ACC/ACF3100 Advanced Financial Accounting

Lecture 5

Leases

Department of Accounting
1
Minimum Readings

Deegan 8th Ed: Chapter 11

AASB16 Leases
(Issued February 2016, Mandatory 1 January, 2019)

2
 Learning Objectives
Understand the principles and scope of AASB16
Understand that lessee shall recognise assets and liabilities
arising from a lease
Understand how lessee measures lease assets and liabilities,
lease-related expenses and prepares journal entries
Understand what interest rate shall be used to calculate the
present value of leased assets and liabilities
Understand how the lessor measures lease receivable, lease
revenues, and prepares journal entries
Understand dealer or manufacturers leases
3
 Lease definition: AASB16 Appendix A
A contract, or part of a contract, that conveys the right to
use an asset (the underlying asset) for a period of time in
exchange for consideration
For accounting purposes issues to consider:
1. Does it matter who is the assets owner?
2. Who has the control over the asset?
Conceptual framework definition
A firm may recognise assets it does not own, as long as it
is able to control the use

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 Lease definition

Lessee controls the use of the underlying asset:

obtains substantially all of the economic benefits from

the use of the identified asset throughout the period of
use; and

directs the use of the asset throughout the period of

use. The lessee has the ability to change how, and for
what purpose, the asset is used during the contractual
term.
5
 Lease contracts: key terms

With the lease contract a lessor conveys the right to use an

asset to a lessee in exchange for lease payments throughout
the lease term.

Lessor: the individual/firm providing the asset and receiving a

payment at established dates
Lessee: the individual/firm acquiring the right to use the asset
and having an obligation to pay the lessor at established dates

6
 Lease contracts: key terms

Lease payments: fixed payments + initial direct costs

(excluding service cost component, if any) + (if included in
the lease contract) residual value guarantee and/or price of
a purchase option

Lease term: the period for which a lessee has the right to use
the underlying asset, from the commencement date of the
contract. Based on expectations about whether lessee likely to
exercise an option to extend the lease term

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 The accounting issue

Can the right-of-use acquired under the lease contract be considered

an asset?
Future So should
Description of right Control Past event economic asset be
benefit recognised?
Delivery
Legally enforceable
Right to use machinery following
right established by Yes Yes!
during the lease term signing of the
the lease contract
lease contract

Can the obligation to make lease payments in the future be

considered a liability?
Outflow of So should
Description of economic liability be
obligation Present obligation Past event benefits recognised?

Obligation to pay Legally enforceable Delivery following Yes (cash Yes!

rentals obligation signing of the payments)
established by the lease contract
lease contract

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 The accounting issue (cont.)
As a consequence:

An entity shall recognise assets and liabilities

arising from a lease (AASB 16)

ALL LEASES are represented in the statement of

financial position

With two exceptions: Para 5

1. Leases with a duration of 12 months or less
2. Leases of low value assets (tablets, phones,
laptops etc)
9
 New vs old lease accounting standard

AASB 117 criticised because:

1. Many leases were not represented on the entitys
balance sheet
2. The accounting model failed to meet the needs of
users of financial statements
3. The requirements for recognition of leases were
too complicated

AASB 16 is an improvement because:

1. ALL LEASES are represented on the balance
sheet of the lessee (with only two exceptions)
2. Reduced complexity of application
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 Implications of new accounting standard

Some large retailers who lease many retail outlets will need
to recognise more leased assets and lease liabilities
Will increase their reported debt and assets and this will
increase their reported leverage
Could have implications for various accounting-based debt
covenants
New standard means that expenses tend to be front
loaded i.e. higher in the earlier years (see Worked
Example 11.9(c)).
Could have implications for reported profits and contractual
arrangements that use reported profits

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 How to account for leases under AASB 16

When to recognise a lease?

At the commencement date, a lessee shall

recognise a right-of-use asset and a lease liability.
Para 22

Commencement date Appendix A:

The date on which a lessor makes an underlying asset
available for use by a lessee.

