Leasing Accounting

8/8/2019 Leasing Accounting

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Lease

An agreement whereby the lessor conveys

to the lessee in return for a payment or series

of payments the right to use the asset for an

agreed period of time. (IAS 17)

A lease in an agreement whereby a party,

the lessor, transfers an asset and the right touse it to another party, called the lessee in

exchange for periodic lease payments.



Why Lease

Leasing is an attractive way for many entities to acquire

the right to use an asset without actually buying

the property due to following reasons:-

Financing can be arranged with a small amount of down payment.

100 % financing for the leased asset is possible.

Greater tax relief is available than in outright purchase. Risk of obsolescence is reduced, like due to rapid

change in technology.



Why Lease

Off-balance sheet financing is possible, thus theborrowing capacity of lessee is increased

In the case of an operating lease, the debt-equity

ratio is improved. Financial statements reflect an improved return

on investment.

The definition of IAS-17 implies that the lease

does not convey the lessee 100% ownershiprights. The lessor, who owns the asset, onlyallows the lessee to use the asset for specificperiod of time in return of agree amount of rent.



Essentials of Lease

The lease, being a contract should set out certainessential provisions which are :-

the duration of lease

amount and timings of rentals Lessors obligations for taxes, insurance and

maintenance.

Restrictions on lessee relating to incurrence of debts or

dividend declarations Lessees rights regarding early termination or purchase

of asset at the end of lease term, or to renew the lease.



Types of lease

Finance Lease

IAS-17 provides for capitalization of leases where thelease transfers substantially all of the risks (losses due

to idle capacity or obsolescence) and rewards(ownership, profitable, residual value) incident to theownership of the property to the lessee.

In such cases, the lessee record the lease as an assetand a corresponding liability. The lessee treats the

transaction as if the asset was purchased completely. In such cases, the lessor will treat his investment leasepayments receivable instead of leased asset.



Criteria to determine when the risks and reward are transferred

paragraphs 8 & 9 of IAS-17

Transfer of ownership at the end of lease term

Purchase option to the lessee at a price which isexpected to be sufficiently lower than the fair value atthe date the option becomes exercisable such that, atthe inception of the lease, it is reasonably certain thatthe option will be exercised;

The lease term is for the major part of the economiclife of the asset even if title is not transferred;

At the inception of the lease the present value of theminimum lease payments amounts to at leastsubstantially all of the fair value of the leased asset;and



Criteria to determine when the risks and reward are transferred

paragraphs 8 & 9 of IAS-17

The leased asset is of a specialized nature such that onlythe lessee can use it without major modifications beingmade.

If the lessee can cancel the lease, the lessors losses

associated with the cancellation are borne by the lessee; Gains or losses from the fluctuation in the fair value of the

residual fall to the lessee (for example in the form of a rentrebate equaling most of the sales proceeds at the end of the lease); and

The lessee can continue the lease for a secondary period ata rent which is substantially lower than market rent.



Lease Terminologies

Non-cancelable lease (Conditional cancellation)

A non-cancelable lease is a lease which is cancelable either as a result of a remotecontingency or involves substantial penalty that it is unlikely that the lease will be canceled.

Note : only no-cancelable leases can be treated as finance leases. If the lease is cancelable and

even meets all the criteria in para 8 it cannot be capitalized.

Inception of lease

The date of inception of lease is the lease agreement date. The only exception is where thecommitment to the principal provisions of the lease has been made prior to the leaseagreement.

Lease term

Lease term is usually fixed and non cancelable term. This period normally cannot be reduced.The lease period however may be extended if the agreement provides for bargain renewaloption. This option allows the lesee to renew the lease at a substantial lower rental than theexpected fair rate at the date the option becomes exercisable.



Lease Terminologies

Minimum Lease Payments

From standpoint of the Lessee :

Bargain purchase option, or

Residual value guaranteed to the lessor by the lessee or by a party related to the lessee

When a lease contains a bargain purchase option the minimum lease payments include only:-

Minimum rental payments

Bargain purchase option.

Thus, in a lease agreement either bargain purchase option will be included or the guaranteed

residual value.

The lessees obligation to pay executor costs are excluded from minimum lease payments.



Lease TerminologiesFrom standpoint of lessor :

The minimum lease payments as set out above plus residual valueguaranteed by an independent third party.

(The guarantor should be financially capable of meeting the

guarantee) It should be noted that the residual value guaranteed by a party

related to lessee has same effect as a guarantee by the lessee.

The definition of MLP is important because

(i) The criterion as set out in paragraph 8 (d) compares MLP withfair value

(ii) MLP is the basis for recording finance lease.



