Chapter 9 LEASES

Chapter Learning Objectives

Upon com pletion of this chapter you will be able to:

· Explain why recording the legal form of a finance lease can be

m isleading to users m aking reference to the com m ercial
substance of such leases

· Define a finance lease and an operating lease

· Determ ine whether a lease is a finance lease or an operating

lease

· Account for finance lease assets in the records of the lessee

· Account for operating lease assets in the records of the lessee

· Explain the effect on the financial statem ents of a finance lease

being incorrectly treated as an operating lease

· Bullet point 9

LEASED ASSETS

FINANCE
LEASES
OPERATING
LEASES

REPORTINGCH9ACCAF7INTJCV1 -1-
 1 Finance leases and operating leases
1.1 What is a leasing agreement?

A leasing agreem ent is an agreem ent whereby:

. one party, the lessee, pays lease rentals to another party, the lessor
. in order to gain the use of an asset over a period of tim e

1.2 Types of lease

There are two types of lease:

. a finance lease
. an operating lease

A finance lease is a lease that transfers substantially all the risks and rewards incident to
ownership of an asset to the lessee.

IAS 17 defines a lease as an agreem ent whereby the lessor conveys to the lessee, in return for a
paym ent or series of paym ents, the right to use an asset for an agreed period of tim e.

An operating lease is any lease other than a finance lease.

1.3 Accounting for leases

IAS 17 Leases deals with:
. the accounting treatm ent of finance leases and operating leases
. the disclosure requirem ents for finance leases and operating leases

Expandable text
In som e countries there is a widespread practice of acquiring non-current assets by
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instalm ents spread over a period of several years. O wnership of the asset does not pass until the
final instalm ent is paid.
The m ain difference between a hire purchase contract and other form s of lease is that under a
hire purchase contract, ownership in the goods does pass to the purchaser, usually well before
the end of the useful life of the asset.

REPORTINGCH9ACCAF7INTJCV1 -2-
Hire purchase contracts satisfy the definition of finance leases in IAS 17.
Hire purchase contracts in the records of the buyer are treated in the sam e w ay as other
finance leases

Test your understanding

Test your understanding 1

W hat is the definition of a finance lease?

Test your understanding

Solution

Show answer

Solution
A finance lease is a lease agreem ent whereby the significant risks and rewards of ownership of
an asset are transferred to the lessee.

2 Substance over form

2.1 The meaning of substance over form

In m any types of transactions there is a difference between the com m ercial substance and the
legal form :
. com m ercial substance reflects the financial reality of the transaction
. legal form is the legal reality of the transaction

2.2 Leasing and substance over form

W hen an asset leased there is a difference between the legal form of that transaction and its
com m ercial substance:
. the legal form is that the asset rem ains legally owned by the party leasing it out (the
lessor)
. the com m ercial substance is that under a finance lease agreem ent the party m aking the
lease paym ents (the lessee) has the use of the asset for m ost or all of its useful life
. the lessee has effectively purchased the asset by taking out a loan (the finance lease
com m itm ents)

2.3 Accounting treatment of the commercial substance of a lease

REPORTINGCH9ACCAF7INTJCV1 -3-
As the com m ercial substance of finance leases is that the lessee is the effective owner of the
asset the accounting treatm ent required is:
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. record a liability for the lease paym ents payable to the lessor

2.4 Recording a finance lease according to its legal form

If a finance lease was accounted for according to its legal form :
. the lessee would show no asset on the balance sheet
. the lessee would show no liability in the balance sheet
. the only effect would be to charge the lease paym ents as an expense in the incom e
statem ent
. assets being used in the business would be understated
. liabilities would be understated
. return on capital em ployed would be m isleading
. gearing levels would be understated

Expandable text

IAS 17 is m ainly concerned with regulating the accounting for finance leases. The IAS 17
treatm ent follows the definition of an asset in the ,$6%¶VFram ework for the Preparation and
Presentation of Financial Statem entsµDQDVVHWLVDUHVRXUFHFRQWUROOHGE\WKHHQWHUSULVHDVD
result of past events and from which future econom ic benefits are expected to flow to the
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IAS 17 thus argues that an asset leased under a finance lease m ust be recorded as an asset and
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3 Identifying a finance lease

