BKAF3063 – A1221Chapter 2Accounting for Leases(MFRS 117)
Chapter OutlineBKAF3063 – A1222 Nature and classification of leases. Accounting by lessee: operating lease finance lease Accounting by lessor: operating lease direct financing lease Sales and leaseback transactions. Disclosure requirement.
Learning outcomes:BKAF3063 – A1223 Define what is lease & differentiate betweenoperating & finance lease Record the leases transactions in the book oflessor and lessee Define and record sales and leasebacktransantions
Definition of LeaseBKAF3063 – A1224MFRS 117 (Para 4):An agreement whereby the lessor conveys tothe lessee in return for a payment or series ofpayments the right to use an asset for anagreed period of time.
Advantages of LeaseBKAF3063 – A12251) 100% financing at fixed rates – without requiring any downpayment, lease payments often remain fixed.2) Protection against obsolescence – reduce risk ofobsolescence.3) Flexibility – less restrictive provision than other debtagreements.4) Less costly financing.5) Off-Balance-Sheet financing – specifically on operatinglease.
Finance Lease if it transfers substantiallyall the risks and rewardsincidental to ownership.DMartOperating Lease if it does not transfersubstantially all the risksand rewards incidental toownership.Classification of LeaseBKAF3063 – A1226
Classification of Lease …cont.BKAF3063 – A1227Risks include thepossibilities of losses fromidle capacity ortechnological obsolescenceand of variations in returndue to changing economicconditionsRewards may be representedby the expectation ofprofitable operation over theasset’s economic life and ofgain from appreciation invalue or realization of aresidual value.
Ownership TransferBKAF3063 – A1228Legal form:- Title remains with the lessor for all types of lease.Accounting view: “Substance over form” A lease that transfers substantially all of the benefits andrisks incidental to the ownership of property should beaccounted for as acquisition of an asset and the incurrenceof an obligation by the lessee. “practically how the asset treated/used…” vs. “legally whoown the asset…”Conclusion: The ownership rights differs according to type of the lease.
Classification of Lease:Para 10 - depends on the substance of thetransaction rather than the form of the contract.BKAF3063 – A1229Operating LeaseNONONONONOYESYESYESYESYESOwnership transfers at the end of the lease?Bargain Purchase Option?Lease term is for majority of economic life?75% ormorePV of MLP equals at least substantially all of FV ofthe leased asset? 90% or moreLeased asset(s) specialised?Finance LeaseFinance LeaseFinance LeaseFinance LeaseFinance Lease
Classification of Lease (Cont.’):Para 11: Indicators of situations which individually or in combinationcould also lead to a lease being classified as a finance lease are:BKAF3063 – A12210Operating LeaseFinance LeaseNONONOYESYESYESCancellation losses borne by lessee?Changes in FV of residual borne by lessee?Bargain lease renewal option?
TermsBKAF3063 – A12211☺ Lease Term- Non-cancellable period for which lessee has contracted to lease.- Commencement of lease term = when recognition takes place.☺ Inception date- the earlier of the date of the lease agreement and the date ofcommitment by the parties to the principle provision of the lease.- Inception of the lease = when leases are classified.☺ Bargain purchase option (BPO)- option to purchase the asset at a price lower than fair value at the dateof the option become exercisable.
Terms… (cont)BKAF3063 – A12212Minimum Lease Payment (MLP) Payments over the lease term that the lessee is or can be requiredto make excluding contingent rent, cost for services, and taxes, tobe paid and reimbursed to the lessor; together with(+) Guaranteed residual value:a) lessee: any amounts guaranteed by the lessee or relatedparty; orb) lessor: any residual value guaranteed by lessee or partyrelated to lessee, or third party.(+) BPO (bargain purchase option)
Terms …(cont.)BKAF3063 – A12213☺ Guaranteed Residual Value- Lessee: part of the RV guaranteed by the lessee or by a party related tothe lessee (being the max amounts payable at the end of lease term)- Lessor: part of RV guaranteed by the lessee or by a third party unrelatedto the lessor who is capable to pay the guaranteed amounts.☺ Initial direct cost- incremental cost that are directly attributable to negotiating andarranging a lease, except for such costs incurred by manufacturer ordealer lessors.- Example: legal fees, lease agreement commission etc.
