluding any rental relating to costs to be met by the lessor and any contingent rentals.
If a lease is cancellable at limited cost to the lessee, the lessee has limited risks and the lease is considered to be an operating lease. For the lessee to be considered to bear the risks associated with asset ownership, it is logical that there should be costs for the lessee should the lessee choose to cancel the lease. This is why para-graph 11(a) is considered to be an important consideration in determining whether a lease should be classified a finance lease. How a lease is classified will depend on the economic substance of the lease agreement and, as already indicated, the exercise of professional judgement is required. Leases that do not appear to satisfy any of the above criteria (in paragraphs 10 to 12) will typically be classified and accounted for by the lessee as oper-ating leases (which means that they do not require disclosure within the statement of financial position as an asset and liability will not be recognised, and lease payments are typically treated as rental expenses). At this stage of the discussion, further clarification of some of the above terms (and others) might be useful; notably such terms as:
■ ■ fair value ■ ■ non-cancellability ■ ■ contingent rent ■ ■ transfer of ownership ■
■ bargain purchase option ■
■ lease term ■
■ economic life ■
■ minimum lease payments
As we know, consideration of the fair value of a leased asset is necessary in determining the amount to be included for the leased asset in the statement of financial position of the lessee. IAS 17 defines ‘fair value’ as ‘the amount for which an asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm’s length transaction’. This definition of the term is consistent with those adopted in other accounting standards.
As already indicated, if a lessee was able to cancel a lease at short notice with limited penalty, the lessee would not be considered to be holding the risks and rewards associated with asset ownership and so the lease would be considered to be an operating lease. Hence, it is important to determine that the lease is non-cancellable before it is considered to be a finance lease. IAS 17 states that:
A non-cancellable lease is a lease that is cancellable only: (a) upon the occurrence of some remote contingency; (b) with the permission of the lessor;
(c) if the lessee enters into a new lease for the same or an equivalent asset with the same lessor; or
(d) upon payment by the lessee of such an additional amount that, at inception of the lease, continuation of the lease is reasonably certain.
Again, if a lease is considered to be cancellable it would, regardless of the remaining terms of the lease, be clas-sified an operating lease. Cancellability has the effect of minimising the risks to the lessee.
The existence of contingent rents is a factor that works against a lease being considered a finance lease, as the variability in future potential payments effectively shifts some of the risks and rewards of ownership back to the lessor.
Transfer of ownership
Transfer of ownership is referred to in paragraph 10(a) in IAS 17. Logically, if the lease includes transfer of owner-ship of the asset to the lessee at the end of the lease term and the lease is non-cancellable, the lease agreement is really just another type of debt agreement with title transfer occurring after the final payment has been made. As with any other purchase of an asset financed by debt, both the asset and the liability should be recognised in the books of the purchaser/lessee. Consequently, the asset and the liability should be accounted for separately. Again, remember that in accounting for leases we consider the economic substance of the underlying transaction. If the substance of the lease transaction is similar to what would be involved if an entity borrowed to acquire an asset, the lease transaction should be dealt with for accounting purposes in a fashion similar to the ‘borrow and buy’ transaction.
Bargain purchase option
While it is not a term that is used explicitly within IAS 17, a bargain purchase option is a provision that allows the lessee to purchase the leased asset for a price that is expected to be significantly lower than the expected fair value of the asset at the date the purchase option becomes exercisable. This is effectively what paragraph 10(b) of IAS 17 (repro-duced above) is referring to. The difference between the option price and the expected fair market value must be large enough to make exercise of the option reasonably assured. This evaluation is made at the inception of the lease. If the exercise of the option is likely (by definition, a rational party would not forgo a ‘bargain’), it is also likely that transfer of ownership will occur, and the risks and rewards of ownership are therefore assumed to be transferred.
‘Lease term’ is defined in IAS 17 as the non-cancellable period for which the lessee has contracted to lease the asset, together with any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option.
‘Economic life’ is either: ■
■ the period over which an asset is expected to be economically usable by one or more users; or ■
■ the number of production or similar units expected to be obtained from the asset by one or more users. It follows that the lease term and the economic life of the asset might not be the same. As already indicated (paragraph 10(c) of IAS 17), if the non-cancellable lease term is for the major part of the economic life of the asset, the lease is generally considered to be a finance lease. IAS 17 does not define ‘major part’ and therefore requires accountants to exercise professional judgement. However, it is generally accepted that if the lease term is greater than, or equal to, 75 per cent of the economic life of the leased asset, the risks and rewards of owner-ship are effectively transferred to the lessee (that is, it is a finance lease).
As we will see shortly, in determining the period over which the leased asset is depreciated we need to con-sider the shorter of the lease term and the economic life of the asset.
Minimum lease payments
The determination of the minimum lease payments and the present value of those payments are important in that:
■ the present value of the minimum lease payments is used in determining whether a lease is a finance or an operating lease (refer to paragraph 10(d) of IAS 17, reproduced earlier), and
■ if the lease is considered to be a finance lease, the amount to be initially recognised in the statement of financial position for the asset and liability is, pursuant to paragraph 20, the fair value of the leased prop-erty or, if lower, the present value of the minimum lease payments as determined at the inception of the lease.
Therefore the determination of minimum lease payments is a very important part of applying IAS 17. Minimum lease payments themselves are defined at paragraph 4 of IAS 17 as:
the payments over the lease term that the lessee is or can be required to make, excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor, together with:
(a) for a lessee, any amounts guaranteed by the lessee or by a party related to the lessee; or (b) for a lessor, any residual value guaranteed to the lessor by:
(i) the lessee;
(ii) a party related to the lessee; or
(iii) a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee.