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 Accounting for leases by the lessee
Commencement End of the
date lease term

Fixed payments Last fixed payment

+Direct Costs
+Guaranteed
If any Residual
+Price of bargain
purchase option
The lessee acquires the right to use the asset and commits to
lease payments.
How is this accounted for?
Initial measurement of lease liability Para24, 26 and 27
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 Lease accounting for lessees
Direct costs - Illustration 1
As at 1 July 2018, Winki Company enter into a 10-year lease
contract for a building. Lease payments are $400 000 per
year, starting on 30 June 2019 and there is no purchase
option or residual value guaranteed. Winki pays $5000
direct costs. The implicit interest rate is 15 per cent.
(Use the textbook Appendixes to calculate PVs).

REQUIRED
(a) Determine the initial measurement of the lease liability
(b) Determine the initial measurement of right-of-use asset
cost
(c) Provide the accounting journal entries for the year ended
30 June 2019
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 Illustration 1: Solution
(a) Determine the initial measurement of the lease liability
Present value of 10 lease payments of $400 000 discounted
at 15 per cent
= $400 000 x 5.0188 = $2 007 520
lease liability =
$2 007 520
(b) Determine the initial measurement of right-of-use asset
cost.
right-of-use asset cost = lease liability + any payment
before the commencement + any direct cost

right-of-use asset cost = $2 007 520 + $5 000 = $2 012 520

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 Illustration 1: Solution (cont.)
Calculate the interest expense and the principal repayment
on 30 June 2019

Date Lease payment Interest Principal Outstanding

expense repayment balance

01/07/2018 2 007 520

30/06/2019 400 000 301 128 98 872 1 908 648

Income statement; Balance sheet;

Debit/expenses Debit (reduction in
liability)

11-16
 (c) Accounting journal entries

1 July 2018
Dr Leased machine 2 012 520
Cr Lease liability 2 007 520
Cr Cash/payables etc 5 000

30 June 2019
Dr Interest expense 301 128
Dr Lease liability 98 872
Cr Cash at bank 400 000

Dr Lease amort exp 201 252

Cr Accum lease amort 201 252

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 Accounting for leases by the lessee
Illustration 2 Direct Costs + Bargain Purchase Option
On 1 July 2018, Mini Ltd enters into a four-year lease of a machine.
Mini will pay fixed annual payments of $100 000 for four years with the first
payment on 30 June 2019.
To enter the lease Mini incurs direct costs of $10 000 at the
commencement of the lease term.
There is a bargain purchase price option (that Mini is willing to exercise)
for $25 000 at the end of the lease term.
The machine is expected to have a useful life of 10 years and no residual
value.

Additional information:
Lessees incremental borrowing rate: 6%.
PV of an annuity in arrears of $1 for 4 periods at 6% = 3.4651
PV of $1 in 4 periods at 6% = 0.7921

Determine the initial measure of the lease liability and right-of-use asset
and prepare the related accounting journal entry.

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 Accounting for leases by the lessee
Lease liability
It is measured as the present value of the lease payments* that are to be made
over the lease term by the lessee.

= $100 000
= $25 000

To determine their present value, the lease payments shall

be discounted using the interest rate implicit in the lease or
the lessees incremental borrowing rate (6 per cent).

* = fixed payments + (if included in the lease contract) expected payment under a
residual value guaranteed and/or price of bargain purchase option

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 Accounting for leases by the lessee
Lease liability
Fixed payments are to be multiplied for present value of an
annuity in arrears of $1 for 4 periods at 6 per cent
Purchase options is to be multiplied by the present value of
$1 in 4 periods at 6 per cent

$100 000 x 3.4651 = $346 510 +

$25 000 x 0.7921 = $19 802 =

Lease liability $366 312

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Accounting for leases by the lessee

The lessee shall measure the right-of-use asset at

COST Para 24
The cost comprises:
(a) the initial lease liability
(b) any lease payments made at or before the commencement
date
(c) any initial direct costs incurred by the lessee, and
(d) an estimate of costs to be incurred by the lessee in
dismantling and removing the underlying asset
right-of-use asset =
Lease liability $366 312 +
Direct costs $10 000 = $376 312
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 Accounting for leases by the lessee

On initial recognition, the accounting journal entry would

be:

1 July 2018
DrLease machine 376 312
CrLease liability 366 312
CrCash/payables etc 10 000

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 Accounting for leases by the lessee
Subsequent measurement Lease liability
The liability will be reduced each period with each
lease payment being part interest expense, and part
repayment of the lease liability using the effective
interest method
Lease payment (cash outflow) = $100 000

Interest expense = Principal repayment =

6% of $366 312 = $21 979 $100 000 $21 979 =
$78 021

Interest expense and repayment are recalculated every period on the

outstanding lease liability

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 Subsequent measurement (cont.)