Terms …(cont.)BKAF3063 – A12214☺ Gross Investmenta) the MLP receivable by the lessor under a finance lease, andb) any unguaranteed residual value accruing to the lessor.☺ Net Investment- the gross investment in the lease discounted at the interest rateimplicit in the lease.
Classification of Lease…cont.BKAF3063 – A12215Para 15A – 18:☞ When a lease includes both land and buildings elements, an entityassesses the classification of each element as a finance or anoperating lease separately in accordance with paragraphs 7–13.☞ Land usually operating due to indefinite useful life. if title passed – finance lease.☞ MLP allocated in the proportion to the relative FV of bothelements. if cannot reliably allocated: entire lease is considered financelease, unless it is clear that both are operating.
Classification of LeaseBKAF3063 – A12216Illustration 1:Pajakan Co. (Lessor) and Trojan Co. (Lessee) entered into leasingagreement on 1 January 2012. The term of lease is 15 years. Thelease agreement is non-cancellable and has minimum leasepayments with a present value of RM450,000. The leaseinvolves the use of machinery that has a 17 years estimateduseful life and is valued at RM460,000. The lease stated thatTrojan has an option to purchase the asset for RM20,000 at theend of leased period.
Classification of LeaseCriteria Satisfied?Y / NExplanationTransfer oftitleN Not transferred.BPO Y BPO = RM20,000Length of leasetermY useful life = 17 years;Lease term = 15 years.PV of MLP Y FV = RM460,000;PV of MLP = RM450,000.SpecialisedassetsN Not specified.BKAF3063 – A12217Solution to illustration 1:
Finance and operating leases: Differences(Lessee)Finance Lease Operating LeaseRecognition of PPE andliabilities on the bookRecognition of rentalexpenses/revenue asincurred/earnedPPE subject to impairmentand testNot applicableBKAF3063 – A12218
Let’s take a look atOperating Lease inthe book of LesseeBKAF3063 – A12219
Operating Lease:Accounting by LesseeBKAF3063 – A12220Para 33 – 34:☞ Lease payments - should be recognised as an expense in theincome statement on a straight-line basis over the leaseterm.☞ Lease payments – should exclude costs for services such asinsurance and maintenance.☞ No records on the assets or liability related to the value ofthe assets (off balance sheet).
Operating Lease:Accounting by LesseeBKAF3063 – A12221Illustration 2:Pajakan Company (lessor) leased an equipment costing RM450,000 toTrojan Company. The economic useful life of the asset is 20 years. Thelease is classified as operating lease with the lease term of 5 yearsstarting from 1/1/2011. Payments are made in advance as follows:1/1/11 RM18,0001/1/12 RM16,0001/1/13 RM14,0001/1/14 RM12,0001/1/15 RM10,000Asset is used evenly throughout the lease term. The accountingperiod of both parties ends on 31 December.
Operating Lease :Accounting by LesseeBKAF3063 – A12222Solution to Illustration 2:Total payment for the lease period:= RM18,000 +RM16,000 + RM14,000 + RM12,000 + RM10,000)= RM70,000Expenses recognized per year = RM70,000/5= RM14,000Journal entries?
Let’s take a look atOperating Lease inthe book of LessorBKAF3063 – A12224
Operating Lease:Accounting by LessorBKAF3063 – A12225Para 49 – 55:☞ Title is not transferred, therefore lessor should presentassets in their balance sheet according to the nature of theassets.☞ Payments received from lessee are recorded as RentRevenue on a straight-line basis over the lease term.☞ Costs including depreciation incurred in earning the leaseincome are recognised as an expense.☞ Initial direct costs incurred by lessor shall be added to thecarrying amount of the leased asset and recognised as anexpense over the lease term.
