Chapter 2

Accounting for Leases

(MFRS 117)

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Chapter Outline
Nature and classification of leases. Accounting by lessee: operating lease finance lease operating lease direct financing lease

Accounting by lessor:

Sales and leaseback transactions.

Disclosure requirement.
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Learning outcomes:
Define what is lease & differentiate between

operating & finance lease Record the leases transactions in the book of lessor and lessee Define and record sales and leaseback transantions

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Definition of Lease
MFRS 117 (Para 4):
An agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.

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Advantages of Lease
1) 100% financing at fixed rates without requiring any down payment, lease payments often remain fixed. 2) Protection against obsolescence reduce risk of obsolescence. 3) Flexibility less restrictive provision than other debt agreements. 4) Less costly financing. 5) Off-Balance-Sheet financing specifically on operating lease.
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Classification of Lease
Finance Lease

Operating Lease

if it transfers substantially all the risks and rewards incidental to ownership.

if it does not transfer substantially all the risks and rewards incidental to ownership.

DMart

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Classification of Lease cont.

Rewards may be represented by the expectation of profitable operation over the assets economic life and of gain from appreciation in value or realization of a residual value.

Risks include the possibilities of losses from idle capacity or technological obsolescence and of variations in return due to changing economic conditions

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Ownership Transfer
Legal form: Title remains with the lessor for all types of lease. Accounting view: Substance over form A lease that transfers substantially all of the benefits and risks incidental to the ownership of property should be accounted for as acquisition of an asset and the incurrence of an obligation by the lessee. practically how the asset treated/used vs. legally who own the asset Conclusion: The ownership rights differs according to type of the lease.
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Classification of Lease: Para 10 - depends on the substance of the

transaction rather than the form of the contract.

Ownership transfers at the end of the lease?

NO

YES

Finance Lease Finance Lease Finance Lease

Bargain Purchase Option?

NO

YES

Lease term is for majority of economic life?75% or more

NO

YES

PV of MLP equals at least substantially all of FV of the leased asset? 90% or more
NO

YES

Finance Lease
YES

Leased asset(s) specialised?

NO

Finance Lease

Operating Lease
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Classification of Lease (Cont.): Para 11: Indicators of situations which individually or in combination could also lead to a lease being classified as a finance lease are:

Cancellation losses borne by lessee?

NO

YES

Changes in FV of residual borne by lessee?

NO

YES

Bargain lease renewal option?

NO

YES

Operating Lease

Finance Lease

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Terms
Lease Term - Non-cancellable period for which lessee has contracted to lease. - Commencement of lease term = when recognition takes place. Inception date - the earlier of the date of the lease agreement and the date of commitment by the parties to the principle provision of the lease. - Inception of the lease = when leases are classified. Bargain purchase option (BPO) - option to purchase the asset at a price lower than fair value at the date of the option become exercisable.
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Terms (cont)
Minimum Lease Payment (MLP)
Payments over the lease term that the lessee is or can be required to make excluding contingent rent, cost for services, and taxes, to be paid and reimbursed to the lessor; together with (+) Guaranteed residual value: a) lessee: any amounts guaranteed by the lessee or related party; or b) lessor: any residual value guaranteed by lessee or party related to lessee, or third party.
(+) BPO (bargain purchase option)
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Terms (cont.)
Guaranteed Residual Value - Lessee: part of the RV guaranteed by the lessee or by a party related to the lessee (being the max amounts payable at the end of lease term) - Lessor: part of RV guaranteed by the lessee or by a third party unrelated to the lessor who is capable to pay the guaranteed amounts. Initial direct cost - incremental cost that are directly attributable to negotiating and arranging a lease, except for such costs incurred by manufacturer or dealer lessors. - Example: legal fees, lease agreement commission etc.
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Terms (cont.)
Gross Investment
a) the MLP receivable by the lessor under a finance lease, and b) any unguaranteed residual value accruing to the lessor.

Net Investment - the gross investment in the lease discounted at the interest rate implicit in the lease.

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Classification of Leasecont.
Para 15A 18:
When a lease includes both land and buildings elements, an entity

assesses the classification of each element as a finance or an operating lease separately in accordance with paragraphs 713. Land usually operating due to indefinite useful life. if title passed finance lease.

