Chapter 9 - Leases

Question 1

Leasing agreement

Answer 1

An agreement where one party (lessee) pays lease rentals to another party (lessor) in order to gain the use of an asset over a period of time.

IAS 17 provides:

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

Operating lease:
Any lease other than a finance lease.

Risks

1. Lessee carries out repairs and maintenance.
2. Lessee insures asset.
3. Lessee runs the risk of losses from idle capacity.
4. Lessee runs the risk of technological obsolescence.

Rewards
1. Lessee has right to use asset for most or all of its useful life.

Question 2

Substance over form

Answer 2

There is a difference between commercial substance and the legal form.

Commercial substance reflects the financial reality of the transaction.

Legal form is the legal reality of the transaction.

Accounts are generally required to reflect commercial substance rather than legal form.

Question 3

Accounting treatment of the commercial substance of a lease.

Answer 3

Record the asset as a non current asset in the lessee’s statement of financial position.

Record a liability for the lease payments payable to the lessor.

Question 4

Accounting for operating leases

Answer 4

1. An asset is not recognised in the statement of financial position.
2. Instead, rentals under operating leases are charged to the statement of profit or loss on a straight line basis over the term of the lease.
3. Any difference between amounts charged and amounts paid will be prepayments and accruals.
4. The full commitments of the operating lease are therefore not shown as a long term liability but a disclosure note is included showing the users the amounts that the company is committed to. This is split between the amounts due within one year, between two to five years and over five years.

Question 5

Finance or operating lease

Answer 5

1. Finance lease
Asset capitalised
Liability recognised
Finance charge
Depreciation charge

2. Operating lease
No asset
No liability
Full rental charge
No depreciation

Question 6

Sale and leaseback

Answer 6

A sale and repurchase agreement can be in the form of a sale and leaseback.

• 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/ lessor is normally a bank.
• the leaseback is classified as finance or operating in accordance with the usual IAS 17 criteria.

Question 7

Accounting for sale and leaseback

Answer 7

Sale and operating leaseback:

1. A sale is recorded and asset de recognised. This means a profit or loss on disposal will be recorded.
2. Operating lease rentals are recorded in the statement of profit or loss.

Sales and finance leaseback:

1. Asset de recognised, with any profit or loss deferred over the lease term.
2. Asset then reinstated in accordance with IAS 17 finance lease rules (lower of fair value or PV of minimum lease payments).
3. Asset value depreciated over lease term and lease interest charged to statement of profit or loss in accordance with actuarial method.

Question 8

Finance lease treated as an operating lease

Answer 8

If a finance lease is incorrectly tested as an operating lease it will have the following effects on the financial statements.

1. Assets understated and ROCE overstated.
2. Liabilities understated and gearing understated.
3. Little effect on statement of profit or loss.