11-1PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Accounting for leases

Chapter 11

Learning objectives

• Distinguish between operating and financial leases• Demonstrate how the interest rate for PV of minimum

lease payments is calculated• Explain how lessors and lessees should account for:

– financial leases– operating leases

• Demonstrate how a sale and leaseback transaction would be accounted for

• Explain the implications for accounting based contracts.

11-2PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Introduction

NZ IAS 17 applies to accounting for leases other than:– Leases to explore for or use minerals, oil, natural gas and

similar non-regenerative assets– Licensing agreements for such items as motion picture

films, video recordings, plays, manuscripts and copyrights

Lease defined:

‘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’

11-3PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Introduction

Central accounting issue:•Should the leased assets and associated commitments relating to the lease appear in the reporting entity’s financial postion?•Should lack of legal ownership preclude the lessee’s reporting of the asset and the related liability in the balance sheet?

11-4PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Introduction

Question of ‘control’ and not ‘ownership’•A firm may recognise assets it does not own

– as long as it is able to control their use.

•Do leases transfer control of the asset to the lessee?– Depends on the terms of the lease agreement– It is, in fact, possible for control of the asset to be vested in

the lessee.

•Central issue concerns whether lease is:– A finance lease; or– An operating lease.

11-5PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Introduction

• Finance leases must be disclosed in the financial position:– Lease asset– Corresponding lease liability.

• Finance lease– A lease that transfers substantially all the risks and rewards

incidental to ownership of an asset.– Title may or may not be eventually transferred.

11-6PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Introduction

Risks and rewards of ownership central to the application of NZ IAS 17•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.

•If the risks and benefits 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.

11-7PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Introduction

• Not always straightforward to determine whether the risks and rewards incidental to ownership have passed substantially to the lessee.

• Requires professional judgment.• Guidance offered in NZ IAS 17 (pars 10–12).

11-8PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Introduction

NZ IAS 17 (par. 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 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 the title is not transferred.

11-9PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Introduction

NZ IAS 17 (par. 11):•Indicators of situations that, individually or in combination, could also lead to a lease being classified 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 sale 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 the market rent.

11-10PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Introduction

Note (NZ IAS 17, par. 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 all risks and rewards incidental to ownership, the lease is classified an operating lease.•For example, 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 bear substantially all such risks and rewards.

11-11PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Key terms

1. Fair value:a) The amount for which an asset could be exchanged or a

liability settled between knowledgeable, willing parties in an arm’s length transaction.

b) Necessary for determining the amount to be included for the leased asset in the balance sheet of the lessee.

11-12PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Key terms

2. Non-cancellabilityA non-cancellable lease is a lease that is cancellable only:

a) Upon 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 certaini. If the lessee was able to cancel the lease at short notice

with limited penalty the lessee would not be considered to be holding the risks and

rewards associated with asset ownership.

ii. If lease cancellable—regardless of remaining terms the lease would be considered to be an operating lease.

11-13PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Key terms

3. Contingent rent (NZ IAS 17, par. 4)That portion of the lease payments that is not fixed in amount:

– 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).

Why important?– When the amount of rent paid by the lessee is contingent

upon the amount of future sales, future use, future interest rates, etc., there is effectively a shift of some of the risks and rewards of ownership back to the lessor.

– ‘Contingent rent’ therefore decreases the likelihood that the lease will be a ‘finance’ lease.

11-14PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Key terms

4. Transfer of ownership– If lease transfers ownership of the asset to the lessee

at the end of the lease term it is considered a finance lease. – If the lease is also non-cancellable, the lease is really

only another type of debt agreement with title passing after last payment is made.

11-15PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Key terms

5. Bargain purchase option– A provision that allows a lessee to purchase a 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

– Difference between the option price and expected fair market value must be large enough to make exercise of the option reasonably assured evaluation made at inception of lease

11-16PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Key terms

5. Bargain purchase option continued:– If exercise of option is likely (bargain) it is also likely that

transfer of ownership will occur risks and rewards of ownership are assumed to be transferred

– Included in the calculation of 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

11-17PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Key terms

6. Lease term– 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.

11-18PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Key terms

7. Economic life– 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.

– Why important? If the non-cancellable lease term is for the major part of the

economic life of the asset the lease is generally considered a finance lease.

