10 STEPS TO UNLOCKING AN UNDERSTANDING OF LEASE ACCOUNTING – PART 3

In this concluding part of the series titled “10 Steps to Unlocking an Understanding of Lease Accounting”, you will learn about what sales and leaseback transaction is, and how it is

accounted for in the books of account. More precisely, you will learn how to treat sales and leaseback transaction whether it is classified as operating lease or finance lease.

To begin with, a sales and leaseback transaction is a transaction in which a seller sells its item of equipment or asset and immediately leases it back from the buyer. For example, if A Ltd, a dealer in the sale of machinery sells a machine to B Ltd on January 1, 2002 and immediately leases back the machine on that same day from B Ltd. This type of transaction is a sale and leaseback transaction.

In this afore-mentioned transaction, A Ltd is both the seller and the leasee with respect to the leased machine. The main crux of sales and leaseback transaction is how to recognize the gain or loss on the sale of the asset or the item sold that is leased back by the seller.

Step 9: How do you treat gain or loss on an asset in a sales and leaseback transaction classified as operating lease from the sellers’ perspective?

Where a sales and leaseback transaction is classified as an operating lease based on the circumstances of the lease, the gain (or loss) on the sale of the asset is recognized or recorded based on the following rules:

1. If the asset is sold at fair value, gain or loss should be recognized immediately. That is, if the price at which the seller sells the asset to the buyer who is now the leasor, is the fair value (i.e. value in an arm’s length transaction) of the asset, then the gain or loss on disposal should be recorded as gain immediately, and taken to profit or loss account. The journal entries for this is given as:

DR: DISPOSAL OF ASSET ACCOUNT

      CR: PROFIT OR LOSS ACCOUNT

With the gain on the sale of an asset in a sale and leaseback transaction classified as operating lease where selling price is at fair value.

2. If the asset is sold at a price which is below its fair value, but the lease payment under the operating sales and leaseback transaction is at fair value, loss should be recognized or recorded immediately. Therefore, the journal entries will be as stated below:

DR: PROFIT OR LOSS ACCOUNT

      CR: DISPOSAL OF ASSET ACCOUNT

With the loss on the disposal of an asset, sold at a price below fair value in a sale and leaseback transaction classified as an operating lease.

3. Where the selling price of the asset is below its fair value and in the same vein the lease payment is also below fair value, the rule is that loss should be deferred and amortized on the same basis as the lease payments. Therefore, the journal entries will be as stated below:

DR: DEFERRED LOSS ACCOUNT

      CR: DISPOSAL OF ASSET ACCOUNT

With the loss on the asset sold at a price below fair value and leased back at annual lease payments that is also below fair value.

4. Where the selling price of the asset is greater than its fair value, the excess of sales price over fair value should be deferred and amortized over the estimated useful life of the asset. Therefore, the journal entries will be as stated below:

DR: DISPOSAL OF ASSET ACCOUNT

      CR: PROFIT OR LOSS ACCOUNT

      CR: DEFFERED GAIN ACCOUNT

With gain on disposal (i.e. excess of fair value over carrying value) and the excess of selling price over the fair value of the asset in a sales and leaseback transaction.

5. Where the fair value of the asset is less than its carrying amount, impairment should be recognized, and loss on sale should also be recognized immediately by the seller/leasee if the selling price is below the fair value.

DR: IMPAIRMENT LOSS ACCOUNT

      CR: DISPOSAL OF ASSET ACCOUNT

With the impairment loss on the asset sold in sales and leaseback transaction (i.e. the excess of carrying value over the fair value).

DR: PROFIT OR LOSS ACCOUNT

      CR: DISPOSAL OF ASSET ACCOUNT

With the loss on the disposal of the asset in a sales and leaseback transaction where it is sold at a price below fair value.

Step 10: How do you treat gain or loss on an asset in a sales and leaseback transaction classified as finance lease from the sellers’ perspective?

Where a sales and leaseback transaction is classified as a finance lease, the gain on disposal or sale of the asset is deferred in the books of the seller/leasee and amortized (i.e. allocated) over the lease period.

ILLUSTRATION 9:

Clara Ltd sold an asset which cost =N=100,000.00 to Mara Ltd on January 1, 1992 at a selling price of =N=120,000.00.  Clara Ltd, on that same day, immediately leased back the asset under the following terms:

1. The lease period is 3 years beginning from January 1, 1992 with an annual lease rentals of =N=50,000.00 payable on the last day of each year.
2. The interest rate implicit in the lease is 10%.
3. The asset has an estimated useful life of 3 years and depreciation should be calculated on a straight-line basis.
4. The lease is assumed to be a finance lease in accordance with the principles of IAS 17.

Required:

Calculate the gain of loss to be recognized by Clara Ltd on the sale of the asset.

SOLUTION 9:

According to the principles of IAS 17, the gain on sales and leaseback transaction that is classified as finance lease should be deferred and amortized over the lease period.

Gain on disposal = Selling Price – Cost/Carrying Value

                        = N120, 000.00 - N100, 000.00

                        = N20, 000.00

Since the lease period is 3 years, the amount to be released from the deferred gain to profit or loss account is calculated as N20,000.00/3 years, which is N6,666.67 for each accounting year.

Therefore the accounting entries for the 3 years are given below:

CONCLUSION

In conclusion of the three-part series on 10 steps to Unlocking an Understanding of Lease Accounting; to solve a lease problem just provide answers to the following questions: What type of lease are you faced with? From whose perceptive are you treating the lease (i.e. is it the leasor’s or the leasee’s perspective?); and is it at commencement or during the period of the lease?

Based on the answers to these questions, for a finance lease, determine the present value of the minimum lease payments, compute the finance charges/income and make necessary entries in the ledger accounts. But for an operating lease, just account for the minimum lease payments in an equal amount over the duration of the lease.

In a sales and leaseback transaction the major issue is when and how to account for the gain or loss on the sales of the asset which is immediately leased back by the seller. Once the type of lease involved (whether finance or operating lease) is determined, then the rules involved are simple: Just deferred the gain or loss on finance sales and leaseback transaction and amortized it over the lease period. But for an operating sales and leaseback transaction just follow the rules enumerated in step 10 based on the relationships between the carrying amount, fair value, minimum lease payments and the selling price of the leased asset.