For the lessee, as we have seen above, minimum lease payments include guaranteed residual values. Lease con-tracts will sometimes include residual value guarantees. Under these guarantees, the lessee will compensate the lessor if the value of the leased item at the end of the lease falls below a specified value. A residual value guaran-tee may require the lessee to purchase the property for a certain or determinable amount or make up a deficiency
bargain purchase option Provision that allows a lessee to purchase leased property for a price expected to be far lower than the expected fair value of the property at the date the option becomes exercisable. Key terms used in accounting for leases 245
below a stated amount upon termination of the lease. Residual value guarantees are used to protect the lessor’s expected return.
For the lessee, IAS 17 defines the guaranteed residual value as:
that part of the residual value that is guaranteed by the lessee or by a party related to the lessee (the amount of the guarantee being the maximum amount that could, in any event, become payable).
That is, payment of the guaranteed residual is contractually required. From the perspective of the lessor, IAS 17 defines the guaranteed residual as:
that part of the residual value that is guaranteed by the lessee or by a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee.
If something is ‘guaranteed’ obviously there is the expectation that it will be paid. A residual might or might not be guaranteed. The payment of this guaranteed residual will often lead to the asset being legally transferred to the lessee. If there is a guaranteed residual (the maximum amount that could become payable), then, as noted above, this amount is included in the minimum lease payments, as its payment is reasonably assured. Unguaranteed residuals are not included in the minimum lease payments, as there is not sufficient certainty that the amount will be paid. In IAS 17 they are defined as ‘that portion of the residual value of the leased asset, the realisation of which by the lessor is not assured or guaranteed solely by a party related to the lessor’.
Lease contracts often include a bargain purchase option (defined earlier). A bargain purchase option would be included as part of the minimum lease payments because the exercise of a ‘bargain’ option is reasonably assured and it is therefore probable that the amount will ultimately be paid by the lessee (stipulated in paragraph 4 of IAS 17).
The definition of minimum lease payments adopted within IAS 17 excludes costs for services and taxes (often referred to as executory costs) that are paid to the lessor in reimbursement. The exclusion of such costs is consistent with the general capitalisation principles used for assets. Periodic repairs, insurance and rates would not typically be recognised as part of the cost of an asset, as they merely maintain the asset in the state it was in at the beginning of the period, rather than increasing its service potential.
10.3 Interest rate for determining the present value of the minimum
lease paymentsWhen determining the present values to measure leased assets and lease liabilities (IAS 17, paragraph 20) we need to use a discount rate. IAS 17 stipulates that the discount rate to be used in calculating the present value of the minimum lease payments is the interest rate implicit in the lease, if this is practicable to determine; if not, the lessee’s incremental borrowing rate is to be used (IAS 17, paragraph 20).
According to IAS 17, the interest rate implicit in the lease is:
the discount rate that, at the commencement of the lease term, causes the aggregate present value of: (a) the minimum lease payments; and
(b) the unguaranteed residual value to be equal to the sum of: (i) the fair value of the leased asset; and
(ii) any initial direct costs of the lessor.
While not certain, the unguaranteed residual (discussed earlier) represents the expected recoverable amount of the asset at the end of the lease term. An example of how a discount rate is computed is given in Worked Example 10.1, while classifying a lease as a finance lease or an operating lease is explained in Worked Example 10.2.
Given that we have satisfied this test (paragraph 10(c)), we really do not need to consider the test of whether the present value of the minimum lease payments amounts to at least substantially all of the fair value of the asset. This is because we have already largely satisfied ourselves that the risks and rewards of ownership have been transferred to the lessee. However, for the sake of completeness we will consider this test.
It is not clear from the standard what ‘substantially all of the fair value of the leased asset’ means. It would seem to be a higher amount than ‘major part’. Again, accountants are required to exercise professional judgement. ‘Substantially all’ would appear to mean an amount very close to 100 per cent of fair value. This is supported by paragraph 21 of IAS 17, which refers to the present value approximating the fair value of the leased asset at the inception of the lease. But the standard does not provide any precise guidelines or percentages. However, it is generally considered that, if the present value of the minimum lease payments amounts to at least 90 per cent
Worked Example 10.1
Example of computing discount rateMcTavish plc decides to lease some machinery from Nielsen plc on the following terms: Date of entering lease 1 July 2015
Duration of lease 10 years
Life of leased asset 11 years Unguaranteed residual value £2,000
Lease payments £4,000 at lease inception, £3,500 on 30 June each year (that is, 10 yearly payments of £3,500 each)
Fair value of leased asset at date of lease inception £26,277
Determine the interest rate implicit in the lease.
The implicit rate is the rate that, when used to discount the minimum lease payments plus any unguaranteed residual, equates the sum of the discounted minimum lease payments and the discounted unguaranteed residual to the fair value of the asset at the commencement of the lease. The present value of an annuity of £1 in arrears (‘in arrears’ means the amount is received, or paid, at the end of each year) for ten years discounted at 10 per cent is £6.1446 (see the present value tables in the appendices). The present value of £1 in ten years, discounted at 10 per cent, is £0.3855. Hence, the present value of the ten payments of £3,500 discounted at 10 per cent is £3,500 multiplied by 6.1446, which equals £21,506, and the present value of the unguaranteed residual discounted at 10 per cent is £771, which is £2,000 multiplied by 0.3855. The present value of the up-front payment of £4,000 is not discounted. Therefore, using a rate of 10 per cent for discounting purposes, the present value of the minimum lease payments and the unguaranteed residual is:
Present value of payment on 1 July 2015 £4,000 Present value of 10 yearly payments £21,506 Present value of unguaranteed residual £771 £26,277
The discounted value of £26,277 is the same as the fair value of the asset at lease inception. Thus, 10 per cent is the implicit rate in this example. Note that some degree of trial and error might be involved in determining the discount rate.