Note:

‘Major part’ not defined but generally accepted that if lease term is greater than or equal to 75% of the economic life of the leased asset risks and rewards are effectively transferred to the lessee (finance lease).

11-19PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Key terms

8. Minimum lease payments– The payments over the lease term what the lessee is or can

be required to make excluding contingent rent, costs for services and taxes paid by and reimbursed to the lessor together with: For the lessee, any amounts guaranteed by the lessee or by a

party related to the lessee; or for a lessor, any residual value guaranteed to the lessor by:

• the lessee• a party related to the lessee; or• a third party unrelated to the lessor that is financially capable

of discharging the obligations under the guarantee.

11-20PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Key terms

8.Minimum lease payments continued:– Why important?

PV of minimum lease payments determines whether a lease is a finance or operating lease:• If at the inception of the lease the present value of the

minimum lease payments amounts to at lease substantially all of the fair value of the asset

– normally leads to lease classified as ‘finance’-type lease• If a finance lease the amount to be initially recognised in the

balance sheet for the asset and liability is (par. 20) the fair value of the leased property or, if lower, the present value of the minimum lease payments as determined at inception of lease.

– Expressly excludes contingent rent.

11-21PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Key terms

8. Minimum lease payments continued:– Include guaranteed residual values

a) Guaranteed residual value defined for the lessee:

i. 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.

b) Guaranteed residual value defined for the lessor:

i. 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.

11-22PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Key terms

8. Minimum lease payments continued:c) Amount of a guaranteed residual value:

i. The amount that the lessor has the right to require the lessee or a related party to the lessee to pay at the end of the lease term

ii. Payment of this residual will often lead to the asset being legally transferred to the lessee.

– Minimum lease payments Do not include costs for services and taxes (executory costs) that are

paid to the lessor in reimbursement.

11-23PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Key terms

9. Guaranteed/unguaranteed residuala) Guaranteed residual

i. The maximum amount that could become payable—included in the minimum lease payments as its payment is reasonably assured.

b) Unguaranteed residuali. Not included in minimum lease payments as there is not

sufficient certainty that the amount will be paid.

11-24PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Interest rate for determining PV of minimum lease payments

Why interest in PV of minimum lease payments?•Lessees recognise finance leases as assets and liabilities:

– at amounts equal to the fair value of the leased property; or – (if lower) the present value of the minimum lease payments

•Discount rate to be used in calculating present value:– Interest rate implicit in the lease (if stated); or– The lessee’s incremental borrowing rate.

11-25PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Interest rate for determining PV of minimum lease payments

• Interest rate implicit in the lease:– The aggregate present value of:

the minimum lease payments + the unguaranteed residual value to be equal to the sum of:

• the fair value of the leased asset +• any initial direct costs of the lessor.

• Where fair value of asset cannot be determined by lessee:– Implicit interest rate cannot then be determined– Lessee discounts minimum lease payments by using

incremental borrowing rates The rate they would pay on a similar lease.

11-26PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Finance or operating lease

11-27PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

yes

yesyes

yes

yes

no

yes

Accounting for lessee leases

• Similar to acquiring assets by long-term loan.• Lessee records an asset (leased) and a lease

liability.• Asset and liability recorded at fair value

– Or (where lower) at PV of minimum lease payments.

• Consideration is given to PV of future cash flows.• Unguaranteed residual excluded in financial

statements of lessee.

11-28PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Accounting for lessee leases

• Rental payments include:– payment of principal +– interest—to be apportioned by lessee.

• Interest expense calculated by applying the interest rate implicit in the lease to outstanding lease liability at beginning of each lease period.

• Balance of payment represents a reduction of principal of lease liability.

11-29PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Depreciation of leased assets

• Leased assets should be depreciated (amortised) using similar policies to regular assets.

• Depreciation period = – number of accounting periods to end of lease term or useful

life, whichever is shorter.