MLP allocated in the proportion to the relative FV of both elements. if cannot reliably allocated: entire lease is considered finance lease, unless it is clear that both are operating.
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Classification of Lease
Illustration 1: Pajakan Co. (Lessor) and Trojan Co. (Lessee) entered into leasing agreement on 1 January 2012. The term of lease is 15 years. The lease agreement is non-cancellable and has minimum lease payments with a present value of RM450,000. The lease involves the use of machinery that has a 17 years estimated useful life and is valued at RM460,000. The lease stated that Trojan has an option to purchase the asset for RM20,000 at the end of leased period.

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Classification of Lease
Solution to illustration 1:
Criteria
Transfer of title BPO Length of lease term PV of MLP Specialised BKAF3063 A122 assets

Satisfied? Y/N
N Y Y Y N

Explanation
Not transferred. BPO = RM20,000 useful life = 17 years; Lease term = 15 years. FV = RM460,000; PV of MLP = RM450,000. Not specified.

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Finance and operating leases: Differences (Lessee)

Finance Lease Recognition of PPE and liabilities on the book PPE subject to impairment and test Operating Lease Recognition of rental expenses/revenue as incurred/earned Not applicable

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Lets take a look at Operating Lease in the book of Lessee

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Operating Lease: Accounting by Lessee

Para 33 34:

Lease payments - should be recognised as an expense in the income statement on a straight-line basis over the lease term. Lease payments should exclude costs for services such as insurance and maintenance.
No records on the assets or liability related to the value of the assets (off balance sheet).

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Operating Lease: Accounting by Lessee

Illustration 2:
Pajakan Company (lessor) leased an equipment costing RM450,000 to Trojan Company. The economic useful life of the asset is 20 years. The lease is classified as operating lease with the lease term of 5 years starting from 1/1/2011. Payments are made in advance as follows: 1/1/11 RM18,000 1/1/12 RM16,000 1/1/13 RM14,000 1/1/14 RM12,000 1/1/15 RM10,000 Asset is used evenly throughout the lease term. The accounting period of both parties ends on 31 December.
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Operating Lease : Accounting by Lessee

Solution to Illustration 2:
Total payment for the lease period: = RM18,000 +RM16,000 + RM14,000 + RM12,000 + RM10,000) = RM70,000 Expenses recognized per year = RM70,000/5 = RM14,000 Journal entries?

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Date
1/1/11
31/12/11 1/1/12 31/12/12 1/1/13 31/12/13 1/1/14 31/12/14 1/1/15 31/12/15
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Particulars
Dr. Prepaid rent Cr. Cash Dr. Rent expense Cr. Prepaid rent
Dr. Prepaid rent Cr. Cash Dr. Rent expense Cr. Prepaid rent Dr. Prepaid rent Cr. Cash Dr. Rent expense Cr. Prepaid rent Dr. Prepaid rent Cr. Cash Dr. Rent expense Cr. Prepaid rent Dr. Prepaid rent Cr. Cash Dr. Rent expense Cr. Prepaid rent

Debit
18,000
14,000

Credit
18,000 14,000

16,000

16,000
14,000 14,000 14,000 14,000 14,000 14,000 12,000 12,000 14,000 14,000 10,000 10,000 14,000 14,000

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Lets take a look at Operating Lease in the book of Lessor

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Operating Lease: Accounting by Lessor

Para 49 55:

Title is not transferred, therefore lessor should present assets in their balance sheet according to the nature of the assets.
Payments received from lessee are recorded as Rent Revenue on a straight-line basis over the lease term. Costs including depreciation incurred in earning the lease income are recognised as an expense.