Lease Terminologies

Minimum rental payments

These are the minimum payments required to be made under thelease agreement by the lessee to the lessor. IAS 17 has not defined theterm minimum rental payment the word minimum here indicates

that additionally payments may be involved over and above suchminimum rental payments.

Cost of services and taxes to be paid and reimbursable to lessor arenot included in minimum lease payments.

Executor costs may either be assumed by the lessor or lessee or

shared between them. Executor costs are not included by the lessee in thecomputation of MLP.

If the lessor has the responsibility to pay the executor costs. Suchcosts should be excluded from MLP in computing present value of MLP.



Lease Terminologies

Guaranteed residual value

Residual value is the estimated fair market value of the property at the end of lease term. Sometimes the lessor at inception of the lease, may like to place aspecific value to the residual value.

From lessors point of view, the guaranteed residual value includes residual valueguaranteed to lessor by an independent third party.

Unguaranteed residual value

Unguaranteed residual value is that portion of the residual value of the leased

asset (estimated at the inception of the lease), the realization of which by lessor isnot assured or is guaranteed solely by a party related to the lessor

From lessee point of view, in the context of capitalisation of the asset, a lease withunguaranteed residual value has the same effect as lease with no residual value.



Lease Terminologies

Bargain purchase option

This term also has not been defined in IAS 17. Thebargain purchase option represents a payment by the

lessee to the lessor, at the end of the lease term virtueof which the lessee obtains legal title to the property.

Fair value

Fair value is the price at which the asset can be sold toan unrelated party. It generally represents cost lesstrade discount.



Lease Terminologies

Gross investment in the lease

Gross investment in the lease equals minimum lease payments from viewpoint of lessor plus unguaranteed residual value. In case the lessor has topay any executor costs which are reimbursable to him, such costs are

excluded from the gross investment.

Net investment in the lease

Net investment in the lease is the gross investment less unearned financeincome.

Unearned finance income It is the difference between gross investment in thelease and the present value or the gross investment.



Lease Terminologies

Interest rate implicit in the lease

It is discount rate that, at the inception of the lease, causes theaggregate resent value of the minimum lease payments and theunguaranteed residual value to be equal to the fair value of thelease asset, net of any grants and tax credits receivable by thelessor.

Lessees incremental borrowing rate

It is rate of interest that the lessee would have to incur on a similarlease, or if it is not determinable, the rate that, at the inception of lease, the lessee would incur to borrow on a similar term, and witha similar security, the funds necessary to purchase the asset.



Lease Terminologies

Present value of minimum lease payment

Present value of minimum lease payments is the value at thepresent time of future sums of minimum lese payments

discounted at compound interest.

Contingent rentals

Contingent rentals are not fixed per period, but dependupon future events and therefore cannot be ascertained ateh inception of lease. The rentals are based upon any basisother than time period.



INTERPRETATIONSConsistency in classification of leases by the lessee and the lessor

Paragraph 7 recommends that so far as possible, both the lessor and the lessee shouldclassify the lease in the same way. It however, states the application of these definitions to thediffering circumstances of the two parties may sometimes result in the same lese being classifieddiffertly by lessor and lessee

Real estate leases

Paragraph 11 provides that the classification criteria for land and building are the sameas that for any other lease.

IAS 17 does not provide guidance in situations where a lease involves both the land andbuilding. In such cases the S GAAPs recommend that ownership criteria is met both the land andbuilding will be treated as finance lease but it would be necessary to define separately the presentvalue of the assigned to building will be depreciated over its economic life and the land will not bedepreciated.

If land and building are treated as a single unit, following criteria will be applied to theassigned value of the building in order to determine lease classification.



INTERPRETATIONS

The lease term is for the major part of the useful life of the asset.

or

The present value of the minimum lease payments is substantially the fir value

assigned to the building.In case of any above conditions, the building will be classified as finance lease. Incase

none of the conditions above the building will be treated as an operating lease.

Leases involving land only

In case of land the risks and rewards are transferred to lessee only if title istransferred or the lease contains bargain purchase option.The lease for land is classified as finance only of any one of the first two criteria of Para 8 of IAS 17 is met: otherwise it will be operating lease.



