Accounting for leases | | | ACCA Page 1 of 9

ACCOUNTING FOR LEASES

by Tom Clendon
05 Feb 2000

Where appropriate the article makes reference to SSAP 21, Accounting for Leases which is
applicable for the UK variant papers but, internationally IAS 17(revised effective from 1
January 1999) Accounting for Leases, in Singapore SAS 15 Accounting for Leases and in
Hong Kong HK SSAP 15 are the relevant accounting standards. They all currently adopt
the same approach to accounting for leases. The accounting for leases is examinable at
both paper 10 accounting and audit practice and paper 13 financial reporting environment.
This article has been written for students studying paper 10 accounting and audit practice
but it is also relevant to students studying paper 13 financial reporting environment as
preparatory work. This article will consider the issues essential to paper 10, including the
audit aspects. A second article to be published in next month’s Students’ Newsletter will
consider the more advanced issues of leasing relevant to paper 13 students only.

What is a lease?
A lease is simply an agreement between two parties for the hire of an asset. The lessor is
the legal owner of the asset who rents out the asset to the lessee. At the end of the lease
the asset is returned to the lessor. The lessee will pay a lease rental to the lessor in return
for the use of the asset. The accounting treatment for the lease entirely depends on the
nature of the lease. For accounting purposes all leases are classified into one of two
categories, they are either deemed to be ‘finance leases’ or ‘operating leases’.

What are operating leases?

If you are studying the UK stream and have studied group accounts then you should be
aware that FRS 6, Accounting for Acquisitions and Mergers has a similar problem in that it
has to provide guidance for distinguishing business combinations between take-overs and
mergers. The approach adopted by FRS 6, Accounting for Acquisitions and Mergers is that
it goes into a lot of detail in the identification of business combinations which are mergers
(i.e., a pooling of interests) but then simply states that all other business combinations must
be take-overs. The accounting standards take a similar approach as an operating lease is
defined as a lease which is not a finance lease!

An operating lease is defined as a lease other than a finance lease.

At its most clear cut an operating lease is a very short-term agreement for the temporary
hire of an asset, e.g., hiring a car for two weeks to take on holiday.

Accounting treatment for operating leases

The accounting treatment for an operating lease is straightforward for both the lessor and
the lessee. The lessee has incurred an operating expense, so the lease rental payable is
written off in the profit and loss account. The lessee has to disclose in the notes to the
accounts the amount charged in the year and the amount of the payments to which the
entity is committed at the year end.

The lessor has earned revenue from renting out the asset and accordingly recognises the
lease rental receivable as income in the profit and loss account.

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What are finance leases?

A finance lease is one where the risks and rewards of the ownership pass to the lessee.
How it is determined that risks and rewards have passed is a subjective issue and one on
which accounting standards give guidance (see below). At its most clear cut, however, a
finance lease is a long-term agreement representing a loan made by the lessor to the
lessee to buy the asset.

A finance lease is a lease that transfers substantially all the risks and
rewards of the ownership of an asset to the lessee.
Legally, of course, a finance lease is a rental agreement, and legally the lessee has not
bought the asset as title remains with the lessor. However, to account for the finance lease
in accordance with its legal form would be a betrayal of the concept of ‘substance over
form’. This important concept (identified as such in both the Accounting Standards Board
draft Statement of Principles for Financial Reporting and the International Accounting
Standards Committee’s Framework for the Preparation and Presentation of Financial
Statements) requires that the commercial reality of events and transactions be reported in
the financial statement if they are to be relevant to the users of the financial statements and
if the financial statements are to be true and fair.

Accounting treatment of finance leases - by the lessee

When a lessee enters into a finance lease it is getting access to the risks and rewards of
the asset and accordingly the lessee reflects substance by recognising the asset in its own
accounts. This is consistent with the ASB’s Statement of Principles definition of and
recognition criteria of an asset.

An asset is defined as the rights or other access to the future economic

benefits controlled by an entity as a result of past transaction or events

When a lessee enters into a finance lease it is obliged to make the lease rental payments
for the duration of the lease, and accordingly the lessee reflects the substance by
recognising a liability. This is consistent with the ASB’s Statement of Principles definition of
and recognition criteria of a liability.

A liability is defined as an obligation to transfer economic benefits as a

result of past transaction or events.
The lessee strictly capitalises the present value of the minimum lease payments as the
fixed asset and this is the amount also recorded as the liability. The present value of the
minimum lease payments normally equates to the cash price. The asset has to be
depreciated over the shorter of the period of the lease and the useful life of the asset. The
loan accrues interest which should be recognised to give a constant periodic return on the
balance of the outstanding loan. The rental payment is not therefore simply a revenue
expense but represents partly the repayment of the capital element of the loan and partly
the finance charge on the loan (i.e., interest). The total finance charge is the difference
between the minimum lease payments and the present value of the minimum lease
payments.

