Accounting for Leases and Hire Purchase Contract Final.docxmary

7/28/2019 Accounting for Leases and Hire Purchase Contract Final.docxmary

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ACCOUNTING FOR LEASES AND HIRE PURCHASE CONTRACTS


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UNIVERSITY OF NAIROBI

SCHOOL OF BUSINESS

MASTER OF BUSINESS ADMINISTRATION

ADVANCED FINANCIAL ACCOUNTING

DAC 601

TERM PAPER

PRESENTED

TO

MR. BARASA J.L

BY

YASIR ALI

AND

MARY GORRETY


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ABSTRACT.

The leasing of assets is now a popular alternative to the outright purchase of assets. By

leasing assets businesses have less capital invested in non-current assets. Leasing frees up

capital that can be used to finance business operations or additional business ventures.

The widespread practice of leasing assets brought new challenges to the accounting

profession as non-current assets and their associated liabilities did not appear in the balance

sheet. These transactions were termed off-balance-sheet. Meaningful analysis and

interpretation of the financial statements could not be undertaken without these transactions

being reflected in the balance sheet.

Over the years the accounting profession has developed and refined an accounting standard

for leases. This accounting standard ensures that the financial statements of a businessproperly disclose leasing transactions.

This paper examines the classification of leases, analysis of lease payments and the

associated accounting entries for the recording and disclosure of lease transactions.

The current accounting standard for leases is AASB 117. This accounting standard as with all

accounting standards has been developed to provide more meaningful financial statements

that are consistently prepared across businesses.

The accounting standard for leases is the foundation of the material in this paper.

Terminology relating to leases, finance and operating leases, accounting for finance and

operating leases, and the disclosure requirements of leases in the accounts form the basis of

the paper. Advantages and disadvantages of leasing and how leases may be terminated are

also considered.


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CHAPTER ONE

INTRODUCTION

The acquisition of assets - particularly expensive capital equipment - is a major commitment

for many businesses. How that acquisition is funded requires careful planning.

Rather than pay for the asset outright using cash, it can often make sense for businesses to

look for ways of spreading the cost of acquiring an asset, to coincide with the timing of the

revenue generated by the business. The most common sources of medium term finance for

investment in capital assets are Hire Purchase and Leasing.

Leasing and hire purchase are financial facilities which allow a business to use an asset over a

fixed period, in return for regular payments. The business customer chooses the equipment it

requires and the finance company buys it on behalf of the business.

Many kinds of business asset are suitable for financing using hire purchase or leasing,

including:

Plant and machinery, land, motor vehicles etc.

Lease is covered by IAS 17 and defines lease as an agreement whereby the lessor conveys to

the lessee in return for a payment or series of payment the right to use the asset for an agreed

period of time.

Under lease purchase, the legal title is obtained when the final instalment is paid and the

purchase option is exercised. Lease is a contract made between a lessor and lessee for the hire

or specific asset. Under lease the legal title can never pass to the lessee. This is very common

method used in practice and is very popular. It also means that one party retains ownership ofan asset but conveys the right to the use of asset to another party for agreed period of time in

return for an agreed amount.

TERMINOLOGY

The following terms are commonly used in relation to accounting for leases:

Commencement of the lease term is the date when the lessee has the right to use the leased

asset. It is also the date when the details of the lease are recorded in the accounting records.


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Economic life is the anticipated life of a leased asset.

Fair value in general terms is the market price.

Finance lease is a lease that transfers substantially the risks and rewards of ownership

without transferring ownership. The title to the asset may eventually be transferred to the

lessee. A finance lease as the name suggests is a method of financing the acquisition of an

asset. Payments under a finance lease are a payment of interest and repayment of capital. The

criteria for determining a finance lease is considered later in the chapter.

Gross investment in the lease is the total of the minimum lease repayments and the

unguaranteed residual value of the leased asset.

Guaranteed residual value is that part of the residual value of the leased asset that is

guaranteed by the lessee under the lease agreement.

Inception of the lease relates to the commencement of the lease and is the earlier of the date

of the lease agreement and the date of commitment by the parties to the principal provisions

of the lease.

Initial direct costs are costs of negotiating and arranging a lease that have not been incurred

by manufacturer or dealer lessors.

Interest rate implicit in the lease is the discount rate that causes:

the minimum lease payments the fair value of the leased asset

+ = +

the unguaranteed residual value any initial direct costs of the lessor

Lease is an agreement where the lessee makes a series of payments to the lessor and in return

has the right to use the asset subject to the lease.

Lease commitments are the total amount of lease payments and other expenses owing over the

remainder of the lease.

Lease term is the period of the lease plus any further terms that the lessee has options to

continue the lease, and that it is reasonably certain the lessee will exercise the option.


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Lessee under a lease agreement has the right to use an asset in return for a series of payments

to the lessor.

Lessorunder a lease agreement provides an asset and receives a series of payments from the

lessee.

Minimum lease repayments. These are the payments over the lease term that the lessee is

required to make plus any amounts guaranteed by the lessee.

If the lessee has an option to purchase the asset at the end of the lease, and it is anticipated the

asset will be purchased, then the minimum lease repayments will be the lease repayments and

the amount payable to exercise the option to purchase the asset.

Novated lease for a motor vehicle is a tax effective method of acquiring a motor vehicle by

employees. The employee enters into a lease with a finance company to finance a motor

vehicle. The employer and the employee then enter into a sub-lease. The employee has the

use of the motor vehicle and if he assumes all the benefits, risks and responsibilities of the

original lease it is classified as an operating lease.

Operating lease is any lease that is not classified as a finance lease. Payments under an

operating lease are for the rental of the asset.

Residual value of a leased asset is the estimated amount that would be obtained from the

disposal of the asset at the end of the lease.

Sale and leaseback transaction involves the sale of an asset that is then leased back from the

purchaser.

