Nanyang Technological University

Nanyang Business School

AC2101 – Accounting Recognition and Measurement

Semester 1, 2017-18

Outline for Seminar 5:

Leases II

Learning objectives:

 Understand and apply the accounting requirements for a sales-type lease and sales
and leaseback arrangement

Required readings:

 Per Seminar 4

Illustration 1

KLIS Airlines Ltd (KLIS) faced cash flow problems. So, on 1 January 20x6, it
sold one of its aeroplanes to LLL Leasing Ltd (LLL) and immediately leased it
back.

Assume that the terms and conditions of the transaction are such that the transfer
of the airplane by KLIS satisfies the requirement for determining when a
performance obligation is satisfied in FRS 115.

The aeroplane was purchased by KLIS in January 20x1 for $200 million. Its useful
life was estimated to be 20 years with no material salvage value. KLIS adopted a
31 December accounting year-end and the straight line method of depreciation.

The sales price was based on the fair value of the aeroplane as at 1 January 20x6
of $180 million. The book value was $150 million (cost of $200 million less
accumulated depreciation of $50 million).

KLIS was to lease back the aeroplane for only 5 years. Given that LLL required a
10% rate of return on the lease transaction, assume the annual lease payments are
$23,665,000.

In this case, the sales and leaseback transaction will be recorded in KLIS’s books
on 1 January 20x6 as follows (in $’000):

1
 Dr Cash 180,000
Dr Right-of-use asset 74,758
Dr Accumulated depreciation 50,000
Cr Aeroplane 200,000
Cr Gain on sale of aeroplane 15,048
Cr Lease liability 89,710
(to record the sale and leaseback)

Notes:
1: Lease liability = $23,665 x PV factor of 3.79079 = $89,710
2: Right-of-use asset = $150,000 x ($89,710 / $180,000) = $74,758
3: Gain = $30,000 x (($180,000 - $89,710) / $180,000) = $15,048
4: Since the leaseback is for less than the remaining life (or FV) of the
underlying asset, the seller-lessee is deemed to have sold part of the
underlying asset. Consequently, the gain or loss arising therefrom should
be recognised, and the right-of-use asset will be capitalised at an amount
proportionately less than the CA of the underlying asset before the sale
and leaseback.

The sales and leaseback transaction will be recorded in LLL’s books on 1 January
20x6 as follows (in $’000):

Dr Aeroplane 180,000
Cr Cash 180,000
(Purchase of aeroplane)

The leaseback should be accounted for as an "operating lease" (assuming it does

not meet the criterion of a "finance lease").

Illustration 2

Refer to Illustration 1

Case A (Sales consideration is lower than the fair value of the underlying asset)

Assume that the airplane was sold for $160 million (instead of at its FV of $180
million). Given that LLL required a 10% rate of return on the lease transaction, the
ALPs is assumed to be $18,390,000 (all numbers in illustration are rounded to the
nearest thousand).

In this case, para. 101 requires that the sale should still be deemed as $180 million
(as in Illustration 1), except that KLIS has paid $20 million of the lease payment up
front on 1 January 20x6. Hence, KLIS will receive a net cash inflow of $160 million.
The lease liability would be recognised at $69.71 million, which is the PV of the

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lease payments.

The journal entries are:

Dr Cash 160,000
Dr Right-of-use asset 74,758
Dr Accumulated depreciation 50,000
Cr Aeroplane 200,000
Cr Gain on rights transferred 15,048
Cr Lease liability 69,710
(to record the sale and leaseback)

Notes:
1: Lease Liability = PV lease payments = $18,390 * PV factor of 3.79079
= $69,710
2: Right-of-use asset = Book value x ((Lease liability + Prepayment)/ FV)
= $150,000 x ($89,710 / $180,000)
= $75,758
3: Gain on rights transferred = Gain x (FV – (Lease liability + Prepayment))
/ FV
= $30,000 x ((180,000 – $89,710) / 180,000)
= $15,048