This can all be explained again in double entry terms!

When a finance lease is entered into the lessee has to record an asset and a liability:

DR Fixed Assets X

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CR Creditors - Obligations under finance leases X

When a lease rental is paid this is recorded as:

DR Creditors - Obligations under finance leases X

CR Cash X

At the end of the financial period depreciation will have to be provided

on the asset

DR Profit & Loss a/c depreciation expense X

CR Provision for Depreciation X

At the end of the financial period a finance charge (interest) has to be

recorded on the creditor:

DR Profit & Loss a/c interest payable and similar charges X

CR Creditors - Obligations under finance leases X

On the balance sheet the finance lease creditor obligation under finance leases will have to
be split between current and long-term creditors. In the notes to the balance sheet a
separate listing in the fixed asset schedule is required to distinguish assets legally owned
and those held subject to finance leases. In the notes to the profit and loss account the
amount of the interest charged that was in respect of finance leases must be disclosed.

Accounting treatment of finance leases - by the lessor

Such lessors are normally banks or similar lending institutions. When entering into a
finance lease the lessor is in substance making a loan which will be repaid with interest.
Despite having legal title to the asset subject to the lease, the lessor does not recognise
this as an asset on its balance sheet, as it does not control the asset and does not have
access to the future economic benefits. The lessor does however have the asset of a future
income stream and accordingly recognises a debtor ‘net investment in finance leases’ .

Why is the classification of leases important?

To recap, if a lease is classified and correctly accounted for as a finance lease, the lessee
will recognise an asset, but more significantly a liability as well; but if the lease is treated as
an operating lease then no liability is recognised in the lessee’s financial statements. Some
companies may be concerned about the level of debt included on the balance sheet, as
this will increase the reported gearing ratio. A high gearing ratio might be perceived as
undesirable if, for example, the company was looking to borrow more funds. It might prove
more difficult or expensive to do so as the company’s accounts would already include high
liabilities. Accordingly lessees may well have a preference to account for a lease as an
operating lease rather than a finance lease to take the liability off the balance sheet. Prior
to the introduction in the UK of SSAP 21, Accounting for Leases many lessees did not
distinguish between the two types of leases and accounted for all leases in accordance
with their legal form. It is argued that this amounted to creative accounting as it took
liabilities off the balance sheet.

How are leases classified?

The classification of a lease as either a finance lease or an operating lease hinges on
whether the risks and rewards of ownership pass to the lessee. This is subjective and it is
important that all the terms of the lease are reviewed so that the substance of the lease
agreement can be identified. For example:

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Repairs, maintenance, insurance

If the lessee is responsible for repairing, maintaining and insuring the asset then this is
consistent with the behaviour of the owner of the asset, and would support the contention
that the lease is a finance lease. In these circumstance the lessee has the risk of the cost
of repairs and of idle time but has the reward if the asset never breaks down!

Length of the lease

If the lease period is for substantially all of the assets estimated useful economic life, then
this would support the argument that the lease was a finance lease. The lessee would be
the beneficiary of the economic value of the asset as only an immaterial residue value
would be returned to the lessor.

Bargain options
If the lease contains a clause to the effect that the lessee can either renew the lease or buy
the asset at the end of the lease term for a peppercorn (notional) amount then this would
support the contention that the lease is a finance lease. The lessee will enjoy the reward if
the asset turns out to have a longer than expected life. It suggests that the lessee will have
exclusive access to the future economic benefits of the asset which is consistent with the
concept that the asset ‘belongs’ to the lessee even though the lessee does not have legal
title.

The 90% test

If at the inception of the lease the present value of the minimum lease payments amounts
to substantially all (90% or more) of the fair value of the leased asset (this normally equates
to the cash price), it is presumed to be a finance lease. It is often commented that this test
is over relied on in practice. It should be noted that the 90% test is a guide not a rule.

Question

Often the key to passing the paper 10 accounting and audit practice exam is being able to
master the compulsory 30 mark Question 4 which is an integrated accounting and audit
question. Typically this question takes a single topic and seeks to examine the accounting
and auditing aspects. Leasing has yet to be examined in this way but does lend itself to
being the subject of Question 4 as the auditing of leases is not examined at paper 6 Audit
Framework. The following is a question and answer that I have written to show you how
this topic may be examined at paper 10.

