Maynard: Financial Reporting, 2nd edition

CHAPTER 15
LEASES

Quick test

Question 1

(a) Off balance sheet financing refers to situations where some or all of a business‟s debt
obligations are excluded from the statement of financial position. Debt balances are
included in key financial ratios such as return on capital employed and gearing. If
debt can be excluded from the statement of financial position these ratios will appear
improved, so companies may wish to reduce their levels of debt in order to look more
attractive to potential investors. However if a company has obligations which are not
recognised, then its financial statements cannot be said to be faithfully representative,
and are misleading.

IAS 17 Leases partially addresses one cause of off balance sheet financing – leases.
A lease is where one company (the lessee) acquires the right to use an asset for a
period of time in return for a payment or series of payments to another company (the
lessor), which retains legal ownership of the asset. Prior to any standards dealing
with this, the accounting treatment followed the legal form, and the asset remained on
the books of the lessor. The lessee‟s financial statements showed neither the asset
nor the obligation for the payments, and the payments were accounted for as rental
expenses.

IAS 17 has built on previous US and UK financial reporting standards whose

requirements were considered the most acceptable financial reporting solution to the
problem of off balance sheet leases as they grew in popularity in the 1970s and
1980s. IAS 17 requires that certain leases, entitled finance leases, follow the
substance over form principle and are brought onto the statement of financial position
– the asset and the related debt obligation are both recognised. However other
leases, entitled operating leases, are still accounted for as rental agreements, with
neither the asset nor the lease obligation recognised, and the payments included in
the statement of profit or loss on the accruals basis. The obligations of these leases
are included only as a disclosure note. Users of the financial statements of
companies which have operating leases still have to make approximations to reported
figures in the statement of financial position to fully understand the exposure of the
companies to all obligations.

The distinction between a finance lease and operating follows the principles of
whether the lessee assumes the “risks and rewards” of ownership of the asset under
the lease agreement. This requires the application of judgement, although guidelines
are provided in IAS 17 to assist.

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 Maynard: Financial Reporting, 2nd edition

(b) Few details are provided of the details of this lease to determine whether it is a
finance or an operating lease (IAS 17).

Present value of the rental payments

= 150,000 + 150,000/1.1 + 150,000/1.12 +150,000/1.13
= £523,028
which is equivalent to the cost (or fair value) of the leased asset, and is therefore
“substantially all” of the fair value.

Taken with the fact that the lessee can continue to rent the computer for an indefinite
period after the end of the four-year lease term for a “peppercorn rent”, this indicates
that the lease is a finance lease.

Year Obligation Instalment Obligation Interest Obligation

end at start of after @ 10% at end of
year instalment year
£ £ £ £ £
20X7 523,028 (150,000) 373,028 37,303 410,331
20X8 410,331 (150,000) 260,331 26,033 286,364
20X5 286,364 (150,000) 136,364

Statements of financial position at 31 March 20X7 20X8

£ £
Non-current assets – assets held under finance leases
Cost 523,028 523,028
Accumulated depreciation 523,028 / 5* 104,606 209,212
Net book value 418,412 313,816

Current liabilities – obligations under finance leases

150,000 150,000
Non-current liabilities - obligations under finance leases
260,331 136,364

Statements of profit or loss

Depreciation* 104,606 104,606
Interest 37,303 26,033

* The expected useful life is 5 years, so the asset is depreciated over this period in
accordance with IAS 16, and not the lease term.

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 Maynard: Financial Reporting, 2nd edition

Question 2

(a) Based on the case, the risks and reward of ownership of the machine have been
transferred to Power Tools plc because:
- The lease term of three years is for the majority part of the economic life of the
asset
- At the inception of the lease, the present value of the minimum lease payments
amounts to substantially all of the fair value of the leased asset:
PV = 700,000 + 700,000/1.1 + 700,000/1.12 + 700,000/1.13 + 700,000/1.14 +
700,000/1.15 = £3,353,550
which is greater than the fair value of the machine (i.e. is substantially all)
- Power Tools is required to insure for the machine and hence has taken on a risk
related to the asset
Hence it is accounted for as a finance lease (IAS 17).

(b) £000
Statement of profit or loss for the year ended 31 December 20X0
Depreciation (3,000 / 3 years) 1,000
Interest (300 + 260) 560

Statement of financial position at 31 December 20X0

Non-current liabilities 1,144
Current liabilities (2,160 - 1,144) 1,016

Working
Opening Closing
Period obligation Interest Instalment obligation
£000 £000 £000 £000
1 to 30/6/X0 3,000 300 (700) 2,600
2 to 31/12/X0 2,600 260 (700) 2,160
3 to 30/6/X1 2,160 216 (700) 1,676
4 to 31/12/X1 1,676 168 (700) 1,144

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 Maynard: Financial Reporting, 2nd edition