Each period we need to amortise the leased asset

The leased asset shall be amortised over the life of the
lease if the lessee is not going to retain the asset at the
end of the lease term
If the lessee is expected to retain the leased asset at the
end of the lease term, then the leased asset shall be
amortised over its expected useful life AASB16 Para 32
In this example, the leased asset will be acquired at the
end of the lease term, so useful life of the asset is used for
amortisation purposes

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 Accounting for leases by the lessee
Subsequent measurement Lease liability
Date Lease Interest Principal Present value of
payment expense reduction lease liability

1 July 2018 0 0 0 366 312

30 June
100 000 21 979 78 021 288 291
2019
30 June
2020 100 000 17 297 82 703 205 588

30 June
2021 100 000 12 335 87 665 117 923

30 June
2022 125 000 7 076 117 923 0

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 Accounting for the lease by the lessee

The subsequent accounting journal entries would be:

30 June 2019
Dr Interest expense 21 979
Dr Lease liability 78 021
Cr Cash 100 000

Dr Lease amortisation 37 631

expense
Cr Accum lease amort 37 631
expensemachine
($376312/10 years)

(Hence Asset =$338,681, Liab=$288,291)

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 Implicit Interest Rate

Interest rate Para 26

For a lessee, the interest rate implicit in the lease is to be
used to discount the lease payments if this is practicable to
determine; if not, the lessees incremental borrowing rate is to
be used. The rate implicit in the lease is the rate of interest
being charged by the lessor and is defined in the accounting
standard as:
The rate of interest that causes the present value of (a)
the lease payments and (b) the unguaranteed residual
value to equal the sum of (i) the fair value of the
underlying asset and (ii) any initial direct costs of the
lessor. AASB16 Appendix A

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 Determining the interest rate implicit in the
lease - Illustration 3
McTavish Ltd decides to lease some machinery from Cornish
Ltd on the following terms:
Date of entering lease 1 July 2019
Duration of lease 10 years
Life of leased asset 11 years
Unguaranteed residual value $2000
Lease payments $4000 at lease inception, $3500 on 30 June
each year (i.e. 10 yearly payments in arrears of $3500 each)
Fair value of leased asset at date of lease inception $26 277

REQUIRED
Determine the interest rate implicit in the lease.

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 Determining the interest rate implicit in the
lease Illustration 3: Solution
The present value of the up-front payment of $4000 is not
discounted. Therefore, using a rate of 10 per cent for
discounting purposes, the present value of the lease
payments and the unguaranteed residual is:
PV of payment 1 July 2019 (not discounted) $ 4 000
PV of 10 yearly payments (3500x6.1446) $21 506
PV unguaranteed residual (2000x0.3855) $ 771
$26 277
The discounted value of $26 277 is the same as the fair value
of the asset at lease inception. Thus, 10 per cent is the
implicit rate in this Example 11.7 p392
Note that some degree of trial and error might be involved in
determining the discount rate.

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 Some further issues to consider

Service cost component

Contracts for the use of an asset often also include
associated services (a service agreement).
For example, a customer might sign a contract to lease a
car and the contract could include a requirement that the
lessee pay a specific ongoing amount to have the car
maintained and serviced by a particular service
provider.
The service cost component is not treated as part of the
lease and therefore is not capitalised as part of the lease
liability or lease asset.
See Example 11.3 p.388

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 Bargain Purchase Option + Service Component
Illustration 4
Trigger Ltd enters into a five-year lease agreement with
Brothers Ltd on 1 July 2019 for an item of machinery.
There is a bargain purchase option that Trigger Ltd will be
willing to exercise at the end of the fifth year for $80 000. The
machinery is expected to have a useful life of six years.
There are to be five annual payments of $100 000, the first
being made on 30 June 2020. Included within these payments
is $10 000 representing payment to the lessor for insurance
and maintenance of the equipment.
Additional information:
Implicit interest rate: 12 per cent
PV of an annuity in arrears of $1 for five years at 12 per cent =
3.6048
PV of $1 in five years at 12 per cent = 0.5674
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 Illustration 4 (cont.)