3.1 General rule

A lease will be classified as a finance lease if:

. substantially all the risks and rewards of ownership of the asset are transferred to the
lessee
. if not it will be an operating lease

Risks and rewards of ownership include:

. lessee carries out repairs and m aintenance
. lessee insures asset
. lessee has right to use asset for m ost or all of its useful life

REPORTINGCH9ACCAF7INTJCV1 -4-
3.2 IAS 17 guidance

IAS 17 provides guidance as to the classification of leases as finance leases or operating leases.
It gives the following list of situations in which a lease would norm ally be classified as a finance
lease.
· The lease transfers ownership of the asset to the lessee by the
end of the lease term (thus hire purchase transactions qualify).
· The lessee has the option to buy the asset at a price expected to
be lower than fair value at the tim e the option is exercised.
· The lease term is for the m ajor part of the econom ic life of the
asset even if title is not transferred.
· At the beginning of the lease, the present value of the m inim um
lease paym ents (see below) is approxim ately equal to the fair
value of the asset.
· The leased assets are of a specialised nature so that only the
lessee can use them without m ajor m odification.
· If the lease gives the lessee the right to cancel the lease, the
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lessee.
· Gains or losses from fluctuations in fair value are borne by the
lessee.
· The lessee has the ability to continue the lease for a secondary
period at a rent below the m arket rent.

3.3 Minimum lease payment test

The test is carried out as follows:
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. present value calculated based on im plicit interest rate in the lease
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Illustration
Illustration 1
W arner leases an asset which has a useful econom ic life of five years. It could be purchased
outright for $16,500. The rate of interest im plicit in the lease is 10%.

Five annual rentals of $3,956 are payable in advance. W arner is responsible for the m aintenance
of the equipm ent.
Is the lease a finance lease or an operating lease?

REPORTINGCH9ACCAF7INTJCV1 -5-
Solution
Discounting the lease paym ents using a rate of 10% gives us the following result

Year Discount factor …

1 1 3,956
2 0.909 3,596
3 0.826 3,268
4 0.751 2,971
5 0.683 2,702
_____

Net present value 16,493

_____

This is 99.9% of the fair value of the asset. The lease term is five years, which is the sam e as the
useful life of the asset. The lessee bears the cost of m aintaining the equipm ent.
Conclusion: The lease is a finance lease.

Expandable text
M inimum lease paym ents±WKHSD\P HQWVRYHUWKHOHDVHWHUP WKDWWKHOHVVHHLVRUFDQEH
required to m ake (excluding contingent rent, costs for services and taxes to be paid by and
reim bursed to the lessor), together with:
· in the case of the lessee, any am ounts guaranteed by the lessee; or
· in the case of the lessor, any residual value guaranteed to the lessor by the lessee.

Contingent rent±WKDWSRUWLRQRIWKHOHDVHSD\P HQWVWKDWLVQRWIL[HGLQDP RXQWEXWLVEDVHGRQD

factor other than just the passage of tim e (for exam ple, percentage of sales, am ount of usage,
price indices, m arket rates of interest).

Test your understanding

Test your understanding 2

A com pany has entered into a four-year lease for a m achine, with lease rentals of $150,000
payable annually in advance, and with an optional secondary period of three years at rentals of
60%, 40% and 20% of the annual rental in the prim ary period. It is agreed that these rentals
represent a fair com m ercial rate. The m achine has a useful life of eight years and a cash value of
$600,000.

W ould this lease agreem ent be a finance lease or an operating lease?

Test your understanding

Solution

REPORTINGCH9ACCAF7INTJCV1 -6-
Show answer

Solution

The contracted lease term is only for half of the useful econom ic life of the m achine and there is
no strong likelihood that the com pany will exercise the option in four years' tim e, because the
option is priced at fair value, not a discount. Thus the risks and rewards of ownership have not
passed to the lessee and this lease should be treated as an operating lease.

