Lease Accounting

Presented to : Sir, Zir u Rehman

Presented by : Muhammad Umar Saleem 54146 (Gp Ldr)
Laique Ahmad 52552
Nasir Habib 52669
Hassan Ahmed 52397
Furqan Ahmad 52434
 Lease

• “An agreement whereby the lessor conveys

to the lessee in return for a payment or series
of payments the right to use the asset for an
agreed period of time.” (IAS – 17)
• A lease in an agreement whereby a party,
the lessor, transfers an asset and the right to
use it to another party, called the lessee in
exchange for periodic lease payments.
 Why Lease
Leasing is an attractive way for many entities to acquire
the right to use an asset without actually buying
the property due to following reasons:-
• Financing can be arranged with a small amount of
down payment.
• 100 % financing for the leased asset is possible.
• Greater tax relief is available than in outright purchase.
• Risk of obsolescence is reduced, like due to rapid
change in technology.
 Why Lease
• Off-balance sheet financing is possible, thus the
borrowing capacity of lessee is increased
• In the case of an operating lease, the debt-equity ratio is
improved.
• Financial statements reflect an improved return on
investment.
• The definition of IAS-17 implies that the lease does not
convey the lessee 100% ownership rights. The lessor, who
owns the asset, only allows the lessee to use the asset for
specific period of time in return of agree amount of rent.
 Essentials of Lease
• The lease, being a contract should set out certain
essential provisions which are :-
• the duration of lease
• amount and timings of rentals
• Lessor’s obligations for taxes, insurance and maintenance.
• Restrictions on lessee relating to incurrence of debts or
dividend declarations
• Lessee’s rights regarding early termination or purchase of
asset at the end of lease term, or to renew the lease.
 Types of lease
Finance Lease
• IAS-17 provides for capitalization of leases where the lease
transfers substantially all of the risks (losses due to idle
capacity or obsolescence) and rewards (ownership, profitable,
residual value) incident to the ownership of the property to
the lessee.
• In such cases, the lessee record the lease as an asset and a
corresponding liability. The lessee treats the transaction as if
the asset was purchased completely.
• In such cases, the lessor will treat his investment “lease
payments receivable” instead of “leased asset”.
Criteria to determine when the risks and reward are transferred
paragraphs 8 & 9 of IAS-17

• Transfer of ownership at the end of lease term

• Purchase option to the lessee at a price which is expected
to be sufficiently lower than the fair value at the date the
option becomes exercisable such that, at the inception of
the lease, it is reasonably certain that the option will be
exercised;
• The lease term is for the major part of the economic life of
the asset even if title is not transferred;
•  At the inception of the lease the present value of the
minimum lease payments amounts to at least substantially
all of the fair value of the leased asset; and
Criteria to determine when the risks and reward are transferred
paragraphs 8 & 9 of IAS-17

• The leased asset is of a specialized nature such that only

the lessee can use it without major modifications being
made.
• If the lessee can cancel the lease, the lessor’s losses
associated with the cancellation are borne by the lessee;
• Gains or losses from the fluctuation in the fair value of the
residual fall to the lessee (for example in the form of a rent
rebate equaling most of the sales proceeds at the end of
the lease); and
• The lessee can continue the lease for a secondary period at
a rent which is substantially lower than market rent.
 Lease Terminologies
Non-cancelable lease (Conditional cancellation)

A non-cancelable lease is a lease which is cancelable either as a result of a remote contingency or

involves substantial penalty that it is unlikely that the lease will be canceled.

Note : only no-cancelable leases can be treated as finance leases. If the lease is cancelable and even
meets all the criteria in para 8 it cannot be capitalized.

Inception of lease
 
The date of inception of lease is the lease agreement date. The only exception is where the
commitment to the principal provisions of the lease has been made prior to the lease agreement.

Lease term

Lease term is usually fixed and non cancelable term. This period normally cannot be reduced. The lease
period however may be extended if the agreement provides for bargain renewal option. This option
allows the lesee to renew the lease at a substantial lower rental than the expected fair rate at the date
the option becomes exercisable.
 Lease Terminologies
Minimum Lease Payments

From standpoint of the Lessee :

Bargain purchase option, or
Residual value guaranteed to the lessor by the lessee or by a party related to the lessee

When a lease contains a bargain purchase option the minimum lease payments include only:-

Minimum rental payments

Bargain purchase option.