REQUIRED
(a) Determine the initial measurement of the lease
liability
(b) Determine the initial measurement of right-of-use
asset cost.
(c) Provide the accounting journal entries for the year
ended 30 June 2020

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 Illustration 4: Solution
(a) Determine the initial measurement of the lease liability
PV of five lease payments of $90 000 discounted at 12 per
cent
= $90 000 x 3.6048 = $324 432 +
+ Present value of the bargain purchase option
= $80 000 x 0.5674 = $45 392 =

lease liability = $369 824

(b) Determine the initial measurement of right-of-use asset cost.
Right-of-use asset cost = lease liability, as there are no
other costs to add
Right-of-use asset cost = $369 824

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 Illustration 4: Solution (cont.)
Calculate the interest expense and the principal
repayment on 30 June 2020

Date Lease payment Interest expense Principal Outstandi

repayment ng
balance
01/07/2019 369 824

30/06/2020 90 000 44 379 45 621 324 203

11-34
 (c) Accounting journal entries
1 July 2019
Dr Leased machine 369 824
Cr Lease liability 369 824

30 June 2020
Dr Service costs 10 000
Dr Interest expense 44 379
Dr Lease liability 45 621
Cr Cash at bank 100 000

Dr Lease amort exp 61 637

Cr Accum lease amort 61 637
Example 11.6 p.391

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 Lease accounting by Lessors
Illustration 5
Considering the information from Illustration 4 for Lessors
accounting.

Lessor: the individual/firm providing the asset and

receiving a payment at established dates

Initial measurement
What constitutes a
liability for the
lessee
Its a receivable for the
lessor, which replaces
the underlying asset
which has been leased
to the lessee
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 Lease accounting by lessors

Subsequent measurement
What constitutes interest Its interest revenue
expense for the Lessee for the Lessor

Date Lease payment Interest Principal Outstanding

received revenue repayment balance lease
receivable
01/07/2018 2 007 520

30/06/2019 400 000 301 128 98 872 1 908 648

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 Subsequent measurement (cont.)

1 July 2018
Dr Lease receivable 2 007 520
Cr Machinery 2007 520

30 June 2019
Dr Cash at bank 400 000
Cr Interest revenue 301 128
Cr Lease receivable 98 872

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For the time being, the IASB has retained the old
leasing system for accounting for leases by Lessors
From the perspective of the Lessor, leases shall still be
classified as either finance leases or operating leases
A finance lease is a lease that transfers substantially all of the
risks and rewards incidental to ownership of an underlying
asset from lessor to lessee
An operating lease is a lease that does not transfer
substantially all of the risks and rewards of ownership
Short-term leases are typically operating leases
Finance leaselease receivable recognised
Operating leaseexpensed
The examples that follow we will assume are finance leases

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Classification of leases by Lessors

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 Lessor accounting for direct financing leases

Direct financing lease

A lease where the lessor provides the financial resources
to acquire the asset
Lessor typically acquires the asset, giving the lessor legal
title, then enters a lease agreement to lease the asset to
the lessee, who subsequently controls the asset
No sale is recorded
Lessor derives income through periodic interest revenue
Where risks and rewards of ownership are held by lessee,
the lessor substitutes lease receivable for the underlying
asset

41
 Accounting for leases by the lessor
Illustration 6

To show how the entries for a lessor compare with the

entries made by the lessee, we will use the same data as
that used in Illustration 3 except this time we will be doing
the exercise from the perspective of Brothers Ltd.

REQUIRED
Prepare the journal entries for the years ending 30 June
2020 and 30 June 2021.

42
 Illustration 6: Solution

Date Lease receipt Interest revenue Principal Outstanding

(exclusive of reduction balance
service costs)
01/07/2019 369 824

30/06/2020 90 000 44 379 45 621 324 203

30/06/2021 90 000 38 904 51 096 273 107

30/06/2022 90 000 32 773 57 227 215 880

30/06/2023 90 000 25 906 64 094 151 786

30/06/2024 170 000 18 214 151 786 0

530 000 160 176 369 824

11-43
 Illustration 6: Solution (cont.)