Unearned finance income is the interest component of future lease payments under a lease

agreement.

Useful life is the estimated period over which the asset is economically usable. This may be

longer than the period of the lease.

ADVANTAGES AND DISADVANTAGES

There are many advantages in using leasing to finance the assets of the business and these

include:

1.

Capital Conserved- Large outlays of cash are avoided allowing business funds to be usedfor operating activities and expansion.


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2. Acquisition of assets. When new business opportunities arise new assets are readily

acquired by leasing.

3. Finance. Where the business does not have the capacity to borrow large amounts of funds

leasing may provide a viable alternative to finance new assets.

4. Upgrading equipment. At the end of the lease period obsolete assets can be replaced with

assets of the latest technology eg computer equipment.

5. Short term needs. Leasing allows the business to use assets that are required for a short

period of time without having to purchase them

6. Latest equipment. Having modern equipment creates a favourable impression for existing

and prospective clients. Productivity also increases by having the latest equipment. This

can be achieved by leasing assets.

7. Tax advantages. Leasing provides better income tax advantages over other forms of

financing the acquisition of assets.

Disadvantages also exist with leasing arrangements:

1. Cost of finance. Lease finance is generally more expensive than alternative forms of

financing.

2. Adverse cash flow. Lessees can over-commit themselves to a large number of leases with

high repayments.

3. Lease obligations. The business may struggle to meet lease payments if it is having

liquidity and/or profitability problems.

4. Guaranteed residual value. The business will have to pay the shortfall in the guaranteed

residual value if the leased asset does not realise the amount guaranteed under the lease.

5. Capital Gains. By leasing land and buildings the business may miss out on any capital

gain opportunities.

6. Ownership. Leased assets do not give the same prestige as ownership of the asset.

7. Credit rating. The lessee is required to have a good credit rating

8. Under-utilised equipment. With a downturn in demand equipment may be idle whilst

lease payments are still required to be made.

TERMINATION OF THE LEASE

The lease may be terminated (brought to an end) in a number of ways:

1. Renew the lease. The lease may be renewed for a further period. The value of the asset isthe residual value from the original lease


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2. Purchase the leased asset. The asset subject to the lease can be purchased for its residual

value.

3. Return the asset. Prior to the completion of the lease the asset may be returned to the

lessor. The lessee is responsible for any losses and outgoings incurred by the lessor.

4. At the end of the lease the lessee can return the asset to the lessor. The lessee is only

liable for any shortfall in the guaranteed residual value.

5. Trade in. The leased asset can be traded in on a replacement item that may be acquired on

a new lease.


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CHAPTER TWO

1.0 TYPES OF LEASE AGREEMENTS

1.1 FINANCE LEASE.

Long-term, non-cancellable lease contracts are known as financial leases. The essential point

of financial lease agreement is that it contains a condition whereby the lessor agrees to

transfer the title for the asset at the end of the lease period at a nominal cost. At lease it must

give an option to the lessee to purchase the asset he has used at the expiry of the lease.

Under this lease the lessor recovers 90% of the fair value of the asset as lease rentals and the

lease period is 75% of the economic life of the asset. The lease agreement is irrevocable.

Practically all the risks incidental to the asset ownership and all the benefits arising there

from are transferred to the lessee who bears the cost of maintenance, insurance and repairs.

Only title deeds remain with the lessor. Financial lease is also known as 'capital lease'. In

India, financial leases are very popular with high-cost and high technology equipment.

The finance lease or 'full pay out lease' is closest to the hire purchase alternative. The leasing

company recovers the full cost of the equipment, plus charges, over the period of the lease.

Although the business customer does not own the equipment, they have most of the 'risks and

rewards' associated with ownership. They are responsible for maintaining and insuring the

asset and must show the leased asset on their balance sheet as a capital item. Risk and

rewards associated with asset ownership include:

Risk:

1. Losses from idle capacity

2. Losses from technological obsolescence

3. The variations in return due to changing economic conditions.

Rewards:

1. Expectation of profitable operations over the assets economic life

2. Gain from appreciation in value of an asset, or realisation of a residual value.


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When the lease period ends, the leasing company will usually agree to a secondary lease

period at significantly reduced payments. Alternatively, if the business wishes to stop using

the equipment, it may be sold second-hand to an unrelated third party. The business arranges

the sale on behalf of the leasing company and obtains the bulk of the sale proceeds.

Under the substance-over-form concept, a transaction should be accounted for according to

economic substance rather than its legal form. In finance leases, the economic substance is

that a person uses an asset as if it is his own. The legal form of finance leases is that the asset

is owned by a different person- lessor.

A financial lease is usually non-cancellable, but may be cancelled under the 3 following

conditions:

a) Upon occurrence of some remote contingency

b) With permission of the lessor

c) If the lease is extended or renewed.

1.1.1 Characteristic of finance lease

1. Lease term consist of primary (3-4 years) and secondary period2. The lease term is equal to 75% or more of the economic or useful life of the asset. 3. The payments made to the lessor during the primary period are substantial and non-

cancellable. The present value of the minimum lease payments must be 90% of the fair

value of the asset.

4. Rentals paid during the secondary period are nominal in amount and cancellable at the

option of the lessee.

5. Where the lessee wishes to terminate the lease during the secondary period, the item

is sold and substantially all of the sale proceed will be paid to the lessee as rebate of

rentals. The lease agreement contains a bargain purchase option.

6. The lessee will be responsible for insurance, repair and maintenance.

7. Lessor retains the title to the items.

8. The lessee cannot sell the asset. The lease often transfers ownership of the leased

asset to the lessee by the end of the lease term, but till then the lessor retains the title to

the asset.