The rate of interest is then used to determine the interest expense incurred each period. The present value of the liability at the beginning of the period is multiplied by the rate of interest to determine the interest expense for the period. The balance of the lease payment is then treated as a reduction of the lease liability.
Worked Example 10.2
Classification of a lease as a finance
lease or an operating lease
Lonsdale plc has entered into a lease arrangement with Queenscliffe plc in which it has agreed to lease an item of machinery from Queenscliffe plc on the following terms:
Date of commencement of lease 1 July 2015
Duration of lease 8 years
Fair value of machine at lease inception €871,172 Initial up-front payment €200,000 Lease payments at the end of each year €100,000 Implicit rate of interest 6 per cent
The lease is considered to be non-cancellable. The economic life of the machinery is considered to be ten years. However, Lonsdale plc will return the machinery to Queenscliffe plc at the end of the lease term. At this stage it is expected that the machinery will have a residual (unguaranteed) value of €80,000 at the end of the lease term.
(a) Determine what the minimum lease payments are.
(b) Prove that the rate of interest implicit in the lease is 6 per cent.
(c) Determine whether the lease should be classified an operating lease or a finance lease.
(a) Minimum lease payments are the payments over the lease term that the lessee is or can be required to make. They exclude contingent rent, costs for services and taxes to be paid by and reimbursed to the les-sor. They include any amounts guaranteed by the lessee or by a party related to the lessee. Minimum lease payments would include any bargain purchase option that is included. In this case the minimum lease pay-ments would also include the up-front payment of €200,000 plus the subsequent lease paypay-ments of €100,000 per annum.
(b) The implicit rate is the rate that, when applied to the minimum lease payments plus any unguaranteed residual, causes the sum of these present values to equal the fair value of the asset at lease inception. It is emphasised that unguaranteed residuals are not part of the minimum lease payments because the lessor is not required to make such payments. Nevertheless, knowledge of the unguaranteed residual is necessary to determine the interest rate implicit in the lease. Using 6 per cent, the present value of the minimum lease payments, plus the unguaranteed residual, is:
€200,000 × 1.00 = €200,000 €100,000 × 6.2098 = €620,980 €80,000 × 0.6274 = €50,192 €871,172
Given that the above amount of €871,172 is equivalent to the fair value of the asset at lease inception, 6 per cent is the rate of interest implicit in the lease.
(c) For a lease to be considered a finance lease, it must first be considered to be non-cancellable. The lease agree-ment between Lonsdale plc and Queenscliffe plc satisfies this requireagree-ment. If the lease was cancellable at mini-mum cost to the lessee, it would not have effectively transferred the risks inherent in asset ownership to the lessee. For the lease to be considered a finance lease, it must also satisfy the test of whether the risks and rewards of ownership have effectively been transferred to the lessee. Some of the indicators of this are provided in paragraphs 10 to 12 of IAS 17. Had the lease transferred ownership or included a bargain purchase option, it would be a fairly straightforward matter to conclude the lease to be a finance lease (see parts (a) and (b) of paragraph 10 of IAS 17). As this is not the case, we have to consider some of the other indicators provided by paragraph 10 of IAS 17. In this case, two important tests are the following (either of which should be met before we can conclude it is a finance lease):
(i) The lease term is for the major part of the economic life of the asset, even if title is not transferred.
(ii) At the inception of the lease the present value of the minimum lease payments amounts to at least substan-tially all of the fair value of the leased asset.
The two key terms above are ‘major part’ and ‘substantially all’. It is not clear from the standard what the ‘major part’ of the economic life of the asset actually means. ‘Major part’ clearly means considerably more than 50 per cent of the economic life of the asset, but also clearly means considerably less than ‘substantially all’. The exact percentage is a matter for interpretation and professional judgement. The standard does not provide a precise guideline but it is generally held that a lease term of 75 per cent or more of the economic life of the asset would be sufficient. In this case, the lease term is for 80 per cent of the economic life of the asset. On this basis, we would argue that the lease is a finance lease.
of the fair value of the leased asset (which in itself means that any unguaranteed residual value is relatively small), the lease is a finance lease. Nevertheless, it needs to be appreciated that given the ambiguity of the requirements stipulated in the accounting standard, it could be argued that 85 per cent is close enough, or that 90 per cent is not enough, and it should be at least 95 per cent. It is not clear where to draw the line, but it is clear that it must be a very high percentage.
In this case, the present value of the minimum lease payments is €200,000 plus €620,980, which equals €820,980. This amount is 94 per cent of €871,172, so this test, included in paragraph 10(d), is satisfied. Because
the present value of the leased asset at the conclusion of the lease is assumed to be only
€50,192, the majority of the asset’s service potential has been consumed by the lessee.
Given that the lease is non-cancellable and that at least one of the above tests has been satisfied, the lease is classified as a finance lease.
In some circumstances the lessee might be unable to determine the fair value of the asset at the inception of the lease (perhaps because the asset has unique attributes), or the lessee might not be able to reliably estimate the residual value. In such circumstances it would not be possible to determine the implicit interest rate. In these circumstances the lessee is to discount the minimum lease payments by using the lessee’s incremental borrowing rate. The incremental borrowing rate can be defined as the rate of interest the lessee would have to pay on a similar lease or, if that is not determinable, the rate that, at the inception of the lease, the lessee would incur to borrow over a similar term, and with a similar security, the funds necessary to purchase the asset.
10.4 Lessee accounting for finance leases
In substance, where a lessee enters a finance lease arrangement, it is essentially the same as acquiring an asset by way of a long-term loan. The lessee will record an asset (a leased
asset) and a lease liability. As we have stated, the asset and liability will be recorded at the fair value of the leased asset or, where lower, at the present value of the minimum lease payments. The present value of the minimum lease payments will be lower where there are such things as unguaranteed residuals in place (unguaranteed residuals do not form part of the minimum lease payments).