Question 3

There is evidence that lease described is a finance lease as defined by IAS 17:
 after the lease term expires, Conex has the right to continue with the lease at a
“peppercorn rent” of £1
 Conex bears all maintenance and insurance costs (the “risks and rewards of
ownership” have passed to the lessee)
 PV of minimum lease payments = £55,405, which is equal to the fair value of the asset

Working

Year Quarter Opening Instalment Capital after Finance Closing

obligation instalment charge obligation
£ £ £ £ £
20X7 1 55,404 5,404 50,000 1,500 51,500
2 51,500 5,404 46,096 1,383 47,479
3 47,479 5,404 42,075 1,262 43,337
4 43,337 5,404 37,933 1,138 39,071
5,283
20X8 1 39,071 5,404 33,667 1,010 34,677
2 34,677 5,404 29,273 878 30,151
3 30,151 5,404 24,747 742 25,490
4 25,490 5,404 20,086 603 20,688
3,233
20X9 1 20,688 5,404 15,284 459 15,743
2 15,743 5,404 10,339 310 10,649
3 10,649 5,404 5,245 157 5,402
4 5,402 5,402 - - -
926

Four- year depreciation period as this is the expected useful life of the asset:
Annual depreciation = £55,404 / 4 = £13,851

Statements of financial position

Non-current assets Cost Accumulated NBV
depreciation
£ £ £
Plant and machinery under finance leases
20X7 55,404 13,851 41,553
20X8 55,404 27,702 27,702
20X9 55,404 41,553 13,851
20Y0 55,404 55,404 -

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 Maynard: Financial Reporting, 2nd edition

The total finance lease payable will be split into amounts due within one year (current) and
amounts due after one year (non-current).

Non-current liabilities £
Amounts due under finance leases
20X7 20,086

Current liabilities
Amounts due under finance leases
20X7 (39,071 – 20,086) 18,985
20X8 20,688

Statements of profit or loss £

Interest payable (includes finance charge)
20X7 5,283
20X8 3,233
20X9 926

Depreciation
20X7 13,851
20X8 13,851
20X9 13,851
20Y0 13,851

Question 4

(a) The distinction between a finance and an operating lease (IAS 17) is determined by
considering the commercial substance of the lease agreement.

Finance lease
This is a lease agreement which transfers substantially all the risks and rewards
incidental to ownership to the lessee. The rewards of owning an asset include
obtaining profitable returns or gains from an appreciation in value. Risks of owning an
asset include obtaining variable returns from the use of the asset as economic
conditions alter or possible losses resulting from the asset lying idle or because it has
become technologically obsolete. IAS 17 provides some typical indicators of what
may lead a lease to be classified as finance:

 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 price lower than the fair value
at the date the option becomes exercisable and it is likely that the lessee will
exercise this option
 the lease term is for the major part of the economic life of the asset
 at the inception of the lease the present value of the minimum lease payments
amounts to at least substantially all (often in practice taken as meaning > 90%) of
the fair value of the leased asset

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 Maynard: Financial Reporting, 2nd edition

 the leased assets are of such a specialised nature that only the lessee can use
them without major modifications

Operating lease
An operating lease is any other lease. Indicators of an operating lease are that the
risks and rewards incidental to ownership remain with the lessor, and the lessee pays
rental for the hire of the asset for a period which is usually less than useful life of
asset.

The distinction between the two types of lease is important because the accounting
treatment of each is different. That for finance leases addresses one off balance
sheet financing issue.

Finance lease
 The asset is capitalised and depreciated over its useful life
 A liability for the lease obligation is recognised
 Payments by the lessee to the lessor are for the full cost of asset plus a return on
the provision of finance and so are split between repayment of liability and finance
charge shown in statement of profit or loss

Operating lease
 The asset is not capitalised
 The payments are written off to the statement of profit or loss as incurred

(b) The details given indictate that this is a finance lease (IAS 17):
 Nottingham is responsible for maintenance (a risk of ownership)
 PV of the minimum lease payments > substantially all of the fair value of asset:
PV = 45,000 + 45,000/1.05 + 45,000/1.052 + 45,000/1.053 + 45,000/1.054 +
45,000/1.055 = £239,827

Accounting treatment:
The asset is capitalised at „fair value‟ i.e. the lower of the fair value (the cost of
£240,000) and the PV of the minimum lease payments = £239,827. It is depreciated
in accordance with IAS 16, over its useful economic life of 5 years.
Annual depreciation = £47,965

Liability is set up at inception of lease for £239,827.

