Leases
1
Learning Objectives
• Explain the nature and economic
substance of lease transactions.
• Describe different types of leases.
• Explain the accounting treatment for
finance lease & operating lease.
• Compare and contrast the finance lease
and operating lease method.
• Explain the accounting treatment for sale
and leaseback.
• List the disclosure requirements for
leases.
2
Introduction
What is a lease?
• A contractual agreement between a lessor and a
lessee.
• This arrangement gives the lessee the right to use
specific property, owned by the lessor, for a specified
period of time.
• In return for the use of the property, the lessee makes
rental payments over the lease term to the lessor.
MFRS117 defined Lease as:
• A lease is an agreement whereby lessor conveys to
the lessee in return for a payment or series of
payments (minimum lease payments) right to use an
asset for the agreed period of time (lease term). 3
Leases
• Leases are the great example of “off-balance sheet”
financing if not recorded properly in the
financial statements.
• In the past, many companies used to hide their finance
lease liabilities and they reported all lease payments
directly to profit or loss when paid. So no real picture of
the transaction was shown.
• Therefore, MFRS117 was issued to tackle this problem.
• From 2012 until recently, MFRS 117—Leases was used
for accounting for lease.
– MFRS 16 takes effect from 1 January 2019
4
Leases
• Advantages of Leases
– For lessor
• a periodic receipt provides interest
revenue.
• ability to retain ownership of the asset
• boost their sales revenue.
– For lessee
• flexibility in using assets.
• less costly financing
Leases
• Commonly found in information technology,
transportation, construction and agriculture.
– Information technology assets - allows a
company to quickly adapt to changes in
technology.
– Transportation assets - require huge financial
commitments. Leases are a great financing
option.
– For construction and agriculture - minimizes
the possibility that some assets might become
idle at certain periods of time.
Leases
MFRS 117 is applicable to all leases except the
following;
property held by lessees that is accounted for as
investment property (see MFRS 140 Investment
Property);
investment property provided by lessors under
operating leases (see MFRS 140);
biological assets held by lessees under finance
lease (see MFRS 141 Agriculture); or
biological assets provided by lessors under
operating leases (see MFRS 141).
7
Leases
• Although the contract may say that a company leases
an asset from another company, in fact, the contract’s
conditions may be very similar to purchase.
• Eg: The lessee will lease an asset for almost all of its
useful life, will be responsible for maintaining and
repairs, etc.
• MFRS 117 requires to record such a transaction not in
accordance with the strict legal form (legally, the owner
of an asset remains the lessor), but in line with the
“substance over form” principle.
8
Which leases shall be recorded in line with
“substance over form”?
Economic substance of lease is determined by risks
and rewards incident to the ownership; whether they
are transferred to the Lessee or still with the Lessor.
MFRS117 define risks and rewards as :
Risks in the asset – possibility of losses incurred due
to the asset becoming idle or technological obsolete
and variations in return due to changing economic
conditions.
Rewards of beneficial ownership – expectation of
profitable operation from the use of the asset and/or
gain from appreciation in value of asset or a gain on
realization of residual value.
9
Classification of leases
MFRS117 classifies leases into 2 types:
• Finance lease – a lease that transfers
substantially all the risks and rewards incident to
ownership of an asset to the lessee, while legal
title does not necessarily need to be transferred.
(recorded with substance over form principle).
• Operating lease –a lease that does not transfer
substantially all the risks and rewards incidental to
ownership
10
Lease Classification Criteria
11
How shall we determine whether the
lease is finance or operating?
5 basic situations that normally lead to a finance lease:
1. The lease transfers the ownership of an asset to the lessee by the
end of the lease term.
2. The lessee has an option to purchase the asset at a price
sufficiently lower than its fair value at the date of purchase .
3. The lease term is for the major part of the economic life of the
asset even if the title is not transferred .
4. At the inception of the lease, present value of the minimum lease
payments comes close to the fair value of the leased asset.