Alternatively, the above sales and leaseback transaction will be recorded in

KLIS’s books on 1 January 20x6 as follows (in $'000):
Dr Cash 180,000
Dr Right-of-use asset 74,758
Dr Accumulated depreciation 50,000
Cr Aeroplane 200,000
Cr Gain on rights transferred 15,048
Cr Lease liability 89,710
(to record the sale and leaseback)

Dr Lease liability 20,000

Cr Cash 20,000
(to record the assumed prepayment of lease liability)
Notes:
1: Lease liability = PV of lease payments + Prepayment
= $69,710 + $20,000
= $89,710
The above sales and leaseback transaction will be recorded in LLL’s books on 1
January 20x6 as follows (in $'000):
Dr Aeroplane 180,000
Cr Cash 180,000
(Purchase of aeroplane)

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 Dr Cash 20,000
Cr Unearned income 20,000
(assumed prepayment of lease payment)

The leaseback should be accounted for as an "operating lease" (assuming it does not
meet the criterion of a "finance lease").

Assume the rental income is amortised on a straight-line basis. On 31 December

20x6, LLL’s journal entries are as follows:

Dr Cash 18,390
Dr Unearned Income 4,000
Cr Lease Income 22,390
(to record lease income)

Dr Depreciation Expense 12,000

Cr Accumulated Depreciation 12,000
(to record depreciation expense)

Case B (Sales consideration is higher than the fair value of the underlying asset)

Assume that the aeroplane was sold for $200 million (instead of at its fair value of
$180 million). Given that LLL required a 10% rate of return on the lease transaction,
the annual lease payments are assumed to be $28,940,000 (rounded to the nearest
thousand).

In this case, para. 101 requires that the sale to still be recorded at $180 million (as in
Illustration 1), except that LLL has lent additional $20 million to KLIS up front on 1
January 20x6.

The journal entries are:

Dr Cash 200,000
Dr Right-of-use asset 74,758
Dr Accumulated depreciation 50,000
Cr Aeroplane 200,000
Cr Gain on rights transferred 15,048
Cr Lease Liability 109,710
(to record the sale and leaseback)

Notes:
1: Lease Liability = PV of lease payments = $28,940 * PV factor of 3.79079
= $109,710

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 2: Right-of-use asset = Book value x ((Lease liability – Additional Loan) /
FV)
= $150,000 x ($89,710 / $180,000)
= $74,758
3: Gain on rights transferred = Gain x (FV – (Lease liability – Additional
Loan)) / FV
= $30,000 x ((180,000 – 89,710) / 180,000)
= $15,048

The payment of $28,940,000 on 31 December 20x6 will be recorded in KLIS’s

books as follows (rounded to nearest $’000) *

Dr Lease Liability 17,969

Dr Interest Expense 10,971
Cr Cash 28,940
(to record liability repayment)
*: Lessee also separately records the depreciation expense of the right-of-use asset

Alternatively, the above sales and leaseback transaction will be recorded in

KLIS’s books on 1 January 20x6 as follows (in $'000):

Dr Cash 180,000
Dr Right-of-use asset 74,758
Dr Accumulated depreciation 50,000
Cr Aeroplane 200,000
Cr Gain on rights transferred 15,048
Cr Lease Liability 89,710
(to record the sale and leaseback)

Dr Cash 20,000
Cr Loan Payable 20,000
(to record the additional financing)

Notes:
Lease liability = PV of lease payments –Loan Payable
= $109,710-$20,000
= $89,710
The payment of $28,940,000 on 31 December 20x6 will be recorded in KLIS’s
books as follows (rounded to nearest $'000):

Dr Loan Payable 3,275

Dr Interest Expense (10% * 20,000) 2,000
Cr Cash 5,275
(to record loan repayment)

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 Dr Lease Liability 14,694
Dr Interest Expense (10% * 89,710) 8,971
Cr Cash 23,665
(to record lease liability repayment)

The above sales and leaseback transaction will be recorded in LLL’s books on 1
January 20x6 as follows (rounded to nearest $'000):

Dr Aeroplane 180,000
Dr Loan Receivable 20,000
Cr Cash 200,000
(to record purchase of aeroplane)

On 31 December 20x6, LLL’s journal entries are as follows:

Dr Cash 5,275
Cr Interest income (10% x 20,000) 2,000
Cr Loan Receivable 3,275
(to record loan receivable)

Dr Cash (28,940-5,275) 23,665

Cr Lease Income 23,665
(to record lease income)

Dr Depreciation Expense 12,000

Cr Accumulated Depreciation 12,000
(to record depreciation)
The leaseback should be accounted for as an "operating lease" (assuming it does not
meet the criterion of a "finance lease").