9. The lessee of any claims made indemnifies the lessor.


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1.2 OPERATING LEASE

If a business needs a piece of equipment for a shorter time, then operating leasing may be the

answer. The leasing company will lease the equipment, expecting to sell it second-hand at the

end of the lease, or to lease it again to someone else. It will, therefore, not need to recover the

full cost of the equipment through the lease rentals.

This type of leasing is common for equipment where there is a well-establishedsecond-hand

market (e.g. cars and construction equipment). The lease period will usually be for two to

three years, although it may be much longer, but is always less than the working life of the

machine.

Assets financed under operating leases are not shown as assets on the balance sheet. Instead,

the entire operating lease cost is treated as a cost in the profit and loss account.

An operating lease stands in contrast to the financial lease in almost all aspects. Thislease

agreement gives to the lessee only a limited right to use the asset. The lessor isresponsible for

the upkeep and maintenance of the asset. The lessee is not given anyuplift to purchase the

asset at the end of the lease period. Normally the lease is for ashort period and even otherwise

is revocable at a short notice. Mines, Computershardware, trucks and automobiles are found

suitable for operating lease because therate of obsolescence is very high in this kind of assets.

The lease assets are rented out to many different lessees over their useful economic lives.

The lessee pays for the hire or use of the asset. Ownership of the asset remains with the

lessor, who assumes all the risks and rewards of the asset and takes responsibility for repairs,

maintenance and insurance expenses.

According to IAS 17 rentals under operating lease should be recognized as expense and

charged on straight line method over the lease term even though the payments are not made

on such basis, unless another systematic and rational basis is more appropriate.

1.2.1 CONTRACT HIRE

Contract hire is a form of operating lease and it is often used for vehicles.


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The leasing company undertakes some responsibility for the management and maintenance of

the vehicles. Services can include regular maintenance and repair costs, replacement of tyres

and batteries, providing replacement vehicles, roadside assistance and recovery services and

payment of the vehicle licences.

1.3 SALE AND LEASE BACK

It is a sub-part of finance lease. Under this, the owner of an asset sells the asset to a party (the

buyer), who in turn leases back the same asset to the owner in consideration of lease rentals.

However, under this arrangement, the assets are not physically exchanged but it all happens

in records only. This is nothing but a paper transaction.

Sale and lease back transactions occur when the owner sells an asset and immediately

reacquires the right to use the asset by entering into a lease with the purchaser.

Sale and lease back transaction is suitable for those assets, which are not subjected

depreciation but appreciation, say land. The advantage of this method is that the lessee can

satisfy himself completely regarding the quality of the asset and after possession of the asset

convert the sale into a lease arrangement.

The lease payment and the selling price are interdependent as they are negotiated as a

package. The accounting treatment depends on whether it results to operating lease or finance

lease.

1.3.1 Finance lease-sale and lease back

In this situation any excess of sales proceed over the carrying amount should be deferred and

amortized over the long term. An impairment loss is dealt according to IAS 36.

1.3.2 Operating lease-sale and lease back

Transaction should be established at a fair value.

a) Any excess of fair value and carrying value shall be recognized as profit or loss

immediately.

b) Where selling price is less than the fair value any profit or loss should be recognised

immediately. Unless the loss is compensated for by future lease payment at below market


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price it should be deferred and amortized in proportion to the lease payment over the

period the asset is expected to be used.

c) Where price is more than the fair value the excess over fair value shall be deferred and

amortized over the period for which the asset is expected to be used.

d) Where the fair value at the time of sale and lease back transaction is less than the carrying

amount of the asset, a loss equal to the amount of the difference between the carrying

amount and fair value should be recognized immediately.

1.4 LEVERAGED LEASING

Under leveraged leasing arrangement, a third party is involved beside lessor andlessee. The

lessor borrows a part of the purchase cost (say 80%) of the asset from thethird party i.e.,lender and the asset so purchased is held as security against the loan.

The lender is paid off from the lease rentals directly by the lessee and the surplus

aftermeeting the claims of the lender goes to the lessor. The lessor, the owner of the assetis

entitled to depreciation allowance associated with the asset.

1.5 DIRECT LEASING

Under direct leasing, a firm acquires the right to use an asset from the manufacturer directly.

The ownership of the asset leased out remains with the manufacturer itself.

The major types of direct lessor include manufacturers, finance companies, independent lease

companies; special purpose leasing companies own your asset while spreading the cost


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CHAPTER THREE

ACCOUNTING FOR LESSEES

CAPITALIZATION CONCEPT

It should be noted that in finance leases the lessees right and obligation are such that the

risks and rewards from the use of asset are substantially similar to those of an outright

purchaser though not completely identical.

The contentious issue is whether the leased asset should be capitalized. IAS 17 requires the

leased asset to be recognized in the balance sheet as an asset and as an obligation, in the sense

that there will be future lease payment. The amount to be recorded is the greater of fair value

of the leased asset or present value of the minimum lease payment. The applicable discount

rate for discounting the present value of minimum lease will be the interest rate explicit in the

lease. However, if it is not possible and practicable the incremental borrowing rate should be

used.

The initial direct cost incurred in securing and negotiation should be added to the recognized

amount of asset.

Operating leases:operating leases pose few problems. Amounts are payable for the use ofan

asset. From the point of view of the lessee, the amounts payable are the costs of using anasset

for particular periods and hence are charged to the profit and loss account using theaccruals

concept.

Finance leases:Accounting for finance leases is a little more complicated. Prior to the

introduction of SSAP21, finance leases were usually treated by both lessee and lessor in the

same way as operatingleases. However, it was widely recognised that such treatment, while

being justified on astrict legal interpretation of the agreement, failed to recognise the financial

reality or substanceof the transaction. The substance of the transaction was that the lessee

acquired anasset for its exclusive use with finance provided by the lessor; which in economic

terms hasfew (if any) differences from the case of an asset purchased on credit. If financial

statementsare to be realistic it is necessary to find a way of accounting for finance leases

which accordswith the reality of the transaction rather than its legal form.


