Relevant to ACCA Qualification Paper F7The accounting topic of leases is a popular Paper F7 exam area that could feature to varying degrees in Questions 2, 3, 4 or 5 of the exam This topic area is currently covered !y "#$ %7, Leases "#$ %7, Leases ta&es the concept of substance over formand applies it to the specific accounting area of leases'hen applying this concept, it is often deemed necessary to account for the su!stance of a transaction ( ie its commercial reality, rather than its strict legal form "n other )ords, the legal !asis of a transaction can !e used to hide the true nature of a transaction "t is argued that !y applying su!stance, the financial statements !ecome more relia!le and ensure that the lease is faithfully representedWHY DO WE NEED TO APPLY SUBSTANCE TO A LEASE?# lease agreement is a contract !et)een t)o parties, the lessor and the lessee The lessor is the legal o)ner of the asset, the lessee o!tains the right to use the asset in return for rental payments*istorically, assets that )ere used !ut not o)ned )ere not sho)n on the statement of financial position and therefore any associated lia!ility )as also left out of the statement ( this )as &no)n as +off !alance sheet, finance and )as a )ay that companies )ere a!le to &eep their lia!ilities lo), thus distorting gearing and other &ey financial ratios This form of accounting did not faithfully represent the transaction "n reality a company often effectively +o)ned, these assets and +o)ed a lia!ility,-nder modern day accounting the "#$. frame)or& states that an asset is +a resource controlled!y an entity as a result of past events and from )hich future economic !enefits are expected to flo) to the entity, and a lia!ility is +a present o!ligation of the entity arising from past events, the settlement of )hich is expected to result in an outflo) from the entity of resources em!odying economic !enefits, These su!stance/!ased definitions form the platform for "#$ %7, LeasesSO HOW DOES IAS 17 WORK?"#$ %7 states that there are t)o types of lease, a finance lease and an operating lease The definitions of these leases are vital and could !e re0uired )hen preparing an ans)er in the examFinance lease# finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset to the lesseeOpea!in" lease#n operating lease is defined as !eing any lease other than a finance leaseClassi#ica!i$n $# a lease"n order to gain classification of the type of lease you are dealing )ith, you must first loo& at the information provided )ithin the scenario and determine if the ris&s and re)ards associated )ith o)ning the asset are )ith the lessee or the lessor "f the ris&s and re)ards lie )ith the lessee then it is said to !e a finance lease, if the lessee does not ta&e on the ris&s and re)ards, then the lease is said to !e an operating leaseFinance lease in%ica!$sThere are many ris&s and re)ards outlined )ithin the standard, !ut for the purpose of the PaperF7 exam there are several important areas The main re)ard is )here the lessee has the right to use the asset for most of, or all of, its useful economic life The primary ris&s are )here the lessee pays to insure, maintain and repair the asset'hen the ris&s and re)ards remain )ith the lessee, the su!stance is such that even though the lessee is not the legal o)ner of the asset, the commercial reality is that they have ac0uired an asset )ith finance from the leasing company and, therefore, an asset and lia!ility should !e recognised1ther indicators that a lease is a finance lease include2 #t the inception of the lease the present value of the minimum lease payments3 amountsto su!stantially all of the fair value of the asset The lease agreement transfers o)nership of the asset to the lessee !y the end of the lease The leased asset is of a specialised nature The lessee has the option to purchase the asset at a price expected to !e su!stantially lo)er than the fair value at the date the option !ecomes exercisa!leFINANCE LEASE ACCOUNTIN&Ini!ial acc$'n!in"The initial accounting is that the lessee should capitalise the finance leased asset and set up a lease lia!ility for the value of the asset recognised The accounting for this )ill !e24r 5on/current assets6r Finance lease lia!ility7This should !e done !y using the lo)er of the fair value of the asset or the present value of the minimum lease payments38*Note !he present value of the "ini"u" lease pay"ents is essentially the lease pay"ents over the life of the lease discounted to present value # you will either be $iven this fi$ure in the Paper F7 e%a" or& if not& use the fair value of the asset' (ou will not be e%pected to calculate the "ini"u" lease pay"ents'SUBSE(UENT ACCOUNTIN&Depecia!i$nFollo)ing the initial capitalisation of the leased asset, depreciation should !e charged on the asset over the shorter of the lease term or the useful economic life of the asset The accounting for this )ill !e24r 4epreciation expense6r #ccumulated depreciationLease en!al)in!ees!'hen you loo& at a lease agreement it should !e relatively easy to see that there is a finance cost