Illustration 3

XYZ Airlines Ltd (XYZ) faces cash flow problems. So, on 1 January 20x6, it sells
one of its airplanes to a leasing company and immediately leases it back for its entire
remaining life of 15 years.
Assume that the terms and conditions of the transaction are such that the transfer of
the airplane by XYZ does not meet the definition of a sale in FRS 115.

The airplane was purchased by XYZ in January 20x1 for $210 million. Its useful life
was estimated at 20 years with a salvage value of $10 million and a residual value of
nil. XYZ adopts 31 December accounting year ends and the straight line method of
depreciation.

On 1 January 20x6 (ie, after 5 years’ usage), the fair value of the airplane is $100

6
million. However, since XYZ needs $150 million cash, the sales price is fixed at $150
million. The leasing company, LLL Leasing Ltd (LLL), requires a 10% rate of return
and thus the annual lease payment is fixed at $19,721,000 ($150 million / PV factor
of 7.60608) for each of the 15 years.

In this case, since the transfer of the asset is not a sale, the sale and leaseback
transaction should be accounted for as a financing transaction. XYZ is, in substance,
borrowing from the leasing company, using the airplane as the collateral.

In accordance with the para. 103 of FRS 116, the arrangement should be accounted
for as follows (rounded to nearest $ '000): (Note: For purposes of illustration, only the
journal entries related to the loan for the first two years are shown.)

XYZ
1/1/x6
Dr Cash 150,000
Cr Loan payable 150,000
(to record loan arrangement)

31/12/x6
Dr Loan payable 4,721
Dr Interest expense 15,000 [10% x 150,000]
Cr Cash 19,721
(to record repayment of loan)

31/12/x7
Dr Loan payable 5,193
Dr Interest expense 14,528 [10% x (150,000 – 4,721)]
Cr Cash 19,721
(to record repayment of loan)

LLL
1/1/x6
Dr Loan receivable 150,000
Cr Cash 150,000
(to record loan arrangement)

31/12/x6
Dr Cash 19,721
Cr Loan receivable 4,721
Cr Interest income 15,000
(to record repayment of loan)

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 31/12/x7
Dr Cash 19,721
Cr Loan receivable 5,193
Cr Interest income 14,528
(to record repayment of loan)

Write-up:

Following is a write-up on the accounting issues concerning sales-type lease:

In a sales-type lease, the seller/lessor earns two distinct streams of revenue, namely,
(a) gross profit on sales, and
(b) interest income on financing.

Gross profit on sales = the difference between the cost of goods sold and the sales price.

Interest income = the difference between gross investment and its present value (note that
the present value of gross investment is net investment).

The total of the gross profit and interest income is equal to the difference between the
gross investment (as defined under direct finance lease for lessor) and the inventory cost
of the asset to the seller/lessor.

Note that FRS 116 discusses sales-type leases under the heading “Manufacturer or
dealer lessors (paras 71-74). A sales-type lease is accounted for by the manufacturer or
dealer lessor as a finance lease. Further note that like direct finance leases, sales-type
leases do not necessarily always lead to a transfer of title.

Journal entries:

Dr Lease receivable (gross investment, G)

Dr Cost of goods sold
Cr Inventory
Cr Sales (lower of PV of LPs or fair value)
Cr Unearned interest (lease receivable (or G) – PV of G (or N))

The cost of goods sold is the cost, or carrying amount, if different, of the underlying asset
less the present value of the unguaranteed residual value. The date of recognition of the
selling profit or loss is the commencement date of the sales-type lease agreement.

One major problem relating to accounting for sales-type lease is where the seller/lessor, in
order to attract sales, charges an artificially low interest rate for the financing of the lease.
In this case, the gross investment will be reduced while the cost of sales remains the same.
The problem is how this reduced total income should be apportioned between the two
revenue elements of gross profit and interest income.

