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Nanyang Technological University

Nanyang Business School

AC2101 – Accounting Recognition and Measurement

Semester 2, 2013-14

Outline for Seminar 5:

Leases II

Learning objectives:

Understand the accounting requirements of operating and finance leases for both

lessee and lessor (cont.)

Understand the accounting of investment property held by lessee under an

operating lease under FRS 40

Understand the accounting requirements for a sales-type lease and sales and

leaseback arrangement

Identify potential usage of leases in earnings management & the accounting

implications

Required readings:

Per Seminar 4

FRS 40 and NCKL on FRS 40

Seminar requirements:

1. Precision Ltd manufactures engineering precision equipment. Some customers

prefer to buy directly from them and some customers, particularly the smaller

engineering firms, prefer to lease from them. Its accounting year end is 31

December.

The cost of manufacturing the engineering precision equipment is $50,000 per

piece of equipment. The useful life of the machinery is ten years with no residual

value anticipated. The fair market selling price of the equipment is $80,000 per

piece and the fair market interest rate is 5% per annum.

Since mid-December 2008, Precision Ltd has been in negotiations with a new

customer regarding the lease of one unit of its equipment. The customer drives a

hard bargain and indicates that he has other avenues to acquire this piece of

equipment. To close the sale, Precision decides to offer the customer a special

interest rate of 3% on the lease arrangement.

On 1 January 2009, Precision Ltd signs the lease agreement with this customer.

The agreement provides for the following terms:

Lease period: 10 years

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Lease payments: 10 annual lease payments, with the first payment commencing 1

January 2009 upon the signing of the agreement, with subsequent payments

thereafter due on 1 January every year.

Interest rate charged: 3%

Required

In compliance with FRS 17 Leases, prepare the journal entries to record this lease

arrangement for Precision Ltd up to 1 January 2010. Show all workings. (Key:

ALP = $9,105; net investment = $73,822; gross profit = $23,822)

2. On 1 January 2010, Lee Ltd had some short-term liquidity problems and

approached a leasing company Goh Ltd to sell a major piece of its equipment and

immediately lease it back. The designated piece of equipment was purchased by

Lee Ltd on 1 January 2009 for $2 million. Its useful life was estimated to be 10

years with no residual value. Lee Ltd has a 31 December accounting year-end. It

uses the straight-line method of depreciation and accounts for its equipment using

the cost model under FRS 16 Property, Plant and Equipment.

The fair value of the equipment on 1 January 2010, after one year of use, was

determined to be $1.9 million, due to a steep rise in the price of the materials

required in its manufacture.

Lee Ltd sold the equipment to Goh Ltd for $2.2 million on 1 January 2010 and

agreed to lease it back for 3 years at an annual lease payment of $450,000 payable

on 31 December. Lee Ltd has an incremental borrowing cost of 6% and accounted

for the leaseback as an operating lease. The auditor of Lee Ltd confirms that the

leaseback meets the requirements for an operating lease under FRS 17 Leases.

Required

Prepare all the relevant journal entries for Lee Ltd to account for the above

transactions from 1 January 2010 to 31 December 2010 in accordance with FRS

17 Leases. (Key: On 1/1/10, gain = $100,000 & deferred gain = $300,000)

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Following is a write-up on the accounting issues concerning sales-type lease:

Sales-Type Leases

In a sales-type lease, the seller/lessor earns two distinct streams of revenue, namely,

(a) gross profit on sales, and

(b) interest income on financing.

Gross profit on sales = the difference between the cost (of producing and/or purchasing

the asset) and the fair market value of the asset.

Interest income = the difference between gross investment and its present value (which

is also equal to the fair market value of the asset).

The total of the gross profit and interest income is equal to the difference between the

gross investment (as defined under direct finance lease for lessor) and the cost of the

asset to the seller/lessor.

Journal entries:

Dr Lease receivable (gross investment)

Cr Sales (PV of MLPs=sales price = fair value)

Cr Unearned interest (lease receivable (or GI) – sales (or NI))

Dr Cost of goods sold (cost)

Cr Inventory

OR combining the two journal entries into one:

Dr Lease receivable (gross investment)

Dr Cost of goods sold (cost)

Cr Sales (PV of MLPs=sales price = fair value)

Cr Inventory

Cr Unearned interest (lease receivable (or GI) – sales (or NI))

One major problem relating to accounting for sales-type lease is where the seller/lessor,

in order to attract sales, charges an artificially low interest rate for the financing of the

lease. In this case, the gross investment will be reduced while the cost of sales remains

the same. The problem is how this reduced total income should be apportioned between

the two revenue elements of gross profit and interest income.

FRS 17 para 42 provides that in a sales-type lease where artificially low interest rates are

quoted, the selling profit should be restricted to that which would apply if a commercial

rate of interest were charged. This may be achieved by recording the sale at the PV of

MLPs discounted at the fair interest rate.

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Journal entries:

Dr Lease receivable (gross investment)

Cr Sales (PV of MLPs @ fair market rate)

Cr Unearned interest (lease receivable (or GI) – sales (or NI))

Dr Cost of goods sold (cost)

Cr Inventory

OR combining the two journal entries into one:

Dr Lease receivable (gross investment)

Dr Cost of goods sold (cost)

Cr Sales (PV of MLPs @ fair market rate)

Cr Inventory

Cr Unearned interest (lease receivable (or GI) – sales (or NI))

The rationale for this provision is that an artificially low interest rate, being a marketing

strategy, has the same effect as granting a "trade discount", and therefore the effect

should be accounted for as a reduction of the sales amount.

