10 STEPS TO UNLOCKING AN UNDERSTANDING OF LEASE ACCOUNTING – PART 1
10
STEPS TO UNLOCKING AN UNDERSTANDING OF LEASE ACCOUNTING – PART 1
A clear understanding of the principles of IAS 17, Lease, of the International Financial
Reporting Standards is important in order to account for, strictly speaking, the substance of
a lease transaction instead of its legal form. This will be
treated in this article-cum-lesson: 10 steps to unlocking an understanding of
lease accounting. Please join me as we embark on this journey into the world of
lease accounting.
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STEP
1: What is lease?
You definitely want a simple and clear definition of
what lease is as against the technical jargon used in IAS 17. So, in a simple
language, lease is an arrangement whereby a person (or organization) obtained
the right of use of a non-current asset from another person (or organization)
without buying it outright, in exchange for periodic payments of a sum of money
for the asset use.
Supposing I obtain from you a luxury bus that you newly
purchased with an arrangement that I will pay at the end of each year, for a
period of 7 years, a sum of N50,000 for
the use of the luxury bus. Such an arrangement between you and I could be
deemed a lease.
The person (or organization) obtaining the use of the
non-current asset is called the LEASEE, while the person (or organization)
giving the non-current asset out to the leasee is known as the LEASOR. The periodic
payments and other payments made by the leasee to the leasor for the use of the
asset, including the sum paid for the asset purchase at the end of the lease period
are called the MINIMUM LEASE PAYMENTS, or LEASE RENTS.
ILLUSTRATION 1:
On January 1, 1995 Congo Plc leases out a machinery with
a fair value of N700,000 to Orange Plc for a period of 5 years. Orange Plc is to pay an
annual rent of N150,000 to Congo Plc at
the end of each period for the use of the asset. Who is the leasor and who is the
leasee?
SOLUTION 1:
In the above illustration, as you would have correctly
guessed, Congo Plc is the leasor, while Orange Plc is the leasee.
STEP
2: What are the types of lease?
So now that you understand what lease is, you also need
to know the various types of lease. Discerning the type of a lease in a problem
will help you in deciding on the accounting treatment you will give to such a
lease transaction. Broadly speaking, lease can be classified into FINANCE LEASE
and OPERATING LEASE.
Finance lease is a type of lease in which the risks and
rewards associated with the ownership of the leased asset are transferred to the
leasee by the leasor at the inception of the lease. An accounting jargon right?
To put it simply, a finance lease is a lease arrangement in which it has been
agreed at the beginning of the lease that the leasee will both enjoy the
rewards and suffer the loss associated with owning such an asset. The reward
may be the use of the asset for generating revenue, while the risk could be in
term of the cost of maintaining the asset.
On the other hand, operating lease is a type of lease in
which the risks and rewards of ownership of the leased asset are NOT transferred to the leasee at the
commencement of the lease. (This should be simple to understand by looking at
the opposite of the explanation given on finance lease).
Well, According to IAS 17, you can identify a finance
lease by one or more of the following characteristics:
1. The
leasor, at inception, has the intention to cede ownership of the leased asset
to the leasee at the end of the lease term or period.
2. At
the end of the lease, to buy the asset, the leasee will just pay a price that
is less than the fair value of the asset.
3. It
is expected that the leasee will buy the asset at the end of the lease period.
4. The
lease period should at least cover a substantial part of the useful life of the
asset.
5. The
present value of all the lease payments is substantially equaled to the fair
value of the asset.
6. The
lease agreement cannot be cancelled by the leasee. Where he plans to do that, he
must undertake to reimburse the leasor for all possible loss to him.
According to the IFRS, any lease that is not a finance
lease is an operating lease.
Before you move to the next step, you must understand
that the period of a lease, for accounting purpose, can be divided into the inception
or commencement of the lease and during the period of the lease. The inception or commencement of the lease
is the beginning of the lease; the point in time when the lease arrangement is made
between the leasor and the leasee. While during
the period of the lease is the time interval between the inception of the
lease and the end of the lease term.
Then, how is lease accounted for in the books of
account?
Oh! Lest I forget, lease of land by its nature may not
be classified as finance lease. Instead, lease of land is usually deemed an
operating lease. Where a land is leased together with the building on its top;
both the land and the building should be classified as the same type of lease.