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FRS 116 para 73 provides that in a sales-type lease where artificially low interest rates are
quoted, the selling profit should be restricted to that which would apply if a commercial
rate of interest were charged. This may be achieved by recording the sale at the PV of LPs
discounted at the fair interest rate.

Journal entries:

Dr Lease receivable (gross investment, G)

Dr Cost of goods sold
Cr Inventory
Cr Sales (PV of LPs @ fair market rate)
Cr Unearned interest (lease receivable (or G) – PV of G (or N))

The rationale for this provision is that an artificially low interest rate, being a marketing
strategy, has the same effect as granting a "trade discount", and therefore the effect should
be accounted for as a reduction of the sales amount.

The net effect of this provision is that the effective interest income should be maintained
at fair market rate and gross profit on sales should be reduced for the reduction in the total
income due to the artificially low interest rate charged.

Assume a seller/lessor sells machinery. He buys them at a cost of $100. He enters into a
sales-type lease agreement with his customer where the payment for the machinery is to
be made at the end of the first year. The fair market interest rate = 25%. The fair value of
the asset at the start of the sales-type lease agreement is $160

Arrangement 1 – Assuming the seller/lessor charges a normal rate of interest where the
customer is required to make a lease payment amounting to $200 at the end of the first
year.

Note here in this scenario where n = 1 year, PV = $160, future value = $200, the IRR =
25% which equals to the fair market rate.

Assuming normal rate of interest

$100 $160 $200
╚════════════════════════╩═════════════════╝
Cost Sale Lease receivable

G = Sum of LPs + unGRV = $200 + $0

In this case, Sales=N = PV of LPs at fair market rate = $160
Unearned Interest = G – N = $40
Gross Profit = $160 - $100 = $60

Dr Lease receivable (gross investment, G) $200

Dr Cost of goods sold (cost) $100
Cr Inventory $100
Cr Sales (PV of LPs = fair value) $160
Cr Unearned interest (lease receivable (or G) – PV of G (or N)) $ 40

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Arrangement 2 – Assuming the seller/lessor charges an artificially low rate of interest
where the customer is required to make a lease payment amounting to $170 at the end
of the first year.

Note here in this scenario where n = 1 year, PV = $160, future value = $170, the IRR =
6.25% which is significantly lower than 25%, i.e. an artificially low interest rate has been
charged.

The questions then are, should sales revenue still be recorded at $160 or some other
amount (“XX”) and should unearned interest income be $10 or some other amount
(“YY”)? As mentioned earlier, FRS 116 para 73 provides that in a sales-type lease where
artificially low interest rates are quoted, the selling profit should be restricted to that which
would apply if a commercial rate of interest were charged.

Hence, for n = 1, future value = $170 and a fair market rate = 25%, PV = XX = $136.

Artificially low interest rate

$100 $160 or XX $170

╚════════════════════════╩════════════╝
Cost Sale Lease receivable

Unearned interest = $10

or YY

GI = Sum of LPs + unGRV = $170 +$0

In this case, Sales= N = PV of LPs at fair market rate = $136 (rather than $160)
Unearned Interest = G– N= $34 (rather than $10)
Gross Profit = $136 - $100 = $36

Dr Lease receivable (gross investment, G) $170

Dr Cost of goods sold (cost) $100
Cr Inventory $100
Cr Sales (PV of LPs at fair market rate) $136
Cr Unearned interest (lease receivable (or G) – PV of G (or N)) $ 34

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Seminar Questions:

Seminar Question 1 (Team Activity #1)

Precision Ltd manufactures engineering precision equipment. Some customers

prefer to buy directly from them and some customers, particularly the smaller
engineering firms, prefer to lease from them. Its accounting year end is 31
December.

The cost of manufacturing the engineering precision equipment is $50,000 per piece
of equipment. The economic life of the machinery is ten years with no residual
value anticipated. The fair market selling price of the equipment is $80,000 per
piece and the fair market interest rate is 5% per annum.