Period Obligation Instalment Obligation Interest Obligation

at start of after @ 5% at end of
period instalment period
£ £ £ £ £
End 30/9/X3 239,827 (45,000) 194,827 9,741 204,568
End 31/3/X4 204,568 (45,000) 159,568 7,978 167,546
End 30/9/X4 167,546 (45,000) 122,546 6,127 128,673
End 31/3/X5 128,673 (45,000) 83,673

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 Maynard: Financial Reporting, 2nd edition

Statement of financial position at 31 March 20X4

£
Non-current assets – assets held under finance leases
Cost 239,827
Accumulated depreciation 47,965
Net book value 191,862

Non-current liabilities - obligations under finance leases 83,673

Current liabilities – obligations under finance leases

(167,546 – 83,673) 83,873

Statement of profit or loss for the year ended 31 March 20X4

Depreciation 47,965
Interest (9,741 + 7,978) 17,719

Develop your understanding

Question 5

Off balance sheet financing refers to situations where some or all of a business‟s debt
obligations are not recognised on its statement of financial position. If a company has
obligations which are not recognised, then its financial statements cannot be said to be
faithfully representative. The statement of financial position is used by users to evaluate
the financial health of a business. If debt is excluded key financial ratios, such as return
on capital employed and gearing, will be improved, and therefore the company may look
more attractive to potential investors than one with higher debt. The company may also
be able to acquire further debt financing as debt covenants will be more easily met.

A variety of financial transactions can give rise to off balance sheet financing. Leases is a
key area, whereby a business obtains the use of a non-current asset for a number of
years without acquiring legal title in return for a series of payments over the period. Prior
to accounting standards dealing with this issue, companies accounted for leases
according to the legal form, and recognised neither the asset nor the obligation for the
payments on their statements of financial position. The lease payments were treated as a
period expense. In the 1970s and 1980s the use of lease agreements grew enormously,
such that it was estimated in the US that billions of dollars of leased items and related
obligations were not recognised in the financial statements. IAS 17 Leases was the
international accounting standard which partially addressed this area, by requiring that
certain leases, finance leases, were brought “on balance sheet”. However other leases,
operating leases were still “off balance sheet”.

This international standard follows a “substance over form” approach for finance leases
which is consistent with the principles-based approach to financial reporting advocated by
the IASB. IAS 17 defines a finance lease as one where substantially all the risks and

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 Maynard: Financial Reporting, 2nd edition

rewards of ownership are transferred to the lessee, although legal title has not passed.
The accounting treatment is based on the commercial or economic substance of the
finance lease rather than the legal form. The commercial reality is that the company has
acquired the use of a non-current asset and some or all of the risks and benefits, as if the
asset were owned, hence the asset is recognised. The corresponding obligations under
the agreement are also recognised as a liability. This accounting is consistent with the
definitions of assets and liabilities in the IASB‟s Conceptual Framework.

This principles based approach requires the exercise of judgement in the determination of
whether a lease is a finance one or an operating one. Some guidance is provided by the
standard, but there is evidence that companies structure lease agreements so that they do
not quite meet the suggested criteria and therefore remain “off balance sheet”. IAS 17
requires that all other operating leases are accounted for as rental agreements, off
balance sheet, and with payments accounted for through the statement of profit or loss.

This situation is controversial, with users wanting to see all obligations recognised in the
statement of financial position. The IASB has now issued IFRS 16 Leases which requires
that the vast majority of leases are on balance sheet.

There are many other financial issues that give rise to off balance sheet financing. One
key one which has been tackled recently by the IASB, is the question of which
investments should be consolidated in an investing company‟s financial statements. This
issue was highlighted particularly by the collapse of the US giant, Enron, where it was
discovered that many of its investments, in the form of special purpose entities in which
much of Enron‟s debt had been recognised, were not consolidated, and thus the debt was
off the consolidated balance sheet of Enron. The IASB‟s IFRS 10 Consolidated Financial
Statements addresses this issue and takes control by the investor over the investee as the
criterion to determine whether the investment is consolidated. Again this requires the
exercise of judgement.

Other issues giving rise to off balance sheet financing mainly involve the legal sale of
assets, but with obligations being incurred to re-acquire the assets in the future.
Examples are sale and leaseback arrangements, inventories sold under consignment,
debt factoring, and the securitisation of assets. IAS 17 also includes details of how to
account for a sale and leaseback arrangement. The IASB has addressed the issue of the
potential for an asset and obligation to be off balance sheet from the other types of
transactions by considering what constitutes a sale and when revenue from a sale should
be recognised in IFRS 15 Revenue from Contracts with Customers. This takes a
principles-based approach, with the recognition of revenue from a sale being based on
transfer of control. This is obviously more consistent with the latest approach to
consolidations.

Other complex transactions in financial instruments are continually evolving, and some of
these have meant that companies have been able to avoid recognising all their debts on
their statements of financial position. The recently completed project on financial
instruments has resulted in IFRS 9 Financial Instruments which has addressed these sorts
of transactions.

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Question 6

(a) The substance over form principle ties in with a principles-based approach to
accounting. The accounting treatment is based on the commercial or economic
substance (reality) of a transaction rather than the legal form.

Instead of purchasing an asset outright, companies will enter into arrangements to

lease the asset for a period of time by making regular payments over the period of the
lease. Legal ownership remains with the lessor, but the company gains economic
benefits from the use of the asset. The commercial substance of many of these
transactions is that the company has over the period of the agreement acquired the
use of a non-current asset and some or all of the risks and benefits as if the company
owned the asset. The asset is used in a similar manner to other non-current assets,
even though, legally, it belongs to the lessor.

