Chapter 11

Accounting for leases

Review questions
11.1 According to AASB 117, a lease is defined as:
an agreement whereby the lessor conveys to the lessee in return for a payment or
series of payments the right to use an asset for an agreed period of time.

11.2 Pursuant to AASB 117 we should capitalise a lease transaction (meaning that the leased
asset and lease liability will be included within the statement of financial position) when
substantially all the risks and rewards of ownership pass to the lessee, and the lease
payments are deemed to be material. AASB 117 describes the risks and rewards of
ownership as follows:
Risks include the possibilities of losses from idle capacity or technological
obsolescence and of variations in return because of changing economic conditions.
Rewards may be represented by the expectation of profitable operation over the
assets economic life and of gain from appreciation in value or realisation of a
residual value.
AASB 117 dedicates a number of paragraphs (paragraphs 10 to 12) to assist in determining
whether a lease is a finance lease or an operating lease. A finance lease is to be capitalised.
These paragraphs state:
10. Whether a lease is a finance lease or an operating lease depends on the substance of
the transaction rather than the form of the contract. Examples of situations that
individually or in combination would normally lead to a lease being classified as a
finance lease are:
(a) the lease transfers ownership of the asset to the lessee by the end of the lease
term;
(b) the lessee has the option to purchase the asset at a price that is expected to be
sufficiently lower than the fair value at the date the option becomes exercisable
for it to be reasonably certain, at the inception of the lease, that the option will
be exercised;
(c) the lease term is for the major part of the economic life of the asset even if title
is not transferred;
(d) 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
(e) the leased assets are of such a specialised nature that only the lessee can use
them without major modifications.
11. Indicators of situations that individually or in combination could also lead to a lease
being classified as a finance lease are:
(a) if the lessee can cancel the lease, the lessors losses associated with the
cancellation are borne by the lessee;
(b) gains or losses from the fluctuation in the fair value of the residual accrue to the
lessee (for example, in the form of a rent rebate equalling most of the sales
proceeds at the end of the lease); and
 (c) the lessee has the ability to continue the lease for a secondary period at a rent
that is substantially lower than market rent.
12. The examples and indicators in paragraphs 10 and 11 are not always conclusive. If it
is clear from other features of the lease that the lease does not transfer substantially
all risks and rewards incidental to ownership, the lease is classified as an operating
lease. For example, this may be the case if ownership of the asset transfers at the
end of the lease for a variable payment equal to its then fair value, or if there are
contingent rents, as a result of which the lessee does not have substantially all such
risks and rewards.
Students should be made aware that although the material above is correct as it pertains to
AASB 117, in the foreseeable future we can anticipate that the distinction between operating
and financial leases will be removed. At that point in time an asset entitled something like
right to use asset and a lease obligation would be recognised even if the risks and rewards
of ownership of an asset have not been transferred to the lessee.

11.3 If the lease is considered to be a finance lease (also referred to as a capital lease or a
financial lease), the amount to be initially capitalised by the lessee for the asset and liability
is the fair value of the leased property, or if lower, the present value of the minimum lease
payments as determined at the inception of the lease.
Minimum lease payments are defined at paragraph 4 of AASB 117 as:
The payments over the lease term that the lessee is or can be required to make,
excluding contingent rent, costs for services and taxes to be paid by and reimbursed
to the lessor, together with:
(a) for a lessee, any amounts guaranteed by the lessee or by a party related to
the lessee; or
(b) for a lessor, any residual value guaranteed to the lessor by:
(i) the lessee;
(ii) a party related to the lessee; or
(iii) a third party unrelated to the lessor that is financially capable of
discharging the obligations under the guarantee.
However, if the lessee has an option to purchase the asset at a price that is expected
to be sufficiently lower than the fair value at the date the option becomes exercisable
for it to be reasonably certain, at the inception of the lease, that the option will be
exercised, the minimum lease payments comprise the minimum payments payable
over the lease term to the expected date of exercise of this purchase option and the
payment required to exercise it.
As the last part of the above requirement indicates, for a lessee, the minimum lease
payments include any bargain purchase option, even though the lessee might not be
contractually obliged to exercise the option to buy the asset.
The discount rate to be used in computing the present value of the minimum lease payments
(and hence, the amount to be included in the statement of financial position for the leased
asset and lease liability if the present value of the minimum lease payments is less than the
fair value of the asset at the inception of the lease) is the interest rate implicit in the lease.
The interest rate implicit in the lease is the discount rate that, when applied to the minimum
lease payments and the unguaranteed residual value accruing to the lessor (if any), causes
 the aggregate present value to be equal to the fair value of the leased asset and any initial
direct costs to the lessor. If it is not practicable to determine the interest rate implicit in the
lease, the lessees incremental borrowing rate shall be used.