Thus, in a lease agreement either bargain purchase option will be included or the guaranteed
residual value.
 
The lessee’s obligation to pay executor costs are excluded from minimum lease payments.
 Lease Terminologies
From standpoint of lessor :

• The minimum lease payments as set out above plus residual value
guaranteed by an independent third party.

• (The guarantor should be financially capable of meeting the guarantee)

• It should be noted that the residual value guaranteed by a party related to

lessee has same effect as a guarantee by the lessee.

• The definition of MLP is important because

(i) The criterion as set out in paragraph 8 (d) compares MLP with fair value

(ii)MLP is the basis for recording finance lease.

 Lease Terminologies
Minimum rental payments

• These are the minimum payments required to be made under the lease
agreement by the lessee to the lessor. IAS 17 has not defined the term “
minimum rental payment” the word “minimum” here indicates that additionally
payments may be involved over and above such minimum rental payments.
 
• Cost of services and taxes to be paid and reimbursable to lessor are not included
in minimum lease payments.
 
• Executor costs may either be assumed by the lessor or lessee or shared between
them. Executor costs are not included by the lessee in the computation of MLP.
 

• If the lessor has the responsibility to pay the executor costs. Such costs should be
excluded from MLP in computing present value of MLP.
 Lease Terminologies
Guaranteed residual value
 
Residual value is the estimated fair market value of the property at the end of lease term.
Sometimes the lessor at inception of the lease, may like to place a specific value to the
residual value.
 
From lessor’s point of view, the guaranteed residual value includes residual value
guaranteed to lessor by an independent third party.
 
Unguaranteed residual value
 
Unguaranteed residual value is that portion of the residual value of the leased asset
(estimated at the inception of the lease), the realization of which by lessor is not assured
or is guaranteed solely by a party related to the lessor
From lessee point of view, in the context of capitalisation of the asset, a lease with
unguaranteed residual value has the same effect as lease with no residual value.
 Lease Terminologies
Bargain purchase option

This term also has not been defined in IAS 17. The bargain
purchase option represents a payment by the lessee to the
lessor, at the end of the lease term virtue of which the lessee
obtains legal title to the property.

Fair value

Fair value is the price at which the asset can be sold to an

unrelated party. It generally represents cost less trade discount.
 Lease Terminologies
Gross investment in the lease

Gross investment in the lease equals minimum lease payments from view point
of lessor plus unguaranteed residual value. In case the lessor has to pay any
executor costs which are reimbursable to him, such costs are excluded from the
gross investment.

Net investment in the lease

Net investment in the lease is the gross investment less unearned finance
income.

Unearned finance income It is the difference between gross investment in the

lease and the present value or the gross investment.
 Lease Terminologies
Interest rate implicit in the lease
 
It is discount rate that, at the inception of the lease, causes the
aggregate resent value of the minimum lease payments and the
unguaranteed residual value to be equal to the fair value of the lease
asset, net of any grants and tax credits receivable by the lessor.
 
Lessee’s incremental borrowing rate
 
It is rate of interest that the lessee would have to incur on a similar lease,
or if it is not determinable, the rate that, at the inception of lease, the
lessee would incur to borrow on a similar term, and with a similar
security, the funds necessary to purchase the asset.
 Lease Terminologies
Present value of minimum lease payment

Present value of minimum lease payments is the value at the present

time of future sums of minimum lese payments discounted at
compound interest.
 
Contingent rentals
 
Contingent rentals are not fixed per period, but depend upon future
events and therefore cannot be ascertained at eh inception of lease.
The rentals are based upon any basis other than time period.
 INTERPRETATIONS
Consistency in classification of leases by the lessee and the lessor

Paragraph 7 recommends that so far as possible, both the lessor and the lessee should classify
the lease in the same way. It however, states “ the application of these definitions to the differing
circumstances of the two parties may sometimes result in the same lese being classified differtly by
lessor and lessee”
 

Real estate leases

Paragraph 11 provides that the classification criteria for land and building are the same as that
for any other lease.
 