The substance over form principle implies that an asset acquired under such a lease
arrangement should be capitalised and accounted for as all other assets that have
been purchased. This accounting treatment also follows from the IASB‟s definition of
an asset – a resource controlled by the entity as a result of past transactions and from
which future economic benefits are expected to flow to the entity. The statement of
financial position will include the resources which are controlled by the lessee.

IAS 17 takes this approach and therefore requires that assets under lease
agreements which transfer substantially all the risks and rewards incidental to
ownership to the lessee, i.e. finance leases, are brought onto the statement of
financial position. Finance leases are ones where the asset is usually transferred to
the lessee for the major part of the asset‟s life. They are often identified as such if the
present value of minimum lease payments is substantially all of the fair value of the
asset.

This accounting treatment also implies that a corresponding liability for the obligations
under the lease agreement is recognised. This is in accordance with the IASB‟s
definition of a liability – a present obligation arising from past events, the settlement of
which is expected to result in an outflow of resources.

Not all lease agreements are treated as finance leases. An operating lease is any
other lease. This is treated as a hire agreement since the lessor is considered to
retain the risks and rewards of ownership, and the asset is usually leased out to more
than one lessee for different periods. Thus neither the asset, nor the corresponding
liability is recognised on the statement of financial position.

(b) (i) Machine X – finance lease (IAS 17)

- Ferrars bears the risks of ownership (maintenance and insurance costs)
- Lease non-cancellable, so Ferrars bears the risks of gains/losses from the
fluctuations in the residual value
- The lease term of 6 years is the same as the economic life
- PV of minimum lease payments (= £60,000 x 8.3840 = £503,040) is

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 Maynard: Financial Reporting, 2nd edition

substantially the fair value of the machine (£503,030)

Machine is capitalised at the lower of fair value and PV of minimum lease payments
and depreciated over its useful life.
Liability shown for finance provided. Lease payments reduce liability and
provide finance charge.

Machine Y – operating lease (IAS 17)

- Lease term is only half of the useful life of the machine
- At the end of the lease term, the machine will revert back to the lessor
- PV of minimum lease payments (= £84,000 x 2.6901 = £225,968) is only three
quarters of the fair value of the machine (£300,000)

Lease payments treated as expense in statement of profit or loss.

(ii) Machine X
£
Statement of financial position at 31 December 20X7
Non-current assets
Cost 503,030
Accumulated depreciation (503,030/6) 83,838
NBV 419,192

Non-current liabilities
Obligations under finance leases 372,587

Current liabilities
Obligations under finance leases (441,605 – 372,587) 69,018

Opening Closing
Period obligation Interest Instalment obligation
£ £ £ £
1 to 30/6/X7 503,030 30,182 (60,000) 473,212
2 to 31/12/X7 473,212 28,393 (60,000) 441,605
3 to 30/6/X8 441,605 26,496 (60,000) 408,101
4 to 31/12/X8 408,101 24,486 (60,000) 372,587

Statement of profit or loss for the year ended 31 December 20X7

Expenses £
Depreciation 83,838
Finance charge (30,182 + 28,393) 58,575

Machine Y

Statement of profit or loss for the year ended 31 December 20X7

Expenses £

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 Maynard: Financial Reporting, 2nd edition

Operating lease rentals 84,000

Question 7

Note – the accounting treatments also refer to IAS 18 Revenue

(i) This is a sale and finance lease back. Although Alpha has given up legal title to the
asset it immediately reacquires the risks and rewards of ownership. In such
circumstances, there has not in substance been a sale. This transaction represents a
secured loan and should be accounted for accordingly. No profit can be reported and
the “sales proceeds” are accounted for as a liability. The finance lease rentals are
accounted for partly as a capital repayment of the loan and partly as a finance charge
in the statement of profit or loss.

(ii) There has been an actual sale as a result of the transfer of risks and rewards of
ownership. Because the sale is at fair value, the profit on the transaction is
recognised immediately. The asset is derecognised and the operating lease rentals
expensed in the statement of profit or loss.

(iii) There has been an actual sale as a result of the transfer of risks and rewards of
ownership. The asset is derecognised and the operating lease rentals expensed in
the statement of profit or loss. The treatment of the loss on sale depends on the
circumstances. If the lease payments are under value, then the loss is deferred and
amortised over the period until the end of the lease. Otherwise, the loss is recognised
immediately.

(iv) There has been an actual sale as a result of the transfer of risks and rewards of
ownership. The asset is derecognised and the operating lease rentals expensed in
the statement of profit or loss. The profit on the disposal of the asset must be
restricted to the difference between the fair value of the asset and its carrying amount
(i.e. £2,000). IAS17 requires that the excess profit (£5,000) is deferred and amortised
over the period of the lease. This treatment assumes that the buyer/lessor will charge
lease rentals above the market rate to compensate for the loss.