4 Accounting for finance leases

4.1 Initial recording

At the start of the lease:

the fair value (or, if lower, the present value of the M LPs) should be included as a non-
current asset, subject to depreciation
the sam e am ount (being the obligation to pay rentals) should be included as a loan, i.e. a
liability.
. In practice, the fair value of the asset or its cash price will often be a sufficiently close
approxim ation to the present value of the M LPs and therefore can be used instead.

4.2 Depreciation

The non-current asset should be depreciated over the shorter of:

the useful life of the asset (as in IAS 16)
the lease term .

The lease term is essentially the period over which the lessee has the use of the asset.
It includes:
the prim ary (non-cancellable) period
any secondary periods during which the lessee has the contractual right to continue to
use the asset, provided that it is reasonably certain at the outset that this right will be exercised.

4.3 Payment of rentals and allocation of finance charge

Each individual rental paym ent should be split between:

finance charge (an expense in the profit and loss account)
repaym ent of obligation to pay rentals (a reduction in the balance sheet liability).

REPORTINGCH9ACCAF7INTJCV1 -7-
Two m ain m ethods of allocating the finance charge each period:
. actuarial m ethod
. sum of the digits m ethod

Expandable text
How should finance charges be allocated over the term of the lease? The basic aim is to allocate
the charge in such a way as to produce a constant periodic rate of return on the rem aining
balance of liability. There are three possible m ethods:
· actuarial method
· sum of the digits (rule of 78) m ethod
· straight-line m ethod.
The actuarial m ethod gives the m ost accurate result, while the sum of the digits m ethod will
norm ally give an acceptable approxim ation to it. The straight line m ethod will norm ally not give
such an acceptable approxim ation.
IAS 17 requires the actuarial m ethod, though it allows som e form of approxim ation to sim plify the
calculation.

4.4 The actuarial method

The actuarial method allocates interest to each period:

. at a constant rate on the outstanding am ount.

. using the interest rate im plicit in the lease (you will be given this figure)

Illustration
Illustration 2

A com pany has two options. It can buy an asset for cash at a cost of $5,710 or it can lease it by
way of a finance lease. The term s of the lease are as follows:
1 Prim ary period is for four years from 1 January 20X2 with a rental of $2,000 p.a. payable on
the 31 Decem ber each year.
2 The lessee has the right to continue to lease the asset after the end of the prim ary period for
an indefinite period, subject only to a nom inal rent.
3 The lessee is required to pay all repair, m aintenance and insurance costs as they arise.

REPORTINGCH9ACCAF7INTJCV1 -8-
4 The interest rate im plicit in the lease is 15%.
The lessee estim ates the useful econom ic life of the asset to be eight years. Depreciation is
provided on a straight-line basis.

Solution
Step 1
W e m ay check to confirm whether the lease is a finance lease by com paring the present value of
the M LPs with the cash price.
If you do this you will find that the present value of the four paym ents of $2,000 is in fact $5,710,
the cash price. The lease is for the full value of the asset and it is therefore a finance lease.

Step 2
The asset is presented as a non-current asset in the balance sheet at $5,710 (subject to
depreciation).
Depreciation is over eight years (presum ably the asset has no residual value at the end of eight
years).
Annual depreciation charge = 1/8 ´ $5,710 = $714

Step 3
The liability is initially shown in the balance sheet at $5,710 but subsequently reduced by the
capital portion of the leasing paym ents.
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paym ent and the consequent capital sum outstanding is calculated as follows:
1 2 3 4 5 6
Period Capital sum Finance Subtotal Rental Capital
(year ended at start of charge paid sum at end
31 December) period at 15% p.a. of period
$ $ $ $ $
20X2 5,710 856 6,566 (2,000) 4,566
20X3 4,566 685 5,251 (2,000) 3,251
20X4 3,251 488 3,739 (2,000) 1,739
20X5 1,739 261 2,000 (2,000) -
____ ____
2,290 8,000
____ ____

