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An Example To Illustrate How To Classify A Lease As Finance Lease

slang — Wed, 02 Dec 2009 14:40:25 +0000

Below example demonstrate how to classify a lease into a finance lease:

Question:

ABC Ltd enters a lease agreement on 1 January 2009 to have the right to use the asset for 10 years. The economic life of the asset is 11 years. The fair value of the asset is $12 million. The lessee agreed to pay $1.6 million annually for 10 years at the beginning of each year. The present value of the minimum lease payment is $10.5 million.

Required: How should the lease be classified?

Answer:

On the inception date 1 January 2009, the lease will be classified as a finance lease due to:

the lease period is 10 years, which is 91% of the economiclife of the asset. Therefore it meets the criteria being the lease forms the major part of the economic life of the assets, even if its title is not transferred
the present value of the minimum lease period is substantially all (87.5%) of the fair value of the asset

The asset will be depreciated over 10 years.

Sale And Leaseback-How To Determine whether it is A Finance Lease or Operating Lease And Accounting Treatment

slang — Mon, 07 Jul 2008 10:46:13 +0000

The following are some criteria to classify a sale and leaseback transaction as an operating lease [IAS17.7-14(R.05)]:

A sale has genuinely occurred, where all major risks and rewards were transferred to the buyer;
The buyer (lessor) cannot transfer the leased asset back to the seller (lessee);
The lessee has no bargain repurchase option and the lessor assumes the exposure to risk that the value of the leased asset will fall
The lessee has no option to prolong the lease agreement at conditions significantly more favourable than the market conditions;
The fair value of assets sold and leased is substantially higher than the present value of the minimum lease payments;
The lessor is more than simply a lender – the lessor’s income and exposure to gain and loss is related to property market conditions (for example, rental prices and property values), not just interest rates.

The transaction should be accounted for as a finance lease if any of the conditions above is not fulfilled.

The commerciality of sale and leaseback transactions between related parties in particular should be considered to determine the appropriate lease classification [IAS17.10,21(R.05)]

Accounting treatment:

If the sale and leaseback is a finance lease:

the arrangement is to be treated as a “loan” arrangementand any gain is to be deferred and amortized over the lease period

If the sale and leaseback is an operating lease:

if the entire transaction is at fair value, the gain or loss on disposal is recognized immediately.

If the sale price is above fair value and the rental is above normal market rental, the excess over the fair value is deferred and amortized over the lease period
If the sale price is below fair value and the future rentals are at below commercial rate, the loss is deferred and amortized over the lease period in proportion to the rental payments.

Characteristic Of Finance Lease

slang — Mon, 07 Jul 2008 10:44:20 +0000

Tabulate below are the characteristic that indicates it as a Finance lease:-

Transfer of ownership at the end of the lease term to a lessee [IAS17.10(a)(R.05)].
The lessee has a bargain purchase option [IAS17.10(b)(R.05)].
The lease term covers the major part of the asset’s economic life [IAS17.10(c)(R.05)].
Payments made by a lessee that are a substantial portion of a leased asset’s fair value might be presumed to give rise to a finance lease
The leased asset is constructed to the lessee’s specification and could not be used by others without significant modification [IAS17.10(e)(R.05)]

Accounting For Finance Lease

slang — Sun, 06 Jul 2008 08:15:35 +0000

Summarized below the basic accounting treatment for Finance Lease.

In The Books of Lessee

At the inception the lessee should recognize the lease as an asset and a liability at an amount equal to the fair value of the leased assets.

The liability for a leased asset should be presented separately in the balance sheet as a current liability or a long term liability

Initial direct costs like commission and legal fee incurred in connection with leasing activities to be recognized as part of the leased asset

Lease payments should be apportioned between the finance charges and the reduction in the outstanding liabilities

The depreciation expense should be allocated over the period of the lease similar for assets which are owned.

In The Books Of Lessor

The lessor should recognize assets under a finance lease in the Balance Sheet as a receivable at an amount equal to the net investment in the lease.

The recognition of finance income should be based on a constant rate of return on the net investment.

Initial direct costs like commissions and legal expenses to be debited either immediately in the Income Statement or allocated against the finance income over the lease term.

Accounting For Operating Lease

slang — Sun, 06 Jul 2008 08:02:13 +0000

Summarized below the basic accounting treatment for Operating Lease.

In The Books of Lessee

The lease payment should be recognized as an expense in the Income Statement on a straight line basis over the lease term.

In The Books Of Lessor:

The asset in its balance sheet is under fixed assets

Lease income is recognize in the Income Statement on a straight line basis over the lease term

Costs including depreciation, incurred in earning the lease income are recognized as expense

Initial direct cost are either deferred and allocated to income over the lease term in proportion to the rental income or treated as expense in the Income Statement

The depreciation of leased assets are like the normal way of treating depreciation of fixed assets.

Understand The Differences Between Finance Lease And Operating Lease

slang — Sun, 06 Jul 2008 07:45:50 +0000

For those unfamiliar between Finance Lease and Operating Lease, tabulated below in summary some of the differences:

Finance Lease	Operating Lease
Lease period is normally related to the useful life of the asset	Usually of a shorter duration and bears no relation to economic life of the assets.
Is a non-revocable contract.	Is a revocable one.
The lessee has to bear the risk.	The lessee is protected against risk of obsolescence
Cost of maintainance repairs, taxes, insurance,etc is placed with the lesses unless the contract provides to the contrary	The cost of maintainance,repairs, taxes, insurance,etc are all borne by the lessor.
The lease rental would cover the lessor’s original investment cost plus a reasonable return on the investment.	The lease rentals are generally not sufficient to fully amortize e cost of the asset.