ACCOUNTING FOR LEASES (IAS 17)

 Lease is a contract between a lessor and a leasse, whereby the lessor conveys to the
lessee, in return for the payment of specified rentals, the right to use an asset over an
agreed period of time.
 In lease contract the lessor remains the owner

Terms used in leasing

1. Lessor: This is the person, who under an agreement conveys to another person (the
lessee) the right to use in return for rent, an asset for an agreed period of time.
2. Lessee: this is a person, who under an agreement obtains from another person (the
lessor) the right to use, in return for rent, an asset for an agreed period of time.
3. Non-cancellable lease: A lease that is cancellable only under the following
conditions: Upon the occurrence of some remote contingency, with the permission of
the lessor,if the lessee enters into a new lease for the same or any equivalent asset
with the same lessor, or upon payment by the lessee of an additional amount such that
at inception continuation of lease is reasonably certain
4. Inception of the lease: Thus it is the date that the principal provisions of the lease are
committed to in writing by the parties.
5. Lease term/period : This is the period of the lease contract/agreement
6. Minimum lease payments: the payments over the lease term that the lessee is or can
be required to make (excluding costs for services and taxes to be paid by and be
reimbursable to the lessor) together with the residual value. It’s the sum of all
installments payable by the lessee to the lessor.
7. Fair value: the amount for which an asset could be exchanged between a
knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s length
transaction. It’s the cash purchase price.
8. Present value: This is obtained by discounting the minimum lease payments using
interest rate implicit in the lease as a discount factor
9. Useful life: In the case of an operating lease it is either the period over which a fixed
asset is expected to be used by the enterprise; or the number of production (or similar)
units expected to be obtained from the asset by the enterprise. In case of a finance
lease, the useful life of the asset is the lease term.
 10. Interest rate implicit in the lease: it is the discount rate that equates the present
value of the minimum lease payments plus the unguaranteed residual value to the fair
value of the leased property at the inception of the lease less any investment tax credit
retained and expected to be realized by the lessor.
11. Gross investment in the lease: the aggregate of the minimum lease payments under a
finance lease from the standpoint of the lessor.
12. Unearned finance income: the difference between the lessor’s gross investment in
the lease and its present value.
13. Finance charge: This is any fee representing the cost of credit or the cost of
borrowing. It is interest accrued on and fees charged for some forms of credit. This is
the determined by finding the difference between the minimum lease payments and
the fair value of the asset.
14. Net investment in the lease: the gross investment in the lease less unearned finance
income.
15. Bargain option: it is an option that can be exercised by lessee to renew the lease or
purchase the leased property for an amount which is sufficiently below the expected
future market value. Such an option appears at the inception of the lease.
16. Estimated economic life of the leased property: the expected remaining period
during which the property is expected to be economically usable for the purpose for
which it was intended at the inception of the lease.
17. Unguaranteed residual value: The expected fair value of the leasehold property at
the end of the term (excluding the amount of any guarantee) included in the minimum
lease payments.