5. Leased assets are of such specialized nature that only the lessee
can use them without major modifications.
So long as one of the factors is satisfied, the lease would be classified
as a finance lease.
12
Lease Classification Criteria
MFRS 117 further lists indicators of situation which
could leads to a lease being classified as finance lease.
i. If the lessee can cancel the lease, the lessee’s
losses associated with the cancellation are borne
by the lessee.
ii. Gains or losses from the fluctuation in the fair value
of the residual value fall to the lessee,
iii. The lessee has the ability to continue the lease for
a secondary period at a rent which is substantially
lower than market rent.
13
Finance Lease
Definition according MFRS117 – a finance lease as a
lease that transfers substantially all the risks and
rewards incidental to ownership of an asset.
• The title may or may not eventually be transferred.
• The lessee is the beneficial owner.
• The lessee may make a payment or a series of
payments.
• The lessee may guarantee the residual value for the
leased assets at the end of lease term.
• Total amount payable is called minimum lease
payment.
14
Example for Finance Lease
On 1.1.x1, YYY Bhd entered into lease agreement with ZZZ
Bhd for the use of a plant. The agreement was that YYY Bhd
would make five yearly instalments of RM25,000 in advance
i.e 1st instalment being on 1.1.x1. The machine can be
bought for cash at RM100,000. YYY incremental borrowing
rate is 13% per annum.
Solution:
The present value of the five installments is
RM25,000 + (25,000 x 2.96) = RM99,000
19
Interest Rates for discounting
Minimum Lease Payments
Minimum lease payment (MLP) is the payments over the
lease payment excluding contingent rent, cost of services
and taxes.
MFRS117 : In calculating the present value of the minimum
lease payments – the discount factor is the interest rate
implicit in the lease. If implicit rate is not practical to
determine, the lessee’s incremental borrowing rate is used
Implicit Interest Rate:
Rate that would be used to discount the minimum lease
payments to the fair market value of the leased asset at
the inception of the lease.
Incremental Borrowing Rate:
Rate at which lessee would have to pay on similar lease
or would incur to borrow the amount of money
necessary to purchase the leased asset. 20
Accounting for Finance Lease by Lessee
Subsequent Measurement
There are 2 things to take care about after
initial recognition:
1. Minimum lease payments
MFRS117 stated that MLP should be apportioned
between the finance charge (interest) and the
reduction of the outstanding lease liability.
The basic accounting entry of minimum lease payment
paid to the lessor is as follows:
21
Accounting for Finance Lease
by Lessee
Each lease payment contains the interest, as the finance
lease is in fact a loan. Therefore:
25
Illustration 117.5 - Solution
In this case, the lease would be classified as finance
lease because the lease term of four years was the
major part (> 75%) of the useful life of five years of the
equipment.
ABC Trading Bhd (lessee) would have to capitalise
the leased asset, record the related liability, provide
depreciation, and allocate the interest expense over
the lease term. Thus, three initial calculations would
have to be performed:
a. present value of the minimum lease payment
b. depreciation charge
c. amortisation for interest expenses.