Hence, the accounting standard pertaining to leases specifically requires that consideration be given to the present value of the future cash flows. As we know, for many liabilities that are due beyond 12 months there is a requirement that present values be used. Again, please note that the unguaranteed residual is excluded from the amount recognised for the lease asset and lease liability in the financial statements of the lessee. It was included in the above worked examples to enable the determination of the rate implicit in the lease. Therefore, where there is an unguaranteed residual value, the amount recorded in the lessee’s statement of financial posi-tion as a leased asset at the incepposi-tion of the lease will be less than the asset’s fair value—the difference being the present value of the unguaranteed residual.
Over the term of the lease, the rental payments to the lessor constitute a payment of principal plus interest, and the lessee should apportion each payment between the two. The interest expense is computed by applying the interest rate implicit in the lease to the outstanding lease liability at the beginning of each lease payment period. The balance of the payment is considered a reduction of the principal of the lease liability.
So, for Worked Example 10.1 relating to McTavish plc, the initial lease liability would be £25,506. (We have excluded the unguaranteed residual.) As the first payment of £4,000 was made on the first day of the lease, there would be no interest element and the lease liability would be reduced by £4,000. To determine the interest expense component included within the first year-end payment of £3,500, the opening liability of £21,506— that is, £25,506 less the up-front payment of £4,000—must be multiplied by the implicit rate of 10 per cent. The interest expense for the first year would therefore be £2,151, and £1,349 would be offset against the liability. The entries for the year ending 30 June 2016 would be:
1 July 2015
Dr Leased machinery £25,506
Cr Lease liability £25,506
(to record the leased asset and lease liability at the present value of the minimum lease payments)
Dr Lease liability £4,000
Cr Cash £4,000
(to record the initial up-front lease payment) 30 June 2016
Dr Interest expense £2,151
Dr Lease liability £1,349
Cr Cash £3,500
(to recognise the first annual lease payment)
implicit interest rate The discount rate that causes the aggregate present value of the minimum lease payments plus any unguaranteed residual to be equal to the fair value of the leased property at the inception of the lease.
incremental borrowing rate Rate of interest the lessee would have to pay on a similar lease or the rate that the lessee would incur to borrow the funds to purchase the asset.
Lease Payment Schedule for McTavish plc (Worked Example 10.1)Lease expense (£) Interest expense (£) Principal reduction (£) Present value of lease liability (£) 01 July 2015 21,506 30 June 2016 3,500 2,151 1,349 20,157 30 June 2017 3,500 2,016 1,484 18,673 30 June 2018 3,500 1,867 1,633 17,040 30 June 2019 3,500 1,704 1,796 15,244 30 June 2020 3,500 1,524 1,976 13,268 30 June 2021 3,500 1,327 2,173 11,095 30 June 2022 3,500 1,109 2,391 8,704 30 June 2023 3,500 870 2,630 6,074 30 June 2024 3,500 607 2,893 3,182 30 June 2025 3,500 318 3,182 0
10.4.1 Depreciation of leased assets
A leased asset should be depreciated using the depreciation (amortisation) policies normally followed by the lessee in relation to the assets that are owned (IAS 17, paragraph 27). The period of amortisation/depreciation should be the number of accounting periods that are expected to benefit from the asset’s use. Where there is reasonable assurance at the inception of the lease that the lessee will obtain ownership of the asset at the end of the lease term (the lease might provide for transfer of the asset to the lessee or it might contain a bargain pur-chase option), the asset should be depreciated over its useful life; otherwise, the asset should be depreciated over
the lease term (IAS 17, paragraph 27). If the asset has a residual value, this is subtracted from the capitalised value of the leased asset to determine the depreciable base.
Referring again to Worked Example 10.1 and assuming straight-line depreciation is used, the depreciation on 30 June each year would be £2,551 (£25,506/10). As the lease agreement does not transfer ownership at the end of the lease, the depreciation period would be the term of the lease agreement. The accounting entries on 30 June each year would be:
Dr Lease depreciation expense £2,551
Cr Accumulated depreciation—leased machinery £2,551
Although the amount capitalised as an asset and the amount recorded as an obligation at the inception of the lease are computed at the same present value, the depreciation of the asset and the discharge of the obligation are independent accounting processes during the term of the lease. Hence the carrying amount of the asset and the carrying amount of the liability will not be equal after the initial entry.
residual value The actual or estimated net realisable value of a depreciable asset at the end of its useful life.
The interest expense for the year ended 30 June 2017 would be determined by multiplying the liability at the beginning of the year (£25,506 – £4,000 – £1,349) by the implicit rate of 10 per cent. This provides an interest expense of £2,016. The lease payment schedule for the life of the lease is provided in Exhibit 10.1. As we can see, the interest expense declines across the period of the lease as the outstanding principal decreases in amount.
10.4.2 Lessee’s journal entries for a finance lease
Following on from the above discussion and worked examples, we can now usefully provide general pro forma entries for finance leases in the books of the lessee. These are:
Dr Leased asset £XXX
Cr Lease liability £XXX
(to record the leased asset and the lease liability at the inception of the lease term)
Dr Lease depreciation expense £XXX
Cr Accumulated depreciation—leased asset £XXX
(to record the lease depreciation expense at the end of each reporting period)
Dr Lease liability £XXX
Dr Interest expense £XXX
Cr Cash £XXX
(to record the lease payment, with the payment being allocated between principal and interest)
Dr Executory expenses £XXX
Cr Cash £XXX
(to record the payment of executory costs by the lessee such as rates and maintenance; this journal entry is required only if the lessee is responsible for the payment of these costs; executory costs are not considered to constitute part of the minimum lease payments)
The last three sets of journal entries provided above are repeated throughout the term of the lease, although the amounts recorded for interest expense and lease liability will change. The depreciation expense will also change from period to period if a depreciation method other than the straight-line method is used.