Initial direct costs incurred by lessor shall be added to the carrying amount of the leased asset and recognised as an expense over the lease term. 25
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Operating Lease: Accounting by Lessor

Refer to Illustration 2:
Total payment for the lease period: = RM18,000 +RM16,000 + RM14,000 + RM12,000 + RM10,000 = RM70,000 Expenses recognized per year = RM70,000/5 = RM14,000 Depreciation expense recognized per year = RM450,000/20 = RM22,500 Journal entries?
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Operating Lease :
Accounting by Lessor
Date 1/1/11 31/12/11 Particulars Dr. Cash Cr. Unearned rent revenue Dr. Unearned rent revenue 14,000 Debit 18,000 Credit 18,000

Cr. Rent revenue

Dr. Depreciation expense 1/1/12 31/12/12 Cr. Accumulated depreciation Dr. Cash Cr. Unearned rent revenue Dr. Unearned rent revenue Cr. Rent revenue Dr. Depreciation expense 22,500 14,000 22,500

14,000
22,500 16,000 16,000 14,000

Cr. Accumulated depreciation

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22,500

Lets take a look at Finance Lease in the book of Lessee

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Finance Lease : Accounting by Lessee

Para 20 30:

Should be recognized as assets and liabilities (as if the assets being purchased) at amounts equal to the fair value of leased asset or if lower, at the PV of MLP [Para 20].
Cost of assets recorded in lessees book: Fair value at inception date.
The lower of:

OR
Reason: the leased asset should not be recorded for more than its fair value.
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PV of MLP at inception date.

Finance Lease : Accounting by Lessee

The discount rate (to be used in calculating PV of MLP): implicit in the lease. IF impracticable to determine, use lessees incremental borrowing rate. MFRS 117 requires the lessee to record the obligation arising from finance lease at then same amount as the leased asset ( para 22)
Journal entries :

Dr. Leased asset Cr. Lease Liability

* The lower of fair value or PV of MLP
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xxx *
xxx *

Finance Lease : Accounting by Lessee

Interest: MLP Lease Liabilities/FV of asset :
Lease payment should be apportioned between the finance charge and the reduction of the outstanding liability. Finance charge allocated to periods during the lease term so as to produce a constant periodic rate of interest on the remaining balance of the liability for each period [ Para 27]. Contingent rents: charged as expense as incurred.
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Finance Lease : Accounting by Lessee

Depreciation (Para 27):
Depreciation policy should be consistent with that for depreciable assets which are owned by the lessee (in accordance with MFRS116). Use economic useful life, if the lease: i. transferred rights at the end of lease term; OR ii. contains BPO. Otherwise, use: The lower of:

Lease term

OR
Economic useful life

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Finance Lease : Accounting by Lessee

Illustration 3:
Assume that Pajakan Company (lessor) and Trojan Company (lessee) sign a lease agreement dated 1 January 2012. The terms are as follows: Term of lease is 5 years, it is non-cancellable, requiring equal rental payments of RM20,000 at the end of each year. 1. The FV = RM75,816 at the inception date, estimated useful life of 5 years, and no residual value. 2. The lease contains no renewal options, and the equipment reverts to Pajakan Co. at the termination of the lease. 3. Discount rate agreed by both parties is 10%. 4. Trojan Co. depreciates on a straight line basis, similar equipment that it owns.
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Finance Lease : Accounting by Lessee

Solution to Illustration 3:
Type of lease: Finance lease MLP = 20,000 x 5 years = RM100,000

PV of MLP

= 20,000 x PVOA(5, 10%) = 20,000 x 3.7908 = 75,816 FV = 75,816.

Journal entry on 1 Jan 2012 Dr. Leased asset Cr. Lease Liability (to recognise the asset leased)
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75,816 75,816

Finance Lease : Accounting by Lessee

Lease amortization schedule: Effective interest method
Date Annual lease payment (A)
20,000 20,000

Interest (10%) (B)

7,582 6,340

Principal payment (C)

12,418 13,660

Lease liability (D)

75,816 63,398 49,738

1 Jan 12 31 Dec 12 31 Dec 13

31 Dec 14
31 Dec 15 31 Dec 16

20,000
20,000 20,000

4,974
3,471 1,818 (D) X 10%

15,026
16,529 18,182 (A) - (B)

34,712
18,183 0 Preceeding - (C)

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Finance Lease : Accounting by Lessee

Journal entries:
Date Particulars 31/12/12 Dr. Lease liability Interest expense Cr. Cash Dr. Depreciation expense Cr. Accumulated depreciation 31/12/13 Dr. Lease liability Interest expense Cr. Cash Dr. Depreciation expense Cr. Accumulated depreciation
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Debit Credit 12,418 7,582 20,000 15,163 15,163 13,660 6,340 20,000 15,163 15,163