Step 4
The effect on the financial statem ents of the lessee m ay be sum m arised as follows:
Income statement Balance sheet
Obligation
Year ended Finance 'HS¶Q Non-current Total Non- Current*
31 charge asset (NBV) current
December
$ $ $ $ $ $
20X2 856 714 4,996 4,566 3,251 1,315
20X3 685 714 4,282 3,251 1,739 1,512
20X4 488 714 3,568 1,739 ± 1,739
20X5 261 714 2,854 ± ± ±
20X6 ± 714 2,140 ± ± ±
20X7 ± 714 1,426 ± ± ±
20X8 ± 714 712 ± ± ±
20X9 ± 712 ± ± ± ±

REPORTINGCH9ACCAF7INTJCV1 -9-
 2,290 5,710

The finance charge each year is a constant periodic rate of return (15%) on the rem aining
balance of liability, e.g. $856 is 15% of $5,710, etc.
* For this lease where paym ents are m ade in arrears on the last
day of the financial year, the next paym ent of $2,000 will include
the next year's finance charge. This cannot be a current liability
at the end of the year, so each year the current am ount of the
loan is calculated as the next paym ent less the next year's
finance charge:
$
;± 1,315
;± 1,512
;± 1,739
The form at in Step 3 will be used whenever the paym ents under a lease are m ade in arrears. If
the paym ents are due in advance, the rental paid is deducted from the capital sum at the start of
the period before the interest is calculated. In other words, colum ns 3 and 5 would be reversed.

Test your understanding

Test your understanding 3
P Lim ited entered into a five-year lease on 1 January 20X3 for a m achine with a fair value of
$20,000. Rentals are $5,200 p.a. payable in advance and the residual value at the end of the
lease is calculated as $4,200 which will be returned to P Lim ited.

P Lim ited is responsible for insurance and m aintenance costs. The rate of interest im plicit in the
lease is 15.15% .

You are required to show the allocation of the finance charges over the lease term on an
actuarial basis and calculate the non-current liability for finance leases at 31 Decem ber 20X3.

Test your understanding

Solution

Allocate finance charge on an actuarial basis.

Year Capital Lease Capital Finance Capital
b/f payment outstanding charge at year end
at 15.15%
$ $ $ $ $

Solution

REPORTINGCH9ACCAF7INTJCV1 - 10 -
Allocate finance charge on an actuarial basis.
Year Capital Lease Capital Finance Capital
b/f payment outstanding charge at year end
at 15.15%
$ $ $ $ $
20X3 20,000 5,200 14,800 2,242 17,042
20X4 17,042 5,200 11,842 1,794 13,636
20X5 13,636 5,200 8,436 1,278 9,714
20X6 9,714 5,200 4,514 686 5,200
20X7 5,200 5,200 ± ± ±
Non-current liability at 31 December 20X3
$
$P RXQWVGXHXQGHUILQDQFHOHDVH± 11,842
In this situation the lease paym ents are in advance. So the next paym ent is due in 1 day and the
year end current liability includes the current year's finance charge (which has accrued but not
been paid). To calculate the non-current liability, the full am ount of the next paym ent is deducted
from the year end capital balance.

4.5 Sum of the digits method

The sum of the digits m ethod:

. is a good approxim ation to the actuarial m ethod
. allocates higher interest charges to earlier periods than later periods
. uses an arithm etically sim ple m ethod of weighting the num ber of paym ents and then
sum m ing them .

Under this m ethod a digit is allocated to each instalm ent according to the num ber of instalm ents
outstanding.

Illustration
Illustration 3

In the illustration above the num ber of instalm ents is four, and the digits 4, 3, 2, 1 would be
allocated to them . The sum of these digits is 10.