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The appropriate treatment of a finance lease, which accords with the substance of

thetransaction is, from the point of view of the lessee, to include in the lessees balance sheet

anasset representing the lease and a liability representing the obligation to make

paymentsunder the terms of the lease. At the inception of the lease the asset would be equal

to the liabilitybut this relationship does not hold thereafter. The asset would be depreciated

over theshorter of its useful economic life and the length of the lease, while the liability

would beeliminated by the payments. These payments are not, as in the case of an operating

lease,charged entirely to the profit or loss account nor are they, in general, wholly set off

againstthe liability. Instead the payments are split between that element which is regarded as

representingthe repayment of the liability and the remainder that is debited to the profit and

lossaccount as the financing (or interest) charge. This approach is referred to as the

capitalization of the lease.

The lack of a faithful representation consequent upon the failure of a lessee to capitalize

financial leases is highlighted by the problems that would be experienced when

comparingtwo companies, one of which leases most of its assets, with the other purchasing

fixed assetsusing loans of one sort or another. The latter companys balance sheet would

show the assetswhich it used to generate its revenue thus allowing users of accounts to

estimate the rate ofreturn earned on those assets, whereas the former companys balance sheetwould, if theleases were not capitalised, understate its assets. Similarly, the latter companys

balance sheetwould indicate the liabilities that would have to be discharged if it is to continue

in businesswith its existing bundle of assets, whereas the former companys balance sheet

would not.

Example: An i ll ustration of the basic pri nciples of accounting for a finance lease in the

accounting records of a lessee:

Lombok Limited, a company whose year end is 31 December, leases a machine from

SalatLimited on 1 January 20X1. Under the terms of the lease Lombok is to make four annual

payments11of 35 000 payable at the start of each year. Lombok Limited is responsible for

all themaintenance and insurance costs, so these are not covered by the payments under the

lease.The first step is to decide the amount at which the leased asset should be capitalised,

i.e.shown as an asset and a liability in the first instance. SSAP 21 requires that:

At the inception of the lease the sum to be recorded both as an asset and as a liabilityshouldbe the present value of the minimum lease payments, derived by discounting them at


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the interestrate implicit in the lease. (Para. 32)To do that we need to know what is meant by

the minimum lease payments and the interest rateimplicit in the lease.

Minimum lease payments: The minimum lease payments are the minimum payments over

the remaining part of the leaseterm (excluding charges for services and taxes to be paid by the

lessor) and:

(a) in the case of the lessee, any residual amounts guaranteed by him or by a party related

tohim; or

(b) in the case of the lessor, any residual amounts guaranteed by the lessee or by an

independentthird party. (Para. 20)In the Lombok example we will assume that there are no

residual amounts and thus the minimumlease payments at the inception of the lease are thefour annual payments of 35 000

Interest rate implicit in a lease: The interest rate implicit in a lease is the discount rate that

at the inception of a lease whenapplied to the amounts that the lessor expects to receive and

retain produces an amount (thepresent value) equal to the fair value of the leased asset. The

amounts which the lessorexpects to receive and retain comprise (a) the minimum lease

payments to the lessor (asdefined above) plus (b) any unguaranteed residual value, less (c)

any part of (a) and (b) forwhich the lessor will be accountable to the lessee. If the interest rate

implicit in the lease is notdeterminable, it should be estimated by reference to the rate that a

lessee would be expectedto pay on a similar lease. (Para.24).

Fair value:Fair value is the price at which an asset could be exchanged in an arms length

transaction less,where applicable, any grants receivable towards the purchase or use of the

asset. (Para. 25)

Note that while knowledge of the implied interest rate is required to determine the

appropriateaccounting treatment in the books of the lessee, it is found by reference to the cash

flows of thelessor. In practice the lessee may not know or be able to estimate the various cash

flows but weassume, at this stage, that the lessee can obtain all the necessary data.

If we let FV be the fair value, Lj the lease payment in year j (payable at the beginning of

eachyear) and Rn the estimated residual values received at the end of year n, the last year of

the lease,then using standard present value techniques the implied rate of interest r is found

from the solutionof the following equation:


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If we assume in the case of the Lombok/Salat lease that the fair value is 108 720 and that

thereis no residual value (i.e. Rn = 0) then substituting in the above equation we get:

Inspection of tables showing the present value of an annuity shows that 3.1064 represents an

interest rate of 20 per cent. Thus the interest rate implicit in the lease is 20 per cent and

hencethe present value PV of the minimum lease payments can be found as follows

This is of course equal to the fair value as, in the simple case, the only cash flows that the

lessorwill receive are the minimum lease payments. Later we will describe the circumstances

where thetwo series of cash flows (i.e. the lessees and the lessors) might be different and the

effect ofthese differences on the calculations.

We can now show how the lease should be treated in the books of Lombok (the lessee).

Theoriginal entry recording the lease is:

Dr Leased asset 108 720

Cr Liability under lease 108 720

From this time onwards the two accounts are dealt with separately. The leased machine will

bedepreciated over the shorter of the length of the lease or the assets expected life, using the

companysnormal depreciation policy for assets of its type, while the liability will be

graduallyextinguished as payments are made during the primary period of the lease. The only

problem thatremains is how to spread the total interest charge over the primary period of the

lease.

The total interest charge may be calculated as follows:


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Theoretically, the best approach is to use the actuarial or annuity method that produces a

constantannual rate of interest (in this case 20 per cent) on the outstanding balance on the

liabilityaccount. This is the method specified in SSAP 21, which does, however, allow the

use of anyalternative method that is a reasonable approximation to the annuity method.