1 July 2019
Dr Machinery 369 824
Cr Cash 369 824
(to recognise the initial acquisition of the machinery by the
lessor)

Dr Lease receivable 369 824

Cr Machinery 369 824
(to substitute the lease receivable for the asset as lessor no
longer controls it)

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 Illustration 6: Solution (cont.)
30 June 2020
Dr Cash 100 000
Cr Service costs recoupment
(profit or loss) 10 000
Cr Interest revenue 44 379
Cr Lease receivable 45 621

30 June 2021
Dr Cash 100 000
Cr Service costs recoupment
(profit or loss) 10 000
Cr Interest revenue 38 904
Cr Lease receivable 51 096

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 Manufacturer or dealer Lessors

Where fair value of the property at the inception of the

lease differs from its cost to the lessor
(manufacturer or dealer)
Represents a finance lease as:

Two parts of the transaction

1. A sale with a resulting gain (fair value vs cost to
dealer/manufacturer)
2. A lease transaction that will provide interest
revenue over the period of the lease

46
 General format of journal entries for
manufacturer or dealer lessors
At the commencement of the lease:
Dr Lease receivable x
Dr Cost of goods sold x
Cr Inventory x
Cr Sales x

When lease payment subsequently received:

Dr Cash x
Cr Interest revenue x
Cr Lease receivable x

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 MANUFACTURER OR DEALER LESSOR
Lecture Illustration 7
John Deere Ltd is offering special leasing deals on the range
of farm tractors it manufactures. Interest on the lease is only
4%pa (compounded quarterly) whereas market rates are
8%pa.
On the 31st of March, 2017 the company enters into a five
year lease of a tractor with a fair value of $80 000 on the
following terms:
Quarterly payments in arrears of $3 000 for five years and a
guaranteed residual of $32 000 at the end of that period.
The cost of the tractor is $55 000 and the companys policy is
to recognise all of the profit on the sale in the period of sale.
 Lecture Illustration 7
John Deere

Required:
Prepare the journal entries relating to the lease for the
reporting period ending 30 June, 2017

49
 Lecture Illustration 7
John Deere : Solution

Selling profit = Sales revenue - Cost of sales

Sales revenue: = fair value of asset, or if lower, present

value of lease payments accruing to the lessor, discounted
using a market rate of interest (Para 71a).

Fair value = $80,000 (given)

PV of mlp = $70,589 (calc.)
 Lecture Illustration 7
John Deere : Solution

PV of lease payments - we have to use the market rate 8% not

the special deal rate 4% (interest rates are compounded
quarterly) to determine value lease receivable

C 1 S
1
i 1 i n 1 i n

3, 000 1 32, 000

1 20
$70 ,589
0. 02 1 0 .02 1 0.02 20
 Lecture Illustration 7
John Deere : Solution

What if we use special deal

interest rate of 4%?

C 1 S
1
i 1 i n 1 i n

3, 000 1 32, 000

1 20
$80 ,362
0 .01 1 0.01 1 0 .01 20

PV > Fair value

Difference in profit of $9,773
 Lecture Illustration 7
John Deere : Solution
Cost of sales: = $55,000
cost, or carrying amount, less the present value of any
unguaranteed residual (Para71b)

Selling profit = $70,589 - $55,000 = $15,589

 Lecture Illustration 7
John Deere : Solution
Initial Recognition

31.3.2017 Dr Lease 70589

Receivable
Cr Sales revenue 70589

31.3.2017 Dr Cost of sales 55000

Cr Inventory 55000
 Lecture Illustration 7
John Deere : Solution
Lease receivable
Schedule of Receipts

Lease receipt Interest Investment Lease

revenue recovery receivable
31.3.2017 70,589.00
30.6.2017 3,000 1,411.78 1,588.22 69,000.78

30 6.2017 Dr Cash at bank 3000.00

Cr Interest revenue 1411.78
Cr Lease receivable 1588.22
Example 11.14, p.409
Deegan does not mention the use of market
interest rate Para 71a

Next week: Employee Benefits

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