The form ula to use is: (QQ·ZKHUHQ WKHQXP EHURILQWHUHVWEHDULQJSD\P HQWV,QWKLV
FDVH· 

REPORTINGCH9ACCAF7INTJCV1 - 11 -
The interest allocation would then be:
$
Year 1 4/10 ´ $2,290 916
2 3/10 ´ $2,290 687
3 2/10 ´ $2,290 458
4 1/10 ´ $2,290 229
These figures are an acceptable approxim ation to the actuarial figures used above.

If the instalm ents were payable in advance, the digits allocated would be 3, 2, 1, 0, because the
initial paym ent m ade at the beginning of the contract would reduce the am ount outstanding for
the year, and the paym ent m ade at the beginning of the final year would reduce the debt to nil, so
that the interest cost in that year would also be nil.

Test your understanding

Test your understanding 4

A com pany is entering into a finance lease with half-yearly paym ents in advance of $15,000 for 3
years. The fair value of the leased asset is $78,000. The sum of the digits m ethod is to be used to
determ ine the annual finance charge.

W hat is the finance charge for the first year of the lease?

Test your understanding

Solution

Show answer

Solution

$
/HDVHSD\P HQWV[… 90,000
Fair value 78,000
Total finance charge 12,000

As the paym ents are in advance the finance charge only covers 5 six m onth periods therefore the
sum of the digits is (5 x 6 )/2 = 15.

Allocation of finance charge to first two six m onth periods:

$
$12,000 x 5/15 4,000
$12,000 x 4/15 3,200
7,200

REPORTINGCH9ACCAF7INTJCV1 - 12 -
 4.6 Summary of bookkeeping entries

At the inception of the lease:

Dr Non-current assets: Cost
Cr Lease creditor
with the present value of the m inim um lease paym ents/fair value of
the leased asset.
At the end of each period of the lease:
Dr Depreciation expense (incom e statem ent)
Cr Non-current assets: accum ulated depreciation
with the depreciation charge for the period.
As each rental is paid:
Dr Lease creditor
Cr Cash
with the rental paid, and
Dr Interest expense (incom e statem ent)
Cr Lease creditor
with the finance charge.

4.7 Disclosure

IAS 17 requires the following disclosures by lessees for finance leases:

· for each class of asset, the net carrying am ount at the balance sheet date
· a reconciliation between the total of m inim um lease paym ents at the balance sheet date, and
their present value. In addition, an enterprise should disclose the total of m inim um lease
paym ents at the balance sheet date, and their present value, for each of the following periods:
± not later than one year
± later than one year and not later than five years
± later than five years
· contingent rents recognised as an expense for the period
· the total of future m inim um sublease paym ents expected to be received under non-
cancellable subleases at the balance sheet date
· DJHQHUDOGHVFULSWLRQRIWKHOHVVHH¶VVLJQLILFDQWOHDVLQJDUUDQJHP HQWVLQFOXGLQJEXWQRW
lim ited to, the following:
± the basis on which contingent rent paym ents are determ ined
± the existence and term s of renewal or purchase options and escalation clauses
± restrictions im posed by lease arrangem ents, such as those concerning
dividends, additional debt, and further leasing.
In addition, the requirem ents on disclosure in accordance with IAS 16 Property, plant and
equipm ent, apply to the am ounts of leased assets under finance leases that are accounted for by
the lessee as acquisitions of assets.

REPORTINGCH9ACCAF7INTJCV1 - 13 -
Illustration
Illustration 4

Using the earlier illustration and the calculations under the actuarial m ethod, the following
disclosure would be appropriate:

Extracts from balance sheet

31 Dec 20X2
$
Non-current assets:
Leased property under finance leases 5,710
Less: Accum ulated depreciation 714
____
4,996
____
Non-current liabilities:
Non-current obligations under finance leases 3,251
Current liabilities:
Current obligations under finance leases 1,315

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The future m inim um lease paym ents to which the com pany is com m itted as at 31 Decem ber
20X2 are:
Minim um lease paym ents
Amounts payable Net present value
$ $
Am ounts payable next year 2,000 1,315
Am ounts payable after m ore than one year
and not later than five years 4,000
_____ 3,251
_____
6,000 4,566
Less: Finance charges allocated to future periods1,434 _____
_____
4,566
_____

Extract from statement of accounting policies

W here assets are financed by leasing agreem ents that give rights approxim ating to ownership
µILQDQFHOHDVHV¶WKHDVVHWVDUHWUHDWHGDVLIWKH\KDGEHHQSXUFKDVHGRXWULJKW7KH
corresponding leasing com m itm ents are shown as obligations to the lessor.