10.4.3 Initial direct costs
Initial direct costs are defined in IAS 17 as incremental costs that are directly attributable to negotiating and arranging a lease. They would include commissions, legal fees and costs of preparing and processing documenta-tion for new leases. Paragraph 24 of IAS 17 requires that a lessee capitalise their initial direct costs that relate to a finance lease as part of the cost of the leased asset. Therefore, where such costs are incurred, the lease asset com-prises the present value of the minimum lease payments and the amount of initial direct costs incurred. The total amount would be subject to regular depreciation.
10.5 Lessee accounting for operating leases
As already indicated, an operating lease is a lease that does not transfer substantially all the risks and rewards incidental to ownership of the asset to the lessee. IAS 17 requires that, when a lease is classified as an operating lease by the lessee, the lease payments should be expensed on a basis that is representative of the pattern of benefits derived from the leased asset. If the lease payments do not represent prepayments, they should be expensed in the period in which they are made. Specifically, paragraph 33 of IAS 17 requires:
Lease payments under an operating lease shall be recognised as an expense on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern of the user’s benefit.
If lease payments are made in arrears, recognition of year-end rental liabilities might be required. Worked Example 10.3 provides an example of accounting for an operating lease.
10.6 Lessee accounting for sale and leaseback transactionsA sale and leaseback transaction occurs when the owner of a property (seller/lessee) sells the property to another party, and simultaneously leases it back from the purchaser/lessor (the legal owner). The seller/lessee does not lose control of the asset if the subsequent
sale and leaseback transaction A transaction in which an entity sells an asset and immediately leases it back. Lessee accounting for sale and leaseback transactions 251
lease is a finance lease. Generally, in such a transaction the property is sold at a price equal to or greater than current market value, and is leased back for a term approximating the property’s useful life, and for lease payments sufficient to repay the buyer for the cash invested plus a reasonable return on investment. In addition, the lessee typically pays all executory costs just as if title had remained with the lessee. A sale and leaseback is often consid-ered to represent a useful way of obtaining funds while still allowing the recipient of the funds to maintain control of a particular asset. Sale and leaseback transactions are quite common. Financial Accounting in the News 10.1 provides some information about the use of sale and leasebacks as a means of corporations raising necessary funds.
Where substantially all of the risks and rewards incidental to ownership of the leased property remain with the lessee, the leaseback is classified as a finance lease, as the transaction represents the refinancing of an asset. The same criteria as discussed earlier are applied to determine whether a sale and leaseback transaction should be classified as a finance lease. Where the lessee classifies the leaseback as a finance lease, any profit on the sale should be deferred in the statement of financial position and amortised to the statement of comprehensive income over the term of the lease (IAS 17, paragraph 59).
Worked Example 10.3
Example of accounting for an operating lease
On 1 July 2015 Margaret plc enters a lease agreement with River plc for the lease of a building. The length of the lease is for five years and the terms require annual payments of €60,000. The lease is non-cancellable and the estimated economic life of the building is 20 years. The market value of the building is €2 million. Lease payments are made at the end of each financial year.
Provide the journal entries that would be made in the books of Margaret plc to account for the lease.
First, we must determine whether the lease is a finance lease or an operating lease. Even though the lease is non-cancellable, the lease period is too short for the risks and rewards of ownership of the asset to be considered to have transferred to the lessee. Hence the lease is to be treated as an operating lease. As a result, each payment can be treated as a rental payment, there will be no interest expense and the lessee will not have any depreciation expenses. The aggregated accounting entry each period in the books of Margaret plc would be:
Dr Rental expense—building €60,000
Cr Cash €60,000
If Margaret plc had not paid the lease payment by the end of the reporting period, an amount would need to be accrued as a lease expense payable (a liability), rather than there being a credit to cash.
If we consider the above operating lease, then we will see that, although the organisation has committed to making lease payments for the next five years, and therefore has a probable obligation as well as a right to use an asset for five years, neither the obligation nor the related asset will appear in the financial statements. However, if we consider the definition of a liability as provided within the IASB Conceptual Framework, we see that a liability is defined as:
A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
The obligation relating to the five-year lease arrangement discussed above would certainly seem to fit the definition above, and the obligation would be both probable and measurable with reasonable accuracy (these being the rec-ognition criteria of the elements of financial reporting). Therefore, while IAS 17 would treat the above lease as an operating lease thereby precluding the associated liability and asset from appearing on the statement of financial position, this exclusion does not appear conceptually sound. This is one of the issues that the IASB and FASB have addressed in their project relating to lease accounting, and as we will see at the end of this chapter, when the new accounting standard is finally issued, it will require leases such as that described above to be included in the state-ment of financial position. Classifying leases as operating leases will be abandoned under new rules likely to be mandated from 2015.
In a sense it is assumed that, as a result of the sale and leaseback (where the lease is a financial lease), the asset has not really been ‘sold’ to the lessor and therefore it would be inappropriate to recognise fully any profit related to the ‘sale’. As paragraph 60 of IAS 17 puts it:
If the leaseback is a finance lease, the transaction is a means whereby the lessor provides finance to the lessee, with the asset as security. For this reason it is not appropriate to regard an excess of sales proceeds over the carrying amount as income. Such excess is deferred and amortised over the lease term.
