Financial liability accounting for lease by the lessee
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FINANCIAL LIABILITY: Accounting for Lease by the Lessee. FRS 117 : LEASES. DEFINITION (Para 4). Lease is an agreement whereby the lessor conveys to the lessee in return for a payment or a series of payments the rights to use an asset for an agreed period of time. Classification of leases.

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FINANCIAL LIABILITY: Accounting for Lease by the Lessee

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FINANCIAL LIABILITY:Accounting for Lease by the Lessee

FRS 117 : LEASES


DEFINITION (Para 4)

  • Lease is an agreement whereby the lessor conveys to the lessee in return for a payment or a series of payments the rights to use an asset for an agreed period of time.


Classification of leases

Finance lease

  • Lease that transfers substantially, all of the risks and rewards incident to ownership of an asset. Title may or may not eventually be transferred. ( substance over form principle)

    Operating lease

  • Lease that not transfers all of the risks and rewards incident to ownership of an asset.

    A non-cancellable lease is a lease that is cancellable only:

    (a)upon the occurrence of some remote contingency;

    (b)with the permission of the lessor;

    (c)if the lessee enters into a new lease for the same or an equivalent asset with the same lessor; or

    (d)upon payment by the lessee of such an additional amount that, at inception of the lease, continuation of the lease is reasonably certain.


Criteria to classify lease as a finance lease

  • At least one of the following criteria is satisfied.

  • The ownership of the asset is transferred to the lessee by the end of the lease term;

  • The lessee has the option to purchase the asset, and at the inception of the lease, it is certain that the option will be exercised

  • The lease term is for the major part of the economic life of the asset

  • PV of the minimum lease payments amounts to or at leastsubstantially equal to asset’s fair value (>90% of the assets fair value)

  • the leased assets are of such a specialised nature that only the lessee can use them without major modifications.


FINANCE LEASES Recognition and measurement by Lessee

  • Recognition;

    • On Balance Sheet: As assetsand liabilities

  • Measurement at inception date; the lower of:

    • fair value of the lease assets, and

    • Present Value of the minimum lease payments.


Minimum lease payment

  • Should include;

    • payment of rental over the lease term and plus if any, purchase option price;

    • excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor, together with:(a)for a lessee, any amounts guaranteed by the lessee or by a party related to the lessee; or(b)for a lessor, any residual value guaranteed to the lessor by:(i)the lessee; (ii)a party related to the lessee; or (iii)a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee.


Present Value of the minimum lease payments

Vb= ∑ lease rental + purchase option

t =1 (1+ r )t (1+ r )n

= lease rental (PVIFA r , n) + purchase option(PVIF r ,

n)

r = interest rate

t = time of lease payment

n = lease period


Journal Entry

Dr. Asset under finance leaseRM xxx

Cr. Liability under finance leaseRM xxx

  • THE ASSET should be recognised as fixed asset and accounted for according to FRS 116- PPE

  • The lease asset should be depreciated over its useful life (if ownership is transferred);

  • Otherwise it should be depreciated over the shorter of the leases term or its useful life


FINANCE LEASE LIABILITY

  • The lease liability should be recorded at the same amount as the leased asset.

  • The lease payment – apportioned between

    • Finance charge

    • Reduction of outstanding lease liability

  • INTEREST / FINANCE CHARGEis the different between the sum of the gross lease payments and the fair value of the leases asset.

  • This finance charge should be recognised over the lease term to produce a constant periodic rate of interest on the remaining balance of the lease liability.


Method in allocating the finance charge;

  • Amortisation schedule using the effective/implicit interest rate

  • Sum year digit

  • Straight line method (only if finance charge is not material)

  • Standard requires the 1st method to be used to produce a constant periodic rate of interest.


Entry

  • when lease payment is made

    Dt. Liability under finance lease

    Cr. Cash

  • When finance charge is recognised

    Dt. Lease interest expense

    Cr. Liability under finance lease


Example

  • Example text book – page 275

  • Illustration 1


Illustration 1

  • ABC enters into a finance lease with XYZ on 1 Jan. 2006 for an item of machinery. The lease terms are as follows:

    • Lease rental of RM50,000 per year for 5 years, payable in advance and the first rental is due on 1 Jan. 2006.

    • The useful life of the machine is 5 years with zero residual value. The machine could be bought for cash of RM200,000. ABC adopts a straight-line method depreciation policy for fixed assets. Its financial year ends on 31 Dec.

    • Implicit interest rate 12.6%


Required:

  • Show the journal entry in ABC’s account to record the lease transaction at its inception date

  • Calculate the depreciation required for lease assets

  • Record the lease liability and the allocation of the finance charge in each period using:

    • Interest rate method; and

    • The sum-of-digit method


Illustration 2

  • Lapton Bhd. enters into a leasing with Boh Bhd. on 1 Jan. 2006 for an equipment costing RM100,000. The lease terms are as follows:

    • Lease rental of RM25,000 per year for 5 years, payable in arrears at the end of respective years.

    • After the end of the lease period, the lessee has the right to purchase the asset at a bargain price of RM20,000, and it was certain that Lapton will exercise the right.

    • PV of Min Lease Pay (MLP) is RM96,215

    • The useful life of the machine is 8 years with zero residual value. Lapton adopts a straight-line method depreciation policy for fixed assets. Its financial year ends on 31 Dec.

    • Implicit interest rate 14%


Required:

  • Show the journal entry in ABC’s account to record the lease transaction at its inception date

  • Calculate the depreciation required for lease assets

  • Record the lease liability and the allocation of the finance charge in each period using:

    • Interest rate method; and


OPERATING LEASE

  • Lessee should not capitalise operating lease

  • Lease payment should be recognised as an expense in IS.

  • Standard requires that the lease rental expense should be recognised on a straight line basis over the lease term


DISCLOSURE by lessee: FRS 7: Financial Instrument Disclosure

  • Finance lease [31]

    • Disclosure as per FRS 116 – PPE at Net Carryg Amt.

    • Reconciliation between total of future MLP payment and their PV. To present these info for each of following periods:

      a) no later than one year

      b) later than one year but no later than 5 years

      c) later than 5 years


DISCLOSURE by lessee

  • Finance lease [31]

    • Contingent rents recognised in income statement for the period

    • Total future min sublease payments expected to be received under non-cancellable sublease at the BS date

    • General description of the lessee’s material leasing arrangements, namely:

      (i) basis on which contingent rent payable is determined


DISCLOSURE by lessee

  • Operating lease [35]

    • Total future MLP under the non-cancellable operating lease for each of the following periods:

      i) no later than one year

      ii) later than one year but not later than 5 years

      iii) later than 5 years

    • Total future minimum sublease payments expected to be received under non-cancellable sublease at the BS date


DISCLOSURE by lessee

  • Operating lease [35]

    • Lease and sublease payments recognised as expense in the period, with separate amounts of MLP, contingent rents and sublease payments

    • General description of the lessee’s significant leasing arrangements, namely:

      (i) Existence and terms of renewal or purchase options and escalation clauses


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