Operating Lease:Accounting by LessorBKAF3063 – A12226Refer to Illustration 2:Total payment for the lease period:= RM18,000 +RM16,000 + RM14,000 + RM12,000 + RM10,000= RM70,000Expenses recognized per year = RM70,000/5= RM14,000Depreciation expense recognized per year = RM450,000/20= RM22,500Journal entries?
Let’s take a look atFinance Lease inthe book of LesseeBKAF3063 – A12228
Finance Lease :Accounting by LesseeBKAF3063 – A12229Para 20 – 30:☞ Should be recognized as assets and liabilities (as if the assetsbeing purchased) at amounts equal to the fair value of leasedasset or if lower, at the PV of MLP [Para 20].☞ Cost of assets recorded in lessee’s book:The lower of:Fair value at inception date.PV of MLP at inception date.ORReason: the leasedasset should not berecorded for more thanits fair value.
Finance Lease :Accounting by LesseeBKAF3063 – A12230Dr. Leased asset xxx *Cr. Lease Liability xxx *☞ The discount rate (to be used in calculating PV of MLP): implicit in thelease. IF impracticable to determine, use lessee’s incrementalborrowing rate.☞ MFRS 117 requires the lessee to record the obligation arising fromfinance lease at then same amount as the leased asset ( para 22)☞ Journal entries :* The lower of fair value or PV of MLP
Finance Lease :Accounting by LesseeBKAF3063 – A12231☞ Interest: MLP Lease Liabilities/FV of asset :► Lease payment should be apportioned between thefinance charge and the reduction of theoutstanding liability.► Finance charge – allocated to periods during thelease term so as to produce a constant periodic rateof interest on the remaining balance of the liabilityfor each period [ Para 27].☞ Contingent rents: charged as expense as incurred.
Finance Lease :Accounting by LesseeBKAF3063 – A12232☞ Depreciation (Para 27):► Depreciation policy should be consistent with that for depreciableassets which are owned by the lessee (in accordance withMFRS116).► Use economic useful life, if the lease:i. transferred rights at the end of lease term;ORii. contains BPO.► Otherwise, use:The lower of:Lease termEconomic useful lifeOR
Finance Lease :Accounting by LesseeBKAF3063 – A12233Illustration 3:Assume that Pajakan Company (lessor) and Trojan Company (lessee) sign alease agreement dated 1 January 2012. The terms are as follows:Term of lease is 5 years, it is non-cancellable, requiring equal rentalpayments of RM20,000 at the end of each year.1. The FV = RM75,816 at the inception date, estimated useful life of 5 years,and no residual value.2. The lease contains no renewal options, and the equipment reverts toPajakan Co. at the termination of the lease.3. Discount rate agreed by both parties is 10%.4. Trojan Co. depreciates on a straight line basis, similar equipment that itowns.