11.4 Frequently, a lessee would prefer to treat a lease as an operating lease, rather than a finance
lease. If the lease is treated as a finance lease then both the leased asset and the lease
liability must appear on the statement of financial position (at the fair value of the leased
asset, or if less, at an amount equal to the present value of the minimum lease payments).
This would have the effect of adversely affecting gearing ratios, such as the debt-to-asset
ratio.
If a lessee was subject to a debt contract which had debt-to-asset constraints, and these
constraints were becoming binding, then lessees may be particularly opposed to treating a
lease as a finance lease. The treatment of leases in debenture trust deeds can be quite harsh.
As Whittred and Zimmer (1992, p. 269) note:
the wording of most trust deeds implies that although all of the capitalised liability
would be included in the numerator of a debt/asset constraint, the capitalised asset
would not be included in the denominator since it would not be secured to the trustee
by a registered charge.
The other point that should be appreciated is that in the early years of a lease, the expenses
recognised tend to be relatively high. The interest expense, which is based on the opening
liability, will be higher in early years (as the liability is greater), and coupling this with
depreciation charges associated with the leased asset, may give a total expense significantly
greater than would be the case if the lease was treated as an operating lease. This may be of
concern to particular entities that, for various reasons, may seek to report higher profits in
these earlier years.

11.5 (a) The International Accounting Standards Board (IASB) and the US Financial
Accounting Standards Board (FASB) are currently working together on the
development of a revised accounting standard. In April 2008, the two boards jointly
stated their intention to produce a revised standard for lessees by mid-2011. This,
however, has been delayed and a new accounting standard is not expected to be
released until 2013 with an application date being sometime in 2015. One of the major
concerns of the IASB and the FASB, and which motivated the development of an new
accounting standard, was the differentiation, perhaps somewhat arbitrary, between
finance leases and operating leases. As we know, pursuant to AASB 117 (and IAS 17),
in the case of an operating lease, no asset or liability is included in the statement of
financial position. Current thinking indicates that this differentiation between finance
leases and operating leases should be abandoned such that assets and liabilities
associated with many leases that we would now consider to be operating leases will, in
the future, be included in the statement of financial position.
Hence, it would appear that the key issue to consider in the future will be whether a
lease provides rights to use the asset and generates related obligations, and not whether
the risks and rewards of ownership pass to the lessee, which is the current test under
AASB 117. For example, if a machine is leased for a fixed term of five years, has an
expected life of 10 years, and the lease is non-cancellable, then pursuant to AASB 117
no lease liability or leased asset would be recognised. By contrast, under the proposed
requirements a leased asset and a lease liability would be recognised. In supporting the
view that a lease, such as the example of the five-year lease provided above, should be
 recognised in the statement of financial position, the IASB and FASB (2009,
paragraphs 3.20 and 3.21) state:
3.20 In summary, the boards tentatively concluded that:
(a) the lessee has a present obligation to pay rentals.
(b) this obligation arises out of past eventsthe signing of the lease contract
and the delivery of the item by the lessor to the lessee.
(c) the obligation is expected to result in an outflow of economic benefits
(usually cash).
3.21 Accordingly, the boards tentatively concluded that the lessees obligation to
pay rentals meets the definitions of a liability in the Conceptual Framework.
Accordingly, the IASB and FASB provided a view that the lessees obligation to pay
rentals under a non-cancellable lease meets the definition of a liability as provided in
the IASB Conceptual Framework. This is regardless of whether the risks and rewards
of ownership are passed to the lessee.
(b) Initially there was a view that in the new accounting standard all leases were to be
capitalised and no exceptions would be made for short-term leases; however, this has
now changed. A short-term lease is defined as a lease that, at the date of
commencement of the lease, has a maximum possible term, including any options to
renew, of 12 months or less.
The boards (IASB and FASB) decided that, for short-term leases, a lessee need not
recognise lease assets or lease liabilities. For those leases, the lessee should recognise
lease payments in profit or loss on a straight-line basis over the lease term, unless
another systematic and rational basis is more representative of the time pattern in
which use is derived from the underlying asset.
For those excluded leases, a lessor should continue to recognise and depreciate the
underlying asset and recognise lease income over the lease term on a systematic basis.
All other leases should appear on the statement of financial position.
(c) In terms of how the liability will be measured, a view was presented by the boards
that, consistent with AASB 117 (and therefore IAS 17), the liability should be
measured at present value. To determine the present value, the lessee would use the
rate the lessor charges the lessee when that rate is available, otherwise the lessee is to
use its incremental borrowing rate. The lessees incremental borrowing rate is the rate
of interest that, at the date of inception of the lease, the lessee would have to pay to
borrow over a similar term and with a similar security, the funds necessary to purchase
a similar underlying asset.
(d) Clearly, should the above proposals be incorporated in the revised accounting
standard, then many more leases, which we have traditionally referred to as operating
leases, will thereafter have to be included in the statement of financial position. The
removal of the requirement that a lease must transfer the risks and rewards of
ownership to the lessee before an asset and liability is recognised will have obvious
implications for reporting entities assets and liabilities, and therefore for their gearing
ratios and so forth.

11.6 The accounting standard requires that where a sale and leaseback transaction involves a
leaseback which is classified as a finance lease by the lessee, any material profit or loss
arising on the sale shall be recorded by the lessee as deferred income or deferred expense in
 the statement of financial position and amortised to profit or loss over the lease term.
Specifically, paragraph 59 of AASB 117 states:
If a sale and leaseback transaction results in a finance lease, any excess of sales
proceeds over the carrying amount shall not be immediately recognised as income by
a seller-lessee. Instead, it shall be deferred and amortised over the lease term.
If we assume that the lease was a finance lease then Eastern Nitrogen should recognise the
gain over the lease term, not the assets useful life. Of course, they may in fact be the same.
Nevertheless, it is the lease term, not the life of the asset, which is the basis for recognition
of the gain or loss.
There would not appear to be anything which explicitly prohibits Eastern Nitrogen from
disclosing the unamortised balance of the deferred gain as a deduction from the gross cost of
plant and equipment.

11.7 In relation to the lessor, paragraph 36 of AASB 117 states:

Lessors shall recognise assets under a finance lease in their statement of financial
positions and present them as a receivable at an amount equal to the net investment
in the lease.
Net investment in the lease is defined in AASB 117 as the gross investment in the lease
discounted at the interest rate implicit in the lease. Gross investment in the lease is defined
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.
In relation to the lessee, paragraph 20 of AASB 117 states:
At the commencement of the lease term, lessees shall recognise finance leases as
assets and liabilities in their statement of financial positions at amounts equal to
the fair value of the leased property or, if lower, the present value of the minimum
lease payments, each determined at the inception of the lease.
Minimum lease payments are defined at paragraph 4 of AASB 117 as:
The payments over the lease term that the lessee is or can be required to make,
excluding contingent rent, costs for services and taxes to be paid by and reimbursed
to the lessor, together with:
(a) for a lessee, any amounts guaranteed by the lessee or by a party related to
the lessee; or
(b) for a lessor, any residual value guaranteed to the lessor by:
(i) the lessee;
(ii) a party related to the lessee; or
(iii) a third party unrelated to the lessor that is financially capable of
discharging the obligations under the guarantee.
However, if the lessee has an option to purchase the asset at a price that is expected
to be sufficiently lower than the fair value at the date the option becomes exercisable
for it to be reasonably certain, at the inception of the lease, that the option will be
exercised, the minimum lease payments comprise the minimum payments payable
 over the lease term to the expected date of exercise of this purchase option and the
payment required to exercise it.
Minimum lease payments, from the perspective of the lessee, exclude any unguaranteed
residual (unless there is a bargain purchase option). Therefore, where there is an
unguaranteed residual, the lease receivable will be recorded at a higher amount in the books
of the lessor than the lease payable in the books of the lessee.

11.8 Minimum lease payments have been defined in the answers to some of the earlier questions.
Minimum lease payments are defined at paragraph 4 of AASB 117 as:
The payments over the lease term that the lessee is or can be required to make,
excluding contingent rent, costs for services and taxes to be paid by and reimbursed
to the lessor, together with:
(a) for a lessee, any amounts guaranteed by the lessee or by a party related to
the lessee; or
(b) for a lessor, any residual value guaranteed to the lessor by:
(i) the lessee;
(ii) a party related to the lessee; or
(iii) a third party unrelated to the lessor that is financially capable of
discharging the obligations under the guarantee.
However, if the lessee has an option to purchase the asset at a price that is expected
to be sufficiently lower than the fair value at the date the option becomes exercisable
for it to be reasonably certain, at the inception of the lease, that the option will be
exercised, the minimum lease payments comprise the minimum payments payable
over the lease term to the expected date of exercise of this purchase option and the
payment required to exercise it.

11.9 (a) Firstly, to be classified as a finance lease, the lease must be such that it transfers the
risks and rewards of ownership to the lessee. As already indicated in the answers to
previous questions, AASB 117 dedicates a number of paragraphs (paragraphs 10 to
12) to assist in determining whether a lease is a finance lease or an operating lease.
As we know, a finance lease is to be capitalised, whereas an operating lease is not
capitalised (that is, not included within the balance sheet). These paragraphs state:
10. Whether a lease is a finance lease or an operating lease depends on the
substance of the transaction rather than the form of the contract. Examples of
situations that individually or in combination would normally lead to a lease
being classified as a finance lease are:
(a) the lease transfers ownership of the asset to the lessee by the end of the lease
term;
(b) the lessee has the option to purchase the asset at a price that is expected to be
sufficiently lower than the fair value at the date the option becomes exercisable
for it to be reasonably certain, at the inception of the lease, that the option will
be exercised;
(c) the lease term is for the major part of the economic life of the asset even if title
is not transferred;
 (d) 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
(e) the leased assets are of such a specialised nature that only the lessee can use
them without major modifications.
11. Indicators of situations that individually or in combination could also lead to a
lease being classified as a finance lease are:
(a) if the lessee can cancel the lease, the lessors losses associated with the
cancellation are borne by the lessee;
(b) gains or losses from the fluctuation in the fair value of the residual accrue to
the lessee (for example, in the form of a rent rebate equalling most of the sales
proceeds at the end of the lease); and
(c) the lessee has the ability to continue the lease for a secondary period at a rent
that is substantially lower than market rent.
12. The examples and indicators in paragraphs 10 and 11 are not always
conclusive. If it is clear from other features of the lease that the lease does not
transfer substantially all risks and rewards incidental to ownership, the lease is
classified as an operating lease. For example, this may be the case if ownership
of the asset transfers at the end of the lease for a variable payment equal to its
then fair value, or if there are contingent rents, as a result of which the lessee
does not have substantially all such risks and rewards.
Now turning our attention to part (a) of the question, given the guidance in paragraph
10 above, the lease would not be deemed to be a finance lease. The lease term is five
years and the asset has a useful life of eight years. As such, the lease would not be
considered to cover the major part of the economic life of the asset. (As a rule of
thumb, a major part should constitute at least 75 per cent of the useful life of the
asset.) The period covered by the option would not be included in the lease term as
the lease rental is not low enough to give reasonable assurance of renewal (that is, it
is not below normal commercial rates). We cannot anticipate the market rentals in
five years time with any accuracy.
The present value of minimum lease payments is 80 per cent of the fair value of the
leased property. Eighty per cent would not be construed as at least substantially all
of the fair value of the leased asset. (A rule of thumb might be that the present value
of the minimum lease payments should constitute at least 90 per cent of the fair
value of the leased asset at the inception of the lease.) Hence, given the lease term
and the present value of the minimum lease payments do not satisfy the guidelines
provided in paragraph 10 above, the lease is not considered to transfer the risks and
rewards of ownership. From the perspective of the lessee, the term guaranteed
residual does not include amounts guaranteed by a third party unrelated to the lessee
(although it can include amounts guaranteed by related entities). Hence, from the
perspective of the lessee, the lease would be an operating lease.
From the perspective of the lessor, the minimum lease payments include a residual
guaranteed by a third party unrelated to the lessor that is financially capable of
discharging the obligations under the guarantee. (Contrast this with the lessee
wherein the guarantee by an unrelated third party is excluded from minimum lease
payments.) With the inclusion of the guaranteed residual in the minimum lease
payments to the lessor, and given that at the time of 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, the lessor would classify the lease as a finance
lease.
(b) In this case, the present value of the minimum lease payments includes the lease
payments plus 50% of the residual (from definitions of minimum lease payments
and guaranteed residual value).
This amounts to 87.5% (calculated as 0.75 + 0.5 x 0.25) of the fair value of the
leased asset at the beginning of the leased term. Prima facie, this would not be a
finance lease as it is arguable that 87.5% would not be considered to represent
substantially all of the fair value of the leased asset.
(c) According to the guidelines in AASB 117, this would not be classified as a finance
lease. The renewal period is not included in the definition of the lease term.
However, the existence of the put option is probably sufficient to suggest
classification as a finance lease by both the lessee and the lessor. Assume that the
residual value equals the estimated fair value at the end of the lease term. In this
case, one could argue that the lessee bears substantially all the risks and rewards of
ownership.
One would expect that ownership would revert to the lessee if the market value is
less than the residual value. This is economically equivalent to guaranteeing the
residual value.
(d) At two thirds of the economic life of the asset, the term of the lease is not clearly for
the major part of the assets economic life. More convincing indicators that the lease
should be classified as a finance lease are that it is not cancellable (lessee would
incur lessors losses if cancelling) and the lessees ability to renew the lease at
substantially lower than market rent. The substantial discount is evident because on
renewal the lease payments would stay the same while market rentals have been
increased by the effects of inflation over eight years.

11.10 (a) As the lease is non-cancellable, and for the life of the asset, the lease is clearly a
finance lease from both the lessors and lessees perspective. From the lessees
perspective it is a sale and leaseback, with any profit on sale required to be amortised
over the life of the lease. From the lessors perspective, the lease is a direct finance
lease.
(b) The interest rate implicit in the lease is that rate which, when used to discount the
minimum lease payments plus any unguaranteed residual, equates the discounted
aggregate amounts to the fair value of the asset at the commencement of the lease.
(From the perspective of the lessor the discounted aggregated amounts would be
equated to fair value of the leased asset plus any initial direct costs of the lessorsee
the definition provided within AASB 117.) The present value of an annuity in arrears
of 10 lease payments of $22 784 at 10% is equal to $22 784 x 6.1446 = $140 000.
Therefore, the implicit rate is 10%.
(c) In the books of the Lessee Company Ltd, 1 July 2015
Dr Cash 140 000
Cr Tractor (net) 100 000
Cr Deferred gain on sale of tractor 40 000
 Dr Leased asset 140 000
Cr Lease liability 140 000

30 June 2016
Dr Interest expense 14 000
Dr Lease liability 8784
Cr Cash 22 784
(14 000 = 140 000 x 0.10)

Dr Depreciation of leased asset 14 000

Cr Accumulated depreciation 14 000

Dr Deferred gain on sale of tractor 4000

Cr Profit on sale of leased asset (revenue) 4 000
(d) In the books of the Lessee Company Ltd, 30 June 2017
Dr Interest expense 13 122
Dr Lease liability 9662
Cr Cash 22 784
[13 122 = (140 000 8784) x 0.10]

Dr Depreciation of leased asset 14 000

Cr Accumulated depreciation 14 000

Dr Deferred gain on sale of tractor 4000

Cr Profit on sale of leased asset (revenue) 4 000
It should be noted that whilst we have recorded the partial recognition of the profit
on sale as an income item, some organisations might treat this as an offset against the
depreciation expense. The net effect on profit or loss will be the same.

11.11 (a) As in Question 11.9, the interest rate implicit in the lease is 10 per cent and the
present value of the minimum lease payments is $140 000. Had there been any initial
direct costs to the lessor (amounts that are directly attributable to negotiating and
arranging a lease) then the interest rate implicit in the lease would have been greater
however, there are no initial direct costs identified in this question.
(b) Net method
1 July 2015
Dr Plant and equipmenttractor 140 000
Cr Cash 140 000

Dr Lease receivable 140 000

Cr Plant and equipmenttractor 140 000
30 June 2016
Dr Cash 22 784
Cr Lease receivable 8 784
Cr Interest revenue 14 000
(c) Gross method
1 July 2015
 Dr Plant and equipmenttractor 140 000
Cr Cash 140 000

Dr Lease receivable 227 840

Cr Unearned interest 87 840
Cr Plant and equipmenttractor 140 000
30 June 2016
Dr Cash 22 784
Cr Lease receivable 22 874