Assuming that all payments are made on the due dates, the liability account in the books

ofLombok for the term of the lease can be summarised as follows:

This account provides us with the interest charge to the profit and loss account for each year

andthe liability for inclusion in each balance sheet. The amount of interest charged to theprofit andloss account declines over the life of the lease because the outstanding balance is

reduced bythe annual payments. It is, of course, necessary to distinguish between the current

portion of theliability, that is the amount due to be paid in the coming twelve months, and the

long-term liabilityfor the purposes of balance sheet presentation. In this case, this is

extremely easy as the onlypayment to be made in each of years 20X2 and 20X4 is 35000 per

annum payable on the dayfollowing each balance sheet date. Hence the analysis of the

liability into its current and long-termcomponents is as follows:

One commonly used alternative to the annuity method is the sum of the years digits

method or Rule of 78. If the sum of the digits method were used in the above illustration theresultswould be:


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The impact of residual valuesLet us now complicate matters by assuming that the asset that is

the subject of the lease hasa residual value. We will assume that the manufacturer who

originally supplied the asset toSalat has agreed to reacquire the asset at the end of the lease.

The sum is dependent on thecondition of the machine and the market factors at the end of the

lease, but the manufacturerhas guaranteed to pay 10 000 whatever the circumstances. Let us

assume that at theinception of the lease it is anticipated that the manufacturer will actually

pay 20 000. Letus also assume that Lombok and Salat agree that they will divide any sums

realised on thedisposal of the asset in the ratio 35 : 65. Thus, at the inception of the lease it is

estimatedthat Lombok will receive 7000 (of which 3500 is guaranteed) and Salat 13 000

(6500guaranteed).

For the purposes of calculating the implicit interest rate, the distinction between the

guaranteedand unguaranteed elements of the residual value can be ignored as both have to

betaken into the calculation, but the distinction may be important when deciding whether

thelease is a finance or operating lease.

If we return to the equation above and substitute the estimated value on realization receivable

by Salat, the equation becomes:

Use of tables or a programmable calculation on a computer shows that the above equationwill

be satisfied when r is approximately 25 per cent. This is a higher rate of interest than the20

per cent that was previously calculated as Salat obviously earns a higher return due to

theintroduction of the residual value as an additional cash flow.


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So far as Lombok is concerned the minimum lease payments are unchanged but they willnow

be discounted at the higher rate of 25 per cent that will produce an initial value of theleased

asset of:

The annual payments of 35 000 are the same as in the original example except that the

liabilitythat is to be paid off is lower (103 320 not 108 720). Hence the finance charge in

theprofit and loss account will be higher in the second example. This reflects the fact that in

thefirst example the lease payments can be regarded as acquiring the whole of the

productiveuse of the asset, in that a zero residual value was assumed, whereas in the second

case thesame annual lease payments only acquired a proportion of the assets productive

capacity.

It will be noted that the estimated realisable value that Lombok expects to receive had

noeffect on the calculation of the amount by which the lease should be capitalised or on

theway in which the annual lease payments should be split. This is because these depend on

theminimum lease payments. The recognition of the estimated realisable value does have

aneffect on the amount that has to be depreciated which is the present value of the

minimumlease payments less the estimated realisable value. Thus, the depreciation charges

that wouldemerge from our two sets of assumptions are as follows (assuming the straight-line

methodis used):

In the above examples we assumed that the lessee knows (or is able to find out from

thelessor) the fair value of the asset and the estimated realisable value that the lessor expects

toreceive. In practice this may well not be the case and certain estimates will have to be

made.Often the fair value will be known and the interest rate estimated from a knowledge

ofother leases of a similar type.


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Gross earnings: Gross earnings comprise the lessors gross finance income over the lease

term, representing the difference between his gross investment in the lease [see above] and

the cost of the leased asset less any grants receivable towards the purchase or use of the asset.

(Para. 28)

In order to illustrate the effect of the above definitions assume that the details relating to a

particular lease are as follows:

Let us see how one measures the net investment at the inception of the lease and at the end of

the first year

Hence, at inception the net investment is equal to the cost of the asset less grants receivable

by the lessor. Assume that the gross earnings recognised in the profit and loss account in the

first year are 2500 .Then the net investment at the end of the first year is:

The recognition of gross earnings:

The total gross earnings on any lease are reasonably easy to calculate since the minimum

lease payments will be known and, generally, the residual value, if any, can be estimated. Thedifficulty lies in allocating the gross earnings to the different accounting periods. The


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standard followed existing practice in the leasing industry by specifying that the interest

should be allocated on the basis of the lessors net cash investment in the lease and not on the

basis of the net investment.

The meaning of net cash investment:

The net cash investment in a lease at a point in time is the amount of funds invested in a lease

by a lessor, and comprises the cost of the asset plus or minus the following related payments

and receipts:

a) government or other grants receivable towards the purchase or use of the asset;

b) rentals received;

c) taxation payments and receipts, including the effect of capital allowances;d) residual values, if any, at the end of the lease term;

e) interest payments (where applicable);

f) interest received on cash surplus;

g) profit taken out of the lease.

The actuarial method after tax

The guidance notes to SSAP 21 describe a number of ways of allocating the gross revenue to

accounting periods based on the net cash investment. Of these the most accurate is the

actuarial method after tax. This method produces a constant rate of return on the net cash

investment over that period of the lease in which the lessor has a positive investment (i.e.

before any cash surplus is generated).

Example 9.3 The actuarial method after tax:

Gasp plc, the lessor, acquired an asset for 7735 that it leased out on the following terms:

Period 5 years

Rental 2000 per year payable in advance on 1 January of each year

Residual value Zero

Gasps year end is 31 December and tax in respect of any year is payable on 1 January of thenext year but one. The tax rate is 50 per cent and capital allowances of 100 per cent are


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receivable in the first year. (These rates are unrealistic but they have been chosen to simplify

the figures and hence clarify the example.)