Finance Lease :Accounting by LesseeBKAF3063 – A12234Solution to Illustration 3:Type of lease: Finance leaseMLP = 20,000 x 5 years = RM100,000PV of MLP = 20,000 x PVOA(5, 10%)²= 20,000 x 3.7908= 75,816 FV = 75,816.Journal entry on 1 Jan 2012Dr. Leased asset 75,816Cr. Lease Liability 75,816(to recognise the asset leased)
Finance Lease :Accounting by LesseeDate Annual leasepayment(A)Interest (10%)(B)Principalpayment(C)Lease liability(D)1 Jan 12 - - - 75,81631 Dec 12 20,000 7,582 12,418 63,39831 Dec 13 20,000 6,340 13,660 49,73831 Dec 14 20,000 4,974 15,026 34,71231 Dec 15 20,000 3,471 16,529 18,18331 Dec 16 20,000 1,818 18,182 0(D) X 10% (A) - (B) Preceeding- (C)BKAF3063 – A12235Lease amortization schedule: Effective interest method
Finance Lease :Accounting by LesseeDate Particulars Debit Credit31/12/12 Dr. Lease liabilityInterest expenseCr. CashDr. Depreciation expenseCr. Accumulated depreciation12,4187,58215,16320,00015,16331/12/13 Dr. Lease liabilityInterest expenseCr. CashDr. Depreciation expenseCr. Accumulated depreciation13,6606,34015,16320,00015,163BKAF3063 – A12236Journal entries:
Finance Lease :Accounting by LesseeDate Particulars Debit Credit31/12/14 Dr. Lease liabilityInterest expenseCr. CashDr. Depreciation expenseCr. Accumulated depreciation15,0264,97415,16320,00015,16331/12/15 Dr. Lease liabilityInterest expenseCr. CashDr. Depreciation expenseCr. Accumulated depreciation16,5293,47115,16320,00015,163BKAF3063 – A12237Journal entries:
Finance Lease :Accounting by LesseeDate Particulars Debit Credit31/12/16 Dr. Lease liabilityInterest expenseCr. CashDr. Depreciation expenseCr. Accumulated depreciation20,0001,81815,16320,00015,163Dr. Accumulated depreciationCr. Leased assets(to record the return of the assets)75,81675,816BKAF3063 – A12238Journal entries:
Let’s take a lookat FinanceLease in thebook of LessorBKAF3063 – A12239
Finance Lease :Accounting by LessorBKAF3063 – A12240Para 36 – 40:☞ The receivable to be presented in the BalanceSheet at an amount equal to the net investment inthe lease [Para 36], which is defined in para 4 as“the gross investment in the lease less unearnedfinance income”☞ Initial direct cost – included in the initialmeasurement of finance lease receivable andreduce the amount of income recognised over thelease term [para 38].
Finance Lease :Accounting by LessorBKAF3063 – A12241Refer to Illustration 3:Gross investment = 20,000 x 5 years = RM100,000Net investment = PV of gross investment= 20,000 x PVOA(5, 10%)= 20,000 x 3.7908= 75,816Unearned finance income = 100,000 – 75,816 = 24,184Amortization schedule?Journal entries?
Finance Lease :Accounting by LessorDate Particulars Debit Credit01/01/05 Dr. Lease receivableCr. Fixed assetsUnearned interest revenue100,00075,81624,18431/12/05 Dr. CashCr. Lease receivableDr. Unearned interest revenueCr. Interest revenue20,0007,58220,0007,58231/12/06 Dr. CashCr. Lease receivableDr. Unearned interest revenueCr. Interest revenue20,0006,34020,0006,340BKAF3063 – A12242Journal entries:
Bargain Purchase Option MLP will be increased by the exercise price Useful life will be used as basis for depreciation charge. Example:On 1/1/2011, ABC Bhd entered into lease agreement with terms:a) non-cancellable lease term of four years,b) Lease rental of RM10,000 per year to be paid on 31 Dec,commencing 31/12/2011.c) ABC Bhd has an option to buy the equipment at the end of leaseterm for RM1,000. On 1/1/2011, it was estimated tha the fairvalue of the equipment would be RM5,000 after 4 years’ usage.The FV of the equipment on 1/1/2011 was RM42,000 and haveestimated useful life of 5 years. The implicit rate was 5%.