Where substantially all of the risks and rewards incidental to ownership effectively pass to the lessor as a result of a sale and leaseback transaction, the lease will be classified as an operating lease. If the selling price for the property is established at fair value at the date of sale, there has, in effect, been a normal sale transaction and any profit or loss is to be recognised immediately (as required by paragraph 61 of IAS 17). Where, however, the selling price is more or less than fair value, financial independence between the sale and leaseback cannot be presumed. That is, the sale is not a ‘normal’ arm’s length sales transaction, but rather forms part of a leasing arrangement. IAS 17 provides for different scenarios and treatments when a sale and leaseback involves an oper-ating lease and the sales price of the asset does not equal its fair value. Specifically, paragraph 61 of IAS 17 states:
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. 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.
Paragraph 63 further states:
For operating leases, if the fair value at the time of a sale and leaseback 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 shall be recognised immediately.
An example of a sale and leaseback transaction is provided in Worked Example 10.4.
THE pending recession in Europe and Britain has forced many companies to review how to raise cash from alternative sources rather than trying a bank or the sharemarket. This has led to a huge increase in corporate sale and leaseback transactions.
A report from CB Richard Ellis says that between 2004 and 2007 the total value of this type of transaction rose from 6.7 billion euros to 46 billion euros.
This represented an increase from 6 per cent to 21 per cent of the European investment market for this type of transaction.
The report says that against the backdrop of economic uncertainty and a substantial increase in the cost of corpo-rate debt, these transactions are gaining momentum across Europe and accounted for 21 per cent of all
invest-ment activity in the first half of 2008—their highest per-centage contribution ever.
The head of corporate strategies with CBRE’s global cor-porate services, John Wilson, said a company’s decision to proceed with a sale and leaseback was motivated by a range of factors. These include the increased pressure to raise capital, the high cost of debt, the need for more flex-ible lease structures and the growing acceptability of a company selling its real estate.
‘The wave of sale a nd leasebacks in the banking sector in recent years eradicated the “last resort” stigma previously attached to this type of transaction, transforming it into another viable choice for corporates looking to raise capi-tal,’ Mr Wilson said.
Source: Sydney Morning Herald 2008
LEASEBACK: QUICK WAY TO RAISE CASH
Sydney Morning Herald
25 October 2008
Financial Accounting in the News 10.1Lessee accounting for sale and leaseback transactions 253
Worked Example 10.4
Example of a sale and leaseback transaction
As at 1 July 2015, Winki Company owns a building that cost €5 million and has accumulated depreciation of €3.5 million. The building is sold on 1 July 2015 to Pop plc for €2,007,250, and then immediately leased back by Winki Company for ten years (the remaining life). Lease payments are €400,000 per year, paid at the end of the year. The lease is non-cancellable. The implicit rate is 15 per cent.
(a) Verify that the interest rate implicit in the lease is 15 per cent.
(b) Provide the accounting entries in the books of Winki Company for the year ending 30 June 2016.
(c) Provide the accounting entries in the books of Pop plc for the year ending 30 June 2016.
(a) As paragraph 4 of IAS 17 states, the interest rate implicit in the lease is the discount rate that, at the commence-ment of the lease term, causes the aggregate present value of the minimum lease paycommence-ments and the unguaran-teed residual value to be equal to the sum of:
(i) the fair value of the leased asset, and
(ii) any initial direct costs of the lessor.
To verify that the interest rate implicit in the lease is 15 per cent: €400,000 × 5.0188 = €2,007,250
As the discounted present value of the future lease payments at 15 per cent equals the fair value of the asset at lease inception, 15 per cent is the rate implicit in the lease.
(b) Journal entries in the books of Winki Company
1 July 2015
Dr Cash €2,007,520
Dr Accumulated depreciation €3,500,000
Cr Building €5,000,000
Cr Deferred gain €507,520
(to record the sale of the building to Pop plc; as the lease is a finance lease, any profit on ‘sale’ is to be deferred and amortised throughout the lease term in accordance with paragraph 59 of IAS 17; profit recognition is typi-cally undertaken using the asset’s depreciation policy)
Dr Leased building €2,007,520
Cr Lease liability €2,007,520
(to recognise the finance lease) 30 June 2016
Dr Interest expense €301,128
Dr Lease liability €98,872
Cr Cash €400,000
(to recognise the periodic lease payment; interest = €2,007,520 × 15%)
Dr Depreciation of leased asset €200,752
Cr Accumulated lease depreciation €200,752
(to record depreciation of the leased asset assuming the straight-line method is used)
Dr Deferred gain €50,752
Cr Profit on sale of leased asset €50,752
(to recognise the deferred gain on a straight-line basis) (c) Journal entries in the books of Pop plc
1 July 2015
Dr Building €2,007,520
Cr Cash €2,007,520
(to record acquisition of the building from Winki Company)
Dr Lease receivable €2,007,520
Cr Building €2,007,520
10.7 Lessee disclosure requirements
IAS 17 requires that numerous disclosures be made. For a finance lease, the lessee must disclose the following information within the notes to the financial statements (IAS 17, paragraph 31):
Lessees shall, in addition to meeting the requirements of IFRS 7 Financial Instruments: Disclosures, make the following disclosures for finance leases:
(a) for each class of asset, the net carrying amount at the reporting date;
(b) a reconciliation between the total of future minimum lease payments at the reporting date, and their present value. In addition, an entity shall disclose the total of future minimum lease payments at the reporting date, and their present value, for each of the following periods:
(i) not later than one year;
(ii) later than one year and not later than five years; (iii) later than five years;
(c) contingent rents recognised as an expense in the period;
(d) the total of future minimum sublease payments expected to be received under non-cancellable subleases at the reporting date; and
(e) a general description of the lessee’s material leasing arrangements including, but not limited to, the following: (i) the basis on which contingent rent payable is determined;
(ii) the existence and terms of renewal or purchase options and escalation clauses; and
(iii) restrictions imposed by lease arrangements, such as those concerning dividends, additional debt, and further leasing.