Charges are m ade to the incom e statem ent in respect of:

· GHSUHFLDWLRQ±ZKLFKLVSURYLGHGRQDVWUDLJKWOLQHEDVLVRYHUWKHXVHIXOOLIHRIWKHDVVHW
· WKHWRWDOILQDQFHFKDUJH±ZKLFKLVDOORFDWHGRYHUWKHSULP DU\SHULRGRIWKHOHDVHXVLQJ
the actuarial m ethod.

Test your understanding

Test your understanding 5

Jones plc

REPORTINGCH9ACCAF7INTJCV1 - 14 -
On 1 January 20X7 Jones plc acquired the use of a m ajor piece of heavy agricultural plant, the
Vinnie, under a finance lease. The m achinery has a useful life of 8 years with nil residual value.
The cost of the Vinnie would be $600,000 if it were bought for cash. The lease is an eight-year
lease for the Vinnie, with lease rentals of $110,000 payable annually in advance. The interest rate
im plicit in the lease is 12.8%.

Show the am ounts to be included in the balance sheet of Jones Ltd at 31 Decem ber 20X7 and
the am ounts to appear in the profit and loss account for that year.

Test your understanding

Solution

Show answer

Solution

Balance sheet

$
Non-current liabilities
Non-current obligation under finance leases (W ) 442,720
Current liabilities :
Current obligations under finance leases (W ) 110,

Non-current assets
Leased property under finance leases:
Cost 600,000
600,000
Depreciation 75,000
8

Income statement
Depreciation on plant held under finance leases 75,000
Finance charges on finance leases (W ) 62,720

Workings
Lease table
Year Capital Lease Capital Finance Capital
b/f payment outstanding charge at year
at 12.8% end
$ $ $ $ $
20X7 600,000 110,000 490,000 62,720 552,720
20X8 552,720 110,000 442,720 56,668 499,388

REPORTINGCH9ACCAF7INTJCV1 - 15 -
For leases with annual paym ents in advance the current liability is the full am ount of the next
paym ent due and the non-current liability is the rem ainder of the capital at the year end.

5.1 Accounting treatment

Operating lease assets are very different in nature to finance lease assets as the risks and
rewards of ownership are not transferred to the lessee. Therefore the accounting treatm ent is
also very different:

. an asset is not recognised in the balance sheet

. rentals under operating leases are charged to the incom e statem ent on a straight-line
basis over the term of the lease, unless another system atic and rational basis is m ore
appropriate

. any difference between am ounts charged and am ounts paid will be prepaym ents or
accruals.

5.2 Disclosure
Balance sheet: obligations under operating leases
For non-cancellable operating leases with a term of m ore than one year, com m itm ents should be
disclosed in sum m ary form , giving the am ounts and periods in which the paym ents will becom e
due.

The detailed disclosure requirem ents for lessees for operating leases are:
· the total of future m inim um lease paym ents under non-cancellable operating leases for
each of the following periods:
± not later than one year
± later than one year and not later than five years
± later than five years
· the total of future m inim um sublease paym ents expected to be received under non-
cancellable subleases at the balance sheet date
· lease and sublease paym ents recognised as an expense for the period, with separate
am ounts for m inim um lease paym ents, contingent rents, and sublease paym ents
· DJHQHUDOGHVFULSWLRQRIWKHOHVVHH¶VVLJQLILFDQWOHDVLQJDUUDQJHP HQWVLQFOXGLQJEXWQRW
lim ited to, the following:
± the basis on which contingent rent paym ents are determ ined
± the existence and term s of renewal or purchase options and
escalation clauses
± restrictions im posed by lease arrangem ents, such as those
concerning dividends, additional debt, and further leasing.

