Chapter 6 HKAS 17 Leases

Answer Exercise 1 The contracted lease term is only for half of the useful life of the machine and there is no strong likelihood that the company will exercise the option in four years time, because the option is priced at fair value, not a discount. Thus the risks and rewards of ownership have not passed to the lessee and these lease should be treated as an operating lease. Answer Exercise 2 (a) Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the legal form of the contract. [1 mark] The classification of leases adopted in !"# $% is based on the extent to which risks and rewards incidental to ownership of a leased asset lie with the lessor or the lessee. (i) (ii) &isks include technological obsolescence and decline in return or value of assets due to changing economic conditions. [1 mark] &ewards include the future return from using the asset and of gain from appreciation in value. [1 mark]

(b) The following are indicators, as given by lease being classified as a finance lease' (i) (ii)

!"# $%, which would normally lead to a

the lease transfers ownership of the asset to the lessee by the end of the lease term(

the lessee has the option to purchase the asset at a bargain price and it seems likely that, at the inception of the lease, this option will be exercised( (iii) the lease term is for the ma)or part of the useful life of the asset( and at the inception of the lease, the present value of the minimum lease payments is greater than, or e*ual to substantially all of, the fair value of the leased asset( (iv) if the lessee can cancel the lease any losses associated with the cancellation are borne by the lessee( (v) gains or losses from the fluctuation in the fair value of the residual fall to the lessee (e.g. in the form of a rent rebate e*ualing most of the sales proceeds at
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the end of the lease)( (vi) the lessee has the ability to continue the lease for a secondary period at a rent which is substantially lower than market rent( and (vii) the leased assets are of a specialised nature such that only the lessee can use them without ma)or modifications being made. [1 mark each, total 7 marks] (c) +ear ,rincipal &epayment (opening) . . $1,111 2,334 5,110 0,711 8,000 0,711 0,003 0,711 $$,834 (d) /ournal entries in :ast ;imiteds book' $ /an 01$$ ;eased machinery =ank ;ease obligation ;ease obligation >nterest expense =ank 6epreciation expense "ccumulated depreciation 6r (.) $1,111 <r (.) 2,334 5,110 $,%41 %01 0,711 2,222 2,222 $,332 71% 0,711 2,222 2,222
[Marks] [0.5] [0.5] [0.5] [0.5] [0.5] [0.5] [1] [0.5] [0.5] [0.5] [0.5] [0.5] [0.5]

$ /an 01$$ 2$ 6ec 01$$ 2$ 6ec 01$0 2$ 6ec 01$2

-inance charge . 1 %01 71% 0%$ $,834

,rincipal repaid . 2,334 $,%41 $,332 0,003 $1,111

,rincipal (closing) . 5,110 8,000 0,003 9

[Marks]

[1] [1] [1] [1] [1]

2$ 6ec 01$$

2$ 6ec 01$$

2$ 6ec 01$0 ;ease obligation >nterest expense =ank 2$ 6ec 01$0 6epreciation expense "ccumulated depreciation (e)
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:ast ;imited #tatement of financial position (extracts) as at 2$ 6ecember 01$$ ?on9current assets @achinery held under finance lease <urrent liabilities Abligation under finance lease ;ong9term liabilities Abligation under finance lease . 5,55% $,332 0,003
[Marks] [1] [1] [1]

Answer Exercise 3 (a) >n accordance with !"# $% B;easesC, the lease contract is a finance lease. [2 marks]. "t least three indicators supporting this conclusion' The lease term of four years represents the whole economic useful life( The present value of the minimum lease payments of .$%8,281 is e*ual to the fair value of the e*uipment( and The lease contract is a non9cancelable contract. [1 mark for each s !!este" #oint a$o%e an" an& other %ali" #oint, maxim m 3 marks] '5 marks( (b) "ctuarial method +ear Apening balance . 01$0 01$2 01$8 01$7 $%8,281 $25,%%8 37,87$ 71,111 "nnual payment . (71,111) (71,111) (71,111) (71,111) #ub9total . $08,281 45,%%8 87,87$ 9 -inance charges . $0,828 4,5%% 8,783 9 <losing balance . $25,%%8 37,87$ 71,111 9

(c) #um9of9the9digit method +ear Apening balance . "nnual payment .

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#ub9total .

-inance charges .

<losing balance .