Charlie and his leases!

Charlie plc is a manufacturing company with a financial year end on 31

December. Charlie plc has recently entered into a number of lease
agreements.

On 1 January 2000 Charlie plc entered into a lease with Henry plc in
respect of machine A. The cash price of the machine was £7,710 and
Charlie plc agreed to pay a deposit of £2,000 and four further payments of
£2,000 each subsequent 31 December. Under the terms of the lease
Charlie plc will be responsible for maintaining the asset and has the
option to buy the asset for £1 at the end of the lease. The lease contains
no break clause. The asset has an expected life of four years at which
time it will have a nil residual value. The interest rate implicit in the lease
is 15%.

On 1 April 2000 Charlie plc agreed to lease machine B from Alexander plc
at a cost of £6,000 per month payable in advance. Under the terms of the
lease Charlie plc is responsible for insuring the asset and the agreement

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is terminable at six months’ notice by either party. The machine has an

estimated life of 10 years and has a cash price of £500,000.

On 1 July 2000 Charlie plc entered into a lease with Brampton plc in
respect of machine C. Under the terms of the lease Charlie plc has to
make an immediate payment of £5,000 and subsequently three payments
of £5,000 on the anniversary of the lease agreement. The lease contains
no break clause. The asset has an expected useful economic life of eight
years and has a cash price of £40,000.

Required

(a) Explain and justify for each lease whether it is a finance or an

operating lease. (10 marks)

(b) For each lease, prepare a separate profit and loss account and
balance sheet extract for Charlie plc for the years ended 31 December
2000, 2001, 2002 and 2003 on the basis that the lease with Henry plc is a
finance lease, and that the leases with Alex- ander plc and Brampton plc
are operating
leases. You may assume that Alexander plc does not cancel the lease.
The accounting policy note is not required nor are any of the disclosure
notes. (10 marks)

(c) What are the audit procedures associated with

leases? (10 marks)

Total 30 marks

Answer to Charlie plc and his leases

(a) The distinction between a finance lease and an operating lease is based on the
concept as to whether the risks and rewards of ownership pass to the lessee. Under
a finance lease the risks and rewards associated with the asset do pass and under
an operating lease they do not. In substance, therefore, a finance lease is a
transaction to borrow monies to buy an asset whereas an operating lease is a rental
agreement.

Machine A - Henry
The lease is for the whole of the asset’s life. Charlie plc is responsible for maintaining,
repairing and insuring the asset. These points suggest that Charlie plc will exclusively
benefit from the asset and have the responsibilities associated with ownership.

It is noted that there is an option for Charlie plc to buy the asset at the end of the lease at a
notional sum so that, if the asset does have some residual value, Charlie plc will benefit.

This lease is a finance lease i.e., Charlie plc is really borrowing cash to buy the asset even
though Charlie plc does not obtain legal title during the lease.

Charlie plc will pay a total of £10,000 for an asset with a cash price of only £7,710. The
difference of £2,290 will represent the total finance charge to be allocated to the profit and
loss account as interest.

It is even possible to compute that the present value of the minimum lease payments
amount to 100% of the cash price (fair value) of the asset.

Tutorial note

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It is necessary for you to be familiar with the working below calculating the present value of
the minimum lease payments — but strictly in this question it is an unnecessary calculation.

Present value

Deposit 2,000 2,000

31.12.00 2,000 / 1.15 1,739

31.12.01 2,000 / 1.15 2 1,513

31.12.02 2,000 / 1.15 3 1,315

31.12.03 2,000 / 1.15 4 1,143

£7,710
The present value of minimum payment amounts to 100% of the fair value of £7,710.

Machine B - Alexander
Charlie plc is responsible for insuring the asset which suggests that this could be a finance
lease.

However, the lease can be cancelled at any time by either party giving only six months’
notice in respect of an asset that has a life of 10 years. Charlie plc does not control the
access to the future economic benefits of the asset as the lessor can serve notice to recall
the asset at any time.

The minimum lease payments are only for six months i.e., £36,000 and this is nowhere
near 90% of the fair value (cash price) of £500,000.

This lease is definitely an operating lease!

Machine C - Brampton
The period of the lease agreement is for only half of the asset’s life which suggests that it is
an operating lease. It is reasonable to presume that the asset will still have a high residual
value when it is returned, indeed there is no mention of any terms to suggest that it will not
be returned to the lessor.

The minimum lease payments as a proportion of the cash price (fair value) of the asset
even before discounting comes to only 50%.

This lease is another operating lease.

