UNIT FOUR

4. LEASE
4.1 Definition of Lease:
 World over leasing has emerged as an innovative technique of
financing industrial equipment.
 Leading financial institutions have also entered into the business of
equipment leasing and financing.
 The importance of leasing can hardly be over emphasized.

 Lease finance can be said to be a 

“contract between lessor and lessee whereby the former acquires the
equipment/goods/plant as required a specified sum in a specified mode
at specific interval and at a specified place”.
Conti--

 Under the lease financing, an asset can be acquired without incurring the initial
purchase cost by just making payment of lease rentals over a specified period of
the lease contract.
 The periodical lease rentals paid will be shown in the financial position statement
as business expenditure.
 It is basically a contract whereby the owner of the asset (the lessor) grants to
another party (the lessee) to exclusive right to use the asset for an agreed period
of time, for an agreed amount payable on periodical basis (lease rentals) over the
specified lease period.
4.2 Features of Lease
The important features of lease contract are as follows:
a) The lease finance is a contract.
b) The parties to contract are lessor and lessee.
c) Equipment are bought by lessor at the request of lessee.
d) The lease contract specifies the period of contract.
e) The lessee uses these equipment’s.
f) The lessee, in consideration, pays the lease rentals to the lessor.
g) The lessor is the owner of the assets and is entitled to the benefit of
depreciation and other allied benefits e.g., under sections 32A and 32B of the
Income-tax Act.
h) The lessee claims the rentals as expenses chargeable to his income.
Lease rent structure may be in the following ways:
A.Equal Annual Plan: the annual lease rent payable is divided into equal amounts by
applying the annuity factor for the specified period of lease at a predetermined
interest rate taken as discount rate.
B. Stepped-Up Plan: the annual lease rent will go on increasing every year with a
specified rate of increase.
C.Balloon Payment Plan: the annual lease rent payable in the initial year would be
less, fixed up in such a way to meet the nominal amount comparative to the cost of
investment, but the ending years of lease periods, the rest of the amount is payable
in lump sum.
D.Deferred Payment Plan: the lease rent need not be paid for the initial specified
period. But lease rent payable in the subsequent period, in equal annual amounts will
recover the cost of financing for the deferred payment period also.
Lease agreements are basically of two types. They are:
1) Financial lease, and
2) Operating lease.
1) Financial Lease:
A lease is considered as a financial lease if the lessor intends to recover
his capital outlay plus the required rate of return on funds during the
period of lease.
It is a form of financing the assets under the cover of lease transaction.
This lease is preferred in the following situations:
a) When the lessee want to own the asset but does not have enough funds to invest.
b) The time period to use the asset is substantially long at lower lease rentals.
Finance Lease – Definition and Features
According to the IASC, there is a transfer of a substantial part of the ownership-
related risks and rewards if:
i. The lease transfers ownership of the asset to the lessee by the end of the
lease term; (or)
ii. The lessee has the option to purchase the asset at a price which is expected
to be sufficiently lower than the fair market value at the date
iii. The lease term is for a major part of the useful life of the asset. The title
may or may not eventually be transferred; (or)
iv. The present value of the minimum lease payments (See Glossary) is greater
than or substantially equal to the fair market value of the asset at the
inception of the lease. The title may or may not eventually be transferred.
Features of financial leases:
The above discussion leads to the following features of financial leases:

Financial leases allow the asset to be virtually exhausted by the same lessee. Financial leases put
the lessee in the position of a virtual owner.

The lessor takes no asset-based risks or asset-based rewards. He only takes financial

risks and financial rewards, and that is why the name financial leases.

The lease is non-cancelable, meaning the lessee cannot return the asset and not pay the whole of
the lessor’s investment.

In this sense, they are full-payout, meaning the full repayment of the lessor’s investment is
assured.

As the lessor generally would not take any position other than that of a financier, he would not
provide any services relating to the asset. As such, the lease is net lease

The risk the lessor takes is not asset-based risk but lessee-based risk. The value of the asset is
important only from the viewpoint of security of the lessor’s investment.
Conti--
In financial leases, the lessor’s payback period, viz., primary lease period is
followed by an extended period to allow exhaustion of asset value by the lessee,
called secondary lease period.
As the renewal is at a token rental, this option is called bargain renewal option.

Alternatively, if the regulations permit, the lessee may be given a purchase option
at a nominal price, called bargain buyout or purchase option.
In financial leases, the lessor’s rate of return is fixed: it is not dependant upon the
asset-value, performance, or any other extraneous costs.
The fixed lease rentals give rise to an ascertainable rate of return on investment,
called implicit rate of return.
Financial leases are technically different but substantively similar to secured loans.
Substance of financial lease:

If financial leases are substantively so close to secured financing transactions, the
categorical issue is:
why should they be treated as a lease at all?
Why should they not be regulated, taxed and accounted for as plain loan
transactions?
This question may be significant from viewpoint of :
Regulation of financial leasing activity.
Asset rights of the lessor.
Taxation of the lessor/lessee.Accounting for the lease transaction.
In a finance lease, the lessee is:
responsible for repair, maintenance and insurance of the asset.
 undertakes a “hell or high water” obligation to pay rental regardless of the condition
or the suitability of the asset.
A finance lease which operates over the entire economic life of the equipment is called
a “full pay out lease”.