01$0 01$2 01$8 01$7

$%8,281 $2%,$%1 37,%02 71,111

(71,111) (71,111) (71,111) (71,111)

$08,281 4%,$%1 87,%02 9

$0,421 4,772 8,0%% 9

$2%,$%1 37,%02 71,111 9

Total finance charges D .71,111 x 8 E .$%8,281 D .07,551 +ear 01$0 01$2 01$8 01$7 6igits 2 0 $ 1 5 ,roportion allocated 2F5 x 07,551 0F5 x 07,551 $F5 x 07,551 9 -inance charge . $2,421 4,772 8,0%% 9 07,551

Answer Exercise ) (a) The annual rental charge will be .441,111. =oro will pay .4,411,111 over the ten years of the lease. (There is one rent9free year and =oro receives .011,111 towards its relocation costs.) (b) "t the end of +ear $ there will be an accrual of .$,141,111 in the statement of financial position. This is because =oro will have charged .441,111, but paid nothing and received .011,111 of incentives. The chart below shows how the accrual gets used up over the life of the lease. A <ash payment .111 (011) $,111 $,111 $,111 $,111 $,111 * <harge .111 441 441 441 441 441 441
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+ear

A* 6ifference .111 E $,141 G$01 G$01 G$01 G$01 G$01

$ 0 2 8 7 5

<umulative difference .111 E $,141 E 351 E 481 E %01 E 511 E 841

"ccrual

% 4 3 $1

$,111 $,111 $,111 $,111 4,411 <ash flow statement

441 441 441 441 4,411 >ncome statement

G$01 G$01 G$01 G$01

E 251 E 081 E $01 ?il #tatement of financial position

(c) :xtracts from the notes to the balance sheet at the end of +ear $ =oro is committed to making the following minimum lease payments under non9cancellable operating lease agreements' . Within one year $,111,111 =etween two to five years 8,111,111 "fter five years 8,111,111 3,111,111

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Examination +t&le , estions Answer 1 -ncome statement for the &ear en"e" 31 .ecem$er 2011 'Extract( 6epreciation (01,111F8) -inance costs +tatement of financial #osition as at 31 .ecem$er 2011 'Extract( . /on0c rrent assets ,lant and e*uipment held on finance lease (01,111 E $7,111) /on0c rrent lia$ilities -inance lease liabilities (W$) 1 rrent lia$ilities -inance lease liabilities (W$) ($5,308 E $8,%45) W$ ,ayment schedule
+ear Apening balance . 01$$ 01$0 $4,471 (W0) $5,308 -inance charge ($$H) . 0,1%8 $,450 . 01,308 $4,%45 #ub9total "nnual &epayment . (8,111) (8,111) <losing balance . $5,308 $8,%45

. 7,111 0,1%8

$7,111

$8,%45

0,$24

W0 Apening balance for 01$$ D 01,111 E $,$71 D $4,471 Answer 2 -ncome statement 'extract( for the &ear en"e" 31 .ecem$er 2010 6epreciation (.5$,7%1F$1) Aperating lease rentals (0 x 7,111) -inance cost (W$) +tatement of financial #osition 'extract( as at 31 .ecem$er 2010 /on0c rrent assets
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. 5,$7% $1,111 $,$%$

,roperty, plant and e*uipment (.5$,7%1 E .5,$7%) /on0c rrent lia$ilities -inance lease liability (W$) 1 rrent lia$ilities -inance lease liabilities (73,%8$ E 7$,122) W$
,eriod Apening balance . 2$.$0.01$1 2$.2.01$$ 21.5.01$$ 21.3.01$$ 2$.$0.01$$ 5$,7%1 73,%8$ 7%,4%5 77,3%8 78,122 . (2,111) (2,111) (2,111) (2,111) (2,111) . 74,7%1 75,%8$ 78,4%5 70,3%8 7$,122 &epayment #ub9total -inance charges (0H) . $,$%$ $,$27 $,134 $,173

77,8$2

7$,122

4,%14

<losing balance . 73,%8$ 7%,4%5 77,3%8 78,122

Answer 3 The first task is to decide what sort of lease the asset is held under. This is a finance lease because it transfers substantially all the risks and rewards of ownership to the lessee, as shown by the length of the lease and its cost' The assetIs useful life is five years (as shown by the 01H straight line depreciation policy) and the lease is also for five years. Therefore the asset is being held for the whole of its useful life. The minimum lease payments are .51,111, spread over four years as payments are made in advance. The present value of these payments at an 4H discount rate is .7$,%87, which is almost the same as the assetIs fair value. The asset is capitalised and depreciated over its five year useful life, and the obligation to make lease payments is recognised as a liability. -ncome statement 'extract( for the &ear en"e" 30 +e#tem$er 2012 6epreciation (.70,111 x 01H) -inance costs (411 G $,4%0 (W0)) . $1,811 0,5%0