26
Illustration 117.5 - Solution
28
Illustration 117.5 - Solution
Date Lease Interest Principal Lease
Payment Liability
RM RM RM RM
1.1.x1 35,459
31.12.x1 10,000 1,773 8,227 27,232
(35,459 x 5%) (10,000–1,773) (35,459 – 8,227)
31.12.x2 10,000 1,362 8,638 18,594
31.12.x3 10,000 930 9,070 9,524
31.12.x4 10,000 476 9,524 Nil
40,000 4,541 35,459
29
Illustration 117.5 - Solution
Journal entries to record the lease for each of the four
years (assuming 31 Dec year-end) as follows:
Debit Credit
RM RM
1.1.x1 DR : Leased Equipment 35,459
CR : Lease payable 35,459
(To record the finance lease)
31.12.x1 DR : Lease payable 8,227
DR : Interest expense 1,773
CR : Bank 10,000
(To record lease payment)
DR : Depreciation expense 8,865
CR : Acc. Depreciation 8,865
(To record depreciation expense)
30
Illustration 117.5 - Solution
Journal entries to record the lease for each of the four
years (assuming 31 Dec year-end) as follows:
Debit Credit
RM RM
31.12.x2 DR : Lease payable 8,638
DR : Interest expense 1,362
CR : Bank 10,000
(To record lease payment)
DR : Depreciation expense 8,865
CR : Acc. Depreciation 8,865
(To record depreciation expense)
31
Illustration 117.5 - Solution
Journal entries to record the lease for each of the four
years (assuming 31 Dec year-end) as follows:
Debit Credit
RM RM
31.12.x3 DR : Lease payable 9,070
DR : Interest expense 930
CR : Bank 10,000
(To record lease payment)
DR : Depreciation expense 8,865
CR : Acc. Depreciation 8,865
(To record depreciation expense)
32
Illustration 117.5 - Solution
Journal entries to record the lease for each of the four
years (assuming 31 Dec year-end) as follows:
Debit Credit
RM RM
31.12.x4 DR : Lease payable 9,524
DR : Interest expense 476
CR : Bank 10,000
(To record lease payment)
DR : Depreciation expense 8,865
CR : Acc. Depreciation 8,865
(To record depreciation expense)
37
Illustration 117.6 - Solution
The journal entries to record the lease would be the
same as those under the original lease in illustration
117.5 except changes in figures.
In addition, in the amortisation schedule there would be
a balance of RM1,000 in the lease liability account at the
end of the lease. This is the amount the lessee would
have to pay to exercise the purchase option.
The journal entry to record the exercise of the purchase
option on 31 Dec 20x4 would be as follows:
DR : Lease payable 1,000
CR : Bank 1,000
(To record exercise of purchase option)
38
Illustration 117.6 - Solution
At the end of the lease on 31 Dec 20x4,
while the lease liability would be fully
settled, the leased asset would still carry
a balance because it would be
depreciated over five years.
Also on this date, the leased asset should
preferably be transferred to an ordinary
fixed asset account.
39
Residual Value
44
Illustration 117.8
Date Lease Interest Principal Lease Liability
Payment RM
RM RM RM
1.1.x1 39,572
31.12.x1 10,000 1,979 8,021 31,551
39,572 x 5% 10k – 1,979 39,572 – 8,021
31.12.x2 10,000 1,578 8,422 23,129
31.12.x3 10,000 1,157 8,843 14,286
31.12.x4 10,000 714 9,286 5,000
The journal entries to record the lease would be the same as those under the
original lease in illustration 117.5 except for changes in figures.
In addition, there would be a balance of RM5,000 in the lease liability account at
the end of the lease. This is the amount the lessee guaranteed to pay the residual
value of the leased asset.
The leased equipment account would be carried at BV of RM5,000 [Capitalised
amount $39,572 less accumulated depreciated $34,572 ($8,643 x 4 years)].
45
Illustration 117.8
Assuming the FV of the equipment @ 31.12.20x4 was
RM5,000.
54
EXAMPLE
Think High Enterprise, which makes up its accounts to 31
December each year, leases a piece of plant on 1.1.x2 on
the following terms:
Think High Enterprise is to pay RM40,000 immediately,
with three further yearly instalments of RM40,000 each,
beginning on 1.1.x3. The agreed fair value of the asset is
RM139,474 and the interest rate implicit in the lease is
10%. At the end of the lease period the title to the asset is
transferred to the lessee. The expected economic life of
the asset is five years and the residual value of the asset
at the end of that time is zero.
Required:
Show the relevant information in the books of the lessor.
55
56
Answer
RM
Total rental/installment to be paid
(RM40,000 x 4 years) 160,000
Fair value of the asset 139,474
Finance charge over the lease period 20,526
Under the actuarial method, the interest charged is the interest on the outstanding
capital at the beginning of each year.
