lessee for lease too many problems. The required treatment of lease agreements can seem complex, but if you

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1 The required treatment of lease agreements can seem complex, but if you understand the key points, questions on this topic should not pose too many problems. lessee for lease The required treatment of lease agreements can seem complex, but if you understand the key points, questions on this topic should not pose too many problems. The key points, which are considered in this article, are: What is a lease agreement? What types of lease might an agreement give rise to? How do we decide on the correct classification of a lease? What is the significance of the way in which a lease is classified? How are the values for the required entries calculated? What is the impact of the way a lease is treated? What is a lease agreement? Essentially, a lease agreement is a rental agreement. Under the agreement, the owner (lessor) receives a series of payments which allows the lessee to have use of an asset. Often, a lease agreement does not include the transfer of ownership of the asset to the lessee, although in some cases it may. In those cases where ownership is transferred, this will occur at the end of the agreement. What type of lease might an agreement give rise to? There are two types of leases that might arise from a lease agreement a finance lease or an operating lease. How do we decide on the correct classification of a lease? The key issue is related to the risks and rewards of ownership. The relevant accounting standard (IAS 17) defines a finance lease as a lease that transfers substantially all the risks and rewards incidental to ownership of an asset, while an operating lease is a lease other than a finance lease. RELEVANT TO MODULE A In practice, this can sometimes difficult to tie down, as the inclusion of the word substantially introduces a degree of uncertainty. Moreover, the providers of lease finance can sometimes increase this uncertainty by drafting the agreement so that it can be less than clear whether substantially all the risks and rewards of ownership have been transferred. In an exam, however, classifying a lease should be less problematic. If a question requires a consideration of the classification of a lease, it will normally include information on issues such as whether the lessee or lessor is required to provide insurance for the asset, and which party would suffer monetary loss if the asset was damaged. Responsibility for such matters can be taken to indicate which party enjoys substantially all the risks and rewards of ownership. Alternatively, a lease period which is considerably shorter than the useful life of the asset normally indicates that substantially all of the risks and rewards of ownership rest with the lessor. What is the significance of the way in which a lease is classified? The key thing to remember is that the word substantially is included because accounting for a finance lease provides a specific example of the application of the principle that accounting practice should be based on the underlying economic substance of the transaction, not the legal form. Furthermore, classification of a lease is significant as the accounting treatment of each type of lease is distinctly different. This might be summarised as follows:

2 finance matters 08/2009 EZ accounting agreements Operating lease Finance lease The rentals due under the agreement should be written off to the income statement. The normal practice is to allocate the total amount of the rentals to each accounting period on a straight line basis. An operating lease does not lead to either a non-current asset or a liability for future rentals due under the agreement being reported on the statement of financial position of the lessee. The asset is recorded as a non current asset on the statement of financial position of the lessee. This gives rise to a charge for depreciation, just as all other non-current assets are depreciated. The value of the capital element of future payments required under the lease agreement is reported as liability on the statement of financial position of the lessee. This will be divided into the current liability and the non current liability. Payments are split into two elements a capital repayment (which reduces the liability), and interest on the liability (which is reported as a charge to the income statement). How are the values for the entries calculated? Essentially, a lease agreement is a rental agreement. Under the agreement, the owner (lessor) receives a series of payments which allows the lessee to have use of an asset. For an operating lease, this is quite straightforward. The full value of the rentals is charged to the income statement. Rentals are normally allocated to an accountiing period on a straight line basis. The application of this principle is demonstrated in Example 2. For a finance lease, there are three key principles which must be used. These relate to: initial recognition of the asset depreciation dividing the payments into capital and interest elements Initial recognition IAS 17 states that the value at which the asset (and the corresponding liability) should initially be recognised is the lower of the fair value of the asset, and the present value of the minimum payments due under the lease. Fair value is the value at which the asset could be acquired on the open market. The interest rate implicit in the lease is effectively the internal rate of return of the lease, based on the fair value of the asset and the payments which the lessee must make under the terms of the lease. Discounted cash flow calculations are not part of the syllabus for Module A (they are, however, on the syllabus for Module B). Therefore calculation of the present value will not be required in a DipFM exam for Module A. This means that, more often than not, the initial value will be the fair value of the asset, and this value will be included in the question.

3 Dividing the payments into capital and interest elements is one matter in which the approach required in a DipFM exam is likely to be much more straightforward than most candidates might think. Depreciation The leased asset should be depreciated on the same basis as other assets which are owned by the lessee. One point to be aware of is that, if it is not reasonably certain that ownership of the asset will be transferred to the lessee by the end of the lease period, the depreciation period should be the shorter of the lease term and the useful life of the asset. Example 1 This matter is one in which the approach required in a DipFM exam is likely to be much more straightforward than most candidates might think. The standard requires interest to be calculated so that the interest in each period represents a constant periodic rate of interest on the remaining balance. In simple terms, the interest for each period would be calculated using the interest rate implicit in the lease. As has already been noted, the interest rate implicit in the lease will be provided if candidates are required to use it. This approach is often referred to as the actuarial method, and it is demonstrated in the example. Helpfully, the standard allows the calculation of the finance charge to be simplified by using some form of approximation. In Module A, there are two possible approximation methods which may be used. These are: sum of digits straight line The sum of digits method provides an allocation of the interest to accounting periods so that the proportion of each payment which is deemed to be an interest payment will reduce over the term of the lease, while the straight line method charges the same amount of interest to each accounting period. Therefore, the sum of digits method is a better method, but exam questions may use the straight line method to reduce the number of calculations required. Both methods are illustrated in Example 1. Impact of treatment Clearly, the correct classification of a lease has an impact on an entity s financial statements as a number of key ratios might be affected. A finance lease gives rise to the creation of an asset, as well as current and non-current liabilities. Therefore, classifying a lease as a finance lease will impact on any assessment of performance which utilises the values for non-current assets, current liabilities or non-current liabilities. Examples would be: Return on capital employed total assets are likely to increase, and while this will be offset to some extent by an increase in current liabilities, the net effect will be to increase the value of capital employed Return on Gross Assets Asset turnover Current ratio/quick assets ratio (as current liabilities will be increased) Profitability ratios are unlikely to be affected to any significant extent, as the total income statement charge under both an operating lease (rentals) and a finance lease (depreciation + interest) are likely to be roughly similar. The exception to this is the interest cover ratio, which will appear to be better under a finance lease, due to the classification of part of the charge as interest.