IAS 17 does not provide guidance in situations where a lease involves both the land and building.
In such cases the S GAAPs recommend that ownership criteria is met both the land and building will be
treated as finance lease but it would be necessary to define separately the present value of the
assigned to building will be depreciated over its economic life and the land will not be depreciated.
 
If land and building are treated as a single unit, following criteria will be applied to the assigned
value of the building in order to determine lease classification.
 INTERPRETATIONS
The lease term is for the major part of the useful life of the asset.
 
or
 
The present value of the minimum lease payments is substantially the fir value assigned to
the building.
In case of any above conditions, the building will be classified as finance lease. Incase
none of the conditions above the building will be treated as an operating lease.
 
Leases involving land only
 
In case of land the risks and rewards are transferred to lessee only if title is transferred
or the lease contains bargain purchase option.
The lease for land is classified as finance only of any one of the first two criteria of Para
8 of IAS 17 is met: otherwise it will be operating lease.
 INTERPRETATIONS
BARGAIN PURCHASE OPTION
 

The bargain purchase option gives the lessee an option to purchase the lease asset at a price which is
substantially below its fair value. Another related term is Bargain Renewal Option this option allows
the lessee to renew the lease for a rental that is sufficiently lower than the expected market rental of
the property at the exercise date of the option. Both the lessor and the lessee account bargain
purchase option similar to guaranteed residual value as regards:
 
• Computation of periodic rentals
• MLP computation
• Amount charged to asset under finance lease
• Recognition of lease obligation
• Amortization of lease obligation

The only difference is indicated by paragraph 20 of IAS 17 which requires that in case of reasonable
certainty of transfer of ownership,(Bargain Purchase Option) the lessee uses the useful life of asset as
depreciation base; in case of guaranteed residual value the asset is depreciated over the lease term.
 LEASES IN THE FINANCIAL STATEMENTS OF THE
LESSORS INTERPRETATIONS
(Para 28 thru 33)
Finance lease

I finance lease all risks and reward are transferred to lessee. Assets held under such a
lease should, therefore, be recognized in the books of lessor not as fixed asset but as
receivable. A the amount equal to net investment in the lease. Net investment in the
lease ins basically to gross investment or receivable les the unearned finance income
included in such receivables. The gross investment includes minimum rental payments
plus residual value whether guaranteed or not the residual value is applicable only
when the lessor expects to get back the asset at the end of the lease term.

Paragraph 30 requires that recognition of finance income should be based on a

pattern reflecting a constant periodic rate of return on net investment
outstanding.Paragraph 31 clarifies that the periodic rentals be segregated into
recovery of principal and
finance income.
 LEASES IN THE FINANCIAL STATEMENTS OF THE
LESSORS INTERPRETATIONS
(Para 28 thru 33)
• Total finance income is the difference between the
gross investment an the fair market value of the leased
asset. The allocation of total finance income earned
during the lease term should be made on a basis which
should reflect a costnat rerate of return on the
outstanding balance of the net investment.

• In this connection, institute of chartered accountants of

Pakistan has issued circular to its members, prohibiting
leasing companies to use sum of digits method
 LEASES IN THE FINANCIAL STATEMENTS OF THE
LESSORS INTERPRETATIONS
(Para 28 thru 33)
Residual values

Residual values are particularly important where the useful life of the
asset exceeds the lease term, in case the lesae does not meet criteria
(a) and (b) as set out in paragraph 8 of IAS 17 the lessee will have to
give back the asset to the lessor.

IAS 16 defines residual value as “the amount which the enterprise

expects to obtain for and asset at the end of the useful life after
deducting the expected costs of disposals”
 

In the question involving residual values it is necessary to determine

which party (lessor or lessee) shall own the leased asset and
consequently the residual value at end of lease term.
 LEASES IN THE FINANCIAL STATEMENTS OF THE
LESSORS INTERPRETATIONS
(Para 28 thru 33)
• If the estimated residual value at end of lease
term is purchased by the lessee through bargain
purchase option, such bargain purchase option is
included in the lease accounting both by the
lessor and the lessee.
 