The net effect of this provision is that the effective interest income should be maintained

at fair market rate and gross profit on sales should be reduced for the reduction in the

total income due to the artificially low interest rate charged.

Assume a seller/lessor sells machinery. He buys them at a cost of $100. He enters into a

sales-type lease agreement with his customer where the payment for the machinery is to

be made at the end of the first year. The fair market interest rate = 25%. The fair value of

the asset at the start of the sales-type lease agreement is $160

Arrangement 1 – Assuming the seller/lessor charges a normal rate of interest where the

customer is required to make a lease payment amounting to $200 at the end of the first

year.

Note here in this scenario where n = 1 year, PV = $160, future value = $200, the IRR =

25% which equals to the fair market rate.

Assuming normal rate of interest

$100 $160 $200 ╚════════════════════════╩═════════════════╝

Cost Sale Lease receivable

GI = Sum of MLPs + unGRV = $200

NI = PV of MLPs at fair market rate = $160

Unearned Interest = GI – NI = $40

Gross Profit = $160 - $100 = $60

Dr Lease receivable (gross investment) $200

Cr Sales (PV of MLPs=sales price = fair value) $160

Cr Unearned interest (lease receivable (or GI) – sales (or NI)) $ 40

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Dr Cost of goods sold (cost) $100

Cr Inventory $100

Arrangement 2 – Assuming the seller/lessor charges an artificially low rate of interest

where the customer is required to make a lease payment amounting to $170 at the end

of the first year.

Note here in this scenario where n = 1 year, PV = $160, future value = $170, the IRR =

6.25% which is significantly lower than 25%, i.e. an artificially low interest rate has

been charged.

The questions then are, should sales revenue still be recorded at $160 or some other

amount (“XX”) and should unearned interest income be $10 or some other amount

(“YY”)? As mentioned earlier, FRS 17 para 42 provides that in a sales-type lease where

artificially low interest rates are quoted, the selling profit should be restricted to that

which would apply if a commercial rate of interest were charged.

Hence, for n = 1, future value = $170 and a fair market rate = 25%, PV = XX = $136.

Artificially low interest rate

$100 $160 or XX $170 ╚════════════════════════╩════════════╝

Cost Sale Lease receivable

GI = Sum of MLPs + unGRV = $170

NI = PV of MLPs at fair market rate = $136 (rather than $160)

Unearned Interest = GI – NI = $34 (rather than $10)

Gross Profit = $136 - $100 = $36

Dr Lease receivable (gross investment) $170

Cr Sales (PV of MLPs at fair market rate) $136

Cr Unearned interest (lease receivable (or GI) – sales (or NI)) $ 34

Dr Cost of goods sold (cost) $100

Cr Inventory $100

Unearned interest = $10

or YY

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Following is a write-up on the accounting issues concerning sale and leaseback

arrangement:

Sale and Leaseback arrangements

A sale and leaseback transaction is one in which the owner of an asset sells the asset to

another party and immediately leases it back from the new owner.

INT FRS 27 is applied to determine the substance of a sales and leaseback transactions,

i.e. (A) whether the sale and leaseback transaction is genuine, i.e. determined as

involving a separate sale transaction and a lease transaction; or (B) whether the sales

and leaseback transaction is a series of structured transactions which is in effect some

other arrangement, e.g. a financing arrangement where a loan is extended to the “lessee”

with the asset as a collateral.

INT FRS 27 is out of scope of this course. Hence, for the purpose of this course, we

would only consider Scenario (A), Students who are interested in Scenario (B) are

encouraged to read INT FRS 27 in NCKL.

For a genuine sales and leaseback transaction, FRS 17 is applied to determine how the

“leaseback” transaction should be classified. The main accounting problems relating to

such sale and leaseback transactions are encountered in the seller-lessee's books. Some

of the issues involved are (1) should profit or loss on the sales transaction be recognised

immediately, (2) where the sales price is fixed artificially lower or higher than the fair

market value so as to accommodate a higher-or-lower-than-market lease rental, how

should the profit or loss on the initial sales and the lease rental in the subsequent lease

back be accounted for.

The basis of accounting for the above issues depends very much on the nature of the

leaseback transaction.

(a) If the leaseback transaction = operating lease

The sales transaction is, in substance, a genuine sales transaction. Any profit or

loss on the sales transaction, i.e. the difference between the selling price (SP) and

the carrying amount (CA) should be recognised immediately.

However, the SP could be artificially fixed to accommodate a higher-or-lower-

than-market lease rental.

If SP > FV, excess of SP – FV shall be deferred & amortized over asset

usage period.

If SP < FV, the difference between SP and CA shall be deferred & amortized

in proportion to ALP over asset usage period.

(b) If the leaseback transaction = finance lease

In substance, there was no sales transaction (because the seller-lessee retains the

risks and rewards incident to the ownership of the asset, as if the asset has not

been sold in the first place).

FRS 17 para 59 stipulates that any excess of sales proceeds over the carrying

amount (book value) should not be recognised immediately in the P&L account.

The excess should instead be deferred and amortised over the lease term. FRS 17

is silent on the excess of carrying amount over sales proceeds. For the portion of

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carrying amount over fair value, one could recognise the impairment losses in

the P/L and the remaining loss, i.e. FV less SP, could be deferred and amortised

over the lease term.

NCKL FRS 17 Illustrations 24 and 25 Cases A to C provide more descriptions of the

applications.