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+tatement of financial #osition 'extract( as at 30 +e#tem$er 2012 /on0c rrent assets "ssets held under finance lease (W$) /on0c rrent lia$ilities -inance lease liability (W0) 1 rrent lia$ilities -inance lease liabilities (22,1%0 E 0$,535) W$ <arrying value of asset $ /an 01$$' -air value of leased asset ;ess' 6epreciation to 21 #eptember 01$$ (70,111 x 01H x 3F$0) 6epreciation to 21 #eptember 01$0 (70,111 x 01H) <arrying value 21 #eptember 01$0 W0 ,ayment schedule
,eriod Apening balance . 21.3.01$$ 2$.$0.01$$ 21.3.01$0 2$.$0.01$0 21.3.01$2 70,111 80,811 82,011 22,1%0 22,353 &epayment at $ Act . ($0,111) 9 ($0,111) 9 ($0,111) . 81,111 80,811 2$,011 22,1%0 0$,535 #ub9total -inance charges (4H) . 0,811 (W2) 411 (W8) $,4%0 (W7) 508 (W5)

. 22,411

0$,535

$$,2%5

. 70,111 (%,411) ($1,811) 22,411

<losing balance . 80,811 82,011 22,1%0 22,535

W2 -inance charge to 21.3.01$$ D 81,111 x 4H x 3F$0 D 0,811 W8 -inance charge to 2$.$0.01$$ D 81,111 x 4H x 2F$0 D 411 W7 -inance charge to 21.3.01$0 D 2$,011 x 4H x 3F$0 D $,4%0 W5 -inance charge to 2$.$0.01$$ D 2$,011 x 4H x 2F$0 D 508

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Answer )
(a) &isks The possibilities of losses from idle capacity or technological obsolescence. Jariations in return because of changing economic conditions

&ewards :xpectation of profitable operation over the assets economic life. Kain from appreciation in value or realiLation of a residual value. '1 mark for an& #oint, total ) marks( (b) The above lease is a finance lease due to the following' (i) The lease transfers ownership to the lessee by the end of the lease term as it is mentioned that the lessee will most likely exercise the option to purchase the leased asset at the end of the lease term. (ii) (iii) The lease term of four years is for the ma)or part of the economic life of the leased asset, which is estimated to be five years. The present value of the minimum lease payments, i.e. .771,8%$ (W$), amounts to approximately 37H of all of the fair value of the leased asset (i.e. .741,111) at the inception of the lease. (iv) (v) Kain or losses from the fluctuation in the fair value of the residual value accrue to the lessee. The lessee is responsible for the repair, maintenance and insurance of the asset.

[/ote2 An& other %ali" #oints are acce#ta$le.]

=ased on the above, it can be concluded that @achinery ;td has assumed substantial risks and rewards incidental to the ownership of the leased e*uipment at the inception of the lease contract. '1 mark for an& #oint, total ) marks( (c) 6r >n @achinerys books $ /an 0114 ;eased e*uipment (W$) ;ease obligation
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<r .

Marks

771,8%$ 771,8%$

[1] [0.5]

To record the lease capitaliLation ;ease obligation =ank To record the rental payment 2$ 6ec. 0114 -inance charge (W0) "ccrued interest To record the accrued interest 6epreciation (.771,8%$ F 7) "ccumulated depreciation To provide depreciation for the leased e*uipment $$1,138 $$1,138 84,575 84,575 $87,111 $87,111

[0.5] [1] [0.5] [0.5] [1] [0.5] [0.5] [0.5] '7 marks(

(d) Machiner& 3t" +tatement of com#rehensi%e income 4or the &ear en"e" 31 .ecem$er 2005 'extracts( . -inance charge 6epreciation Machiner& 3t" +tatement of financial #osition As at 31 .ecem$er 2005 'extracts( ?on9current assets :*uipment on finance lease (771,8%$ E $$1,138) <urrent liabilities Abligation under finance lease (817,8%$ E 213,$0%) (W0) "ccrued interest ?on9current liabilities Abligation under finance lease (W0) Mass 3t" +tatement of com#rehensi%e income -or the year ended 2$ 6ecember 0114 (extracts) .
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Marks [0.5] [0.5]

84,575 $$1,138

. 881,2%%

Marks [1]

35,288 84,575

[1] [1]

213,$0%

[1]

Marks

>nterest earned on finance lease (W0)

84,575

[1]