• If asset reverts back to lessor and he retains the

residual value, the lessor has a risk that the leased
asset may not be carefully handled by the lessee.
So it causes two types of residual value
 LEASES IN THE FINANCIAL STATEMENTS OF THE
LESSORS INTERPRETATIONS
(Para 28 thru 33)
Unguaranteed residual value
 
If the lease provides that at the end of the lease term the asset will revert to
lessor, any residual value will be owned by the lessor. If such residual value is
unguaranteed by the lessee, the lessor will compute the periodic rentals b
subtracting the present value of the estimated residual value from the total
amount to be removed under the lease agreement.
 
Guaranteed residual value
 
When the lessor retains the residual value of the asset, the lease agreement
may require the lessee to guarantee all or part of the estimated residual value
at the end of lease term. If the actual, residual value is less than that
guaranteed, the lessee will have to pay the difference to the lessor.
 LEASES IN THE FINANCIAL STATEMENTS OF THE
LESSORS INTERPRETATIONS
(Para 28 thru 33)
Residual value guaranteed by third party
Residual value of a leased asset may be
guaranteed for a fee in full or part by a third
party guarantor and retained by the lessor. In
such case, the lessor will include the present
value of both, the rental payments and
guaranteed residual value in the minimum
lease payments.
 FINANCE LEASING BY MANUFACTURERS OR DEALERS
INTERPRETATION
(PARA 34 TO 38)
• Manufacturers or dealers sometimes offer customers the option of leasing the
asset instead of outright purchase, in such cases the leases result in
manufaturerer’s or dealer’s profits or loss to the lessor. the leasing in such cases
is used by the manufacturers or dealers as marketing technique. leaes of ghese
types are referred to as “sale type” lease.

• The sale type lease transfers substantially all the risks and rewards of the leased
property to the lessee who records the transaction as a finance lease.

• Paragraph 35 provides that a finance leae by a manufacturer or dealer consists of

• The profit or loss arising from outright sale

• The finance income over the lease term
 FINANCE LEASING BY MANUFACTURERS OR DEALERS
INTERPRETATION
(PARA 34 TO 38)

• The manufacturers or dealers sometimes make an arbitrary reduction

in interest rates instead of reducing selling prices of their products.
The basic difference between direct finance leases and sale-type
leases is that in the latter case manufacturer’s or dealer’s profit or
loss is recognized at the inception of lease.
• In an examination question involving the sale-type lease following
amounts need to be determined:-

(a) Gross investment

(b) Fair value of the leased asset
(c) Cost
 FINANCE LEASING BY MANUFACTURERS OR DEALERS
INTERPRETATION
(PARA 34 TO 38)

The above information is required to pass

following entry

Leases receivable X
Cost of goods sold X
Sales X
Inventory X
Unearned finance income X
 FINANCE LEASING BY MANUFACTURERS OR DEALERS
INTERPRETATION
(PARA 34 TO 38)

Leases receivable
 
• Is charged with gross investment, computed as follows

• “minimum lease payments (excluding executor cost) plus

unguaranteed residual value accruing to lessor.

Cost of goods sold

• Is debited with historical cost or carrying value plus initial direct

costs is any
 FINANCE LEASING BY MANUFACTURERS OR DEALERS
INTERPRETATION
(PARA 34 TO 38)

Unearned finance
 
Income is credited by an amount which is equal to:-
 
Gross investment
Less present value of MLP plus present value of
unguaranteed residual value.
 DISCLOSURE BY LESSOR INTERPRETATIONS
(PARA 39-40)
• Following disclosures are mandatory:-
 
(a)A reconciliation between the total gross investment is lease at balance sheet date, and the
present value of minimum lease payments receivable at the balance sheet date. In addition an
enterprise should disclose the total gross investment in leaee and the present value of
minimum lease payments receivable at the balance sheet date, for each of the following
periods
 
(i) not later than one year
(ii)later than one year but not later than five years
(iii) later than five years
 
(b)Unearned finance income
(c) The unguaranteed residual value accruing to the benefit of the lessor
(d)The accumulated allowance for uncollectible lease payment receivable.
(e)Contingent rents recognized in income.
 DISCLOSURE BY LESSOR INTERPRETATIONS
(PARA 39-40)
• Although the following disclosures are not tequired by
IAS 17, it is believed that information regarding
following matters will be use ful for the users of the
financial statements.
 