TYPES OF LEASES
Leases are categorized into finance, operating lease and leveraged
1. Finance/capital leases:
 This is a lease that transfers substantially all the risk and reward of ownership of the
assets to the lessee.
  This leases are usually non-cancellable and at the end of the initial lease period title
may or may not be passed to the lessee.
 The risks associated with asset ownership include losses from idle capacity, losses
from technical obsolescence and the variations in return due to changing economic
conditions
 The rewards associated with asset ownership include expectations of profitable
operations over the assets economic life and gain from appreciation in value of an
asset, or realization of a residual value.
Criteria of categorizing finance/capital leases
1. The lessor often transfers ownership of the leased asset to the lessee at the end of the
lease period but till then the lessor retains the title of the asset
2. The lease agreement contains a bargain purchase option.
3. The lease period is equal to 75% or more of the estimated useful life of the asset
4. The present value of the minimum lease payments must be 90% or more of the fair
value of the leased asset
5. The lessee cannot cancel the lease without paying adequate compensation to the lessor
6. The lessee is responsible for repairs, maintenance and insurance of the asset.
2. Operating leases
 A lease is classified as an operating lease if it does not secure for the lessor the
recovery of his capital outlay plus a return on the funds invested during the lease term.
 This is a lease other than the finance lease i.e. it’s a cancellable lease
 In operating lease assets are ‘rented out’ to many different lessees (users) over the
useful life of the asset and the lessee pays for the hire or the use of the asset.
 Ownership of the asset remains with the lessor, who assumes all the risks and rewards
of the asset and takes responsibility for repairs, maintenance and insurance expenses.
 Therefore, the asset should be treated by the lessor as a fixed asset and rentals
receivable should be included in his/her income over the lease term.
 In case of operating lease, the following transactions is to be passed in the books of
the lessee. when rent is paid on the leased property DR Rent A/c and CR Cash A/c
 In the books of the lessor the following transaction should be passed:
a) When rent is received under the lease contract. Dr: Cash A/c and Cr: Rental income
b) When depreciation is to be charged. Dr: Depreciation A/c and Cr: Accumulated
depreciation A/c
 c) When insurance/maintenance/taxes are paid. Dr: Insurance/maintenance/taxes A/c and
Cr: Cash A/c
Distinction between an operating lease and a finance lease
Operating lease Finance lease
1 It is usually for a shorter duration and bears no It is usually related to the useful life of the asset
relation to the useful life of the asset.
2 It’s a revocable contract/cancellable It’s non -revocable contract i.e. non-cancellable
3 The lessor is responsible for repairs, The lessee is responsible for repairs, maintenance
maintenance and insurance of the asset and insurance of the asset
4 The lessee does not incur any risks associated The risk of the asset ownership is taken by the
with the assets lessee
5 The rentals are not sufficient to fully amortize The rentals would cover the lessor’s original
the cost of the asset investment cost plus a reasonable return on
investment
6 There is no option to review or buy the lease It provides for an option to review the lease or to
buy the asset at a nominal price at the expiration
of the lease period.
3. Leveraged Lease
 A leveraged lease is a finance lease and has all the following characteristics:
(i) It involves at least three parties; a lessee, a lessor and one or more long term creditors
(ii) The creditor’s recourse to the lessor in the event of default is restricted to the proceeds
from the disposal of the leased asset and any unremitted rentals relating thereto; and
(iii) The lessor’s investment in the lease declines in the early years of the lease and
rises in later years before its final elimination.
 This is used in those cases where huge capital outlays are required for acquiring
assets. In this type also, the lessee makes contract for periodical payments over the
lease period and in turn is entitled to use the asset over the period of time.
 Legal ownership of the leased asset remains with the lessor who is, therefore, entitled
to tax deductions such as depreciation and other allowances.
 It is appropriate therefore, that the method of finance income recognition on leverage
lease should take account of the cash flows resulting from the tax benefits. The
following methods can be used to recognize finance income:
a) Net cash investment method
  The net cash investment in the lease is the balance of the cash outflows and inflows in
respect of the lease, excluding flows relating to insurance, maintenance and similar
costs rechargeable to the lessee.
 The cash outflow includes payments made to acquire that asset, tax payments, interest
and principal on third party financing while cash inflows include rentals receipts,
receipts from residual values and grants, tax credits and other savings or repayments
arising from the lease.
 Under the net cash investment, a lessor recognizes finance income based on a pattern
reflecting a constant periodic return on its net cash investment outstanding in respect
of the finance lease.
 Lease rentals relating to the accounting period, excluding costs for services, are
applied against gross investment in the lease to reduce the principal and the unearned
finance income.
 Hence, this method usually involves using a net-of-tax basis for the allocation of
income.
 The net cash investment method is often considered to be the most appropriate
method of accounting for finance income from lease that have been entered into
largely on the basis of the tax benefits that are expected to flow from the lease

b) Net investment method

 The net investment in the lease is the gross investment in the lease less any unearned
finance income.
 Remaining unearned income is allocated to revenue over the lease term so as to
produce a constant periodic rate of return on the net investment in the lease.
 The use of the net investment method is usually supported on the basis that the lessor
earns income for lending money to the lessee, which at any particular time is the
amount of the outstanding net investment in a lease
Sale and lease back
 A sale and leaseback transaction involves the sale of an asset by the vendor and the
leasing of the same asset back to the vendor. The rentals and the sale price are usually
interdependent as they are negotiated as a package and may not represent fair values.
 For a sale and leaseback transaction that results in a finance lease, any excess of
proceeds over the carrying amount is deferred and amortized over the lease term.
  For a sale and leaseback transaction that results in an operating lease the following
applies:
a) If the transaction is clearly carried out at fair value - the profit or loss should be
recognized immediately;
b) If the sale price is below fair value - profit or loss should be recognized immediately,
except if a loss is compensated for by future rentals at below market price, the loss
should be amortized over the period of useful life of the asset;
c) If the sale price is above fair value - the excess over fair value should be deferred and
amortized over the period of useful life of the asset
d) If the fair value at the time of the transaction is less than the carrying amount - a loss
equal to the difference should be recognized immediately.