(b) Workings for the Machine A finance lease creditor

The initial recording of the finance lease is to capitalise the cash price

DR Fixed assets 7,710

CR Creditors 7,710

The first working is the movement on the finance lease creditor. Note that the sum of the
finance charges £2,290 is a familiar figure.

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P&L
Opening Paid in Balance for Paid in Year end
interest at
balance advance the year arrears balance
15%

00 7,710 (2,000) 5,710 857 (2,000) 4,567

01 4,567 - 4,567 685 (2,000) 3,252

02 3,252 - 3,252 488 (2,000) 1,740

03 1,740 - 1,740 260 (2,000) 0

2,290
The annual depreciation charge using the straight line method is £7,710 divided by 4 years
= £1,927.5

On the balance sheet the obligation to the finance lease creditor needs to be split between
current and long-term liabilities. There is no need to accrue for any interest as a lease
payment has just been made. The current liability is the capital element of next year’s lease
payments i.e., next year’s payments net of the future interest. The long-term element of the
creditor is the balance of the year end liability.

Current liability Long-term liability

First year 2,000 - 685 = 1,315 4,567 - 1,315 = 3,252

Second year 2,000 - 488 = 1,512 3,252 - 1,512 = 1,740

Third year 2,000 - 260 = 1,740

Machine A - Henry the finance lease

Profit and loss extracts

00 01 02 03

£ £ £ £

Depreciation 1,927 1,928 1,927 1,928

Interest 857 685 488 260

Balance
sheet

Fixed assets 7,710 7,710 7,710 7,710

Depreciation 1,927 3,855 5,783 7,710

5,783 3,855 1,927 0

Obligations
under finance
leases

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Current
1,315 1,512 1,740 -
liabilities

Long-term
3,252 1,740 - -
liabilities

Total year
4,567 3,252 1,740
end liability
Machine B - Alexander’s operating lease

Profit and loss extracts

00 01 02 03

£ £ £ £

Rental expense

9/12 x (6,000 x 12) 54,000

6,000 x 12 72,000 72,000 72,000

Balance Sheet extracts

None

Machine C - Brampton’s operating lease

Profit and loss extracts

00 01 02 03

£ £ £ £

Rental expense

6/12 x 5,000 2,500

6,000 x 12 5,000 5,000 5,000

Balance Sheet extracts

Balance sheet extracts

Current asset

pre-payment 2,500 2,500 2,500 2,500

6/12 x 5,000

(c) Audit procedures

The principle audit risk, associated with leases concerns their classification. If what are in
substance loans to buy fixed assets are accounted for as operating leases, then the

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financial statements will not show a true and fair view, as there will be off balance sheet
assets and liabilities. This risk is higher if the company’s gearing may be considered too
high.

Assuming that the auditor is not newly appointed, attention first needs to be given to the
classification of the leases entered into in the accounting period and their accounting
treatment.

It is necessary to gather evidence in respect of each new lease (or a sample if appropriate)
as to which party to the lease is bearing the risks and rewards of ownership. It might be
that a company has standard lease terms with just one or two lessors. If there are a large
number of leases with a few lessors (which is common) confirmation should be sought
direct from each lessor as to how many lease agreements the entity has. This will provide
good audit evidence of existence and cut off.

A copy of the lease must be obtained (preferably from the lessor rather than the client’s
own files in order to improve the quality of the audit evidence), read, and the substance of
the agreement understood.

Clauses in the lease relating to maintenance costs, the period of the lease relative to the
useful life of the asset, bargain purchase options and the present value of the minimum
lease payments relative to the fair value (cash price) will be important. If the client has to
maintain the asset in good repair, and if the period of the lease is for the whole of the
asset’s life, and if the client has a bargain purchase option and if the present value of the
minimum lease payments is at least 90% of the fair value of the asset, then it is a finance
lease and the financial statements must reflect both an asset and a liability.

It is not sufficient just to rely on the 90% test rather it is important the substance of the
lease is considered.

In addition, the following work should be performed in respect of the finance leases.

Check fixed asset additions to the calculation of present value of minimum lease
payments;
Check leased assets are depreciated correctly, consider reasonableness of rates
used;
Re-perform depreciation calculation;
Confirm lease payments have been made, by reference to the cash book and the
lessor;
Check allocation of interest to profit and loss account.

The disclosures required by the standard should also be checked for compliance, in
particular the accounting policy note and the note with regard to continuing obligations in
respect of operating leases.

Conclusion
More on leases next month including accounting for sale and lease back arrangements and
the latest proposal from the G4 + 1 group on the future of accounting for leases.

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