Finance / Capital Lease: is nothing but an alternative solution to borrowing.

 Also known as Full Payout Lease,
 it is an agreement between two parties (Lessor and Lessee) whereby the lessor
purchases the asset and transfers primarily all the rights, risks, and rewards to the
lessee against a periodically fixed rental.
 A capital lease is a long-term, non-cancellable lease.
Features of a Capital Lease
a) Ownership: In a capital lease, ownership transfers to the lessee at the end of the lease period.

b) The Term of Lease: The term of a capital lease extends over the economic life of an asset.

c) Monthly Lease Rentals: Monthly lease rentals or payments are the equated monthly payments
that the lessee pays to the lessor

d) Asset: The lessor has nothing to do with the asset. As he is merely a financier to the asset, the
lessee chooses the assets to purchase, who is the ultimate economic user.

e) Processing Time and Fee: Unlike a loan, there is no processing fee for the lease, and the time
for processing is also relatively more petite than a loan.

f) Margin Money: the lessee does not have to pay any margin money, and a full amount of the
equipment can be financed here.

g) Collateral Security: There is no such requirement of collateral security in the case of a lease
which is a must when taking a huge loan from any bank or institution.
Step Wise Process of Capital Lease Structuring
First of all, the lessee selects the equipment or the asset.
Lessee only negotiates with the manufacturer about the price, features, and
functionality of the assets.
Lessor purchases it from either the manufacturer or, at times, from the lessee.
When the lessor purchases an asset from the lessee and leases it back to the
lessee, it is a different leasing arrangement called Sale and Leases Back.
Post-purchase, the lessor leases the asset to the lessee.
Initially, a lease is agreed upon for the non-cancellable period or the primary
lease period.
During this period, the lessor/investor seeks to recover his invested money
with some profits.
1.3 Accounting for Finance Leases
(a) Accounting for Finance Leases in the Financial Statements of Lessee

 where a lessee enters a finance lease arrangement, it is essentially the same

as acquiring an asset by way of a long-term loan.
 Initial Recognition: the lessee will record an asset (a leased asset) and a
leased liability.
 The asset and liability will be recorded:
 at the fair value of the leased asset or,
 if lower, at the present value (PV) of the minimum lease payments (MLP).

 Minimum lease payments are the payments over the lease term that the
lessee required to make together with the amount guaranteed by the lessor.
Conti--
Initial direct costs: Initial direct costs are defined as incremental costs that are
directly attributable to negotiating and arranging a lease.
Measurement subsequent to recognition: Over the term of the lease, the rental
payments to the lessor constitute a payment of principal plus finance charge, and
the lessee should apportion each payment between the two.
Depreciation of leased asset: A leased asset should be depreciated using the
depreciation methods normally followed by the lessee in relation to the assets that
are owned.
 Example 01
 A lessee enters into a finance lease agreement on 1 April 2015 for a equipment costing Birr
47, 456. The lease requires a down payment of Rs.13,610 and three annual rental of Birr13,
610 payable in arrears starting from 31 March 2016. The implicit interest rate of the lease is
10%. The lessee believes that the equipment will last for four years and there is no scrap
value at the end of that period. The lessee depreciates assets of this type using the straight-
line basis Discount factor
Year DF @ 10%
1 0.909
2 0.826
3 0.751

Required
a) Provide the journal entries to record the transactions in the lessee’s books of accounts
b) Provide the extracts from profit or loss for the year ended 31 March 2016 and Statement of
Financial Position as at 31 March 2016.
 Answer
•Initial Recognition Lower of
Fair value 47,456
PV of MLP 47,456

PV of Minimum lease period (MLP) calculation

 Period Discount Factor
Cash flow
0 13610 1.000 13,610
1 13610 0.909 12,373
2 13610 0.826 11,248
3 13610 0.751 10,225
 Total 47,456
Journalize
Conti--
  Leased Amortization Schedule  
Lease Period Leased liability at Interest Expense Rental Leased liability
the beginning @ 10% at the end

1 33,846.00 23,620.60
3,384.60 (13,610.00)
2 23,620.60 12,372.66
2,362.06 (13,610.00)
3 12,372.66 -
1,237.27 (13,610.00)
Extracts from Statement of Profit or
Loss for the year ended 31 March  
2016
Depreciation (11864)  
Interest expenses (3384.60)  
Conti
Extracts from Statement of Financial Position as at 31 March 2016  
Non-Current Assets Cost Accumulated Carrying Amount
Depreciation
Equipment 47,456 11,864 35,592

Non-Current Liabilities
Leased Liability 12,372.66
Current Liabilities
Leased Liability* 11,247.94