INTERPRETATIONS

BARGAIN PURCHASE OPTION

The bargain purchase option gives the lessee an option to purchase the lease asset at a pricewhich is substantially below its fair value. Another related term is Bargain Renewal Optionthis option allows the lessee to renew the lease for a rental that is sufficiently lower than theexpected market rental of the property at the exercise date of the option. Both the lessor andthe lessee account bargain purchase option similar to guaranteed residual value as regards:

Computation of periodic rentals

MLP computation

Amount charged to asset under finance lease

Recognition of lease obligation

Amortization of lease obligation

The only difference is indicated by paragraph 20 of IAS 17 which requires that in case of reasonable certainty of transfer of ownership,(Bargain Purchase Option) the lessee uses theuseful life of asset as depreciation base; in case of guaranteed residual value the asset isdepreciated over the lease term.



LEASES IN THE FINANCIAL STATEMENTS OF THE

LESSORS INTERPRETATIONS

(Par

a 28 thru 33)

Finance lease

I finance lease all risks and reward are transferred to lessee. Assets held undersuch a lease should, therefore, be recognized in the books of lessor not as fixedasset but as receivable. A the amount equal to net investment in the lease. Netinvestment in the lease ins basically to gross investment or receivable les the

unearned finance income included in such receivables. The gross investmentincludes minimum rental payments plus residual value whether guaranteed or notthe residual value is applicable only when the lessor expects to get back the assetat the end of the lease term.

Paragraph 30 requires that recognition of finance income should be based on apattern reflecting a constant periodic rate of return on net investment

outstanding.Paragraph 31 clarifies that the periodic rentals be segregated intorecovery of principal and

finance income.



Total finance income is the difference between thegross investment an the fair market value of the leasedasset. The allocation of total finance income earnedduring the lease term should be made on a basis whichshould reflect a costnat rerate of return on theoutstanding balance of the net investment.

In this connection, institute of chartered accountantsof Pakistan has issued circular to its members,prohibiting leasing companies to use sum of digitsmethod



(Par

a 28 thru 33)



Residual values

Residual values are particularly important where the useful life of the asset exceeds the lease term, in case the lesae does not meetcriteria (a) and (b) as set out in paragraph 8 of IAS 17 the lessee will

have to give back the asset to the lessor.

IAS 16 defines residual value as the amount which the enterpriseexpects to obtain for and asset at the end of the useful life afterdeducting the expected costs of disposals

In the question involving residual values it is necessary todetermine which party (lessor or lessee) shall own the leased assetand consequently the residual value at end of lease term.



(Par

a 28 thru 33)



If the estimated residual value at end of lease

term is purchased by the lessee through bargain

purchase option, such bargain purchase option is

included in the lease accounting both by thelessor and the lessee.

If asset reverts back to lessor and he retains

the residual value, the lessor has a risk that theleased asset may not be carefully handled by the

lessee. So it causes two types of residual value



(Par

a 28 thru 33)



Unguaranteed residual value

If the lease provides that at the end of the lease term the asset will revertto lessor, any residual value will be owned by the lessor. If such residualvalue is unguaranteed by the lessee, the lessor will compute the periodic

rentals b subtracting the present value of the estimated residual valuefrom the total amount to be removed under the lease agreement.

Guaranteed residual value

When the lessor retains the residual value of the asset, the lease

agreement may require the lessee to guarantee all or part of theestimated residual value at the end of lease term. If the actual, residualvalue is less than that guaranteed, the lessee will have to pay thedifference to the lessor.



(Pa

r

a 28 thru 33

)



Residual value guaranteed by third party

Residual value of a leased asset may be

guaranteed for a fee in full or part by a thirdparty guarantor and retained by the lessor. In

such case, the lessor will include the present

value of both, the rental payments and

guaranteed residual value in the minimumlease payments.



(Para 28 thru 33)



FINANCE LEASING BY MANUFACTURERS OR DEALERS

INTERPRETATION

(PARA 34 TO 38)

Manufacturers or dealers sometimes offer customers the option of leasingthe asset instead of outright purchase, in such cases the leases result inmanufaturerers or dealers profits or loss to the lessor. the leasing in suchcases is used by the manufacturers or dealers as marketing technique.leaes of ghese types are referred to as sale type lease.

The sale type lease transfers substantially all the risks and rewards of theleased property to the lessee who records the transaction as a financelease.

Paragraph 35 provides that a finance leae by a manufacturer or dealerconsists of

The profit or loss arising from outright sale

The finance income over the lease term



The manufacturers or dealers sometimes make an arbitraryreduction in interest rates instead of reducing selling pricesof their products. The basic difference between direct

finance leases and sale-type leases is that in the latter casemanufacturers or dealers profit or loss is recognized at theinception of lease.

In an examination question involving the sale-type leasefollowing amounts need to be determined:-

(a) Gross investment

(b) Fair value of the leased asset

(c) Cost


INTERPRETATION

(PARA 34 TO 38)





Leases receivable

Is charged with gross investment, computed as follows

minimum lease payments (excluding executor cost)plus unguaranteed residual value accruing to lessor.