Question 8

Note – parts (c) and (d) as printed belong to part (b)

(a) Although the amount of space the coffee customer uses is specified in the contract,
there is no identified asset. The company controls its owned kiosk. However, the
contract is for space in the airport, and this space can change at the discretion of the
airport. The airport has the substantive right to substitute the space the coffee
company uses because:
 It has the practical ability to change the space used by coffee company throughout
the period of use. There are many areas in the airport that meet the specifications
for the space in the contract, and the airport has the right to change the location at
any time without the coffee company‟s approval.

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 Maynard: Financial Reporting, 2nd edition

 It would benefit economically from substituting the space. There would be minimal
cost associated with changing the space used by the coffee company because the
kiosk can be moved easily. The airport benefits from substituting the space in the
airport because substitution allows it to make the most effective use of the space
at boarding areas in the airport to meet changing circumstances.

Consequently the contract does not contain a lease.

(b) There is an identified asset. The aircraft is explicitly specified in the contract and,
although the aircraft owner can substitute the aircraft, its substitution right is not
substantive because the significant costs involved in outfitting another aircraft to meet
the specifications required by the contract are such that the aircraft owner is not
expected to benefit economically from substituting the aircraft.

Mediterranean Air Group has the right to control the use of the aircraft throughout the
two-year period of use because:
 It has the right to obtain substantially all of the economic benefits from use of the
aircraft over the two-year period of use. Mediterranean Air Group has exclusive
use of the aircraft throughout the period of use.
 It has the right to direct the use of the aircraft. The restrictions on where the
aircraft can fly define the scope of Mediterranean Air Group‟s right to use the
aircraft. Within the scope of its right of use, this company makes the relevant
decisions about how and for what purpose the aircraft is used throughout the two-
year period of use because it decides whether, where and when the aircraft
travels, as well as the passengers and cargo it will transport. Mediterranean Air
Group has the right to change these decisions throughout the two-year period of
use.

Although the operation of the aircraft is essential to its efficient use, the aircraft
owner‟s decisions in this regard do not give it the right to direct how and for what
purpose the aircraft is used. Consequently, the aircraft owner does not control the
use of the aircraft during the period of use and its decisions do not affect
Mediterranean Air Group‟s control of the use of the aircraft.

The contract therefore contains a lease. Mediterranean Air Group has the right to use
the aircraft for two years.

(c) There is no need to assess whether the servers installed at Plantagenet‟s premises
are identified assets. This assessment would not change the analysis of whether the
contract contains a lease because Plantagenet does not have the right to control the
use of the servers.

Plantagenet does not control the use of the servers because its only decision-making
rights relate to deciding upon the level of network services (the output of the servers)
before the period of use – the level of network services cannot be changed during the
period of use without modifying the contract. For example, even though Plantagenet
produces the data to be transported, that activity does not directly affect the

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 Maynard: Financial Reporting, 2nd edition

configuration of the network services and, thus, it does not affect how and for what
purpose the servers are used.

Telcom is the only party that can make relevant decisions about the use of the servers
during the period of use. Telcom has the right to decide how data is transported using
the servers, whether to reconfigure the servers and whether to use the servers for
another purpose. Accordingly, Telcom controls the use of the servers in providing
network services to Plantagenet.

The contract does not therefore contain a lease. Instead, the contract is a service
contract in which Telcom supplies the equipment to meet the level of network services
determined by Plantagenet.

Take it further

Question 9

(a) Under IAS 17 both the lessor and the lessee must determine whether the lease
agreement effectively transfers substantially all the risks and rewards from the lessor
to the lessee.

In this case, based on the following evidence, both the lessor and the lessee should
conclude that such a transfer is achieved and the lease should be classified as a
finance lease.

 The lease is non-cancellable

 The lease term is a major part of the economic life of the leased assets (4 out of 5
years)
 The present value of the minimum lease payments is substantially all of the fair
value of the leased assets:

Minimum lease payment = (125,000 x 3.5771) + (50,000 x 0.735)

= 447,137.50 + 36,750 = £483,887.50

483,887.50 / 497,000 = 97%

(b) Lease payment schedule

Year Opening Payment Obligation Interest Closing

obligation after obligation
payment
£ £ £ £ £
20X8 483,887.50 (125,000) 358,887.50 28,711.00 387,598.50
20X9 387,598.50 (125,000) 262,598.50

Journal entries for the year ended 31 December 20X8

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 Maynard: Financial Reporting, 2nd edition

At 1 January 20X8:
£ £
Dr Cash 497,000
Cr Deferred gain on sales 97,000
Cr Machine 400,000
Sale of machine under sale and leaseback agreement

Dr Leased equipment 483,888

Cr Lease liability 483,888
Recognition of lease agreement

Dr Lease liability 125,000

Cr Cash 125,000
First lease payment

At 31 December 20X8:

Dr Depreciation (483,888 / 5) 96,776

Cr Leased equipment 96,776
Depreciation of the machine

Dr Deferred gain (97,000 / 5) 19,400

Cr Other income 19,400
Recognition of the gain

Dr Interest expense 28,711

Cr Lease liability 28,711
Interest on the lease

Statement of financial position at 31 December 20X8

£
Non-current assets
Cost 483,888
Accumulated depreciation 96,776
NBV 387,112

Non-current liabilities
Obligations under finance leases 262,599
Deferred gain (77,600 – 19,400) 58,200

Current liabilities
Obligations under finance leases (387,599 – 262,599) 125,000
Deferred gain 19,400

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 Maynard: Financial Reporting, 2nd edition

Statement of profit or loss for the year ended 31 December 20X8

Expenses £
Depreciation 96,776
Finance charge 28,711

Other income
Deferred gain on sale of asset under sale and leaseback 19,400

Question 10

(a)
£
Statement of financial position
Non-current asset
Net investment in finance lease (W2) 41,474
Current asset
Net investment in finance lease (W2) (61,474 – 41,474) 20,000

Statement of profit or loss

Finance income (W2) 5,589

Workings

(1) Net investment in finance lease (IAS 17)

Gross Discount Net
investment factor (10%) investment
£ £
1 Jan X4 20,000 1 20,000
1 Jan X5 20,000 1/1.1 18,182
1 Jan X6 20,000 1/1.12 16,529
1 Jan X7 20,000 1/1.13 15,026
31 Dec X7 7,500 1/1.14 5,123
Minimum lease payments 87,500 74,860
Unguaranteed residual 1,500 1/1.14 1,025
89,000 75,885

Note:
Allowance for the initial direct costs will have been made in computing the 10%
interest rate implicit in the lease, so they should be ignored in preparing these
extracts.

(2) Statement of financial position and statement of profit or loss figures

£
Year ended 31 Dec 20X4
1 Jan X4 Net investment (W1) 75,885
1 Jan X4 Instalment (20,000)
55,885

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 Maynard: Financial Reporting, 2nd edition

31 Dec X4 Interest income (55,885 x 10%) 5,589

Balance at 31 Dec 20X4 61,474

Year ended 31 Dec 20X5

1 Jan 20X5 Instalment (20,000)
41,474

(b)
£
Statement of profit or loss
Leasing income 20,000

Statement of financial position

Non-current asset
Property, plant and equipment (W3) 45,962

The lease income of £20,000 per year should be recognised on a straight line basis,
as no other system of recognition seems more appropriate in this case. The expected
residual value of £9,000 is above the guaranteed residual value of £7,500; this should
not be anticipated but recognised at the end of the lease term.

Workings
(3) The asset is measured at its fair value plus direct costs. Direct costs are written off
on a straight line basis over the four year lease term (to match revenue from the
lease), not the life of the asset.

Depreciation on Contract
asset @ 40% acquisition costs, Total
At reducing At written off over carrying
1 January balance 31 December four years amount
£ £ £ £ £
20X4 75,979 (30,392) 45,587 375 45,962
20X5 45,587 (18,235) 27,352 250 27,602
20X6 27,352 (10,941) 16,411 125 16,536
20X7 16,411 (6,564) 9,847 0 9,847

R
Question 11

Option 1
Profit on sale = 2.73 million – 2.4 million = £330,000, which is recognised immediately
in profit or loss.

As the sales price is below the £2.85 million fair value and the £215,000 annual rental is
below the £250,000 market rental, IAS 17 does not require any adjustment to the profit as
calculated above.

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 Maynard: Financial Reporting, 2nd edition

So the profit is recognised immediately and the subsequent rentals are recognised in profit
or loss each year at £210,000. Over the next three years the effect on profit or loss is as
follows:

Year 1 Year 2 Year 3 Total

£000 £000 £000 £000
Profit on derecognition of depot 330 0 0 330
Rental expense recognised (210) (210) (210) (630)
Total income / (expense) 120 (210) (210) (300)

Option 2
This option generates a profit on sale of £600,000 (3 million – 2.4 million).
This sales price is £150,000 above the £2.85 million fair value, but this seemingly
generous extra consideration appears to be clawed back by Goodrich planning to charge
above market rentals for the following three years.

IAS 17 requires any excess profit to be initially recognised as deferred income and
released to profit or loss over the three years of the leaseback. The profit recognised
immediately should be the difference between the £2.85 million fair value and the £2.4
million carrying amount. Over the next three years the effect on profit or loss is as follows:

Year 1 Year 2 Year 3 Total

£000 £000 £000 £000
Profit on derecognition of depot 450 0 0 450
Rental expense recognised (300) (300) (300) (900)
Deferred income released
to profit 50 50 50 150
Total income / (expense) 200 (250) (250) (300)

Question 12

On 1 January 20X3, Alton makes the lease payment for 20X3 and measures the lease
liability at the present value of the remaining 9 payments of £50,000, discounted at the
interest rate of 5% per annum = £355,391.