Bargain Purchase OptionSolution - Lesse:MLP = (10,000 x 4) + 1,000 = 41,000PV of MLP = (10,000 x PV n=4,i=5%) + (1,000 x PVA n=4,i=5%)= 36,2821/1/11 : Dr. Leased Equipment 36,282Cr. Lease Payable 36,282Depreciation exp = 36,282 / 5 = RM7,256.4031/12/14 - exercise of BPO:Dr. Lease Payable 1,000Cr. Cash 1,000
Bargain Purchase OptionSolution - Lessor:Gross Investment = (10,000 x 4) + 1,000 = 41,000PV of MLP = (10,000 x PV n=4,i=5%) + (1,000 x PVA n=4,i=5%)= 36,2821/1/11 : Dr. Leased Receivable 42,000Cr. Equipment 36,282Unearned interest revenue 5,71831/12/14 - exercise of BPO:Dr. Cash 1,000Cr. Leased Receivable 1,000
Guaranteed Residual Value MLP will be increased by GRV GRV will be deducted from the depreciable amountof leased asset. At the end of lease term, the lease liability will have a balance equal with GRV If FV of leased asset < GRV , recognise loss (lessee)
Guaranteed Residual ValueExample:On 1/1/2011, ABC Bhd entered into lease agreement with terms:a) non-cancellable lease term of four years,b) Lease rental of RM10,000 per year to be paid on 31 Dec,commencing 31/12/2011.c) ABC Bhd guaranteed to lessor that the leased asset wouldhave a residual value of RM5,000 at the end of lease term.The FV of the equipment on 1/1/2011 was RM42,000 and haveestimated useful life of 5 years. The implicit rate was 5%. Theestimated residual value at the end of lease term was RM7,000.
Guaranteed Residual ValueSolution – Lessee:MLP = (10,000 x 4) + 5,000 = 45,000PV of MLP = (10,000 x PV n=4,i=5%) + (5,000 x PVA n=4,i=5%)= 39,5721/1/11 : Dr. Leased Equipment 39,572Cr. Lease Payable 39,572Depreciation exp = (39,572- 5,000) / 4 = RM8,64331/12/14, if FV of leased asset is RM3,000,Dr. Lease Payable 5,000Accumulated depreciation 34,572Cr. Leased Equipment 39,572Dr. Loss on finance lease 2,000Cr. Cash 2,000
Guaranteed Residual ValueSolution – Lessor:GI = (10,000 x 4) + 7,000 = 47,000PV of GI = (10,000 x PV n=4,i=5%) + (7,000 x PVA n=4,i=5%)= 41,2181/1/11 : Dr. Leased Receivable 47,000Cr. Equipment 41,218Unearned interest revenue 5,78231/12/14, if FV of leased asset is RM3,000,Dr. Equipment 3,000Cash 2,000Loss on finance lease 2,000Cr. Leased Receivable 7,000
Sales and LeasebackBKAF3063 – A12250☞ Transaction in which the owner of the asset (seller, lessee)sells the asset to another and simultaneously leases it backfrom the new owner.?In the book of Buyer/lessor:- Same as lessor as discuss before.In the book of seller/lessee:- To recognize gain from sales ofasset: immediate or defer.
Sales and LeasebackBKAF3063 – A12251Para 59: for Finance leaseShould not be recognized immediately, instead, shouldbe deferred and amortized over the lease term.Profit = Sales proceed – Carrying amount
Sales and LeasebackBKAF3063 – A12252Para 61: for Operating lease.Should be recognized immediately.Profit = Sales proceed – Carrying amount(a) If Selling price = FV
Sales and LeasebackBKAF3063 – A12253Para 61: for Operating leaseShould be recognized immediately EXCEPT THAT if theloss is compensated by future lease payments at belowmarket price, it should be deferred and amortized.Profit = Sales proceed – Carrying amount(b) If Selling price < FV
Sales and LeasebackBKAF3063 – A12254Para 61: for Operating leasedeferred and amortized.Profit = Sales proceed – FV(c) If Selling price > FV (FV > carrying amount)recognized immediately.Profit = FV - Carrying amountProfit = Sales proceed – Carrying amount
Sales and LeasebackBKAF3063 – A12255Illustration 5:Chocolate Company sold an equipment to Chips Company andlease back the asset. The carrying amount (book value) of theasset is RM60,000. The asset has a fair value of RM70,000.How to recognize profit/loss if the selling price:1. RM70,0002. RM55,0003. RM50,000 (with lower lease payment)4. RM90,000