Cost of goods sold

Is debited with historical cost or carrying value plusinitial direct costs is any


INTERPRETATION

(PARA 34 TO 38)



Unearned finance

Income is credited by an amount which is equalto:-

Gross investment

Less present value of MLP plus present value of unguaranteed residual value.


INTERPRETATION

(PARA 34 TO 38)



DISCLOSURE BY LESSOR INTERPRETATIONS

(PARA 39-40)

Following disclosures are mandatory:-

(a) A reconciliation between the total gross investment is lease at balance sheetdate, and the present value of minimum lease payments receivable at the balancesheet date. In addition an enterprise should disclose the total gross investment inleaee and the present value of minimum lease payments receivable at the balance

sheet date, for each of the following periods

(i) not later than one year

(ii) later than one year but not later than five years

(iii) later than five years

(b) Unearned finance income(c) The unguaranteed residual value accruing to the benefit of the lessor

(d) The accumulated allowance for uncollectible lease payment receivable.

(e) Contingent rents recognized in income.



Although the following disclosures are not tequired byIAS 17, it is believed that information regardingfollowing matters will be use ful for the users of thefinancial statements.

(a) Net investment in respect to associated companiesand subsidiaries

(b) Treatment of residual values in computing totalprofit and in allocating profit over the lease term

(c) Brief description of leasing activities of the lessor.

DISCLOSURE BY LESSOR INTERPRETATIONS

(PARA 39-40)



SALE AND LEASE BACK INTERPRETATIONS

(PARA 49-57)

Following disclosures are mandatory:-

(a) A reconciliation between the total gross investment is lease at balance sheet date, and the present valueof minimum lease payments receivable at the balance sheet date. In addition an enterprise should disclose thetotal gross investment in leaee and the present value of minimum lease payments receivable at the balance sheetdate, for each of the following periods

(i) not later than one year

(ii) later than one year but not later than five years(iii) later than five years

(b) Unearned finance income

(c) The unguaranteed residual value accruing to the benefit of the lessor

(d) The accumulated allowance for uncollectible lease payment receivable.

(e) Contingent rents recognized in income.

Although the following disclosures are not tequired by IAS 17, it is believed that information regarding followingmatters will be use ful for the users of the financial statements.

(a) Net investment in respect to associated companies and subsidiaries

(b) Treatment of residual values in computing total profit and in allocating profit over the lease term

(c) Brief description of leasing activities of the lessor.




(PARA 49-57)

A sale and lease back transaction involves sale of an asset by a vendor and the leasing of the same asset back to the vendor. Both the

transactions take place simultaneously.

In a sale and lease back transaction, one of the following situations may arise:-

(a) the lessee continues the sue of the asset without interruption. Here the transaction is effectively mode of financing. The

lessee borrows the funds from the lessor to improve the liquidity. The lease is classified as finance lease.

(b) the lessee gives up the right of use of asset sold to lessor. In this case the transaction is a sale of asset to lessor. It is an

operating lease.

Accounting treatment case (a)

Para 50 provides that if the sale and lease back transaction results in a finance lease, any excess of sale proceeds over the book value should

not be immediately recognized as income in the financial statements of the seller lessee.

If the sale value is less than book value, the apparent loss arising on such sale and lease back ended not be charged in full to profit anloss unless there has been a permanent diminution in the value of asset

Accounting treatment case (b)

When a sale and lease back transaction does not of the criterion for finance leases and sale prices established at fair value, IAS 17 provides

that any profit and loss should be recognized immediately.



The reason for such treatment is that where fair value of asset is less than the bookvalue, loss should be recognized immediately as it is a real loss.

Sub leases or back to back leases

In case of sub leases three parties are involved:

(a) Original lessor

(b) Intermediate party (lessee on one hand, sub lessor on the other hand)

(c) Ultimate lessee

The accounting treatment in the books of the original lessor and ultimate lessee isnot different from the normal leasing arrangements. The lease is entered betweenthe original lessor and the intermediate party. This agreement is not affected if theintermediate party enters into another agreement with an ultimate lessee.


(PARA 49-57)



PRESENT VALUE COMPUTATIONS

The computations facilitate determining present value of residual value and bargain purchase options, the present value of annuities relating

to minimum rental payments, computation of interest rate and case price. Accounting for leases assumes that money has time value.

The present value concept provides an answer to the following question. What is the value today of an amount to be received or paid

at a future date?