Finance Lease : Accounting by Lessee

Journal entries:
Date Particulars 31/12/14 Dr. Lease liability Interest expense Cr. Cash Dr. Depreciation expense Cr. Accumulated depreciation 31/12/15 Dr. Lease liability Interest expense Cr. Cash Dr. Depreciation expense Cr. Accumulated depreciation
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Debit Credit 15,026 4,974 20,000 15,163 15,163

16,529 3,471
20,000 15,163

15,163

Finance Lease : Accounting by Lessee

Journal entries:
Date Particulars 31/12/16 Dr. Lease liability Interest expense Cr. Cash Dr. Depreciation expense Cr. Accumulated depreciation Dr. Accumulated depreciation Cr. Leased assets (to record the return of the assets) Debit Credit 20,000 1,818 20,000 15,163 15,163 75,816 75,816

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Lets take a look at Finance Lease in the book of Lessor

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Finance Lease : Accounting by Lessor

Para 36 40: The receivable to be presented in the Balance Sheet at an amount equal to the net investment in the lease [Para 36], which is defined in para 4 as the gross investment in the lease less unearned finance income Initial direct cost included in the initial measurement of finance lease receivable and reduce the amount of income recognised over the lease term [para 38].
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Finance Lease : Accounting by Lessor

Refer to Illustration 3:
Gross investment = 20,000 x 5 years = RM100,000 Net investment = PV of gross investment = 20,000 x PVOA(5, 10%) = 20,000 x 3.7908 = 75,816 Unearned finance income = 100,000 75,816 = 24,184 Amortization schedule? Journal entries?
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Finance Lease : Accounting by Lessor

Journal entries: Date Particulars Debit Credit 75,816 24,184 20,000 20,000 7,582 7,582

01/01/05 Dr. Lease receivable Cr. Fixed assets Unearned interest revenue 31/12/05 Dr. Cash Cr. Lease receivable
Dr. Unearned interest revenue Cr. Interest revenue 31/12/06 Dr. Cash Cr. Lease receivable Dr. Unearned interest revenue Cr. Interest revenue

100,000

20,000
20,000 6,340 6,340

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Bargain Purchase Option

MLP will be increased by the exercise price

Useful life will be used as basis for depreciation charge.

Example:

On 1/1/2011, ABC Bhd entered into lease agreement with terms: a) non-cancellable lease term of four years, b) Lease rental of RM10,000 per year to be paid on 31 Dec, commencing 31/12/2011. c) ABC Bhd has an option to buy the equipment at the end of lease term for RM1,000. On 1/1/2011, it was estimated tha the fair value of the equipment would be RM5,000 after 4 years usage. The FV of the equipment on 1/1/2011 was RM42,000 and have estimated useful life of 5 years. The implicit rate was 5%.

Bargain Purchase Option

Solution - Lesse:
MLP = (10,000 x 4) + 1,000 = 41,000

PV of MLP

= (10,000 x PV n=4,i=5%) + (1,000 x PVA n=4,i=5%) = 36,282

36,282 36,282

1/1/11 : Dr. Leased Equipment Cr. Lease Payable Depreciation exp = 36,282 / 5 = RM7,256.40 31/12/14 - exercise of BPO: Dr. Lease Payable Cr. Cash

1,000
1,000

Bargain Purchase Option

Solution - Lessor:
Gross Investment = (10,000 x 4) + 1,000 = 41,000 PV of MLP = (10,000 x PV n=4,i=5%) + (1,000 x PVA n=4,i=5%) = 36,282 1/1/11 : Dr. Leased Receivable 42,000 Cr. Equipment Unearned interest revenue

36,282 5,718

31/12/14 - exercise of BPO:

Dr. Cash Cr. Leased Receivable 1,000 1,000

Guaranteed Residual Value

MLP will be increased by GRV

GRV will be deducted from the depreciable amount

of leased asset. At the end of lease term,

the lease liability will have a balance equal with GRV If FV of leased asset < GRV , recognise loss (lessee)

Guaranteed Residual Value

Example: On 1/1/2011, ABC Bhd entered into lease agreement with terms:
a) non-cancellable lease term of four years, b) Lease rental of RM10,000 per year to be paid on 31 Dec,

commencing 31/12/2011.
c) ABC Bhd guaranteed to lessor that the leased asset would

have a residual value of RM5,000 at the end of lease term. The FV of the equipment on 1/1/2011 was RM42,000 and have estimated useful life of 5 years. The implicit rate was 5%. The estimated residual value at the end of lease term was RM7,000.