The annual rate of return earned over the period when there is a net cash investment is 12 per

cent while it is estimated that surplus cash can be invested at 5 per cent (both rates are before

tax).

The interest paid by Gasp on the funds invested in the lease will be ignored. The cash flows

and the profit recognised on the lease are set out in Table 9.3

Notes:

(a) The profit taken on the lease has been calculated at 12 per cent of the net cash investment

at the start of each year (e.g. 688 = 0.12 5735) while the interest on the cash surplus has

been calculated at 5 per cent of the opening balance (e.g. 45 = 0.05 903). Interest on the

cash surplus in 20X6 has been ignored (otherwise the calculation would never end).

(b) The tax computation for 20X0 (tax payable on 1 January 20X2) is as follows:


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In subsequent years the tax payment is 50 per cent of the sum of the rental income and the

interest earned on the cash surplus.

Although the lease will generate an annual rental of 2000 for each of the five years after tax,

profit recognised in respect of the lease is 688 in year 1, 531 in year 2 and 11 in year 3.

It may be thought that this is a very imprudent way of recognising profit in that most of the

profit is taken in the first two years of the lease. However, it must be recognised that theprofit reported is that which is generated by the lessors financing activities and is calculated

by reference to the amount that the lessor has invested in the lease. As Table 9.3 shows, the

investment falls to zero, to be replaced by a cash surplus by 1 January 20X3.

Arithmetically all the figures in Table 9.3 can be found if you know the cash flows, which

will be specified in the agreement, and either the profit on the lease (12 per cent) or the re-

investment rate (5 per cent). Thus, if one of the two rates is known the other can be

calculated, with the aid of a computer or a lot of patient trial and error. In practice, of course,

the lessor will have made the calculations of these rates when agreeing the terms of the rental

with the lessee. Thus the lessor would start by deciding, on the basis of market conditions and

competitive forces, the return required on the lease (taking into account the return on any

surplus cash invested and hence work out the rent that would need to be charged.

The next step is to calculate the proportion of the annual receipts of 2000, which is deemed

to represent the reduction in the amount due from the lessee. The calculation is based on the

figures in Table 9.4. This table also shows the necessary transfers to and from the deferred

taxation account if it is judged necessary to establish such an account.


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Table 9.4 is constructed from the bottom up. The figures in line 9 are taken from Table 9.3.

The net profit is then grossed up at the appropriate tax rate (50 per cent) to give line 5. Line 6,

which shows the actual tax payments, is also taken from Table 9.3 which means that line 8

(deferred tax) can be derived. Line 4 is taken from Table 9.3 and hence the gross earnings

(line 3) and capital repayments (line 2) can be deduced. If, taking into consideration the

affairs of the company as

a whole, it is decided that it is not necessary to account for deferred tax, one could start Table

9.4 at line 5 and work up from there.

It must be emphasised that Table 9.4 is used only to calculate the capital repayment and, if

appropriate, the deferred taxation transfers. For the purposes of the balance sheet presentation

SSAP 21 requires that the amount due from the lessee should be the net investment (not the

net cash investment) in the lease. Thus in the instance of Gasp plc the asset would be

recorded as follows:


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The gross earnings allocated to future periods are found from line 3 of Table 9.4. Thus, for

example, the figure at 31 December 20X0 is (1062 + 22459852) = 889 and so on.

The method produces the apparently absurd result that the net investment at certain dates is

greater than the remaining lease payments, the extreme case being that at 31 December 20X4

when a net investment of 52 is produced notwithstanding the fact that the lease has

terminated. This odd result derives from the fact that a larger profit is taken in the early years

of the lease in consequence of the anticipated return on the surplus cash invested; thus, for

example, the net investment at 31 December 20X3 of 2150 can be regarded as representing

the final lease payment of 2000 plus the anticipated interest receipts of 150 (98 in 20X4

and 52 in 20X5).

Beyond SSAP 21

Accounting for Leases: A New Approach (1996)

A movement to treat all non-cancellable leases as finance leases has been under way for some

time. The opening shot of the international campaign was the publication of a G4+1

Discussion Paper Accounting for Leases: A New Approach by the Financial AccountingStandards Board, in 1996. Although the author of the report is stated to be Warren McGregor,

the paper is a report of a working party of the G4+1 group of standard setters, made up of

representatives of the IASC and groups from five countries.21 It confirms that leasing

continues to be a major source of financing and suggests that it may become even more

important in the future.

The authors of the paper, drawing largely on research carried out in Australia and the USA,

conclude that there have been many examples of lease agreements for what are, in all

material respects, finance leases that were drawn up in such a way to ensure that they

qualified for treatment as operating leases and hence appear off the balance sheet. The

authors were skeptical of the ability of standard setters to produce criteria that would

overcome this problem. They took a different approach and examined the issue from first

principles, largely relying on the definitions of assets and liabilities contained in the IASCs

Framework.


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The report argues that, in respect of any non-cancellable lease, the lessee possesses both an

asset and a liability and these should be reflected on its balance sheet. Hence, the report

recommends that all non-cancellable leases should be capitalised. This recommendation is

advanced on the grounds of both theory and pragmatism. This is normally a powerful

combination but it appears to be working slowly in this particular case.

Leases: Implementation of a New Approach (1999)

While SSAP 21 remains in force, the battle continues. In 1999 the ASB published another

discussion paper produced by the G4+1 group, Leases: Implementation of a New Approach.

The 1999 report adopts the same position as its 1996 predecessor but advances the argument

in a number of ways.

The cash flows on which the capitalisation is based:

The 1999 paper addresses a range of practical issues concerned with the identification of the

cash flows that should be capitalised to provide the measure of the initial asset and liability in

the books of the lessee, and covers such issues as possible variations in residual values, the

question of contingent rentals and the treatment of long-term property leases.