Alton initially recognises assets and liabilities in relation to the lease as follows:

Dr Right-of-use asset £405,391

Cr Lease liability £355,391
Cr Cash (lease payment for the first year) £50,000

Alton expects to consume the right-of-use asset‟s future economic benefits evenly over
the lease term and, thus, depreciates the right-of-use asset on a straight-line basis.

During the first two years of the lease, 20X3 and 20X4, Alton recognises in aggregate the
following related to the lease:

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 Maynard: Financial Reporting, 2nd edition

Dr Interest expense (17,770 + 16,158 see table below) £33,928

Cr Lease liability £33,928

Year Liability Instalment Liability Interest Liability

at start of after @ 5% at end of
period instalment period
£ £ £ £ £
20X3 405,391 (50,000) 355,391 17,770 373,161
20X4 373,161 (50,000) 323,161 16,158 339,319
20X5 339,319

Dr Depreciation charge (405,391/10 x 2 years) £81,078

Cr Right-of-use asset £81,078

On 1 January 20X5, the lease liability is £339,319. At this date the CPI has increased to
135. The payments made under the lease arrangement are reassessed, and this results
in adjustments to both the lease liability and the right-of-use asset.

The payment made on 1 January 20X5, adjusted for the CPI, is £54,000 (£50,000 x
135/125). The lease liability is remeasured to reflect the revised payments, i.e. the lease
liability now reflects 8 annual lease payments of £54,000.

Remeasurement of liability (PV of 8 payments of £54,000 discounted at an unchanged

discount rate of 5% per annum) = £366,464
The increase in lease liability = 366,464 – 339,319 = £27,145, is accounted for as follows:

Dr Right-of-use asset £27,145

Cr Lease liability £27,145

The 20X5 interest and depreciation are accounted for as follows:

Dr Interest expense (see table below) £15,623

Cr Lease liability £15,623

Year Liability Instalment Liability Interest Liability

at start of after @ 5% at end of
period instalment period
£ £ £ £ £
20X5 366,464 (54,000) 312,464 15,623 328,087
20X6 328,087 (54,000) 274,087

Dr Depreciation charge ((405,391 - 81,078 + 27,145)/8) £43,932

Cr Right-of-use asset £43,932

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 Maynard: Financial Reporting, 2nd edition

Summary:

Statements of financial position at

31 December 20X3 20X4 20X5
£ £ £
Right-of-use asset
Cost 405,391 405,391 432,536
Accumulated depreciation (40,539) (81,078) (125,010)
NBV 364,852 324,313 307,526

Current liabilities
Lease liabilities 50,000 50,000 54,000

Non-current liabilities
Lease liabilities 323,161 289,319 274,087

Statements of profit or loss for the years

ended 31 December 20X3 20X4 20X5
£ £ £

Depreciation expense 40,539 40,539 43,932

Finance charge 17,770 16,158 15,623

Question 13

20X1

On 1 January 20X1, the lease liability and right-of-use asset are measured at the present
value of 10 payments of £100,000, the first of which is in one year‟s time, discounted at
the interest rate of 6% per annum = £736,009

Statement of financial position at 31 December 20X1

£
Right-of-use asset
Cost 736,009
Accumulated depreciation (73,601)
NBV 662,408

Current liabilities
Lease liabilities (680,170 – 620,980) 59,190

Non-current liabilities
Lease liabilities 620,980

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 Maynard: Financial Reporting, 2nd edition

Statement of profit or loss for the year ended 31 December 20X1

£

Depreciation expense (736,009/10) 73,601

Finance charge 44,161

Working
Opening Interest Closing
Year liability @ 6% Instalment liability
£ £ £ £
20X1 736,009 44,161 (100,000) 680,170
20X2 680,170 40,810 (100,000) 620,980
20X3 620,980 37,259 (100,000) 558,239
20X4 558,239 33,494 (100,000) 491,733
20X5 491,733 29,504 (100,000) 421,237

20X6

On 1 January 20X6 the lease is modified by a change in the consideration. The payments
are reassessed, and so the lease liability is remeasured based on:
(a) a five-year remaining lease term,
(b) annual payments of £95,000 and
(c) Grafton‟s incremental borrowing rate of 7% per annum.

Remeasured lease liability = £389,519

The difference between the carrying amount of the modified liability and the lease liability
immediately before the modification = 421,237 – 389,519 = £31,718
This is accounted for as an adjustment to (a reduction in the carrying amount of) the right-
of-use asset

Statement of financial position at 31 December 20X6

£
Right-of-use asset
Cost (736,009 – 31,718) 704,291
Accumulated depreciation (5 x 736,009/10) + 67,257 (435,261)
NBV 269,030

Current liabilities
Lease liabilities (321,785 – 249,310) 72,475

Non-current liabilities
Lease liabilities 249,310

Statement of profit or loss for the year ended 31 December 20X6

£

Depreciation expense (368,005 – 31,718)/5 67,257

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 Maynard: Financial Reporting, 2nd edition