4 finance matters 08/2009 EZ Under the sum of digits method, the digits for each of the years of the lease period are added together to obtain a total sum of digits. The interest charge is then allocated to each year in proportion. This might seem a little complicated, but in practice it is quite straightforward. Example 1 Lessee Co entered into a lease under the following terms: Lease term 5 years Payment terms: 5 annual payments of $110,690, payable in advance, with a further payment of $110,690 due at the end of the lease period Implicit interest rate 13% per annum (approximately) The lease does not include any right of ultimate ownership for Lessee Co. Lessee Co is responsible for maintaining and insuring the asset, as well as all running costs. If the asset had been purchased outright at the start of the lease, the cost would have been $500,000. The asset has an expected useful life of seven years. The depreciation policy of Lessee Co is to fully depreciate non-current assets on a straight line basis over their useful life. Step 1 Classify the lease As Lessee Co is responsible for maintenance, insurance and running costs, this lease appears to be a finance lease, notwithstanding the fact that the lease period is a little shorter than the useful life of the asset. Step 2 Obtain the value at which the asset should initially be recognised In this case, we have been given the fair value, so we use that value $500,000. Step 3 Calculate the depreciation charge As ownership of the asset will not be transferred at the end of the lease, Lessee Co should depreciate it over the shorter of the lease period (five years) and the useful life (seven years). Applying the policy of fully depreciating assets on the straight line basis, the annual depreciation charge is: $500,000 5 = $100,000 Step 4 Calculate the interest charges The total payments due under the lease are $664,140 (6 x $110,690). The fair value of the asset is $500,000. Therefore, the interest element of the total due under the lease is $164,140 ($664,140 - $500,000). Having calculated the total interest, it must be allocated to each year of the lease. The most accurate method is the actuarial method. This is demonstrated in Table 1. Example 2 Assume that the terms of the lease are the same as in Example 1, except that the responsibility for maintenance and insurance of the asset remain with the lessor, and the asset has a useful life of ten years. In this case, the lease is likely to be an operating lease. The annual charge to the income statement is calculated as follows: Total payments $664,140 Lease period 5 years Annual charge $132,828 The payment pattern will therefore lead to an accrual at each year end for rentals charged, but not yet paid, calculated as follows: Year Payment Income Accrual at statement year end charge 1 $110,690 $132,828 $22,138 2 $110,690 $132,828 $44,276 3 $110,690 $132,828 $66,414 4 $110,690 $132,828 $88,552 5 $221,380 $132,828 $ nil Total $664,140 $664,140

5 Sum of digits method This is simply a different method of allocating the total interest of $164,140 to each year of the lease. Under this method, the digits for each of the years of the lease period are added together to obtain a total sum of digits. The interest charge is then allocated to each year in proportion. This might seem a little complicated, but in practice it is quite straightforward. In our example, the lease runs for five years, so we add the digits from 1 to 5. This gives a total of 15 ( ). The first year is assigned the largest digit, and the final year is assigned 1.Thus the interest is allocated to each year as follows: Year Proportion Interest 1 5/15 $ 54, /15 $ 43, /15 $ 32, /15 $ 21, /15 $ 10,943 Total $164,140 Straight line method This is the simplest method as the total interest of $164,140 is equally divided across the five years of the lease period. Thus, $32,828 will be charged for each year. Ronnie Paton is examiner for Module A Table 1 footnote 1 This adjustment arises because the interest rate is closer to %, but 13% was used to simplify the calculations. TABLE 1: Calculate the interest charges acturial Method Actuarial method B balance pa Year 1 Value of asset $500,000 less: payment in advance $110,690 thus: Capital balance at outset $389,310 $50,610 Year 2 Balance brought forward capital $389,310 add: Interest charge for year 1 $ 50,610 $439,920 thus: Capital balance at start of year $329,230 $42,800 Year 3 Balance brought forward capital $329,230 add: Interest charge for year 2 $ 42,800 $372,030 thus: Capital balance at start of year $261,340 $33,974 Year 4 Balance brought forward capital $261,340 add: Interest charge for year 3 $ 33,974 $295,314 thus: Capital balance at start of year $184,624 $24,001 Year 5 Balance brought forward capital $184,624 add: Interest charge for year 4 $ 24,001 $208,625 thus: Capital balance at start of year $ 97,935 $12,732 add: Interest charge for year 5 $ 12,732 $110,667 Adjustment 1 $ 23 $ 23 less: Final payment $110,690 nil Total interest $164,140