Since a lease of land is deemed an operating lease, so also the lease of
building on top of it should also be classified as an operating lease. So now
you know!
Yes, there remains another secret to reveal about lease
type. Where a lease agreement is changed midway during the lease period, such a
lease should be looked into and based on the new characteristics, it should be
re-classified accordingly. For instance, where a lease was initially classified
as an operating lease and midway in the lease period, the leasor, in agreement
with the leasee transferred the rewards and risks of ownership of the asset to
the leasee; such a lease should be re-classified as a finance lease and
accounted for as such in the books of account..
STEP
3: How is finance lease recorded and treated in the books of account of the
leasee at the commencement of the lease?
At the commencement
of the lease, the leasee should record the lease in its books as both a NON-CURRENT
ASSET and a LIABILITY.
DR: LEASED ASSET ACCOUNT
(i.e. PROPERTY, PLANT AND EQUIPMENT)
CR: FINANCE LEASE OBLIGATION-LEASOR
ACCOUNT (LIABILITY)
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But at what value should they – asset and liability – be
recorded at the inception of the lease?
Both the leased asset and the liability mentioned above should
be recorded according to IAS 17, at the lower
of the fair value of the leased asset, and the present value of the minimum
lease payments calculated using the interest rate implicit in the lease
arrangement. Does that seem hard to understand?
Ok, let’s split this into understandable pieces. To start
with, the fair value of an asset, in a layman’s language is the price of the
asset in an open market. Most time, this is the cost of the asset.
The minimum lease payments are all the payments agreed
by leasee to pay to the leasor under the lease agreement.
Minimum lease payments includes:
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Open your eyes wide here and note that minimum lease payments
do not include contingent rent payment, and initial payment in respect of items
such as legal cost, negotiation and agent commission.
The minimum lease payments are discounted at the
interest rate to their present value. But do you understand this last
statement? Discounting a future sum of money to its present value is simply
determining the value of the money expected say in two years time to its value
now or today using an applicable interest rate. You have heard the expression “one
naira received today is worth more than one naira to be received tomorrow”
Therefore, to arrive at the value to attribute to both
the asset and the liability follow these steps:
1. Calculate
the present value of the minimum lease payments using the annuity formulae
below where the lease payments are paid in arrears:
2. If
the minimum lease payments are payable in advance, use the annuity formulae below
instead to calculate the present value of the minimum lease payments:
3. Where
other payments such as guaranteed
residual value are expected to be paid by the leasee to the leasor at the
end of the lease, this should also be discounted using the formulae:
4. Sum
up all the discounted values to get the present value of all the minimum lease
payments.
5. Compare
the fair value of the leased asset to the present value of the minimum lease
payments; the value to bring into the books with respect to the leased asset
and the finance lease obligation (liability) is the lower of the two values.
ILLUSTRATION 2:
Jordan Ltd struck a finance lease arrangement with Niger
Plc to obtain the use of an airplane on January 1, 2000 at an annual rental of N24,000 payable in arrear on December 31 of
each year for a period of 5 years. The market value of the airplane on that
date was N100,000 and the interest rate
implicit in the lease was 20%.
a. Calculate
the value to be accorded the leased asset in the books of Jordan Ltd , the
leasee.
b. Show
the journal entries of this transaction.
SOLUTION
2:
- The present
value of the minimum lease payments is calculated using the formulae below:
Since the present value of the minimum lease payments of
N71,774.69 is less than the fair value
of the leased asset of N100,000,
therefore the leased asset (airplane) and the finance lease obligation will be
recorded by the leasee (Jordan ) in its books as N71,774.69.
b. The
journal entries are:
DR:
AIRPLANE ACCOUNT (ASSET) N71,774.69
CR: LEASE OBLIGATION-NIGER PLC ACCOUNT
(LIABILITY) N71,774.69
With
the present value of the minimum lease payments at the commencement of the
finance lease
Please note that in a situation where the leasee
incurred some other initial direct costs associated with arranging the finance
lease, such as legal cost, negotiation cost or even the cost of bringing the
leased asset to it location and condition of use, such costs should be added to
the value of the leased asset in its books. These costs should be depreciated
on a straight-line basis over the lease period
STEP
4: How is finance lease recorded and treated in the books of account of the
leasee during the lease period?
