P2:Ch15 - Leases

Define a finance and operating lease

A finance lease transfers substantially all the risks and rewards incident to ownership of an asset. An operating lease is a lease other than a finance lease. Whether a lease is a finance lease or an operating lease depends on the substance of the agreement. • A finance lease (as its name suggests) is basically a way of financing the use of an asset (by spreading the payment over the life of the asset, instead of paying the full amount all at once). • An operating lease is similar to a rental agreement. The entity normally rents the asset for only part of its useful life.

How should a lease of land and buildings be handled?

Land and buildings are often leased together, but it is required that the land and buildings elements to be classified separately. • The land element is normally classified as an operating lease unless title passes to the lessee at the end of the lease term. • The buildings element may be classified as either a finance or an operating lease depending upon the nature of the lease contract. • The minimum lease payments are allocated between the land and buildings elements in proportion to their relative fair values.

How should a lease be classified?

A lease is probably a finance lease if one or more of the following apply. • Ownership is transferred to the lessee at the end of the lease (as in hire purchase agreements). • The lessee has the option to purchase the asset for less than its expected fair value at the date the option becomes exercisable (so it is reasonably certain that the option will be exercised). • The lease term is for the major part of the economic life of the asset, even if title is not transferred. The length of the lease includes any secondary period. • At the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset. • The leased assets are of a specialised nature so that only the lessee can use them without major modifications being made. • The lessee will compensate the lessor if the lease is cancelled. • Gains or losses from fluctuations in the fair value of the residual fall to the lessee (for example, by means of a rebate of lease payments). • The lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent.

Define a sale and leaseback transaction

A sale and finance leaseback arrangement is, in essence, a financing arrangement. The substance of the arrangement is that the asset has been used as security for a loan. Under a sale and leaseback transaction an entity sells one of its own assets and immediately leases the asset back. • This is a common way of raising finance whilst retaining the use of the related assets. The buyer and lessor is normally a bank. • There are two key questions to ask when assessing the substance of these transactions: - is the new lease a finance lease or an operating lease - if the new lease is an operating lease, was the original sale at fair value or not?

What is the correct treatment for a sale and leaseback under an operating lease?

A sale and operating leaseback transfers the risks and rewards incident to ownership to the buyer/lessor. Therefore it is treated as a sale. • The asset is removed from the seller's statement of financial position. • Operating lease rentals are recognised as an expense in profit or loss.

How should an operating lease be treated in the accounts of the lessee?

• The lessee does not recognise the leased asset in its statement of financial position. • Rentals are charged as an expense on a straight line basis over the term of the lease unless another systematic and rational basis is more appropriate. • Any difference between amounts charged and amounts paid should be adjusted to prepayments or accruals.

What is the correct accounting treatment for a sale and leaseback transaction?

• The lessee defers any gain or loss on disposal of the asset, which is amortised over the lease term. • The lessee recognises both a finance lease asset and a finance lease obligation. • The finance lease asset is depreciated over the lease term. • The recognition of an annual finance cost, based upon the effective or implicit rate. • The finance lease payments are split between a finance cost (based upon the effective or implicit rate) and capital repayment.

How should an operating lease be treated in the accounts of the lessor?

• Assets held under operating leases are recognised in the statement of financial position as non-current assets. They should be presented according to the nature of the asset and depreciated in the normal way. • Rental income from operating leases is recognised in profit or loss on a straight-line basis over the term of the lease, unless another systematic and rational basis is more appropriate. • Any difference between amounts charged and amounts paid should be adjusted to receivables or deferred income.

How should a finance lease be treated in the accounts of the lessee?

• At the beginning of the lease term, the lessee recognises the leased asset and the obligation to make lease payments as an asset and a liability in the statement of financial position. • The asset and the liability are measured at the lower of: - the fair value of the asset - the present value of the minimum lease payments (discounted at the interest rate implicit in the lease, if practicable, or else at the entity's incremental borrowing rate). • The lease payments are split between the finance charge and the repayment of the outstanding liability. • The finance charge is allocated so as to produce a constant periodic rate of interest on the remaining balance of the liability. The actuarial method gives the most accurate charge, but the sum of the digits is normally a reasonable approximation. • The leased asset is depreciated over the shorter of: - its useful life - the lease term (including secondary period). - Lease liability is split between current & non-current

Summarise a finance lease

• Substance = lessee has the asset • Substance = financing agreement • Lessee recognises asset in SFP • Lessee recognises liability for future rentals • Lessor recognises net investment in lease (a receivable) • Interest accrues on outstanding amount and is paid by lessee/received by lessor • Lease receivable/liability is reduced by lease rentals over the term of the lease

Summarise an operating lease

• Substance = lessor has the asset • Substance = rental agreement • Lessor recognises asset in SFP • Lessor recognises lease rentals as income • Lessee recognises lease rentals as an expense

How should a finance lease be treated in the accounts of the lessor?

• The lessor recognises the lease as a receivable. The carrying value is the lessor's net investment in the lease. • The net investment in the lease equals: - the present value of the minimum lease payments receivable; plus - the present value of any unguaranteed residual value accruing to the lessor (e.g. the residual value of the leased asset when it is repossessed at the end of the lease). • In practice, the lessor's net investment in the lease is the same as the lessee's lease liability. • The lease receipts are split between finance income and a repayment of the principal. The finance income is calculated using a constant periodic rate of interest.