ACCOUNTING FOR FINANCE LEASES

Although the lessee does not obtain the legal title, in the case of finance lease, the lessee’s
rights and obligations are such that the risks and rewards from the use of the asset are
substantially similar to those of an outright purchaser.
The lessee therefore in the statement of financial position will:
 Include finance lease assets together with other owned non-current assets but it must
be clearly stated as leased asset.
 Show a liability in respect of the lease payments not yet made. This liability should be
split into current and non-current/long term liabilities.
The lessee in the statement of income will:
 Show the depreciation on the asset during the year as an expense
 Show the portion of finance charge allocated to the year as expense
NOTES:
1. The amount to be capitalized are recorded in the statement of financial position as an
asset (as well as obligation) should be the present value of the minimum lease rentals
- discounted at the rate of interest implicit in the lease. However, in many cases, the
fair value of the asset will provide a reasonable approximation to the above.
2. The asset should be depreciated over the shorter of the lease term, and the asset’s
useful life. The lease term includes: the period for which the lessee has contracted to
lease the asset (i.e. the non-cancellable primary period) plus Any further secondary
 periods under which the lessee has an option to continue leasing the asset (possibly
renewing on an annual basis)
3. The payments made by the lessee (henceforth known as rentals) should be
apportioned between finance charge and repayment obligation. The finance charge
refers to the difference between the total of rentals Minimum lease payments) and the
fair value of the asset.
4. By the end of the lease period, the total payments would have covered: The full value
of the asset and the full finance charge
Allocation of finance charges
The key principle is that the total finance charge should be allocated to accounting periods
during the lease term so as to produce a constant periodic rate of charge on the obligation
outstanding.
Three methods can be used to allocate the finance charge include:
a) Straight line/level spread method: Under this method the finance charge is divided
uniformly among the accounting periods. This method goes against the requirement of
IAS 18 and therefore it’s not commonly used. To allocate the finance charge the
following can be adopted:
Finance charge/useful life of the asset
b) Sum of digit/rate of 78 method: This method splits the total interest without
reference to a rate of interest in such a way that a greater proportion falls in the earlier
years. The steps to follow to allocate finance charge include:
(i) Number the installments giving the highest digit to the first installment and the lowest
digit to the last installment.
(ii) Add up the digits
(iii) Apportion to each accounting period a proportion of the finance charge for
each installment paid in the period.
The sum of digit may be obtained as by: N (N+1)
2
Where: N – this is the number of financial periods
c) Actuarial method: Under this method the implicit rate of interest is to be calculated.
The cumulative factor is established by:
Fair value
Annual rentals
  Once the factor is determined use the present value of annuity table to establish the
rate of interest
 The rate calculated is then applied on the outstanding liability to determine the
finance charge for each year.
 An amortization schedule is prepared to show how the finance charge is distributed.
The amortization schedule includes the following when the payments are made in
arrears:
(i) The period
(ii) Amount outstanding at the beginning of the year
(iii) Interest charged during the year= (Interest rate* amount outstanding at the
beginning).This is the finance charge allocated for the year
(iv)Amount outstanding at the end of the year ( pre installment)= Amount outstanding at
the beginning + interest charged during the year
(v) Installment paid/rentals amount
(vi)Closing liability = Amount outstanding at the end of the year –installment paid
 When the lease payments are made in advance, the installments for which interest
will apply are reduced by one e.g. if the installment was for 5 years it will be
4.Inorder to compute the cumulative amount in case of actuarial method the following
formula applies.
Fair value- lease payment
Minimum lease payments (rentals)
 The amortization schedule includes the following when the payments are made in
advance
(i) The period
(ii) Amount outstanding at the beginning of the year
(iii) Installment paid/rentals amount
(iv)Amount outstanding at the end of the year after installment= Amount outstanding at
the beginning - installment
(v) Interest charged during the year= (Interest rate* amount outstanding after
installment).This is the finance charge allocated for the year
(vi)Closing liability = Amount outstanding at the end of the year + Interest charged
Accounting for the finance lease
  The lessee will maintain the following accounts: lessors account, Finance charge,
Asset account and Accumulated/provision for depreciation account.
 The following entries are passed in the books of the lessee;
(i) When assets are first acquired: DR Asset account and CR Lessor account with the fair
value or cash price of the asset.
(ii) Dr the asset account and CR lease payable account with the present value of minimum
lease payments
(iii) At the end of the year within the lease period: DR Finance charge account and
CR lessor account with the finance charge apportioned.
(iv)At the end of the year within the lease period: DR Profit and loss account and CR
finance charge with the finance charges apportioned.
(v) When the rentals are paid to the lessor: DR lessor account and CR cash account.
 For the statement of financial position purposes, the outstanding liability at the end of
any year should be split into:
(i) Current liabilities-This is amount of liability payable within one year period
(ii) Non-current liabilities-This is amount of liability payable after expiry of one year
from the end of the statement date.