Know that during and throughout the lease period, the
leasee will carry out two (2) tasks in relation to the finance lease:
- Make periodic
lease payments (and other payments) to the leasor.
- Depreciate the
leased asset.
Now to start with the second task; you as the leasee
should depreciate the leased asset if you planned to purchase it at the end of
the lease, using your depreciation policy. This depreciation policy should
accord with the principles of IAS 16, property,
plant and equipment. But if you did not plan to purchase the asset,
depreciate it on a straight-line basis using the shorter of the lease period
and the useful life of the asset.
ILLUSTRATION 3:
Darek Ltd obtained on lease
a plant from Farek Ltd on January 1, 2011 at an annual lease payment of N20,000 payable on December 31 of each
year for a period of 3 years. The fair value of the plant on that date was N50,000 and the interest rate implicit in
the lease is 10%. Assuming Darek Ltd uses a straight line method of
depreciation, and the lease term and the economic life of the asset are equal.
a. Calculate
the annual depreciation of the asset.
b. Show
the journal entries in the books of the leasee
SOLUTION 3:
- Compute the
present value of the minimum lease payments. This is calculated as
The recorded value of the
leased asset is N49,737.04, while its
economic useful life which is equaled to the lease term is 3 years. Therefore, the
annual depreciation to be charged is calculated below:
- The journal entries
are:
DR: INCOME STATEMENT (PROFIT OR
LOSS) N16,579.01
CR: DEPRECIATION ACCOUNT N16,579.01
With
the annual depreciation charged on the asset to income statement for each
period.
In the same vein, throughout the lease period, you the
leasee will be making periodic lease payments to the leasor. Each lease payment
is composed of 2 components or parts which are the FINANCE CHARGE or FINANCE INTEREST and PAYMENT TO REDUCE THE OUTSTANDING LEASE LIABILITY you recorded at
the inception of the lease.
Finance is used here. The leased asset is assumed to
be financed; that is, the leasor sort of lent the money for the purchase of
the asset to the leasee. As it is with credit advanced or loan given,
interest must be paid. Such interest on loan or advance is term finance
charge, thus the use of finance charge here. You should note that the finance
charge is the interest on the finance or ‘credit’ advanced to the leasee by
the leasor with respect to the value of the asset.
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To begin with, know that the PAYMENT TO REDUCE THE
OUTSTANDING LEASE LIABILITY is just the difference between the MINIMUM LEASE
PAYMENT for a year and the FINANCE CHARGE for that year. The main issue is how
to calculate the finance charge portion.
You should calculate the finance charge for a period by applying the interest rate implicit in
the lease on the outstanding lease liability at the beginning of that period.
ILLUSTRATION 4:
Nimpopo Ltd leased a plant costing N30,000.00 from Benue Plc on January 1, 1999 for a period of 3
years. The lease is a finance lease and Nimpopo Ltd is expected under the terms
of the lease to pay an annual rental of N10,000.00
at the end of each year over the duration of the lease. The interest rate
implicit in the lease is 10%.
a. Calculate
the value to record as both the finance lease obligation (liability) and the
plant (asset).
b. Calculate
the finance charge and the amount paid to
reduce the lease liability at the end of each year.
c. Calculate
the outstanding liability at the end of each year.
d. Show
the ledger entries of this transaction.
SOLUTION 4:
- In this
example, you have to determine the value of the finance lease obligation
liability first. The value to recognize as finance lease liability is the lower of the present value of the
minimum lease payments and the fair value of the plant.
Since the present value of the minimum lease payments
of N24,868.52 is less than the fair value of the plant of N30,000; the value to recognize as finance
lease liability is N24,868.52.
- Finance Charge
= Interest rate X the Opening Balance of Outstanding
Lease Liability. Amount Paid to Reduce Lease Liability = Minimum Lease Payment – Finance Charge.
See the table below for
analysis of how to calculate these items:
Table 1:
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| TABLE 1 |
From this table you can
extract the finance charge and amount paid to reduce the lease liability as:
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| TABLE 2 |
- Outstanding
Lease Liability for each year =
Opening Balance of Outstanding Lease Liability – Amount Paid to Reduce
Lease Liability.
These are given below based
on table 1:
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| TABLE 3 |
- The ledger
entries in the books of Nimpopo Ltd are:
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