Guaranteed Residual Value

Solution Lessee:
MLP = (10,000 x 4) + 5,000 = 45,000 PV of MLP = (10,000 x PV n=4,i=5%) + (5,000 x PVA n=4,i=5%) = 39,572 1/1/11 : Dr. Leased Equipment Cr. Lease Payable 39,572 39,572

Depreciation exp = (39,572- 5,000) / 4 = RM8,643 31/12/14, if FV of leased asset is RM3,000, Dr. Lease Payable 5,000 Accumulated depreciation Cr. Leased Equipment Dr. Loss on finance lease 2,000 Cr. Cash

34,572 39,572 2,000

Guaranteed Residual Value

Solution Lessor:
GI = (10,000 x 4) + 7,000 = 47,000 PV of GI = (10,000 x PV n=4,i=5%) + (7,000 x PVA n=4,i=5%) = 41,218 1/1/11 : Dr. Leased Receivable Cr. Equipment Unearned interest revenue 31/12/14, if FV of leased asset is RM3,000, Dr. Equipment Cash Loss on finance lease Cr. Leased Receivable 47,000

41,218 5,782

3,000 2,000 2,000 7,000

Sales and Leaseback

Transaction in which the owner of the asset (seller, lessee)

sells the asset to another and simultaneously leases it back from the new owner.

?
50

In the book of Buyer/lessor: - Same as lessor as discuss before.

In the book of seller/lessee: - To recognize gain from sales of asset: immediate or defer.
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Sales and Leaseback

Para 59: for Finance lease

Profit = Sales proceed Carrying amount

Should not be recognized immediately, instead, should be deferred and amortized over the lease term.

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Sales and Leaseback

Para 61: for Operating lease.
(a) If Selling price = FV

Profit = Sales proceed Carrying amount

Should be recognized immediately.

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Sales and Leaseback

Para 61: for Operating lease
(b) If Selling price

<

FV

Profit = Sales proceed Carrying amount

Should be recognized immediately EXCEPT THAT if the loss is compensated by future lease payments at below market price, it should be deferred and amortized.
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Sales and Leaseback

Para 61: for Operating lease
(c) If Selling price

>

FV (FV > carrying amount)

Profit = Sales proceed Carrying amount

Profit = Sales proceed FV deferred and amortized.
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Profit = FV - Carrying amount recognized immediately.

Sales and Leaseback

Illustration 5:
Chocolate Company sold an equipment to Chips Company and lease back the asset. The carrying amount (book value) of the asset is RM60,000. The asset has a fair value of RM70,000.

How to recognize profit/loss if the selling price:

1. 2. 3. 4.
55

RM70,000 RM55,000 RM50,000 (with lower lease payment) RM90,000

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Sales and Leaseback

Solution to Illustration 11:
1. SP < FV (SP > CA) = Profit = 70,000 - 60,000 = 10,000 recognize immediately

2. SP < FV (SP < CA)

Loss = 55,000 60,000 = 5,000 loss 3. SP < FV (SP < CA with lower lease payment) Loss = 50,000 60,000 = 10,000 loss
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recognize immediately

defer & amortize

Sales and Leaseback

Solution to Illustration 11:
4. SP > FV = Profit = 90,000 60,000 = 30,000 FV CA = 70,000 60,000 = 10,000 recognize immediately SP FV = 90,000 70,000 = 20,000 defer & amortize

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Disclosure Requirements
For Lessee: Para 31: Finance lease. Para 35: Operating lease.
For Lessor: Para 47: Finance lease. Para 56: Operating lease.

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End of Chapter 2 (Part 1)

References:

MFRS 117 Lease

Ng Eng Juan 2010 Lazar & Huang 2012 Zaimah et al. 2009
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