Illustration

REPORTINGCH9ACCAF7INTJCV1 - 16 -
Illustration 5
A com pany uses two offices, both leased:
/HDVH$H[SLUHVLQ\HDUV±DQQXDOUHQWDO
/HDVH%H[SLUHVLQ\HDUV±DQQXDOUHQWDO
The disclosure would be:
Land and buildings
$
Operating leases which expire:
In the second to fifth years inclusive 30,000
Over five years 20,000
_____

Total annual com m itm ent as at the current year-end 50,000

_____

6 Finance lease or operating lease?

6.1 Significance

The significance of the accounting treatm ent of leased assets is heightened by the difference
between the accounting treatm ent of finance leases and that of operating leases which are
sum m arised:

Finance lease Operating lease

Asset capitalised No asset
Liability recognised No liability
Finance charge Full rental charge
Depreciation charge No depreciation

6.2 Finance lease treated as an operating lease

If a finance lease asset is incorrectly treated as an operating lease it will have the following
effects on the financial statem ents:
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. OLDELOLWLHVXQGHUVWDWHG±JHDULQJXQGHUVWDWHG
. little effect on incom e statem ent

Expandable text

As we have seen in this chapter there is a distinct difference between the accounting treatm ent of
finance leases and the accounting treatm ent of operating leases. Therefore an incorrect
classification of a lease can have a significant effect on the balance sheet of a com pany and on
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If we consider a lessee who has a lease that is a finance lease but it is treated incorrectly as an
operating lease, in the balance sheet there will be no non-current asset recorded which m eans
that the assets that are earning incom e for the com pany are effectively understated. The other
effect on the balance sheet is that there is also no liability recognised for the finance lease
paym ents. This can serve to understate the am ount of gearing that the com pany has.

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In the incom e statem ent there is less effect. The correct treatm ent under a finance lease would
be a depreciation charge based on the fair value of the finance lease asset and the finance
charge elem ent of the lease paym ent. However if the lease is treated as an operating lease then
the entire lease paym ent will be charged to the incom e statem ent. This will probably m ean that
the total charge to the incom e statem ent will be sim ilar under both treatm ents.

Test your understanding

Test your understanding 6

W righty acquired use of plant over three years by way of a lease. Instalm ents of $700,000, are
paid six-m onthly in arrears on 30 June and 31 Decem ber. Delivery of the plant was on 1 January
20X0 so the first paym ent of $700,000 was on 30 June 20X0. The present value of m inim um
lease paym ent is $3,000,000. The interest im plicit in the above is 10% per six m onths. The plant
would norm ally be expected to last three years. W righty is required to insure the plant and
cannot return it to the lessor without severe penalties.

Required:

(a) Describe whether the above lease should be classified as an operating or finance lease.

(b) Calculate the effect of the above on incom e statem ent and B/S for the year ended
31 Decem ber 20X0.
(c) W hy might W righty deliberately choose to report the lease as an operating lease?

Solution

(a) Risks and rewards of ownership of the m achine are with W righty; so this is a finance lease.

(b) Period Opening loan Interest (10%) Instalment Closing loan

$000 $000 $000 $000
1 3,000 300 (700) 2,600
2 2,600 260 (700) 2,160
3 2,160 216 (700) 1,676
4 1,676 168 (700) 1,144

The finance charge to appear in the profit and loss account for the year is $560,000 (300
+ 260)

In the balance sheet there will be:

$000

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Current liabilities
O bligations under finance leases 1,016

Non-current liabilities
Obligations under finance leases 1,144

(c) Creative accounting: off balance sheet finance.

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Chapter Summary

LEASED
ASSETS

FINANCE OPERATING
LEASES LEASES

Capitalise Charge
asset rental to
income
Create statement
liability

Charge
finance
cost to
income
statement

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&KHFNOLVW±VXEPLWZLWKHDFKFKDSWHU
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