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

FINANCIAL LIABILITY:Accounting for Lease by the Lessee

FRS 117 : LEASES


Definition para 4

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

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

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

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

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

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

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

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

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

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

  • Example text book – page 275

  • Illustration 1


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

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

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%


Required1

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

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

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

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 lessee1

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 lessee2

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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