(a)Net investment in respect to associated companies
and subsidiaries
(b) Treatment of residual values in computing total
profit and in allocating profit over the lease term
(c)Brief description of leasing activities of the lessor.
 SALE AND LEASE BACK INTERPRETATIONS
(PARA 49-57)
Following disclosures are mandatory:-
 
(a)A reconciliation between the total gross investment is lease at balance sheet date, and the present value of minimum lease
payments receivable at the balance sheet date. In addition an enterprise should disclose the total gross investment in leaee
and the present value of minimum lease payments receivable at the balance sheet date, for each of the following periods
 
(i) not later than one year
(ii)later than one year but not later than five years
(iii) later than five years
 
(b) Unearned finance income
(c)The unguaranteed residual value accruing to the benefit of the lessor
(d) The accumulated allowance for uncollectible lease payment receivable.
(e)Contingent rents recognized in income.
 
Although the following disclosures are not tequired by IAS 17, it is believed that information regarding following matters will
be use ful for the users of the financial statements.
 
(a)Net investment in respect to associated companies and subsidiaries
(b) Treatment of residual values in computing total profit and in allocating profit over the lease term
(c)Brief description of leasing activities of the lessor.
 SALE AND LEASE BACK INTERPRETATIONS
(PARA 49-57)
A sale and lease back transaction involves sale of an asset by a vendor and the leasing of the same asset back to the vendor. Both the
transactions take place simultaneously.

In a sale and lease back transaction, one of the following situations may arise:-
 
(a) the lessee continues the sue of the asset without interruption. Here the transaction is effectively mode of financing. The lessee
borrows the funds from the lessor to improve the liquidity. The lease is classified as finance lease.

(b) the lessee gives up the right of use of asset sold to lessor. In this case the transaction is a sale of asset to lessor. It is an
operating lease.
 
Accounting treatment case (a)
 
Para 50 provides that if the sale and lease back transaction results in a finance lease, any excess of sale proceeds over the book value should
not be immediately recognized as income in the financial statements of the seller lessee.
 
If the sale value is less than book value, the apparent loss arising on such sale and lease back ended not be charged in full to profit an
loss unless there has been a permanent diminution in the value of asset
 
Accounting treatment case (b)
 
When a sale and lease back transaction does not of the criterion for finance leases and sale prices established at fair value, IAS 17 provides
that any profit and loss should be recognized immediately.
 SALE AND LEASE BACK INTERPRETATIONS
(PARA 49-57)
The reason for such treatment is that where fair value of asset is less than the book value,
loss should be recognized immediately as it is a real loss.
 
Sub leases or back to back leases
 
In case of sub leases three parties are involved:

(a)Original lessor
(b) Intermediate party (lessee on one hand, sub lessor on the other hand)
(c)Ultimate lessee
 
The accounting treatment in the books of the original lessor and ultimate lessee is not
different from the normal leasing arrangements. The lease is entered between the
original lessor and the intermediate party. This agreement is not affected if the
intermediate party enters into another agreement with an ultimate lessee.
 PRESENT VALUE COMPUTATIONS
The computations facilitate determining present value of residual value and bargain purchase options, the present value of annuities relating
to minimum rental payments, computation of interest rate and case price. Accounting for leases assumes that money has time value.
 
The present value concept provides an answer to the following question. “What is the value today of an amount to be received or paid
at a future date”?
 
Time value of money
 
Time value of money is based on the old adage that a rupee in the hand today is worth more than a rupee to be received 6 years from
today.
 
Compound interest
 
If the interest is paid number of times in a year, the compound annual interest rate is not the same as compared to interest payment
yearly.

 
n
(1+X/n) -1
 
Where
 
X= rate of interest
N= number of times interest is paid
 PRESENT VALUE COMPUTATIONS

Present value of single sum

n  
P= S x 1/(1+i)
 
Where
 
S=future value
P=principle value
I=interest rate
N=number of years
 
n
Present value of an ordinary annuity  
P= R x 1-(1+i)/i
 Leasing in Pakistan
In order to regulate the leasing companies in Pakistan, the corporate law authority has
issued a notification dated 4 June, 1996 setting out certain rules. These rules are
called “ The Leasing Companies (establishment and Regulation) Rules 1996”

Leasing companies started operations in Pakistan in 1984. As of today 25

companies are listed at the Karachi Stock exchange with a paid up capital of over
Rs. 3 billion.
 