+tatement of financial #osition as at 31 .ecem$er 2005 'extracts( ?on9current assets ;ease receivable (W0) . 878,$0% Marks [1] '7 marks( (e) The motivation to account for a finance lease as an operating lease is to achieve off9balancing financing, that means to keep the finance liability off a companys financial statement. The beauty of doing so is to window dress (i.e. to reduce) the gearing ratio so that the companys financial position will be perceived as a lower financial risk. '3 marks( Workings' W$ ,J of minimum lease payment .($87,111 G $87,111 x 1.4303 G $87,111 x 1.%3%0 G $87,111 x 1.%$$4 G 41,111 x 1.5277 G $1,111 x 1.5277) D .771,8%$ W0 ;ease amortiLation schedule +ear <apital sum at beginning of period (.) 0114 0113 01$1 01$$ 771,8%$ 878,$0% 285,000 007,254 $87,111 $87,111 $87,111 $87,111 817,8%$ 213,$0% 01$,000 41,254 84,575 2%,137 08,$85 3,588 ;ease payment (.) #ub9total (.) -inance charge (.) <apital sum at end of period (.) 878,$0% 285,000 007,254 31,1$0

Answer 5 (a) The -ramework states that in order to be useful, information must be reliable and the two main components of reliability are freedom from material error and faithful representation. The -ramework describes faithf l re#resentation as where the financial statements (or other information) have the characteristic that they faithf ll& re#resent the transactions an" other e%ents that ha%e occ rre" . Thus a statement of financial position should faithfully represent transactions that result in assets, liabilities and e*uity of an entity. #ome would refer to this as showing a tr e an" fair %iew. "n essential element of faithful representation is the application of the concept
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of s $stance o%er form. This means that assets and liabilities as shown in the statement of financial position exist, are assets or liabilities of the entity and are shown at the correct amount, in accordance with the stated accounting policies of the entity. -or instance, it may seem that a property shown at original cost when its market value is twice that amount is not faithfully represented, but if the disclosed accounting policy of the entity is not to revalue its properties, users will know what they are looking at and can ad)ust accordingly. The most obvious examples of faithful representation not being adhered to involve off9balance9sheet finance transactions, such as sale and leaseback, where secured loans are disguised as the sale of assets. This keeps borrowing out of the statement of financial position and avoids any conse*uent impact on gearing. The accounting scandals of the past decade revealed numerous off9balance9sheet schemes and underlined the importance of faithful representation. (b)(i) The finance directors comment that the &A<: would improve, based on the agreement being classified as an operating lease is correct (but see below). Aver the life of the lease the reported profit is not affected by the lease being designated as an operating or finance lease, but the statement of financial position is. This is because the depreciation and finance costs charged on a finance lease would e*ual (over the full life of the lease) what would be charged as lease rentals if it were classed as an operating lease instead. owever, classed as an operating lease, there would not be a leased asset or lease obligation recorded in the statement of financial position( whereas there would be if it were a finance lease or an outright purchase. Thus capital employed under an operating lease would be lower leading to a higher (more favourable) &A<:. !"# $% ;eases defines a finance lease as one which transfers to the lessee substantially all the risks and rewards incidental to ownership (an application of the principle of substance over form). >n this case, as the asset will be used by -ino for four years (its entire useful life) and then be scrapped, it is almost certain to re*uire classification as a finance lease. Thus the finance directors comments are unlikely to be valid. (b)(ii) 6#eratin! lease >ncome statement (extract)
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cost of sales (machine rental) ($11,111 x 5F$0) #tatement of financial position (extract) <urrent assets ,repayment ($11,111 x 5F$0) 4inance lease >ncome statement (extract) 6epreciation (271,111F8 x 5F$0) -inance costs (W$) #tatement of financial position (extract) ?on9current assets ;eased plant (271,111 E 82,%71) ?on9current liabilities -inance lease liability (W$) <urrent liabilities -inancial lease liability (050,711 E $%7,111) W$ ,ayment schedule
,eriod Apening balance . 21.3.011% 2$.2.0114 21.3.0114 271,111 050,711 0%7,111 &epayment at $ "pr . ($11,111) 9 ($11,111) . 071,111 050,711 $%7,111 #ub9total -inance charges ($1H) . $0,711 (W0) $0,711

. 71,111

. 71,111

. 82,%71 $0,711

. 215,071

$%7,111

4%,711

<losing balance . 050,711 0%7,111

W0 -inance charges to 21.3.011% D 071,111 x $1H x 5F$0 D $0,711

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