Although operating leases are not capitalised for the purposes of inclusion in the statement of financial position, IAS 17 nevertheless requires numerous disclosures with regard to operating leases. Pursuant to paragraph 35 of IAS 17, the following disclosures should be made:
Lessees shall, in addition to meeting the requirements of IAS 17, make the following disclosures for operating leases: (a) the total of future minimum lease payments under non-cancellable operating leases for each of the following
(i) not later than one year;
(ii) later than one year and not later than five years; (iii) later than five years;
(b) the total of future minimum sublease payments expected to be received under non-cancellable subleases at the reporting date;
(c) lease and sublease payments recognised as an expense in the period, with separate amounts for minimum lease payments, contingent rents, and sublease payments;
(d) a general description of the lessee’s significant leasing arrangements including, but not limited to, the following: (i) the basis on which contingent rent payable is determined;
(ii) the existence and terms of renewal or purchase options and escalation clauses; and
(iii) restrictions imposed by lease arrangements, such as those concerning dividends, additional debt, and further leasing.
As an illustration of a lease disclosure note, consider Exhibit 10.2, which reproduces the accounting policy lease note relating to lease commitments that appeared in the 2011 annual report of Ryanair plc. The note provides details not only of the finance lease commitments but also about the organisation’s commitments in relation to operating leases (which, as we know, do not appear on the statement of financial position).
30 June 2016
Dr Cash €400,000
Cr Interest revenue €301,128
Cr Lease receivable €98,872
(to record receipt of periodic lease payment)
Lease commitment note appearing in the 2011
annual report of Ryanair plc
NOTE 1 BASIS OF PREPARATION AND SIGNIFICANT ACCOUNTING
Leases under which the Company assumes substantially all of the risks and rewards of ownership are classi-fied as finance leases. Assets held under finance leases are capitalised in the balance sheet, at an amount equal to the lower of their fair value and the present value of the minimum lease payments, and are depreci-ated over their estimdepreci-ated useful lives. The present values of the future lease payments are recorded as obliga-tions under finance leases and the interest element of a lease obligation is charged to the income statement over the period of the lease in proportion to the balances outstanding.
Other leases are operating leases and the associated leased assets are not recognised on the Company’s balance sheet. Expenditure arising under operating leases is charged to the income statement as incurred. The Company also enters into sale-and-leaseback transactions whereby it sells the rights to acquire an air-craft to an external party and subsequently leases the airair-craft back, by way of an operating lease. Any profit or loss on the disposal where the price achieved is not considered to be at fair value is spread over the period during which the asset is expected to be used. The profit or loss amount deferred is included within ‘other creditors’ and divided into components of greater than and less than one year.
NOTE 23 COMMITMENTS AND CONTINGENCIES (extract)
(a) Finance leases
The Company financed 30 of the Boeing 737-800 aircraft delivered between March 2005 and March 2011 with 13-year euro-denominated Japanese Operating Leases with Call Options (‘JOLCOs’). These structures are accounted for as finance leases and are initially recorded at fair value in the Company’s balance sheet. Under each of these contracts, Ryanair has a call option to purchase the aircraft at a pre-determined price after a period of 10.5 years, which it may exercise. The following table sets out the total future minimum payments of leasing 30 aircraft (2010: 20 aircraft; 2009: 20 aircraft) under JOLCOs at March 31, 2011, 2010 and 2009, respectively:
At March 31, 2011 2010 2009 Minimum payments Present value of minimum payments Minimum payments Present value of minimum payments Minimum payments Present value of minimum payments €M €M €M €M €M €M
Due within one year 61.9 48.7 38.9 32.5 45.1 31.1
Due between one
and five years 305.2 262.8 203.7 183.7 184.5 139.3
Due after five years 556.3 535.7 353.7 345.3 443.0 417.4
Total minimum lease payments 923.4 847.2 596.3 561.5 672.6 587.8 Less amounts allocated to future financing costs (76.2) – (34.8) – (84.8) – Present value of minimum lease payments 847.2 847.2 561.5 561.5 587.8 587.8
Commitments resulting from the use of derivative financial instruments by the Company are described in Notes 5 and 11 to the consolidated financial statements.
The Company financed 61 of the Boeing 737–800 aircraft delivered between December 2003 and March 2011 under seven-year, sale-and-leaseback arrangements with a number of international leasing compa-nies, pursuant to which each lessor purchased an aircraft and leased it to Ryanair under an operating lease. Between October 2010 and March 2011,10 operating lease aircraft were returned to the lessor at the agreed maturity date of the lease. At March 31, 2011 Ryanair had 51 operating lease aircraft in the fleet. As a result, Ryanair operates, but does not own, these aircraft. Ryanair has no right or obligation to acquire these air-craft at the end of the relevant lease terms. 5 of these leases are denominated in euro and require Ryanair to make variable rental payments that are linked to EURIBOR. Through the use of interest rate swaps, Ryanair has effectively converted the floating-rate rental payments due under 2 of these leases into fixed-rate rental payments. Another 30 leases are also denominated in euro and require Ryanair to make fixed rental payments over the term of the leases. 16 remaining operating leases are U.S. dollar-denominated, of which two require Ryanair to make variable rental payments that are linked to U.S. dollar LIBOR, while the remaining 14 require Ryanair to make fixed rental payments. The Company has an option to extend the initial period of seven years on 28 of the 51 remaining operating lease aircraft as at March 31, 2011, on pre-determined terms. 3 operating lease arrangements will mature during the year ended March 31, 2012. The Company has decided not to extend any of these operating leases for a secondary lease period. The following table sets out the total future minimum payments of leasing 51 aircraft (2010: 55 aircraft; 2009: 43 aircraft), ignoring interest, foreign currency and hedging arrangements, at March 31, 2011, 2010 and 2009, respectively: At March 31, 2011 2010 2009 Minimum payments Present value of minimum payments Minimum payments Present value of minimum payments Minimum payments Present value of minimum payments €M €M €M €M €M €M
Due within one
year 100.2 91.7 77.8 71.5 85.8 78.8
Due between one
and five years 325.5 248.5 208.8 160.3 177.8 134.9
Due after five
years 164.8 91.8 112.2 64.3 29.1 17.2
Total 590.5 432.0 398.8 296.1 292.7 230.9
Exhibit 10.3 provides details of the information that must be disclosed in respect of the tangible assets that are leased. The net carrying amounts of the aircraft controlled by Ryanair plc that have been obtained using finance leases as at the end of the reporting period are provided for each year (note the cost and associated cumulative depreciation are not required). This exhibit is useful because it shows the extent to which leased assets are used by large organisations such as Ryanair. As we can see, organisations can lease hundreds of mil-lions of euros worth of assets, and therefore how we account for such assets, and related liabilities, has a major effect on corporate financial statements.