The corporate law authority (CLA) grants permission for formations of leasing
companies, CLA and State Bank of Pakistan are responsible for regulations of the
leasing companies.
 
Major items available for leasing include manufacturing equipment, printing
presses, contactors’ machinery, computers and office equipment, motor vehicles,
aircraft, medical equipment and other machinery and equipment.
 Summary of significant regulations relating to leasing
{The leasing companies (establishment and regulation) rules 1996}

• Leasing companies in Pakistan have to follow IAS 17

 
• The form of organization allowed is only public listed company
 
• No leasing company can start operations unless it has been registered and a license has been obtained
•  
• Except for computer lease term has to be minimum three years
 
• Exposure of the leasing company to its directors, affiliated companies, and companies in which director or his family
members hold controlling interest, is restricted to 10% of the overall port folio of leasing
 
• Financing for real estate is not permitted (except for factory building)
 
• Current ration should not fall below 1:1
 
• Debt equity ratio is required to be maintained at 60:40
 
• Minimum paid up capital should be Rs200 million
 
• Unsecured facilities are not permitted
 Summary of significant regulations relating to leasing
{The leasing companies (establishment and regulation) rules 1996}

• 20% of net profit is to be transferred to a special reserve until this reserve matches the paid up capital, afterwards, 5%
of earnings shall be transferred to reserves
 
• At least 5% of the fund based facilities are to be provided to small entities having fixed assets of not more than 20
million
 
• Maximum exposure to a single group is restricted at 30% of net investment in lease finance of the company
 
• Leasing modrabas are provided with tax exemption if at least 90% of profits are distributed to share holders in the form
of cash dividends
 
• All leasing companies during each of the five financial years beginning July 1, 1998 and ending June 30, 2003, shall
provide deferred tax liability arising in that year together with further amount equal to one-fifth of the unprovided
deferred tax liability as at the beginning of the financial year ending june 30, 1999. The un provided deferred tax liability
at each year end together with other pertinent information shall continue to be disclosed
 
• Subject to full compliance with the provision o f IAS 12, the requirements in the preceding para shall be deemed to be
met where during each o the five financial years beginning July 1, 1998 and ending June 30, 2003, a leasing company
consistently transfers to a capital reserve an amount equal to the aggregate amount determined in accordance with the
provisions of the said para, reduced by the amount, if any, provided for deferred tax liability. This capital reserve shall
not be available for utilization for any purpose other than to provide for deferred tax liability.
 INSTALLMENT SALES
Significant characteristics of installment sales
 
1.Seller has a night to property
 
2.Installment sales is high risk business because of heavy bad debts
 
3.Accordingly revenue recognition is related to the periods in which cash is collected rather than in which made 4 each
collection on an installment contract is regarded as representing both a return of cost and realizable the same in which
the cost and profit has been computed at the time of signing the
 
4.Contract the profit the life of the contract
 
5.A provision may be required for possible failure to realize full amount of profit in the event of default
 
6.The difference between sales and cost of sales is recorded as deferred gross profit
 
7.Deferred gross profit is amortized and taken to income on the basis of collections
 
8.Ending balance of deferred gross profit is equal to gross profit percentage applied to balance on Installment receivable
 INSTALLMENT SALES
9.in other words
 
(a) Gross profit percentage applied to collections represents gross profit recognized for period
 
(b) Gross profit percentage applied to installments receivable at end of period is equal to deferred gross at end of period
 
10. Deferred gross profit effectively represents deferral of revenue related costs and gross profit
 
11. Operating expenses are recognized in the period in which they are incurred
 
12. In case of default it will be necessary to
 
(a) Cancel the balance of the customer
(b) Cancel deferred gross profit
(c) Record property at its fair value
(d) Gain or loss on repossession will be the difference of
 
(i)Property recognized and
(ii) Customer balance cancelled