AC301: ACCOUNTING FOR LEASES

1
AC301 ACCOUNTING FOR LEASES

• SOME BASIC TERMS
• LEASE is a contract between a lessor and a lessee
  for the hire of a specific asset. The lessor
  retains the ownership of the asset but conveys
  the right to use the asset to the lessee for an
  agreed period of time in return for specific
  rentals.
• LESSOR is the legal owner of the asset. Lessor
  rents out the asset to a lessee and receives
  income
• LESSEE pays rents in accordance with the terms of
  the lease receives economic benefits associated
  with the asset and also incurs future obligations.

2
AC301 Accounting for Leases

• BACKGROUND
• In the UK - Leasing became popular during 1970s
  when profits were falling
• Government attempted to encourage capital
  investment by granting large (sometimes 100)
  capital allowances to companies which purchased
  fixed assets
• Banks large profits but few fixed assets
• Manufacturers small profits and substantial
  fixed assets
• 1070s onwards Leasing became a tool for Off
  Balance Sheet Financing

3
Appeal of Leasing

• Bank (lessor) buys asset (and gets benefit of
  tax allowance) because it is awash with cash
• Bank post tax cash flow is improved because it
  receives tax allowances
• Bank can offer reduced interest rate (which
  benefits manufacturer)
• Bank (lessor) leases asset to manufacturer
  (lessee) who may not have adequate taxable
  profits. Thus leasing results in smaller charge
  against PL compared to outright purchase
• Inland Revenue had no problem with these
  arrangements
• Now more sophisticated forms to improve balance
  sheets.

4
Impact of Leasing

• Leasing now covered by IAS 17 and SSAP 21 (US FAS
  13)
• PRIOR TO SSAP 21 NO FORMAL ACCOUNTING FOR LEASES
  IN THE UK
• Lease rental payments charged to PL
• Obligations for future lease payments not
  disclosed
• Leasing functioned as a form of Off Balance Sheet
  Finance
• IN THE ABSENCE OF FORMAL ACOCUNTING
• ASSETS/LIABILITIES UNDERSTATED
• ROCE DISTORTED
• GEARING DISTORTED
• FINANCIAL RISK MAY BE MIS-SPECIFIED
• COST OF CAPITAL MISPRICED
• MARKETS MISLED, RESOURCES MISALLOCATED

5
SSAP 21

• IAS17 and SSAP21 EMPHASISE SUBSTANCE OVER FORM
• Recognise commercial/economic substance rather
  than the legal form
• ENHANCES PREDICTIVE VALUE OF FINANCIAL STATEMENTS
  
• SEEKS TO CURB OFF BALANCE SHEET FINANCING
• BRINGS ASSETS AND LIABILITIES ON TO BALANCE SHEET
  THAT MIGHT OTHERWISE BE EXCLUDED

6
Leases and Hire Purchase

• Leasing
• Main distinction between Hire Purchase Contract
  and lease contract is that under a lease
  contract, title (ownership) does not pass to
  lessee.
• LESSOR rents asset to
  LESSEE
• asset ?
• ? regular
  cash payments

7
Types of Leases

• OPERATING LEASES
• Relatively short term agreement akin to hiring
  an asset e.g. a taxi, car for holidays
• Easily cancellable arrangement
• Risk/rewards do not usually pass to the lessee.
• Lessor remains responsible for repairs and
  maintenance.
• Payments by the lessee to the lessor are charged
  to P/L account on a straight line basis
• Receipts are shown as revenue in the P/L account
  of the lessor on a straight line basis.
• Note to the accounts if amounts are material

8
FINANCE LEASE

• Long term arrangement. Covers most of the asset
  life. Lessee responsible for risk of
  technological obsolescence
• Generally non-cancellable
• Transfers risk/reward of ownership to lessee. The
  lessee responsible for maintenance and insurance.
• Lessee pays full cost of asset plus a return on
  finance provided by lessor
• Minimum Lease Payment by the lessee 90 of the
  fair value of the asset.
• Assets specifically manufactured may be treated
  as finance leases
• US has additional tests e.g. The life of the
  lease is greater than 75 of the economic life of
  the asset.