*At the reporting date, the leased liability should be classified as current
liabilities and non-current liabilities. The current liability should be what is
expected to be settled in the next reporting period. At the reporting date (31
March 2016) it is derived from deducting the non-current leased liability from
the total liability (23620.60-12372.66= 11247.94). This can be easily taken
from the lease amortization schedule.
(b) Accounting for Finance Leases in the Financial Statements of Lessor
Initial Recognition: The lease receivable is recorded at the net investment.
 Net investment is ‘the gross investment in the lease discounted at the
interest rate implicit in the lease’.
 LKAS 17 defines the ‘gross investment in the lease’ as the aggregate of:
a) the minimum lease payments receivable by the lessor under a finance lease and
b) any unguaranteed residual value accruing to the lessor( proportion of the residual
value of the leased asset guaranteed by a party related to the lessor).

Measurement subsequent to recognition: The interest to be earned by the

lessor over the lease term will be represented by:
 the difference between the fair value of the leased asset,
 the sum of the undiscounted minimum lease payments and
 any unguaranteed residual value.
Conti--
 The recognition of finance income should be based on a pattern reflecting a
constant periodic rate of return on the lessor’s net investment in the finance lease.
 Consistent with the interest expense for the lessee, the interest revenue for the
lessor is determined by multiplying the opening present value of the lease
receivable by the interest rate implicit in the lease.
Example 02
 A lessee enters into a leasing agreement on 1 April 2015 for a piece of equipment
costing Rs.47, 456. The lease requires a down payment of Rs.13,610 and three
annual rental of Rs.13, 610 payable in arrears starting from 31 March 2016. The
implicit interest rate of the lease is 10%.. The lessee believes that the equipment
will last for four years and will have no scrap value at the end of that period. The
lessee depreciates assets of this type using the straight-line basis. Both the lessee
and the lessor have accounting periods ending on 31 March.
Discount factor table

Year DF @10%
1 0.909
2 0.826
3 0.751
Required
a) Provide the journal entries to record the transactions in the lessor’s books of
accounts
b) Provide the extracts from profit or loss for the year ended 31 March 2016 and
Statement of Financial Position as at 31 March 2016.
Answer
Initial recognition at net investment

PV of MLP 47,456
PV of gross investment calculation
Period   Cash flow Discount Factor Discounted Cash Flow
  0 13610 1.000 13,610
  1 13610 0.909 12,373
  2 13610 0.826 11,248
  3 13610 0.751 10,225
  47,456
Conti--
Extracts from Statement of Profit or Loss for
the year ended 31 March 2016
Interest Income 3,384.60

Extracts from Statement of Financial Position as at

31 March 2016
Non-Current Assets
Leased Receivables 12,372.66

Current Asset
Leased Receivables* 11,247.94
2. Operating Lease:
An operating lease is similar to the financial lease in almost all aspects.

This lease agreement gives to the lessee only a limited right to use the asset and is
generally for a short-term
The main characteristics of operating lease are as follows:
a) The lease can be cancelled by the lessee prior to its expiration at a short notice.
b) The lessor is responsible for upkeep and maintenance of the asset.
c) The lessee is not given any uplift to purchase the asset at the end of the lease period.
d) The lease is for a smaller period.
e) The sum of all the lease payments by the lessee does not necessarily fully provide
for the recovery of cost of the asset.
f) The lessor has the option to lease out the asset again to another party.
 1.4 Accounting for Operating Leases
(a) Accounting for Operating Leases in the Financial Statements of Lessee

 Lessee should handover asset to the lessee after the lease perid. Therefore there is no
ownership to the lessee. Eg : Taking an asset on rental basis. Lease payments are recognised
as an expenses over the lease period.
Example 4
On 1 January 2015 ABC PLC entered in to an operating lease agreement with PQR PLC for the lease
of machinery.
The lease period 3 years

Annual lease instalment Birr.120,000 (Payable on 31 December)

Required:
Provide the journal entries to record the transactions in books of lessee

Operating lease expense Dr 120,000

Cash Cr 120,000
(Recognition of operating lease expenses on machinery)
 1.6 Disclosures
Finance leases (lessees)
a) For each class of asset, carrying amount at the end of the reporting period
b) Reconciliation between the total of future minimum lease payments at the
end of the reporting period and their present value.
c) General description of the lessee’s material leasing arrangements
d) Requirements for disclosure in accordance with LKAS 16, LKAS 36, LKAS
38 apply to lessees for assets leased under finance leases
Finance leases (lessors)
e) Reconciliation between the gross investment in the lease at the end of the
reporting period and the present value of minimum lease payment
receivable at the end of the reporting period
f) Unearned finance income
g) Unguaranteed residual values accruing to the benefit of the lessor
h) General description of the lessor’s material leasing arrangements  
Operating leases (lessees)
a) Total of future minimum lease payments
b) Lease and sublease payments recognized as an expense in the period
c) General description of the lessee’s significant leasing arrangements
Operating leases (lessees)
d) Total of future minimum lease payments
e) General description of the lessor’s significant leasing arrangements

THE END