11-30PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Depreciation of leased assets

Journal entries

Dr Leased asset

Cr Lease liability

Recording the leased asset and the lease liability at start of lease term

Dr Lease depreciation expense

Cr Accumulated depreciation leased asset

Recording the lease depreciation expense

Dr Lease liability

Dr Interest expense

Cr Cash

Recording the lease payment with allocation between principle and interest

Dr Executory expenses

Cr Cash

Recording the payment of executory costs (eg rates/maintenance)

11-31PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Initial direct costs

• Costs directly associated with negotiating and executing a lease agreement.

• Include commissions, legal fees, costs of preparing and processing documentation.

• Initial direct costs relating to a finance lease must be capitalised as part of the leased asset.

• Where such costs are incurred the lease asset comprises the present value of the minimum lease payments and the amount of the initial direct costs incurred—total amount subject to amortisation.

11-32PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Lessee accounting for operating leases

• Leases that do not substantially transfer all risks and rewards of ownership to the lessee.

• Lease payments are expensed on a basis representative of the pattern of benefits derived from the leased asset.

• If lease payments do not represent prepayments:– they are expensed in the period made.

• Rental expense of an operating lease to be recognised on a straight-line basis over the lease term:– unless another systematic basis is more representative of the

time pattern of the user’s benefits.

11-33PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Lessee accounting for operating leases

Journal entry:

Dr Rental expense

Cr Cash

11-34PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Lessee accounting for sale and leaseback transactions

• Occurs when the owner of a property sells property to another and simultaneously leases it back from the purchaser/lessor (the legal owner).

• Seller does not lose control of the asset if a finance lease.

• Property often sold at a price equal to or greater than current market value:– leased back for a term approximating useful life.

11-35PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Lessee accounting for sale and leaseback transactions

• Lease payments sufficient to repay the buyer for cash invested plus reasonable return on investment.

• Lessee typically pays all executory costs as if title remained with lessee.

• Often considered a useful way of obtaining funds while allowing recipient of the funds to maintain control of the asset.

11-36PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Lessee accounting for sale and leaseback transactions

Finance lease•Where substantially all risks and rewards incidental to ownership remain with lessee

– represents refinancing of an asset.

•Any profit or loss on sale deferred in the balance sheet and amortised to the profit and loss over the term of the lease.•Asset considered not to have been ‘sold’ to lessor, therefore inappropriate to recognise profit or loss.

11-37PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Lessee accounting for sale and leaseback transactions

Operating lease•Where substantially all risks and rewards incidental to ownership effectively pass to lessor.

Treatment:•Transaction established at fair value

– any profit and loss shall be recognised immediately.

•If sale price is below fair value:– Any profit or loss shall be recognised immediately– Unless 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.

11-38PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Lessee accounting for sale and leaseback transactions

• If sale price is above fair value– Excess over fair value is deferred and amortised over the

period for which the asset is expected to be used.

• If fair value at the time of the 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 is to be recognised immediately.

11-39PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Lessee disclosure requirements

• Finance lease– Numerous disclosures required—Refer to NZ IAS 17,

par. 31.

• Operating lease– Numerous disclosures required—Refer to NZ IAS 17,

par. 35.

• See exhibits 11.1 and 11.2 for examples.

11-40PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Accounting by lessors

Lessor’s perspective:•Leases classified either as operating leases or finance leases.•Adoption of same criteria for non-cancellable lease as for lessee.•Factors addressed in NZ IAS 17, pars 10–12.

Finance leases can be further classified into:•Leases involving manufacturers or dealers.•Direct finance leases.

11-41PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Accounting by lessors

Direct financing lease:•A lease where the lessor provides the financial resources to acquire the asset.•Lessor typically acquires the asset, giving the lessor legal title, then enters a lease agreement to lease the asset to the lessee, who subsequently controls the asset.•No sale is recorded.•Lessor derives income through periodic interest revenue.•Where risks and rewards of ownership are held by the lessee, the lessor substitutes lease receivable for the underlying asset.•Lessors recognise assets held under a finance lease in their respective balance sheets and present them as a receivable at an amount equal to the net investment in the lease.

11-42PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Accounting by lessors

Net investment in lease•The gross investment in the lease discounted at the interest rate implicit in the lease.