Separation of current and non-current liability

1. The total liability at the end of year is the balance c/d in the lessor account at the end
of the year
2. The amounts of liability payable in the following year is the current liability in the
balance sheet for the end of year 1
3. The long term liability in the statement of financial position for the end of the year is
arrived as follows:
 Splitting the installment payments after the expiry of one year from the balance sheet
date into interest charges(finance charge) and liability repayment
 Adding all the liability repayments together
 The total is the long term liability
This can be summarized as follows:
In the lessor A/C, the balance c/d at the end of any given year makes up the total liability for
the end of that year. If this amount is to be split into current and long term liabilities, the
amount of balance c/d, at the end of the following year is deemed to be the long term liability.
Lessor A/C__________________________________
Year 1 Amount
Year 1 Amount
Cashbook XX Asset A/C XX
(2) Balance c/d X Finance Charges XX
XX XX
Year 2 Year 2
Cashbook XX Balance b/d XX
(1)Balance c/d XX Finance Charges XX
XX XX
N/B: The balance b/d in year 2 is the balance c/d the end of year 1
Statement of financial position Extract for (year 1)
Non-current assets Cost Depreciation N.B.V
Assets XXX (XX) XXX
Current Liabilities:

Obligations under finance XX XXX

lease (2) - (1)
Long term liabilities
Obligations under finance XX XXX
lease (1)
Example I:
B limited entered into an agreement to lease a vehicle from M limited that had a fair value of
shs 100,000.M limited accepted the agreement on condition that B limited makes 5
installment of lease payments of shs 25,710.The rental are paid in arrears and the vehicles
depreciates on a straight line basis.
Required:
a) Determine the how finance charge will be apportioned to each year using straight line
method, sum of digit method and actuarial method.
b) Prepare the relevant ledgers in the books of the lessee for all the lease period
c) Show an extract of the statement of financial position for each of the year
Example II
On 1st Jan 2008, ABC limited acquired an item of plant on a finance lease agreement with
XYZ company. The agreement provided that ABC ltd would pay XYZ Company 5 annual
lease payments of shs 62,500 commencing from 1st Jan 2008. XYZ had paid shs 250,000 for
the plant in question. ABC Ltd accounts for the interest charge on the actuarial method and
depreciates the plant at 20% per annum on original cost.
Required:
i) Show how the interest charge will be allocated over the years
ii) Prepare the relevant ledgers in the books of the lessee for all the lease period
iii) Show an extract of the statement of financial position for each of the year

Disclosures requirements in the financial statements of lessees in accordance with

Accounting standards
1) Disclosures should be made of the amount of the assets and liabilities that are subject
of finance leases at each balance sheet date. Liabilities should be divided into either
current or non-current liabilities.
2) Disclosure should be made on the commitments for minimum lease payments under
finance leases and under non-cancellable operating lease with a term of more than one
year by giving the amounts and periods in which the payments will become due.
3) Disclosures should be made of significant financing restrictions, renewal or purchase
options, contingent rentals and other contingencies arising from leases.
4) Disclosures should be made of the basis used for allocating interest expense so as to
produce a constant periodic rate of return
5) Disclosures should be made with regard to accounting policies used when accounting
for finance charge under finance lease, valuation of assets given on the lease and
charge for depreciation.