Time value of money

Time value of money is based on the old adage that a rupee in the hand today is worth more than a rupee to be received 6 years from

today.

Compound interest

If the interest is paid number of times in a year, the compound annual interest rate is not the same as compared to interest payment

yearly.

(1+X/n) -1

Where

X= rate of interest

N= number of times interest is paid

n



Present value of single sum

P= S x 1/(1+i)

Where

S=future value

P=principle value

I=interest rate

N=number of years

Present value of an ordinary annuity

P= R x 1-(1+i)/i

n

n

PRESENT VALUE COMPUTATIONS



Leasing in Pakistan

In order to regulate the leasing companies in Pakistan, the corporate lawauthority has issued a notification dated 4 June, 1996 setting out certain rules.These rules are called The Leasing Companies (establishment and Regulation) Rules 1996

Leasing companies started operations in Pakistan in 1984. As of today 25companies are listed at the Karachi Stock exchange with a paid up capital of over Rs. 3 billion.

The corporate law authority (CLA) grants permission for formations of leasingcompanies, CLA and State Bank of Pakistan are responsible for regulations of the leasing companies.

Major items available for leasing include manufacturing equipment, printingpresses, contactors machinery, computers and office equipment, motorvehicles, aircraft, medical equipment and other machinery and equipment.



Summary of significant regulations relating to leasing{The leasing companies (establishment and regulation) rules 1996}

Leasing companies in Pakistan have to follow IAS 17

The form of organization allowed is only public listed company

No leasing company can start operations unless it has been registered and a license has been obtained

Except for computer lease term has to be minimum three years

Exposure of the leasing company to its directors, affiliated companies, and companies in which director or hisfamily members hold controlling interest, is restricted to 10% of the overall port folio of leasing

Financing for real estate is not permitted (except for factory building)

Current ration should not fall below 1:1

Debt equity ratio is required to be maintained at 60:40

Minimum paid up capital should be Rs200 million

Unsecured facilities are not permitted



20% of net profit is to be transferred to a special reserve until this reserve matches the paid up capital, afterwards,5% of earnings shall be transferred to reserves

At least 5% of the fund based facilities are to be provided to small entities having fixed assets of not more than 20million

Maximum exposure to a single group is restricted at 30% of net investment in lease finance of the company

Leasing modrabas are provided with tax exemption if at least 90% of profits are distributed to share holders in theform of cash dividends

All leasing companies during each of the five financial years beginning July 1, 1998 and ending June 30, 2003, shallprovide deferred tax liability arising in that year together with further amount equal to one-fifth of the unprovideddeferred tax liability as at the beginning of the financial year ending june 30, 1999. The un provided deferred taxliability at each year end together with other pertinent information shall continue to be disclosed

Subject to full compliance with the provision o f IAS 12, the requirements in the preceding para shall be deemed

to be met where during each o the five financial years beginning July 1, 1998 and ending June 30, 2003, a leasingcompany consistently transfers to a capital reserve an amount equal to the aggregate amount determined inaccordance with the provisions of the said para, reduced by the amount, if any, provided for deferred tax liability.This capital reserve shall not be available for utilization for any purpose other than to provide for deferred taxliability.

Summary of significant regulations relating to leasing{The leasing companies (establishment and regulation) rules 1996}



INSTALLMENT SALES

Significant characteristics of installment sales

1. Seller has a night to property

2. Installment sales is high risk business because of heavy bad debts

3. Accordingly revenue recognition is related to the periods in which cash is collected rather than in which made 4each collection on an installment contract is regarded as representing both a return of cost and realizable thesame in which the cost and profit has been computed at the time of signing the

4. Contract the profit the life of the contract

5. A provision may be required for possible failure to realize full amount of profit in the event of default

6. The difference between sales and cost of sales is recorded as deferred gross profit

7. Deferred gross profit is amortized and taken to income on the basis of collections

8. Ending balance of deferred gross profit is equal to gross profit percentage applied to balance on Installmentreceivable



9. in other words

(a) Gross profit percentage applied to collections represents gross profit recognized for period

(b) Gross profit percentage applied to installments receivable at end of period is equal to deferred gross at end of period

10. Deferred gross profit effectively represents deferral of revenue related costs and gross profit

11. Operating expenses are recognized in the period in which they are incurred

12. In case of default it will be necessary to

(a) Cancel the balance of the customer

(b) Cancel deferred gross profit

(c) Record property at its fair value

(d) Gain or loss on repossession will be the difference of

(i) Property recognized and

(ii) Customer balance cancelled

INSTALLMENT SALES

Documents

Leasing Accounting