11-43PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Accounting by lessors

Gross investment in the lease•The aggregate of:

– the minimum lease payments receivable by the lessor under a finance lease; and

– any unregulated residual value accruing to the lessor

•Interest earned by lessor over lease term– Difference between fair value of leased asset and sum of

the undiscounted minimum lease payments and any unregulated residual value.

11-44PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Accounting by lessors

Gross investment in the lease continued:•Initial indirect costs incurred by lessor

– Incremental costs that are directly attributable to negotiating and arranging a lease, except for such costs incurred by manufacturer or dealer lessors

– Includes commissions, legal fees, and costs associated with processing new leases If material, are to be included in the lessor’s investment in the lease

Recovery of executory costs:•Costs are related to operation and maintenance of leased property

– e.g. insurance, maintenance and repairs– Should be treated as revenue by lessor in financial years in

which related costs are incurred.

11-45PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Accounting by lessors

Direct financing lease – Net vs. gross method•Either net method or gross method can be used.

Net method•Most commonly used.

11-46PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Accounting by lessors

Gross method•Lease receivable recorded at the sum of the undiscounted minimum lease payments and the unguaranteed residual.•Unearned interest revenue also recorded (contra account) and amortised to interest revenue over the lease term.•Unearned interest revenue is subtracted from lease receivable to determined carrying (present value) of the lease receivable.•Receivable recorded at its present value and does not use contra account (unearned interest revenue).

11-47PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Accounting by lessors – journal entries

Net methodTo record initial acquisition of asset:

Dr Asset

Cr Cash/payables etc

To record lease receivable at inception:

Dr Lease receivable

Cr Asset

To record receipt of lease payments:

Dr Cash

Cr Lease receivable

Cr Interest revenue

11-48PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Accounting by lessors – journal entries

Gross methodTo record initial acquisition of asset:

Dr Asset

Cr Cash/payables etc

To record lease receivable:

Dr Lease receivable

Cr Asset

Cr Unearned interest revenue

To record receipt of lease payment:

Dr Cash

Dr Unearned interest revenue

Cr Lease receivable

Cr Interest revenue

11-49PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Lessor disclosure requirements for finance leases

NZ IAS 32 disclosures:

a)A reconciliation between the gross investment in the lease at the balance sheet date, and present value of minimum lease payments receivable at the balance sheet date. In addition, an entity shall disclose the gross investment in the lease and the present value of minimum lease payments receivable at the balance sheet date, for each of the following periods:

– not later than one year

– later than one year and not later than five years

– later than five years.

11-50PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Lessor disclosure requirements for finance leases

NZ IAS 32 disclosures continued:

b)Unearned finance income.

c)The unguaranteed residual values accruing to the benefit of the lessor.

d)The accumulated allowance for uncollectible minimum lease payments receivable.

e)Contingent rents recognised as income in the period.

f)A general description of the lessor’s material leasing arrangements.

11-51PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Accounting for lessors that are manufacturers or dealers of leased assets

Where fair value of the property at the inception of the lease differs from its cost to the lessor•Represents a finance lease.

Two parts of the transaction:•A sale with a resulting gain

– fair value vs. cost to dealer/manufacturer.

•A lease transaction that will provide interest revenue over the period of the lease.

11-52PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Accounting for lessors that are manufacturers or dealers of leased assets

Lessor’s investment in lease accounted for in same manner as direct financing lease:•Value of sale recorded as fair value of asset at date of sale

– equal to present value of minimum lease payments).

•Indirect costs– e.g. commissions, legal fees, etc.– accounted for by lessor as a cost of sales in year in which

transaction occurs not as part of net investment in lease receivable.

•Lease rentals representing a recovery of executory costs (if material) to be treated by lessor as revenue in year in which costs incurred.

11-53PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Lessor’s journal entries for a lease involving a dealer or manufacturer

Net methodTo record receipt of lease payment:

Dr Cash

Cr Lease receivable

Cr Interest revenue

To record sale and lease receivable:

Dr Lease receivable

Dr Cost of goods sold

Cr Inventory

Cr Sales•Cost of sales represent cost of the asset to lessor

– assumed that asset being sold was part of the inventory of the lessor.