Finance charge 27,266

Working
Opening Interest Closing
Year liability @ 7% Instalment liability
£ £ £ £
20X6 389,519 27,266 (95,000) 321,785
20X7 321,785 22,525 (95,000) 249,310

Question 14

Years ended 30 June 20X4 – 20X8

On 1 July 20X3, the lease liability and right-of-use asset are measured at the present
value of 10 payments of £50,000, the first of which is in one year‟s time, discounted at the
interest rate of 6% per annum = £368,005

Summary:

Statements of financial position at 30 June

20X4 20X5 20X6 20X7 20X8
£ £ £ £ £
Right-of-use asset
Cost 368,005 368,005 368,005 368,005 368,005
Accumulated depreciation (36,801) (73,601) (110,402) (147,202) (184,003)
NBV 331,204 294,404 257,603 220,803 184,002

Current liabilities
Lease liabilities 29,595 31,371 33,253 35,248 37,363

Non-current liabilities
Lease liabilities 310,490 279,119 245,866 210,618 173,255

Statements of profit or loss for the years ended 30 June

20X4 20X5 20X6 20X7 20X8
£ £ £ £ £

Depreciation expense 36,801 36,800 36,801 36,800 36,801

Finance charge 22,080 20,405 18,629 16,747 14,752

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 Maynard: Financial Reporting, 2nd edition

Workings:

Opening Interest Closing

Year liability @ 6% Instalment liability
£ £ £ £
20X4 368,005 22,080 (50,000) 340,085
20X5 340,085 20,405 (50,000) 310,490
20X6 310,490 18,629 (50,000) 279,119
20X7 279,119 16,747 (50,000) 245,866
20X8 245,866 14,752 (50,000) 210,618
20X9 210,618 12,637 (50,000) 173,255

The right-of-use asset is depreciated on the straight-line basis with a life of 10 years
Annual depreciation = 368,005 / 10 = £36,800.50

Years ended 30 June 20X9 – 20Y3

On 1 July 20X8 there is a lease modification, with the lease being reduced as a result of
the modification. Effectively part of the asset has been sold, and so a gain or loss on the
disposal has to be accounted for at this date. This is determined by proportionately
reducing both the carrying values of the asset and the lease liability, with the net
difference taken to profit or loss as the gain or loss. The lease liability is then remeasured,
and the resulting difference between this and the adjusted lease liability is accounted for
as for a reassessment.

On 1 July 20X8 Howarth calculates the proportionate decrease in the carrying amount of
the right-of-use asset on the basis of the remaining right-of-use asset. (2,500 square
metres corresponds to 50% of the original right-of-use asset.)

50% of the pre-modification right-of-use asset = 50% x 184,002 = £92,001

50% of the pre-modification lease liability = 50% x 210,618 = £105,309

The accounting is as follows:

Dr Profit or loss 92,001
Cr Right-of-use asset 92,001

Dr Lease liability 105,309

Cr Profit or loss 105,309

resulting in a gain to profit or loss of 105,309 – 92,001 = £13,308

Howarth then remeasures the lease liability based on:

(a) a five-year remaining lease term,
(b) annual payments of £30,000 and
(c) its incremental borrowing rate of 5% per annum.
This equals £129,884

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 Maynard: Financial Reporting, 2nd edition

The difference between the remaining lease liability of £105,309 and the modified lease
liability of £129,884 (= £24,575) is an adjustment to the right-of-use asset reflecting the
change in the consideration paid for the lease and the revised discount rate:

Dr Right-of-use asset £24,575

Cr Lease liability £24,575

Summary:

Statements of financial position at 30 June

20X9 20Y0 20Y1 20Y2 20Y3
£ £ £ £ £
Right-of-use asset
Cost 392,580 392,580 392,580 392,580 392,580
Accumulated depreciation (225,718) (267,434) (309,149) (350,865) (392,580)
NBV 166,862 125,146 83,431 41,715 -

Current liabilities
Lease liabilities 24,681 25,915 27,211 28,571 -

Non-current liabilities
Lease liabilities 81,697 55,782 28,571 - -

Statements of profit or loss for the years ended 30 June

20X9 20Y0 20Y1 20Y2 20Y3
£ £ £ £ £

Gain on part disposal of

right-of-use asset 13,308 - - - -
Depreciation expense 41,715 41,716 41,715 41,716 41,715
Finance charge 6,494 5,319 4,085 2,789 1,429

Workings:

Opening Interest Closing

Year liability @ 5% Instalment liability
£ £ £ £
20X9 129,884 6,494 (30,000) 106,378
20Y0 106,378 5,319 (30,000) 81,697
20Y1 81,697 4,085 (30,000) 55,782
20Y2 55,782 2,789 (30,000) 28,571
20Y3 28,571 1,429 (30,000) -

At 1 July 20X8 the right-of-use asset‟s carrying amount is increased to 184,002 +24,575 =
£208,577 and depreciated over the remaining useful life of 5 years
Annual depreciation = 208,577/5 = £41,715.40

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