ANSWER
JOURNAL ENTRIES TO RECORD THE LEASE FOR YEAR X2
Debit Credit
RM RM
Lease receivable 139,474
Bank 139,474
Bank 40,000
Lease receivable 40,000
Notes to the
financial
statements
Finance lease 120,000 80,000 40,000 -
receivable
Less: Unallocated (10,579) (3,637) - -
interest
109,421 76,363 40,000
60
ANSWER
Working for finance charge under sum-of-digits method
Note:
The number of periods/ instalments, n, is 3 if payment is
made in advance. Sum of digits will be 6. The formula to
arrive at the sum of digits is:
n(n+1)
2
ANSWER
X5 40,000 (40,000) - - -
20,526
DISCLOSURES
A reconciliation between the total of gross investment in the
lease at the balance sheet date, and their present value;
The total of gross investment in the lease and their present
value for each of the following period;
(i) not later than one year;
(ii) later than one year and not later than five years;
(iii) later than five years.
Unearned finance income;
The unguaranteed residual values accruing to the lessor;
The accumulated allowance for uncollectible minimum lease
payment receivable;
A general description of the lessor’s significant leasing
arrangement.
63
MANUFACTURER OR DEALER LESSOR
• The manufacturer of PPE is also a lessor or
dealer.
• The manufacturer sells the asset outright or
leases it out under a finance lease. The
manufacturer lessor earns two types of income:
a) gross profit; and
b) interest income
• Costs incurred by manufacturers or dealer lessor
in negotiating and arranging the lease shall be
recognized as an expense when selling profit
is recognized.
64
MANUFACTURER OR DEALER LESSOR
Sales revenue
The revenue recognised at the inception of the lease (
lower of FV and the PV of MLP).
The cost of sales = cost of carrying value – PV of
unguaranteed residual value.
Gross profit= Sales – Cost of Sales
Finance income
The interest income is spread over the lease term
65
MANUFACTURER OR DEALER LESSOR
Example
ABC Bhd manufactures an equipment for
RM200,000. It can sell it at RM265,300 which is
the fair value. It can also lease the asset under
finance lease by requiring the lessee to make 5
annual installments of RM70,000 each in arrears.
Market interest rate implicit is 10%. Initial cost
incurred in negotiating the lease is RM10,000.
ABC entered into finance lease on 1.1x3.
Required:
Discuss the accounting treatment for ABC Bhd.
66
MANUFACTURER OR DEALER LESSOR
Answer
Sale revenue for year x3 is RM265,300
Cost of sale is RM200,000
FV – Cost = Gross profit
Gross profit = RM265,300 - RM200,000
= RM65,300
MLP = RM70,000 x 5 = RM350,000
PV MLP = RM70,000 x 3.79 (PV Ord. annuity 10%)
= RM265,300
Total finance interest over the lease period is the
difference between FV (RM265,300) – MLP (RM350,000)
= RM84,700 67
MANUFACTURER OR DEALER LESSOR
68
MANUFACTURER OR DEALER LESSOR
69
ACCOUNTING FOR OPERATING LEASE
Journal entry:
Dr Lease rental expense RMxxx
Cr Cash RMxxx
(To record lease rental payment)
70
ACCOUNTING FOR OPERATING LEASE
Disclosures
a) The total future minimum lease payments under non-
cancellable operating leases for each of the following
period;
i) Not later than one year
ii) Later than one year and not later than five years
iii) Later than five years
b) The total future minimum sublease payments expected to
be received under non-cancellable subleases at the
balance sheet date.
c) ) Lease and sublease payments recognised in income for
the period, with separate amounts for minimum lease
payment, contingent rents and sublease payments; and
71
ACCOUNTING FOR OPERATING LEASE
Disclosures
d) A general description of the lessee’s significant leasing
arrangements, but not limited to, the following:
i) The basis on which contingent rent payments are
determined’
ii) The existence and terms of renewal or purchase
options and escalation clauses; and
iii) Restrictions imposed by lease arrangements, such as
those concerning dividends, additional debt and
further leasing.