11-54PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Lessor’s journal entries for a lease involving a dealer or manufacturer

Gross methodTo record sale and lease receivable:

Dr Lease receivable

Dr Cost of goods sold

Cr Inventory

Cr Sales

Cr Unearned interest revenue

•Cost of sales represents the cost of the asset to the lessor—unearned interest revenue represents the gross amount of interest to be earned throughout the term of the lease.

11-55PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Lessor’s journal entries for a lease involving a dealer or manufacturer

To record receipt of lease payment:

Dr Cash

Cr Lease receivable

Dr Unearned interest revenue

Cr Interest revenue

11-56PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Lessor accounting for operating leases

• Leased property accounted for as a non-current asset.• Required to depreciate if a depreciable asset.• Lease receipts treated as rental revenue.

• NZ IAS 17 (par. 53)

The depreciation policy for depreciable leased assets is to be consistent with the lessor’s normal depreciation policy for similar assets, and depreciation is to be calculated in accordance with NZ IAS 16 and NZ IAS 38.

11-57PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Leases involving land and buildings

• Land is an asset with an indefinite life.• Risks and benefits of land cannot be transferred to lessee

unless the lease will, at completion, transfer ownership or has a bargain purchase option.

• Treated as operating lease unless reasonably assured of transferring ownership.

• Minimum lease payments must be allocated between land and buildings in proportion to their relative fair values at lease inception.

• If lease not assured of transferring ownership of land and buildings at end of lease, lease payments allocated to land to be treated as operating lease.

11-58PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Leases involving land and buildings

• Payments allocated to building (operating or finance lease) will depend on whether lease transfers risks and benefits of ownership to lessee– Exception: Where fair value of land is immaterial in relation

to the fair value of total property, it may be treated as a unit for classification purposes and so land component may be ignored.

• If lease then appears to transfer risks and benefits of ownership the total lease for land and buildings may be treated as a finance lease otherwise operating.

11-59PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Lessee accounting for lease incentives under a non-cancellable operating lease

Incentives by lessor•May offer incentives to enter non-cancellable operating leases (particularly for buildings)

– Initial rent-free periods– Financial assistance for fitting out offices– Up-front cash incentives– Financial assistance to terminate existing lease

agreements.

11-60PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Lessee accounting for lease incentives under a non-cancellable operating lease

• Lease incentives not specifically dealt with by NZ IAS 17.

• Generally in exchange for benefits, lessee pays higher lease payments than if no lease incentive were provided.

• NZ SIC-15 provides guidance– Paragraph 3 states:

Incentives for the agreement of a new or renewed operating lease should be recognised as an integral part of the net consideration agreed for the use of the leased asset, irrespective of the incentive’s nature or form or the timing of payments.

11-61PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Future changes in accounting for leases

• IASB and US FASB working on revised standards for leases.

• Criticisms of current accounting treatment include:– Adjustments made to values of leases are not fully explained

by notes– The financial and operating lease accounting treatments are

very different for similar transactions, therefore issue of comparability

– Transactions can be structured to achieve a particular leasing classification This is an unrecognised source of finance difficult for users to

understand.

• 7 Dec 2006 Media statement provided in exhibit 11.3.

11-62PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Implications for accounting-based contracts

• Classification as finance rather than operating lease will affect debt–asset constraints.

• Introduction of accounting standards requiring capitalisation of finance leases have negative cash-flow effects on firms.

• Negative cash-flow effects found to have negative impact on security prices.

11-63PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Summary

• Leases are classified as operating or finance leases.

• Transfer of risks and benefits from lessor to lessee is considered a finance lease– Resulting asset and liability need to be disclosed by lessee.

• Where leases are capitilised, the amount capitalised is the PV of minimum lease payments or fair value of asset (lower of):– Lesee apportions payments between interest payment and

repayment of liability– Must also amortise the leased asset over its expected

economic life.

11-64PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

Summary

• Operating leases raise no asset or liability in the lessee:– Treated as an expense by lessee– Treated as revenue by lessor.

• Lessor finance leases are further classified as involving dealers or manufacturers or as direct finance leases.

11-65PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd