BA322.

1: Financial Accounting Issues

Unit 2: Accounting for Leases
Required reading:
1. Chapter 12 prescribed textbook
2. International Accounting Standards IAS 17

Objectives:
When this unit is completed, students should be able to:

1. Demonstrate an understanding of the nature of leases

2. Distinguish between operating and finance lease
3. Demonstrate an understanding of the principles of accounting for finance leases from both the lessee
and the lessor’ perspective
4. Distinguish between installment sales and hire purchase transactions

Introduction
Leases are used to obtain the use of an asset. Many assets may be obtained by leasing. Leasing is not
a new concept. It has existed for hundreds of years. It is one of the most important sources of finance
for business

What is a lease?
A lease is an agreement that convey from a lessor to a lessee the right to use an asset for an agreed
period of time in return for a payment or series of payments.

What happens at the end of the lease?

It depends on the type of the lease
1. Lessor retains the right to use or dispose the asset
2. Ownership is passed to the lessee for a payment of an guaranteed residue value
3. Lessee has the option to make further payments to acquire the leased asset

During the lease term, the lessor owns the asset but does not have the right of possession or the right
to use it.

A lease is an agreement. The terms vary widely depending on:

 The nature of the leased asset

 The requirements of the lessor and the lessee
 The bargaining power of the lessee and lessor

A typical lease agreement has:

 The period of the lease

 The amount and timing of the lease payments
 A condition whether it is cancellable by either party
 Option of what happens at the end of the least term
 A residue value at the end of the lease term
 An agreement on the responsibility for payments of maintenance and repair costs, insurance,
operating costs…etc
All the above are the subject of negotiation

Classification of Leases
1. Operating lease
2. Finance Lease
3. Sales and Lease Back Agreement
4. Leveraged based Lease

Operating Lease
A short term rental agreement.
 A lease in which the risks and rewards of ownership remains with the lessor – payments are
regarded as expense
 Can be cancelled with little or no costs with reasonable notice
 Do not satisfy the definition of an asset and liability
 Operating leases are off-balance sheet items

Finance Lease
A lease that transfers substantially all the risks and rewards incidental to the ownership of the asset to
the lessee.

 Most risk and benefits associated with ownership of the leased asset are transferred from the
lessor to the lessee
 The role of the lessor is to provide finance
 Finance leases are for periods that represent a substantial part of the assets’ useful life.
 Leased assets and leased liabilities satisfy the definition of assets and liabilities
 Finance leased assets and leased liabilities appear on the balance sheet – on balance sheet
items

Sales-and- Leaseback Agreement

This is an agreement under which the owner of an asset sells the asset to the finance institution for an
amount usually equal to its fair value and immediately leases it back from the institution.

- Sell to the finance organization

- Lease it back from the finance organization

An alternative to raising cash by borrowing, using the asset as a security.

Leveraged Lease
A finance lease where the lessor borrows most of the funds to acquire the asset.

Accounting for Operating Leases

No asset, no liability is recognized

The rent paid for an operating lease is regarded as an expense

Lessee books

Dr Lease Expense xx
Cr Cash at bank xx

Lessor books

Dr Cash at bank xx
Cr Lease rental revenue xx

Finance Lease

There has been controversy about the accounting procedure for finance leases. The controversy
relates to the nature of the agreement establishing a finance lease.

Leases in the books of the lessor/lessee

1. The traditional approach treated all leases as operating leases – no asset/liability was
recognized in the balance sheet
2. The recent approach recognizes leased assets and leased liabilities on balance sheet

There are four capitalization criteria that apply to leases. Three of the four are controversial and can be
difficult to apply in practice.

a) Transfer of ownership test

If the lease transfers ownership of the asset to the lessee, it is a capital lease. This criterion is
not controversial

b) Bargain purchase option test

A bargain purchase option allows the lease to purchase the leased property for a price that is
significantly lower than the property’s expected fair value at the date the option exercisable.

c) Economic life test (75%)

If the lease period equals or exceeds 75 percent of the asset’s economic life, the lessor
transfers most of the risks and rewards of ownership to the lessee. Capitalization is
appropriate. However, determining the lease term and the economic life of the asset can be
troublesome.

d) Recovery of investment test (90%)

If the present value of the minimum lease payments equals or exceeds 90 percent of the fair
market value of the asset, then a lessee should capital the leased asset.

The classification of a lease as either an operating or a finance lease has important financial reporting
consequences and therefore management may have incentives to prefer on classification over another.

Off-balance sheet or operating leases create no lease asset or liability and all lease payments are
recognized as expenses when they are incurred.
Under-on-balance sheet or finance leases, a lease asset and a lease liability is recognized at the
inception of the least and subsequent payments are allocated between an interest component and a
reduction of lease principal component. The lease asset is subject to depreciation.

Measurement of leased assets/liabilities

If rights/obligations arising from lease agreements are to be treated as assets/liabilities of the lease, the
problem is how to measure the lease asset and liability values.

The general agreement is to measure the initial value of leased assets and liabilities at cost.

The following example demonstrates how leases are classified as a finance lease or operating lease.

Demonstration Exercise #1
McTravish Ltd decides to lease some machinery from Nelson Ltd on the following terms:

Date of entering lease 1 July 2016

Duration of lease 10 years
Life of leased asset 11 years
Unguaranteed residual $2000
Lease payments $4,000 at leased inception, $3,500 on 30 June
Each year (that is, 10 yearly payments of $3,500 each)
Fair value of leased assets at
Date of lease inception $26,277

Required: 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 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 for 10 years discounted at 10 percent is $6.1446.

The present value of $1 in 10 years, discounted at 10 percent is $0.3855.

Hence, the present value of the 10 payments of $3500 is $3500 x 6.1446, which equals to $21,506,

and the present value of the unguaranteed residual is $771, which is $2,000 x 0.3855.

The present value of the up-front payment of $4,000 is not discounted. Therefore, using a rate of 10
percent for discounting purposes, the present value of the minimum lease payments and the
unguaranteed residual is:

Present value of payment on 1 July 2016 $4,000

Present value of 10 yearly payments $21,506
Present value of unguaranteed residual $771
Total $26,277
The discounted value of $26,277 is the same as the fair value of the asset at lease inception. Thus 10
percent is the implicit rate in this example.

Demonstration Exercise #2
Lonsdale Ltd has entered into a lease arrangement with Q Ltd in which it has agreed to lease an item of
machinery from Q Ltd on the following terms:

Date of commencement of lease 1 July 2012

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 percent

The lease is considered non-cancellable. The economic life of the machinery is considered to be 10
years. However, Lonsdale Ltd will return the machinery to Q Ltd 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.

Instructions:
1. Determine what the minimum lease payments are
2. Prove that the rate of interest implicit in the lease is 6 percent
3. Determine whether the lease should be classified an operating lease or a finance lease.

Suggest solution
1. The minimum lease payments are the payments over the lease term that the lessee is required
to make. In this case, the minimum lease payments would include the up-front payment of
$200,000 plus the subsequent lease payments of $100,000 per year.

2. Using the 6 percent, the present value of the minimum lease payments, plus the unguaranteed
residual is:
$200,000 x 1.00 $200,000
$100,000 x 6.2098 $620,000
$80,000 x 0.6274 $50,192
$871,172

Given that the above amount of $871,172 is equivalent to the value of the asset at lease inception, 6
percent is the rate of the interest implicit in the lease.

3. For the lease to be considered a finance lease,

a. it must first be non-cancellable. The lease agreement between Lonsdale Ltd and Q Ltd
satisfies this requirement. (transfer of risks inherent in asset ownership to the lessee)
Other indicators
b. the lease term is for the major part of the economic life of the asset, even if title is not
transferred
c. at the inception of the lease the present value of the minimum lease payments amount
to at least substantially all of the fair value of the leased asset. It is 80% of the
economic life in this case.

On the above basis, the lease is a finance lease.

Demonstration Exercise #3
Suppose Z Ltd agrees to an agreement to lease machinery for five years at an annual rental of $1000
payable at the end of each year. It is estimated that at the end of five years, the machinery will have no
residue value. Z Ltd could purchase the machinery for $3605. The amount is regarded as the principal,
and therefore, the amount of the liability and the asset. The following general journal entry would be
passed when the lease agreement is signed.

Machinery under Lease Dr $3605

Lease liability Cr $3605

If the purchase price of the machinery cannot be ascertained, it is necessary to deduce it by reference
to the rate of return earned by the lessor. Suppose that the lessee estimates that the lessor earns 12%
per annum on lease agreements. The present value of the rental payments discounted at lessor’s rate
of return on the agreement will give the amount of the liability. Hence

PV = $1000/0.12 [1 – 1/(1+0.12)5] = $3605

This is also the amount of asset Machinery under lease.

Subsequent measurement
The next problem is to determine the pattern of the reduction in the lease liability. Each rental payment
is divided into an interest expense component. The first step is to determine the rate of interest implicit
in the lease agreement.

Z Ltd knows the liability to be $3605. The rental is five annual payments of $1000. The rate of interest
earned by the lessor is 12% per annum.

In the first year, the interest expense will be 12% of the amount outstanding for the year. The interest is
$3605 x 0.12 = $433. The rental payment is $1000 and the principal repayment is $1000 - $433 = $567

The journal entry at the end of the first year is:

Dr Interest expense $433

Dr Lease liability $567
Cr Cash at bank $1000

The liability will be reduced to $3605 - $567 = $3038. The next year’s interest will be $3038 x 0.12 =
$365 and the principal repayment will be $1000 - $365 = $635. The general entry at the end of the
second year will be:

Dr Interest expense $365

Dr Lease liability $635
Cr Cash at bank $1000

Below are the amounts necessary to make journal entries at the end of each of the five years are
computed:
(dollars)
Year Rental Payment Interest expense Reduction I lease liability Lease liability
0 3605
1 1000 433 567 3038
2 1000 365 635 2403
3 1000 288 712 1691
4 1000 203 797 894
5 1000 106 894

Now what is the pattern of reduction in the amount of the leased asset. See the table below:

End of year Costs Accumulated Depreciation Carrying amount

0 3605 3605
1 3605 721 2884
2 3605 1442 2163
3 3605 2163 1442
4 3605 2884 721
5 3605 3605 0

What are the expenses associated with the lease each year?

End of year Interest expense Depreciation expense Total

1 433 732 1154
2 365 721 1086
3 288 721 1009
4 203 721 924
5 106 721 827

1395 3605 5,000

Finance Lease by the Lessor

Suppose that XYZ Finances acquires machinery costing $3605, which it leases to Z Ltd for five years at
an annual rental of $1000 at the end of each year.

Using the finance method:

 XYZ has given up rights to use the asset in exchange for the right to receive rental payments
 The rate of return earned by the lessor on the lease is 12%
 Journal entry in the lessor’s books

Dr Lease receivables $3605

Cr Asset $3605

When rental payment is received at the end of the first year, the entry is:
 Dr Cash at Bank $1000
Cr Lease Recievable $567
Cr Interest revenue $433

In the second year, the entry will be:

Dr Cash at bank $1000

Cr Lease Receivable $635
Cr Interest revenue $365

The situation for each of the five years is shown below:

End of year Rent received Interest revenue Principal Lease receivable

recovery
0 3605
1 1000 433 567 3038
2 1000 365 635 2403
3 1000 288 712 1691
4 1000 203 797 894
5 1000 106 894 0
$5000 $1395 $3605

Demonstration Exercise #4
As at 1 July 2012, W Company owns a building that cost $5 million and has accumulated depreciation
of $3.5 million. The building is sold on 1 July 2012 to P Ltd for $2,007,520 and then leased back over
10 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 year.

Required:
a) Verify that the interest rate implicit in the lease is 15%
b) Provide the accounting entries in the books of W Ltd for the year ended 30 June 2013.
c) Provide the accounting entries in the books of P Ltd for year ending 30 June 2013

Suggested Answer:

a) The interest rate implicit in the lease is the discount rate that causes the aggregate present
value of the minimum lease payments and the unguaranteed residual value to be equal to the
sum of:
i. The fair value of the lease assets
ii. Plus any initial direct costs of the lessor

To verify that the interest rate implicit in the lease is 15%

$400,000 x 5.0188 = $2,007,520

As the discounted present value of the future lease payments at 15% equals the fair value of
the asset at lease inception, 15 percent is the rate implicit in the lease.
 b) Journal entries in the books of W Ltd

July 1 2012

Dr Cash at bank $2,007,520

Dr Accumulated Depreciation 3,500,000
Cr Building $5,000,000
Cr Deferred gain 507,520

To record the sale of building to P Ltd for lease back agreement

Dr Lease building $2,007,520

Cr Lease Liability $2,007,520
Recognize the lease as finance lease

June 30 2013

Dr Interest Expense $301,128

Dr Lease Liability 98,872
Cr Cash at bank $400,000
Record lease payment (2,007,520 x 15%)

Dr Depreciation of lease asset $200,752

Cr Accumulated Depreciaiton $200,752

To record depreciation of leased assets

Dr Deferred gain $50,520

Cr Profit on Sale of Leased Assets $50,520
To recognized the deferred gain on sale of asset

c) Journal entry in the books of P Ltd

July 1, 2013
Dr Building $2,007,520
Cr Cash at bank $2,007,520
Record acquisition of building from W Ltd.

Dr Lease Receivable $2,007,520

Cr Building $2,007,520
To record the commence of lease to W Ltd.

June 30, 2013

Dr Cash at Bank $400,000

Cr Interest Revenue $301,128
Cr Lease Receivable $ 98,872
To record the receipt of lease payment
Demonstration Exercise #5: Accounting for leases by a lessee
Tiger Ltd enters into a non-cancellable five-year lease agreement with Cat Ltd on July 1, 2012. 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 Tiger Ltd 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 June 30, 2013. Included
within the $100,000 lease payments is an amount of $10,000 representing payment to the lessor for the
insurance and maintenance of the equipment. The equipment is to be depreciated on a straight line
basis.

The present value of an annuity in arrears of $1 for five years at 12 percent is $3.6048, while the
present value of an annuity of $1 for five years at 14 percent is $3.4331. Further, the present value of
$1 in five years discounted at 12 percent is $0.5674, while the present value of $1 in five years
discounted at 14 percent is $0.5194.

Required
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 2013 and 30 June 2014.
c) Prepare the portion of the statement of financial position (balance sheet) relating to the leased
asset and lease liability for the years ending 30 June 2013 and 30 June 2014.
d) Prepare journal entries for the years ending 30 June 2013 and 30 June 2014, assuming (for
purposes of illustration) that the lessee classifies the lease as an operating lease.

Suggest Answer
a) The lease is non-cancellable. The present value of the minimum lease payments amounts to at
least substantially all the fair value of the leased assets, 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 minimum lease payments, and any unguaranteed residue 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 the rate of interest of 12%, the discounted value
of the payments is $369,824

Present value of five lease payments of $90,000

Discounted at 12% (excluding executory costs)
Is $90,000 x 3.6048 $324,432
Present value of bargain purchase option $80,000 x 0.5674) 45,392
Total $369,824

As the amount of the minimum least payments discounted at 12% equates to the fair value of the asset
at lease inception, the interest rate implicit in the lease is 12%

b) When preparing the journal entries, it is often convenient to produce a table such as that given
below. Interest expense in the table is determined by multiplying the opening liability for a
period b the rate of interest implicit in the lease
 Date Lease payment Interest expense Principal reduction Outstanding Balance
(excluding executory
costs)
July 1, 2012 369,824
June 30, 2103 90,000 44,379 45,621 324,203
June 30, 2014 90,000 38,904 51,096 273,107
June 30, 2015 90,000 32773 57,227 215,880
June 30, 2016 90,000 25,906 64,094 151,786
June 30, 2017 170,000* 18,214 151,786 0

I July, 2012

Dr Lease Machinery $369,824

Cr Lease Liability $369,824

Record leased assets and liabilities

30 June 2013

Dr Executory expense $10,000

Dr Interest expense 44,379
Dr Lease liability 45,621
Cr Cash at bank $100,000
To record lease payments 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 likely retain the asset after the lease period, the economic life of the lease is
used for depreciation.

30th June 2014

Dr Executory expense $10,000

Dr Interest expense 38,904
Dr Lease liability 51,096
Cr Cash at bank $100,000
To record the lease payment of $100,000

Dr Lease depreciation expense $51,637

Cr Accumulated Depreciation $51,637
To record depreciation expense (369,824 – 60,000/6)
 c) Portion of the statement of financial position for years ending 30 June

2013 2014
$ $
Assets
Leased assets 369,824 369,824
Less Acc Depreciation 51,637 103,274
318,187 266,550

Current liabilities
Lease liabilities 51,096 57,227

Non-current liabilities 273,107 215,880

As at 30 June 2013, the present value of the outstanding lease liability is $324,203. The current portion
of the liability (51,096) is the amount by which the lease liability will be reduced by the lease payments
in the next 12 months (from the lease payment schedule)

d) Journal entries for years ending 30 June 2013 to June 30 2014, assuming that the lease is an
operating lease

30 June 2013

Dr Executory expense $10,000

Dr Lease expense 90,000
Cr Cash at bank $100,000

30 June 2014
Dr Executory expense $10,000
Dr Lease expense 90,000
Cr Cash at bank $100,000
 Workshop Questions

Problems 1
HP Enterprises Ltd contracts to lease equipment for five years at an annual rental of $10,000 payable
at the start of each year. The equipment could have been purchased from the supplier for $40,373. The
rate of interest implicit in the lease is 12%. Management decides to capitalize the leasehold rights.

a) Prepare the journal entry to record the capitalization of the lease

b) Prepare a schedule showing the division of the rental into interest and principal components for
the first two years.

Suggested solution
a) Dr Lease rights $40,373
Cr Lease liability $40,373

Dr Lease Liability $10,000

Cr Cash $10,000

b) Period Payment Principal Repayment Balance

Lease end Interest
0 $10,000 - $10,000 $30,373
1 $10,000 $3,645 $ 6,355 $24,018
2 $10,000 $ 2,882 $ 7,118 $16,900

Problem 2
Nytex Ltd entered into a financial lease with Ezi-Lease Ltd to obtain the services of a forklift truck. The
term of the lease is four years and in return Nytex Ltd has agreed to make an initial payment of $2,000
followed by 47 monthly payments of $1,000. The rate of interest charged by the lessor is found to be
1% per month.

a) Record the lease of the forklift truck, including the initial payment of $2,000 and the first lease
instalment of $1,000 in the books of the lessor.
b) Record the lease of the forklift truck, including the initial payment of $2,000 and the first lease
instalment of $1,000 in the books of the lessee.

Suggested Solution

EZI- LEASE LTD

a) PV of lease payments = $2,000 + $1,000/0.01 [1 – 1/(1 + 0.01)47 = $39,360

Assuming that the net method is employed then the commencement of the lease:

Dr Lease receivables $39,360

Cr Property $39,360

Dr Cash $2,000
Cr Lease Receivable $2,000
At the end of the first month:
Dr Cash $1,000
Cr Lease Receivables $626
Cr Interest revenue $374

NYTEXZ LTD

At the commencement of the lease:

Dr Machinery under Lease $39,360

Cr Lease Liability $39,360

Dr Lease Liability $2,000

Cr Cash $2,000

At the end of the first Month

Dr Interest expense $374
Dr Lease Liability $626
Cr Cash $1,000