Since mid-December 20x1, Precision Ltd has been in negotiations with a new
customer regarding the lease of one unit of its equipment. The customer drives a
hard bargain and indicates that he has other avenues to acquire this piece of
equipment. To close the sale, Precision decides to offer the customer a special
interest rate of 3% on the lease arrangement.

On 1 January 20x2, Precision Ltd signs the lease agreement with this customer. The
agreement provides for the following terms:

Lease period: 10 years

Lease payments: 10 annual lease payments, with the first payment commencing 1
January 20x2 upon the signing of the agreement, with subsequent payments
thereafter due on 1 January every year.

Interest rate charged: 3%

Required

In compliance with FRS 116 Leases, prepare the journal entries to record this lease
arrangement for Precision Ltd up to 1 January 20x3. Show all workings.

Seminar Question 2 (Team Activity #2)

On 1 January 20x1, Lee Ltd had some short-term liquidity problems and approached
a leasing company Goh Ltd to sell a major piece of its equipment and immediately
lease it back. The designated piece of equipment was purchased by Lee Ltd on 1
January 20x0 for $2 million. Its useful life was estimated to be 10 years with no
residual value. Lee Ltd has a 31 December accounting year-end. It uses the straight-
line method of depreciation and accounts for its equipment using the cost model
under FRS 16 Property, Plant and Equipment.

Assume that the terms and conditions of the transaction are such that the transfer of
the equipment by Lee Ltd satisfies the requirements for determining when a
performance obligation is satisfied under FRS 115.

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The fair value of the equipment on 1 January 20x1, after one year of use, was
determined to be $1.9 million, due to a steep rise in the price of the materials
required in its manufacture.

Lee Ltd sold the equipment to Goh Ltd for $2.2 million on 1 January 20x1 and
agreed to lease it back for 3 years at an annual lease payment of $427,000
payable on 31 December. Lee Ltd has an incremental borrowing rate of 5% per
annum.

Required

Prepare all the relevant journal entries for Lee Ltd to account for the above
transactions from 1 January 20x1 to 31 December 20x1 in accordance with FRS
116 Leases.

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 Seminar 5 Team Activity #1

As a team, discuss and complete the following computations needed to prepare the
journal entries for Seminar Question 1

1. What is the business model of Precision Ltd?

2. Determine the annual lease payment (ALP) that Precision charged its
customer.

3. Gross Investment in the Lease =

4. Net Investment in the Lease =

5. Interest Income =

6. Gross Profit =

7. Amortisation Schedule:

Date Lease Interest Principal Net

Payment (5%) Investment
1/1/x2
1/1/0x2
1/1/x3

Journal Entries:
1/1/x2

Dr Lease Receivable
Cr Sales
Cr Unearned Interest

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Dr COGS
Cr Inventory

Dr Cash
Cr Lease Receivable

31/12/x2

Dr Unearned Interest
Cr Interest Income

1/1/x3

Dr Cash
Cr Lease Receivable

14
 Seminar 5 Team Activity #2

As a team, discuss and complete the following computations needed to prepare the
journal entries for Seminar Question 2

What is the book value or carrying amount of the equipment?

What is the fair value of the equipment?

What is the selling price of the equipment?

ALP that will be charged on the leaseback:

Workings:

Lease Liability:

ROU Asset:

Gain on sale of equipment:

Journal entries

1/1/x1

Dr Cash
Dr Right-of-use Asset
Dr Accumulated Depreciation
Cr Equipment
Cr Gain on sale of equipment
Cr Lease Liability
31/12/x1

Dr Depreciation Expense
Cr Accumulated Depreciation

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 Dr Lease Liability
Dr Interest expense
Cr Cash

Alternatively, the above journal entries may be as follows:

1/1/x1

Dr Cash
Cr Loan Payable

Dr Cash
Dr Right-of-use Asset
Dr Accumulated Depreciation
Cr Equipment
Cr Gain on sale of equipment
Cr Lease Liability

31/12/x1

Dr Depreciation Expense
Cr Accumulated Depreciation

Dr Loan Payable
Dr Interest Expense
Cr Cash

Dr Lease Liability
Dr Interest expense
Cr Cash

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