tied up )ithin the transaction For example, a company could !uy an asset )ith a useful economic life of four years for 9%:,::: or lease it for four years paying a rental of 93,::: per annum"f the leasing option is chosen, over a four/year period the company )ill have paid 9%2,::: in total for use of the asset 793,::: pa x 4 years8 ( ie the finance charge in this example totals 92,::: 7the difference !et)een the total lease cost 79%2,:::8 and the purchase price of the asset 79%:,:::88'hen a company pays a rental, in effect it is ma&ing a capital repayment 7ie against the lease o!ligation8 and an interest payment The impact of this )ill need to !e sho)n )ithin the financialstatements in the form of a finance cost in the statement of profit or loss and a reduction of the outstanding lia!ility in the statement of financial position "n reality there are several )ays that this can !e done, !ut the Paper F7 examiner has stated that he )ill examine the actuarial method onlyThe actuarial method of accounting for a finance lease allocates the interest to the period it actually relates to, ie the finance cost is higher )hen the capital outstanding is greatest, !ut as the capital gets repaid, interest payments !ecome lo)er 7similar to a repayment mortgage that you may have on your property8 To allocate the interest to a specific period you )ill re0uire the interest rate implicit )ithin the lease agreement ( again this )ill !e provided in the exam and you are not re0uired to calculate it1ne of the easiest )ays to apply the actuarial method in the exam is to use a leasing ta!le Please ta&e note of )hen the rental payment is actually due, is it in advance 7ie rental made at !eginning of the lease year8 or is it in arrears 7ie rental made at the end of the lease year8; This )ill affect the completion of the lease ta!le as highlighted !elo)2Ren!al pa*+en!s in a%,anceental6apital o=s"nterest-a!e "i,en. 6=f)d? ? 7?8 ? ? ? T$ s!a!e+en! $# p$#i! $ l$ss-#inance c$s!s.T$ s!a!e+en! $# #inancial p$si!i$n -lia/ili!*.Ren!al pa*+en!s in aeasental 6=f)d? ? ? 7?8 ? T$ inc$+e s!a!e+en! -#inance c$s!s.T$ s!a!e+en! $# #inancial p$si!i$n -lia/ili!*.Tip2 to !e technically accurate the lease lia!ility should !e split !et)een a non/current lia!ility and a current lia!ilityE0a+ple 1 1 Ren!als in aeas !ea!+en!1n % #pril 2::@ .ush 6o entered into an agreement to lease a machine that had an estimated life of four years The lease period is also four years, at )hich point the asset )ill !e returned to the leasing company #nnual rentals of 95,::: are paya!le in arrears from 3% Aarch 2:%: The machine is expected to have a nil residual value at the end of its life The machine had a fair value of 9%4,275 at the inception of the lease The lessor includes a finance cost of %5B per annum )hen calculating annual rentals*o) should the lease !e accounted for in the financial statements of .ush for the year end 3% Aarch 2:%:;S$l'!i$nThe lease should !e classified as a finance lease as the estimated life of the asset is four years and .ush retains the right to use this asset for four years in accordance )ith the lease agreement therefore enCoying the re)ards of the assetInitial accounting2 recognise the asset and the lease lia!ility4r Property, plant and e0uipment %4,2756r Finance lease o!ligations %4,275Subsequent accounting2 depreciation4r 4epreciation expense79%4,275=4 years8 3,5DE6r #ccumulated depreciation 3,5DESubsequent accounting2 lease rental=interestTip2 use the lease ta!le and complete next year as )ell to help you complete the split !et)een non/current and current lia!ilitiesental of 95,::: paid on % 1cto!er24r Fease expense 7statement of profit or loss8 5,:::6r .an& 5,:::This rental ho)ever spans the lease period % 1cto!er 2::@ to 3: $eptem!er 2:%: and therefore 92,5:: 7the last six/months, rental8 has !een prepaid at the year end 3% Aarch 2:%:4r Prepayments 2,5::6r Fease expense 2,5::S!a!e+en! $# p$#i! $ l$ss e0!ac! Fease expense 2,5::S!a!e+en! $# #inancial p$si!i$n e0!ac!Current assetsPrepayments 2,5::E0a+ple 2 1 Ini!ial en! #ee incen!i,e# 6o entered into an agreement to lease office space on % #pril 2::@ for a fixed period of five years #s an incentive to encourage the office space to !e occupied, a first year rent/free period )as included in the agreement after )hich # 6o is re0uired to pay an annual rental of 93D,:::*o) should the lease !e accounted for in the year ended 3% Aarch 2:%:;S$l'!i$nThe total cost of leasing the office space is 9%44,::: 793D,::: 4 years8 4espite there !eing a +rent/free, period the total cost of the lease should !e matched to the period in )hich it relatesTherefore, in year %2S!a!e+en! $# p$#i! $ l$ss e0!ac! >ental79%44,:::=5 years8 2E,E::S!a!e+en! $# #inancial p$si!i$n e0!ac!Current liabilities#ccruals 2E,E::"n summary, the accounting topic of leases is a really important accounting area and is highly examina!le To master this topic, ensure that you &no) the definitions of !oth types of lease, therecognition criteria for a finance lease and practise plenty of examples of accounting for finance leases