One of the reasons why SSAP 21 is thought to be inadequate is the rich variety of types ofleases that have been developed by the financial community. Many leases are far removed

from the simple notion of a predetermined regular flow of resource from lessee to lessor over

the life of the agreement. Much of the 1999 paper is concerned with examining the different

types of leasing agreement that exist and discussing the basis on which they should be

capitalised. We do not have the space to deal with the whole variety of leases discussed in the

paper but it would be helpful to quote one as an example, both to provide a flavour of the

document and to illustrate the thinking that underpins it.

The example we have selected is of a lease where the rent payable varies according to the

revenue generated by the use of the asset. Specifically the example, example 4 in the paper, is

of an agreement where a lessee enters a three-year lease on a retail store. The annual rent

comprises a minimum base rental of 10 000 plus 1/2 per cent of the stores turnover during

that year.

In this example, the authors came to the view that a fair value approach should be used and

an estimate is made of what the rental payments would have been had there not been the


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turnover element. Suppose that this is 10 500 per annum, then the initial carrying value of the

lease should be based on three payments of 10500 and the differences between those amounts

and the amounts actually paid should be credited or debited to the profit and loss account for

the relevant year.

In general the approach taken in the paper is to capitalise on the basis of the minimum lease

payments and to deal with variations on a year-by-year basis unless, as in the above example,

the amount so derived would not provide a reasonable estimate of the fair value of the lease.

The discount rate to be used by the lessee:

As we pointed out earlier, SSAP 21 requires the lessee to use the discount rate that it is

implied in the leasing agreement and which is set by the lessor, which is not something thatthe lessee can always readily determine. The 1999 paper takes a much more sensible

approach and argues that the discount rate to be applied by lessees should be an estimate of

the lessees incremental borrowing rate for a loan of a similar term and with the same security

as is provided by the lease. This proposal underscores the point that a lease is a form of

finance and should be treated as far as possible in a comparable way to other sources of

finance that the entity might employ.

The recognition of lease-related assets in the books of the lessor:

The 1999 paper, unlike the 1996 version, deals with lessors as well as leases. The paper

argues that, in the context of a lease agreement, a lessor possesses two distinct assets:

the right to receive payments from the lessee; and

the right to the return of the asset at the end of the agreement.

The paper argues that these are distinct assets, one financial and one non-financial, and that

they should be reported separately. The paper discusses a number of different ways by which

the necessary measurements might be made


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CHAPTER FIVE

4.1 HIRE PURCHASE ACCOUNTING

With a hire purchase agreement, after all the payments have been made, the business

customer becomes the owner of the equipment. This ownership transfer either automatically

or on payment of an option to purchase fee.

For tax purposes, from the beginning of the agreement the business customer is treated as the

owner of the equipment and so can claim capital allowances. Capital allowances can be a

significant tax incentive for businesses to invest in new plant and machinery or to upgrade

information systems.

Under a hire purchase agreement, the business customer is normally responsible for

maintenance of the equipment.

Hire purchase - otherwise known as lease purchase - is a simple repayment facility, where

you eventually own the asset at the end of your agreement with Lombard.

Hire purchase benefits

Total control - the asset is yours at the end of the agreement

Flexibility in your repayments - makes for easy budgeting

Fixed or variable interest options - it's your decision which is best for you

Tax advantages - normally you can claim writing-down allowances and perhaps

capital grants, while repayment interest may be offset against profits and VAT is

usually reclaimable (special rules apply to cars)

There is great flexibility with this type of asset finance. We can structure it in various ways,

with a flexible deposit, fixed payments and perhaps a balloon final lump sum.

Hire purchase transactions are initially classified into two

1) Books of purchaser

2) Books of the vendor.


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4.1.1 PUCHASERS BOOKS

For any hire purchase transaction it is important to realise that the hire purchase price is more

than cash price such that the difference between the two is hire purchase interest.

Cash price + H.P Interest =H.P price

Cash price- record as an asset

H.P Interest-record as interest in P&L accounts

H.P Price-record as liability to be paid off

The hire purchase contract may last for several years, thus the purchaser should record the

interest expense in the P&Ls of all the years over which the contract lasted. Apportionment of

interest to the various P&Ls is done by any of the following methods.

1. Straight line method

2. Actuarial method

3. Sum-of digits method.

EXAMPLE ONE

Nairobi school acquired 2 new buses on 1 Jan. 1990 for $ 129,150. The cash prices of the

bases were $90,000. The deal was financed by TSPP LTD, and the terms of the hire purchase

contract required a deposit of $30,000 on delivery, followed by 3 instalments on 31 st Dec.

1990, 1991 and 1992 of $33,000, $33,000 and $33,150 respectively. The true interest rate

was 30% per annum.

Required-Prepare the appropriate accounts in the books of Nairobi school to record the above

transaction, accounts after the end of 1992 need to be prepared. Depreciation is to be charged

on vehicle at 20% per annum, using straight line method.

Solution


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Vehicle

$ $

Jan-01

H.P

Supplier 90,000 Dec-31

Balance

c/d 90,000

1990 1990

Jan-01

Balance

b/d 90,000 Dec-31

Balance

c/d 90,000

1991 1991

Jan-01

Balance

b/d 90,000 Dec-31

Balance

c/d 90,000

1992 1992

Jan-01

1993

Balance

b/d 90,000 1993

H.P Suppliers (TSPP LTD)

1990 $

1 Jan. Cashbook 30,000

31 Dec. Cashbook 33,000

31 Dec. Balance c/d 45,000

108,000

1991

1990 $

1 Jan. Motor Vehicle 90,000

31 Dec. H.P Interest 18,000

108,000

1991


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58,500

1992


33,150

1 Jan. Balance b/d 45,000


58,500

1992

1 Jan Balance b/d 25,500


33,150

HIRE PURCHASE

INTEREST (EXP.)