Property, plant and equipment note appearing in the 2011 annual
report of Ryanair plc, with specific disclosure of leased assets
NOTE 2 TANGIBLE ASSETS (extract)
The net book value of assets held under finance leases at March 31, 2011, 2010 and 2009 was €635.1 million, €422.8 million and €435.5 million, respectively.
Worked Example 10.5
Comprehensive example of accounting
for leases by a lessee
Trigger plc enters into a non-cancellable five-year lease agreement with Brothers plc on 1 July 2015. The lease is for an item of machinery that, at the inception of the lease, has a fair value of €369,824.
The machinery is expected to have an economic life of six years, after which time it will have an expected salvage value of €60,000. There is a bargain purchase option that Trigger plc will be able to exercise at the end of the fifth year for €80,000.
There are to be five annual payments of €100,000, the first being made on 30 June 2016. Included within the €100,000 lease payments is an amount of €10,000 representing payment to the lessor for the insurance and main-tenance of the equipment. The equipment is to be depreciated on a straight-line basis.
A review of the appendices to this book shows that the present value of an annuity in arrears of €1 for five years at 12 per cent is €3.6048, while the present value of an annuity of €1 for five years at 14 per cent is €3.4331. Further, the present value of €1 in five years discounted at 12 per cent is €0.5674, while the present value of €1 in five years discounted at 14 per cent is €0.5194.
(a) Determine the rate of interest implicit in the lease and calculate the present value of the minimum lease payments.
(b) Prepare the journal entries for the years ending 30 June 2016 and 30 June 2017.
(c) Prepare the portion of the statement of financial position relating to the leased asset and lease liability for the years ending 30 June 2016 and 30 June 2017.
(d) Prepare the journal entries for the years ending 30 June 2016 and 30 June 2017, assuming (for purposes of illustration) that the lessee classifies the lease an operating lease.
(a) First, as the lease is non-cancellable and the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset (calculations provided below), the lease is a finance lease.
The interest rate implicit in the lease agreement is the interest rate that results in the present value of the mini-mum lease payments, and any unguaranteed residual value, being equal to the fair value of the leased property at the inception of the lease. The minimum lease payments include any bargain purchase option. If we use a rate of interest of 12 per cent, the discounted value of the payments is €369,824, determined as:
Present value of five lease payments of €90,000 discounted at 12 per cent (we eliminate
the executory costs) = €90,000 × 3.6048 = €324,432 Present value of the bargain
purchase option = €80,000 × 0.5674 = €45,392 €369,824
As the amount of the minimum lease payments discounted at 12 per cent equates to the fair value of the asset at lease inception, the interest rate implicit in the lease is 12 per cent.
(b) When preparing the journal entries it is often convenient to produce a table such as that provided below. Interest expense in the table is determined by multiplying the opening liability for a period by the rate of interest implicit
in the lease.
Date Lease payment (exclusive of executory costs)
Interest expense Principal reduction Outstanding balance
€ € € € 1 July 2015 369,824 30 June 2016 90,000 44,379 45,621 324,203 30 June 2017 90,000 38,904 51,096 273,107 30 June 2018 90,000 32,773 57,227 215,880 30 June 2019 90,000 25,906 64,094 151,786 30 June 2020 170,000* 18,214 151,786 0
*Includes bargain purchase option
1 July 2015
Dr Leased machinery €369,824
Cr Lease liability €369,824
(to record the leased asset and liability at the inception of the finance lease) 30 June 2016
Dr Executory expenses €10,000
Dr Interest expense €44,379
Dr Lease liability €45,621
Cr Cash €100,000
(to record the lease payment of €100,000)
Dr Lease depreciation expense €51,637
Cr Accumulated lease depreciation €51,637
(to record depreciation expense [(€369,824 – €60,000) ÷ 6])
As the lessee will most probably retain the asset after the lease period as a result of the bargain purchase option, the economic life of the asset, and not the lease term, is used for depreciation purposes.
30 June 2017
Dr Executory expenses €10,000
Dr Interest expense €38,904
Dr Lease liability €51,096
Cr Cash €100,000
(to record the lease payment of €100,000)
Dr Lease depreciation expense €51,637
Cr Accumulated lease depreciation €51,637
(€369,824 less €60,000 divided by six years)
(c) Portion of the statement of financial position for years ending 30 June 2016 and 30 June 2017
Leased asset 369,824 369,824
less Accumulated depreciation 51,637 103,274 318,187 266,550 Current liabilities Lease liability 51,096 57,227 Non-current liabilities Lease liability 273,107 215,880