72
Accounting for Operating Lease - by Lessor
Since the risks and rewards of ownership do NOT transfer from
lessor to lessee, lessor keeps recognizing the leased asset in
his statement of financial position.
Lease income from operating leases shall be recognized as an
income on a straight-line basis over the lease term, unless
another systematic basis is more appropriate.
• Assets should be retained in lessor’s book as fixed assets.
• Account for depreciation expense annually (Depreciation
policy : MFRS116)
• Lease payment received - Rental income (in income
statement)
• Initial direct cost- added to the carrying amount of the leased
asset and recognised as an expense over the lease term on
the same basis as the lease income. 73
EXAMPLE
Think Well Bhd arranged with XYZ Bhd to
lease a photocopy machine for four years.
The rental payable by Think Well Bhd is
RM20,000 per annum. The fair value of
the asset is RM100,000 and its economic
life is 10 years. The lessor, XYZ Bhd, will
undertake all maintenance and repairs.
74
ANSWER BOOK OF THINK WELL BHD (Lessee)
75
Debit Credit
RM RM
Lease rental expense 20,000
Bank 20,000
Bank 20,000
Lease rental income 20,000
76
SALE AND LEASEBACK
The seller-lessee receives a lump sum for the sales
proceeds when the asset is sold, but will only need to
pay lease rentals periodically under the lease, while
maintaining the right to use the same asset.
Accounting treatment of sale and leaseback transactions
depends on the character of the resulting lease.
The leaseback may be an operating lease or a finance
lease.
77
LEASEBACK IS A FINANCE LEASE
• If the seller-lessee retains the risks and rewards
incident to the ownership of the asset, then it is a
finance lease.
• This transaction is actually a loan securitized by
the leased asset and seller / lessee keeps
recognizing the asset.
• Any excess of proceeds over the carrying amount
of the leased asset is deferred and amortized
over the lease term.
• The lease payments are repayment of capital and
interest.
78
EXAMPLE 1
KR Bhd sold its plant with carrying value of
RM130,000 to FUN Bhd for RM150,000 and
immediately leased it back. The arrangement was
that KR Bhd will use the plant for the rest of its
economic life and pay RM45,000 per annum (4
years) in arrears.
KR Bhd retained all the risks and rewards attached
to the plant.
Solution
Since KR retained all risks and rewards, the lease
are qualifies as finance lease. KR Bhd in essence
borrowed RM150,000.
79
EXAMPLE 1
RM45,000 annual repayment would comprise
interest plus capital repayment. Assume interest
rate is 12.5% p.a, then at the end of the year, the
interest expense would be = RM18,750 (150,000 x
12.5%) + capital repayment = RM26,250 ($45,000 –
18,750)
Any excess of the sales proceeds over the carrying
value should not be recognised as income
immediately. The gain should be deferred and
amortised over the lease period.
RM130,000 (CV) - RM150,000 (SP) = RM20,000
RM20,000 is deferred and amortised over 4 years.
80
EXAMPLE 2
On 1.1.x3 JR Bhd purchased a machine costing
RM800,000 and depreciated it on a straight-line basis
over 10 years.
On 1.1.x6, a sale and leaseback was arranged. The
machine was sold for RM700,000 which was the fair
value. JR leased it back as a finance lease for seven
years at an annual rental of RM110,000, payable in
arrears. Interest is to be allocated using sum-of-digits
method.
Required:
Journalise the transactions in the books of JR Bhd
for year x6. 81
82
ANSWER
Debit Credit
RM RM
Bank 700,000
Accumulated depreciation (80,000 x 3) 240,000
Machine 800,000
Deferred gain 140,000
Machine 700,000
Lease creditor 700,000
ANSWER
Debit Credit
RM RM
Interest expense (70,000 x 7/28)* 17,500
Lease creditor 17,500
84
LEASEBACK IS AN OPERATING LEASE
• If the sale price is below asset’s fair value, then it
is necessary to check the rental payments. If the
future payments are below market price, then the
loss from the sale of asset should be amortized
over the period of use. If the future payments are
close to market rentals, then the loss from the
sale of asset should be recognized immediately.