$ $

Dec 31 H.P Supplier 18,000 Dec-31 P & L 18,000

1990 1990


1991 1991


1992 1992


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PROVISION FOR DEPRECIATION

1990 $


1991


36,000

1992


54,000

1990 $

31 Dec. P & L 18,000

1991


31 Dec. P & L 18,000

36,000

1992


31 Dec. P & L 18,000

54,000

The above solution is on the basis of the actuarial method, where the true rate of interest is

given. If the straight line method is to be used the interest is apportioned as follows:

Cash price + H.P Interest = H.P Price

90,000 + 39,050 = 129,050

39,050/3=13,050 for each of the 3 years.

If the sum of digits methods were used, the interest will be apportioned as follows:

YEAR 1990 = 39,150*(3/6) =19,575

YEAR 1991 = 39,150*(2/6) = 13,050

YEAR 1992 = 39,150*(1/6) = 6,525


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4.1.2 THE VENDORS BOOKS

From the sellers perspective, there are two sets of income

Cost-cash selling price-H.P selling price

Pure gross profit= Cash selling price-Cost

Interest income= H.P Price- Cash selling price

If the items are large and transactions few, a distinction may be made between pure gross

profit and interest, and each recorded individually and independently. However, if the

transactions are many and each of relatively low value, there is no need to make a distinctionbetween pure gross profit and interest, and the total of these may be recorded and accounted

for together.

The books are a mirror image of the purchasers books.

EXAMPLE ONE

TSPP finances ltd supplied bases to Nairobi school at H.P Price of $129,150.The terms of the

contract required a deposit of $30,000 on delivery, followed by 3 instalments on 31 st Dec.

1990, 1991 and 1992 of $33,000, $33,000 and $33,150 respectively. The true interest rate

was 30% per annum. The cost of the vehicle to the supplier was $ 60,000 and the cash selling

price was $ 90,000.

Required-Prepare the appropriate accounts in the books of TSPP LTDto record the above

transaction, accounts after the end of 1992 need to be prepared. Depreciation is to be charged

on vehicle at 20% per annum, using straight line method.

Solution

H.P Sales

1990 $

31 Dec. H.P Trading A/C 90,000

1990 $

1 Jan. H.P Debtor 90,000


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H.P Purchases

1990 $

1 Jan. Bank//Creditor60,000

1990 $

31 Dec. H.P Trading a/c60,000

H.P Trading A/C -1990

$

Purchases ( cost of sales) 60,000

Provision for unrealised profit 15,000

P & L pure gross profit interest 33,000

108,000

$

Sales90,000

H.P Interest income 18,000

108,000

P & L (EXTRACT) 1991

$ $

H.P Interest 13,500


P & L (EXTRACT) 1992

$ $

H.P Interest 7,650


H.P Debtors A/C

1990 $ 1990 $


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1 Jan. Sales 90,000

31 Dec. H.P Interest income 18,000

108,000

1991

1 Jan. Balance b/d45,000

31 Dec. H.P Interest income 13,500

58,500

1992



33,150

1 Jan. Cashbook 30,000



108,000

1991


31 Dec. Balance c/d25,500

58,500

1992

31 Dec. Cashbook33,150

33,150

H.P Interest Income

1990 $

1 Jan. H.P TP & L 18,000

1991

31 Dec. H.P P & L 13,500

1992

31 Dec. H.P P & L 7,650

1990 $

1 Jan. H.P Debtor 18,000

1991

31 Dec. H.P Debtor 13,500

1992

31 Dec. H.P Debtor 7,650


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Provision for unrealised profit

1990 $


1991

31 Dec. P & L (1991)10,000


15,000

1992

31 Dec. P& L (1992)5000

1990 $

31 Dec. H.P T P & L 15,000

1991


15,000

1992



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CHAPTER SIX

5.1EMERGING ISSUESCapitalization of leased assets has been one of the emerging issues. There has been case for and

against capitalization.

5.1.1 ARGUMENT FOR CAPITALIZATIONIAS 17 recognises that lessee acquires the economic benefit of the leased asset for the major part of

its economic life in return for entering into the obligation to pay the right almost equal at the

inception of the lease to the fair value of the asset and the related finance charge. The lessee enjoys

these benefits without the legal title, which is the legal form of the agreement.

5.1.1.1GROUNDS FOR ARGUMENT OF CAPITALIZATION

A) SUBSTANCE OVER FORMThe substance over form recognizes that lessees right are similarto those of an outright purchaser.

As these results represent an economic benefit arising from the use, then leased asset should be

capitalized.

B) FINANCIAL RATIOSIf leased transactions are not reflected in the balance sheet of the lessee, the economic resources and

the level of obligations of an enterprise are understated and hence distort financial ratios.

5.1.2 ARGUMENTAGAINST CAPITALIZATIONThe following are the main arguments against capitalization.

1. Legal form- legal form should not be ignored on the grounds that the benefits arising from

the lease to a lessee is form of an intangible asset. Therefore, it could be misleading if the

obligation under lease is similar to those of a loan stock when an asset is purchased outright.

2. Differentiation. The difficulty of differentiating between finance leases and operating lease

remain.


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3. Capitalization amount. It is not very clear whether to capitalize the whole amount of the

lease or the principle.

4. Complexity. Capitalization computations are very complex for small business to carry out.

5. Consistency. The capitalization process is arbitrary to a lesser extent and therefore lack

consistency.

6. Presentation in financial statement by a note is more understandable than the mere

computation.

Standard committee has rejected the argument against capitalization and they have recommended

for its adoption.


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References:

Richard Lewis andDavid Pendrill, Advanced financial accounting, 7th edition, financial

times prentice hall,2004

Imea P. KamenchuAdvanced applied accounting, 2008

IASB, international accounting standards, IFRS latest publication

Documents

Accounting for Leases and Hire Purchase Contract Final.docxmary