Step-down payments decrease lease payment at one or more points during the lease term, analogous to accelerated depreciation. Lease payments that reflect the seasonal nature of the revenue generated by the leased asset over the lease term are seasonal payments. A balloon payment structure is one that provides for level periodic payments during the lease term that are relatively low and a relatively large final rental payment at the end of the lease, expressed as a percentage of the total asset value e.
On the commencement date, a lessee should determine how certain they are to exercise an option to purchase the underlying asset. The lessee should include the exercise price of the purchase option in the lease payments if they are reasonably certain they will utilize the purchase option. However, if a lessee changes its assessment of how certain it is to exercise the purchase option, it should remeasure the lease liability and discount the new lease payments with the appropriate rate which may or may not be revised.
On the commencement date, a lessee should consider all relevant information to determine how certain they are to exercise an option to terminate the lease early. The lessee should include the early termination in the lease term unless it is reasonably certain not to terminate the lease early. The termination penalty should be included in the measurement of the lease liability.
If a lessee changes its assessment of how certain it is not to terminate the lease early, it should remeasure the lease liability and discount the new lease payments with the appropriate rate which, again, may or may not be revised. Variable lease payments are those that depend on an index or rate, such as payments linked to a benchmark interest rate e. Furthermore, variable payments other than those that depend on an index or benchmark rate are excluded from the lease liability.
Lessees should include fixed lease payments in the lease liability. Example 2 — Rentals in advance treatment On 1 April Shrub Co entered into an agreement to lease a machine that had an estimated life of four years.
The lease period is also four years at which point the asset will be returned to the leasing company. Shrub is required to pay for all maintenance and insurance costs relating to the asset. How should the lease be accounted for in the financial statements of Shrub for the year end 31 March ?
Solution The lease should be classified as a finance lease as the estimated life of the asset is four years and Shrub retains the right to use this asset for four years in accordance with the lease agreement therefore enjoying the rewards of the asset.
In addition to this Shrub is required to maintain and insure the asset, therefore retaining the risks of asset ownership. Example 3 — Split lease year treatment On 1 October Number Co entered into an agreement to lease a machine that had an estimated life of four years. How should the lease be accounted for in the financial statements of Number for the year end 31 March ?
Solution The lease should be classified as a finance lease as the estimated life of the asset is four years and Number retains the right to use this asset for four years in accordance with the lease agreement therefore enjoying the rewards of the asset. Subsequent accounting : depreciation Tip: the depreciation for the year ended 31 March is a straightforward annual charge, but you will also have to take into account the depreciation for the first six months of the lease that was attributable to the year ended 31 March as this will be required to find the closing carrying value in the statement of financial position.
Operating lease accounting As the risks and rewards of ownership of an asset are not transferred in the case of an operating lease, an asset is not recognised in the statement of financial position. Instead rentals under operating leases are charged to the statement of profit or loss on a straight-line basis over the term of the lease, any difference between amounts charged and amounts paid will be prepayments or accruals.
Example 4 — Operating lease treatment On 1 October Alpine Ltd entered into an agreement to lease a machine that had an estimated life of 10 years. How should the lease be accounted for in the financial statements of Alpine for the year end 31 March ? In addition to this, the present value of the minimum lease payments, if calculated you are not required to do this in the exam, only use if the examiner gives to you would be substantially less than the fair value of the asset.
Example 5 — Initial rent free incentive A Co entered into an agreement to lease office space on 1 April for a fixed period of five years. How should the lease be accounted for in the year ended 31 March ? Therefore, in year In summary, the accounting topic of leases is a really important accounting area and is highly examinable.
To master this topic, ensure that you know the definitions of both types of lease, the recognition criteria for a finance lease and practise plenty of examples of accounting for finance leases.
Bobbie-Anne Retallack is a content specialist at Kaplan Publishing. Accounting for leases. Why do we need to apply substance to a lease?
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