Financial Operations

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‘Operating leases are straightforward to account for compared with finance leases, which require you to know two actuarial approaches to allocating interest payments, as well as the sum-of-the-digits method’

There are two classes of lease: finance and operating. A finance lease is one that transfers substantially to the lessee all the risks and rewards associated with ownership. Those that don’t do this are operating leases.

This classification, which is made at the inception of the lease, depends on the substance of the transaction rather than the legal form. Circumstances that would normally cause a lease to be filed under ”finance” include the following:

The lease transfers ownership of the asset to the lessee by the end of the term.
The lessee has the option of buying the asset at a price that’s substantially lower than the asset’s fair value.
The term of the lease covers most of the asset’s useful economic life.
At the inception of the lease, the present value of the minimum lease payments amounts to substantially all of the leased asset’s fair value.
The assets are of a specialised nature.

If an operating lease is deemed to exist, the lease payments are recognised as an expense on a straight-line basis unless another systematic basis is more appropriate. No asset or liability is recognised, so the treatment is as follows:

Dr Income statement.
Cr Bank.

An accrual or prepayment may be necessary when comparing the cash flow and the charges to the income statement.

As an example, consider the following scenario from question 3 of September 2012’s F1 paper. YZ entered into a noncancellable four-year operating lease on 1 October 2011 to acquire machinery. YZ will pay no rent in the first year, but $8,000 is payable for each of three years starting on 1 October 2012. The machinery’s estimated useful life is 10 years.

The charge to the income statement is the total lease payment divided by the term: (3 x $8,000) ÷ 4 = $6,000. The treatment is therefore:

Dr Machinery hire (cost of sales) $6,000.
Cr Accruals $6,000.

The fact that the machinery has an estimated useful economic life of 10 years supports the notion that this is an operating lease, because its term does not cover most of the asset’s useful life.

In situations where a finance lease is deemed to exist, the lessee recognises an asset and liability in the statement of financial position as follows:

Dr Finance lease asset.
Cr Finance lease liability.

The amount that’s initially recognised should be the lower of the fair value of the leased asset and the present value of the minimum lease payments. The discount rate to use in calculating the latter is the interest rate implicit in the lease.

As an example, let’s work through the following part of question 3 from March 2013’s F1 paper. CQ’s trial balance at 31 December 2012 is shown below:

Finance lease payment(iii)12 

(iii) CQ acquired a vehicle on a finance lease on 1 January 2012. The present value of the minimum lease payments is $46,260 and legal title will not pass to CQ at the end. The terms are five annual payments of $12,000 on 1 January from 1 January 2012. The rate of interest implicit in the lease is 15 per cent. Depreciation should be included in the cost of sales. The only entry made for this transaction was to record the first rental payment.

We can see that we have a finance lease and that the first payment is made at the start of the reporting year, so the initial recognition should be:

Dr Finance lease asset $46,260.
Cr Finance lease liability $46,260.

Note that we use the present value of the minimum lease payments, since the fair value of the asset isn’t given.

In essence, CQ owns the asset, so it’s recognised in the statement of financial position as a non-current asset and depreciated over its useful life: five years. So $46,260 ÷ 5 = $9,252 is the depreciation figure, giving us the following entries:

Dr Depreciation expense $9,252.
Cr Accumulated depreciation $9,252.

Now we need to deal with the financing part of the arrangement. This is done either by the actuarial method, using an implicit rate of interest, or by the sum-of-the-digits method.

The actuarial approach – the more appropriate method here, as the question provides an interest rate – varies according to whether the lease payments are made in advance or in arrears. In this case CQ pays on the first day of the year, so it’s clear that the firm is paying in advance.

1. Actuarial method of allocating interest (payments in advance) for CQ
YearOpening balancePaidSubtotalInterestClosing balance
31/12/12Starts with the initial recognition amount = $46,260Amount of the lease payment = $12,000Opening balance - paid = $34,260Implicit interest rate x subtotal = $5,139Subtotal + interest = $39,399

2. Actuarial method of allocating interest (payments in arrears) for ZY
YearOpening balanceInterestPaidClosing balance
31/06/11Fair value of the asset = $120,000Implicit rate x opening balance = $9,516Lease payment = $30,000Opening balance + interest – paid = $99,516

The calculation is shown in table 1. You’ll always need to find the figures up to the year after the one you are accounting for. In this case we’re reporting the year to 31 December 2012, so we must also cover the year to 31 December 2013.

Table 1 shows that the interest charge for the income statement is $5,139 and the total liability outstanding at the end of the year is $39,399. Liabilities are split into current and non-current balances in the statement of financial position - as is the lease liability. The current liability is the $12,000 payment, which is partly the repayment of capital and partly the payment of the $5,139 interest outstanding. The non-current liability is the subtotal in the second year of $27,399, since the interest of $4,110 has not yet accrued.

The relevant part of CQ’s statement of financial position as at 31 December 2012 will therefore be as follows:
Non-current liabilities 
Finance lease$27,399
Current liabilities 
Finance lease$12,000

Now let’s try a scenario involving payments in arrears from question 3 of September 2011’s P1 paper. ZY acquired new vehicles on a five-year finance lease on 1 July 2010. The terms are as follows:

Rental payments of $30,000 are made annually in arrears on 30 June.
The vehicles’ fair value was $120,000.
The interest rate is 7.93 per cent a year.

The initial recognition will be at fair value this time, since the present value of minimum lease payments is not given. The calculation is shown in table 2.

The interest charge for the year ended 30 June 2011 will be $9,516. The liability at the end of the year of $99,516 will be split in ZY’s statement of financial position as at 30 June 2011 as follows:
Non-current liabilities 
Finance lease
(balance at end of following year)
Current liabilities 
Finance lease
(balance at end of current year less that
of following year end: $99,516 - $77,408)

Let’s revisit the CQ question from the March 2013 paper to work through the sum-of-the-digits method of allocating interest. You take this approach if it’s required by the question or if an implicit interest rate is not provided. It uses the formula (n[n + 1]) ÷ 2 where n is the lease term. In CQ’s case, then, the sum of digits will be (5 x 6) ÷ 2 = 15.

Next we find the total interest in the financing arrangement, which is the total lease payments less the asset’s fair value: (5 x $12,000) - $47,000 = $13,000. This is apportioned by applying the sum-of-the-digits fraction to the total interest each year, as shown in table 3.

3. Sum-of-the-digits method of allocating interest for CQ
YearTotal interestSum-of-the-digits fractionInterest charge for the year

Cathy Sibley is a CIMA exam marker and freelance tutor.







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