Financial Accounting- Leases

                      LEASES (IAS 17)

Learning Outcomes:

–        Distinguish between the different types of leases

–        Account for an operating lease

–        Account for a finance lease

–        Explain the advantages of capitalising leased assets

-          Identify the accounting issues involved in leasing assets

Basic Definitions:

•         A lease is a contract between two parties: a lessor and a lessee.

•         The lessor is the legal owner of the asset

•         The lessee rents the asset from the lessor

NB:

IAS17 defines a lease as:

“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”

IAS17 defines a finance lease as:

“A lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred”.

•         In a finance lease, the lessee has acquired the risks and rewards of ownership

•         Risks of ownership

–        Asset breakdown

–        Repairs

–        Theft

•         Rewards of ownership are those benefits derived from the use of the asset

NOTE:

The following would normally suggest that a lease be classified as a finance lease;

–        Present Value of minimum lease payments amounts to substantially all (>90%) of assets fair value

–        Lease term is a major part of economic life of asset

–        Full ownership of asset transferred to the lessee by end of lease

–        Bargain purchase option at end of lease

–        Leased asset is of a specialised nature (specific to lessee)

IAS17 defines an operating lease as:

“A lease other than a finance lease”

Accounting Treatment

Operating leases - in the Income statement- recognise as an expense

-          In the statement of financial position- No effect

Finance leases- In the income statement- Recognise leases payments as expenses

-          In the statement of financial position- Recognise finance leased item as an asset and finance lease obligation as a liability.

Effect of capitalisation

Prior to IAS17

•         A company could have use of – and generate income from – and asset without disclosing either the asset of lease obligations in the statement of financial position

IAS 17 requires the capitalisation of finance

Leases

•         This has an impact on key accounting ratios such as gearing, return on assets and ROI.

Advantages of leasing

•         It permits flexibility

•         It avoids obsolescence

•         It gives tax advantages

•         It improves cash flow

Disadvantages of leasing

•         Capitalising leases can be misleading to the unsophisticated

•         The presentation of the legal form of the transaction is sacrificed in favour of the economic substance