9
SSAP 21

• Finance lease
• Technically, the lessor has legal ownership of
  asset, but in reality the transaction is very
  similar to outright purchase, financed by a loan
  repayable in instalments
• Finance lease confronts issue of substance versus
  form
• Substance - reality or economic substance
• Form - strict legal interpretation
• Prior to 1984 (when SSAP 21 was issued) finance
  leases and operating leases were accounted for in
  a similar way
• Payments by lessee were treated as expenses in
  profit and loss account of lessee

10
SSAP 21

• However, SSAP 21 forces lessees to treat finance
  leases as if an asset is purchased and financed
  by a loan
• In the balance sheet of the lessee, the asset and
  the loan are recorded on the balance sheet
• In the profit and loss account of the lessee,
  depreciation on the asset is recorded and
  interest on the loan is charged

11
Accounting for Finance Leases (1)

• EXAMPLE 1 AN ASSET COSTS (or has market value)
  333. THE LESSEE PAYS 200 P.A. IN ARREARS FOR
  TWO YEARS. RESIDUAL VALUE OF THE LEASE AT THE END
  IS 40 AND THAT IS PASSES TO THE LESSOR.
• STEP 1 WHAT IS THE IMPLIED INTEREST RATE?
• Look for IRR
• 200 20040 333
• (1 i) (1i)2
• BY TRIAL AND ERROR i 20
• P. V of LEASE 200 200 305
• (1 0.2) (10.2) 2

12
Accounting for finance lease continued (2)

• STEP 2 What kind of a lease
• DOES 305 EXCEED 90 OF THE FAIR VALUE OF THE
  ASSET?
• 90 OF 333 300
• 305 IS GREATER THAN 300
• THEREFORE IT IS A FINANCE LEASE!!
• ANALYSIS
• MINIMUM LEASE PAYMENTS 305
• PV OF RESIDUAL VALUE
• ACCRUINGTO THE LESSOR
• 40/(10.2) 2 28
• 333

13
Accounting Entries for Finance Lease (1)

• ACCOUNTING ENTRIES FOR FINANCE LEASE
• If a lease is a finance lease
• DR Fixed Assets CR Creditors for Finance Lease
• When Payment made to the lessor
• DR Creditors for finance lease CR Cash/Bank
• The Asset must be depreciated
• DR P/L Account CR Depreciation Account
• At the year end make an entry for the finance
  charge
• DR P/L Account for Interest Payable
• CR Creditors for Finance Lease
• In Balance Sheet Split Lease liability under
  current and/or long-term.
• Show leased assets separately.
• Notes to accounts to explain finance charges

14
Accounting for finance leases (3)

• STEP 3 Establish an Asset and Liability
• DR Asset 305
• CR Liability 305
• STEP 4 Financing details
• Loan Int Reduction
• Yr At start 20 Rent in Loan
• 1 305 61 200 139
• 2 166 34 200 166
• 95 400
• STEP 5 Depreciation charge
• Assuming straight line 305-zero 152.5
• 2

15
Accounting for finance leases (4)

• In Balance Sheet In P/L Account
• Time Liabs Asset Depn Interest Total
• Start 305 305 ---- --- ------
• End
• Yr1 166 152.5 152.5 61 213.5
• End
• Yr2 Nil Nil 152.5 34 186.5
• 305 95 400

16
Economic consequences of leasing

• When a leasing standard was first proposed, the
  leasing industry was unhappy.
• But, as it turned out, SSAP 21 was not too
  contentious because the government had already
  begun to reduce tax allowances for capital
  investment
• Note that the government did not change the tax
  laws and transfer the capital allowances from the
  lessors to the lessees

17
Accounting for Leases Some Issues

• Recognition of economic substance (FRS 5,
  Reporting the substance of transactions)
• 90 Test is arbitrary Leases can be designed to
  bypass it.
• Should there be additional tests? e.g. 75 of
  economic life of an asset
• Standard may encourage short-term leases
• One suggestion is to treat all leases in same way
  (i.e. make no distinction between operating lease
  and finance lease)
• Accounting for leases does not affect cash flows.
  Therefore, is it worth the managerial time?
• EMH does not matter how you report markets
  absorb information
• Has accounting standard encouraged the rules
  avoidance industry to look for newer pastures

18
Calculation of annual payments in lease contracts

• actuarial method
• sum of digits method
• straight line method