• If the sale price is above fair value, then the
excess over fair value or “profit from sale” should
be deferred and amortized over the period
of use.
85
LEASEBACK IS AN OPERATING LEASE
Treatment for sale and leaseback, if it is an operating lease,
is summarised as follows:
Step 1 : Compare fair value with carrying amount
If the fair value of the asset is less than the carrying
amount, write down the asset to fair value, then proceed
to step 2.
Step 2 : Compare selling price and fair value
If the selling price of the asset is greater than the fair
value, defer and amortise over the period of use.
If the selling price is less than the fair value and rental
is at fair value, recognise loss immediately.
If the selling price is less than the fair value and rental
is not at fair value, defer and amortise over the lease
term. 86
EXERCISE
On 1.1.x3, Tas Berhad purchased a machine costing
RM800,000 and depreciated it on a straight-line basis over 10
years.
On 1.1.x6 a sale and leaseback was arranged. The leaseback
was an operating lease.
Journalise the transactions in the books of Tas Berhad if:
a) the machine was sold for RM700,000 which was the
fair value and leased back for four years at an annual
rental of RM100,000;
b) the machine was sold at RM800,000 (the fair value
was RM700,000) and leased back for four years at an
annual fair rental of RM100,000;
87
EXAMPLE
c) the machine was sold for RM500,000 and leased back
for four years at a fair rental of RM100,000;
d) the machine was sold at RM500,000 and rental was
RM70,000 for four years assuming fair rental to be
RM100,000; and
e) the fair value of the machine on 1.1.x6 was RM500,000
and it was sold for RM530,000 and leased back as an
operating lease at a fair rental of RM100,000.
88
89
ANSWER
a) the machine was sold for RM700,000 which was
the fair value and leased back for four years at
an annual rental of RM100,000
- gain or loss is recognised immediately.
Debit Credit
RM RM
(a) Bank 700,000
Acc. Depreciation (80,000 x 3) 240,000
Machine 800,000
Gain (I/S) 140,000
b) the machine was sold at RM800,000 (the fair value was RM700,000) and
leased back for four years at an annual fair rental of RM100,000
- excess above the fair value should be deferred and amortised over the
period the asset is expected to be used
Debit Credit
RM RM
e)the fair value of the machine on 1.1.x6 was RM500,000 and it was sold
for RM530,000 and leased back as an operating lease at a fair rental of
RM100,000 - asset should write down to FV before recording the sale.
Debit Credit
RM RM
(e) Income statement – Impairment loss * 60,000
Machine 60,000
Bank 530,000
Machine (NBV) 500,000
Deferred gain 30,000
94
Issues In Accounting For Leases
• IFRS 16
– to cater for the issues involving off-balance
sheet financing
– the single lease accounting for lessee based
on the right-of-use model
– effect - lessee will need to recognize all
leases as finance leases, except for short-
term leases and low-value asset leases.
Issues In Accounting For Leases
• Recognition of assets (the right-of-use) and liabilities
(lease obligation) by lessees for all leases
• At the commencement date, a lessee shall measure the
right-of-use asset at cost
• The right-of-use asset would be subsequent measured
using a cost model (Cost – Acc. Amortisation –
Impairment)
• The lease obligation would be initial and subsequent
measured similar way as MFRS 117
Issues In Accounting For Leases
• Other elements of IFRS 16 are:
service contract
standard
Tutorial Question
Questions from Jane Lazar & Huang Ching
Choo. 2014. Financial Reporting Standards for
Malaysia. Revised 4th Edition - Chapter 23
•Question 2
•Question 4
•Question 9
98