Dr Unearned interest 14 000

Cr Interest revenue 14 000

11.12 To undertake this calculation students may use trial and error. The implicit rate is 18%,
proven as follows:
Present value of initial payment $5000 x 1.0 = $5000
Present value of yearly payments ($5500 $500) x 4.4941 = $22 470
Fair value at lease inception $27 470
Alternatively, and more easily, we can divide the liability on 1 July 2015 (which would
exclude the payment of $5000 at lease inception) by the periodic lease payments (after
deducting the executory costs) and then search for the appropriate interest rate within the
present value tables. This is easy because of the absence of a guaranteed residual or a
bargain purchase option.
(27 470 5000) 5000 = 4.494
A review of the present value of an annuity table shows that $4.4941 equals the present
value of an annuity in arrears of $1 per year, for 10 years, discounted at 18 per cent.

11.13 (a) The implicit rate is that rate which when used to discount the minimum lease
payments plus any unguaranteed residual, equates the discounted minimum lease
payments to the fair value of the asset at the commencement of the lease. Bargain
purchase options are included as part of the minimum lease payments. In this
question the implicit rate is 12 per cent, proven as follows:
Periodic lease payments 315 000 x 3.6048 = 1 135 512
Bargain purchase option 280 000 x 0.5674 = 158 872
Fair value at lease inception 1 294 384
(b) 1 July 2015
Dr Leased asset 1 294 384
Cr Lease liability 1 294 384
30 June 2016
Dr Interest expense 155 326
Dr Lease liability 159 674
Dr Executory costs 35 000
Cr Cash 350 000
(155 326 = 1 294 384 x 0.12)
 Dr Depreciation expense 180 731
Cr Accumulated leasehold depreciation 180 731
180 731 = (1 294 384 210 000)/6
Note that the useful life of the asset is used for depreciation purposes given the
existence of the bargain purchase options which would result in the asset being
transferred to the lessee at the end of the 5 year lease.
30 June 2017
Dr Interest expense 136 165
Dr Lease liability 178 835
Dr Executory costs 35 000
Cr Cash 350 000
[136 165 = (1 294 384 159 674) x 0.12]

Dr Depreciation expense 180 731

Cr Accumulated leasehold depreciation 180 731
(c)
30 June 2016 30 June 2017
Non-current assets
Leased asset $1 294 384 $1 294 384
Less accumulated depreciation 180 731 361 462
$1 113 653 $932 922
Current liabilities
Lease liability $178 835 200 295
Non current liabilities
Lease liability $955 875 $755 580
The current portion of the lease liability ($178 835 in 2016, and $200 295 in 2017) is
the amount by which the lease liability will be reduced by the lease payments in the
following 12 months. In 2017 the current liability component would be calculated as:
$315 000 [($1 294 384 $159 674 $178 835) x 0.12]
(d) 30 June 2016
Dr Executory expenses 35 000
Dr Lease expense 315 000
Cr Cash 350 000
To record lease payment for 2016
30 June 2017
Dr Executory expenses 35 000
Dr Lease expense 315 000
Cr Cash 350 000
To record lease payment for 2017

11.14 (a) Present value of minimum lease payments:

 (62 500 6250) x 3.6048 = 202 770
50 000 x 0.5674 = 28 370
Present value of minimum lease payments 231 140

(b) (i) Books of Sanders using the net method

1 July 2015
Dr Lease receivable 231 140
Dr Cost of sales 200 000
Cr Inventory 200 000
Cr Sales 231 140

30 June 2016
Dr Cash 62 500
Cr Executory expense recoupment (statement of 6 250
comprehensive income)
Cr Interest revenue 27 737
Cr Lease receivable 28 513
(27 737 = 231 140 x 0.12)

30 June 2017
Dr Cash 62 500
Cr Executory expense recoupment (statement of 6 250
comprehensive income)
Cr Interest revenue 24 315
Cr Lease receivable 31 935
[24 315 = (231 140 28 513) x 0.12]

(ii) Books of Gregory Ltd

1 July 2015
Dr Leased machinery 231 140
Cr Lease liability 231 140

30 June 2016
Dr Interest expense 27 737
Dr Lease liability 28 513
Dr Executory costs 6 250
Cr Cash 62 500

Dr Depreciation expense 33 020

Cr Accumulated leasehold depreciation 33 020
33 020 = (231 140) 7

30 June 2017
Dr Interest expense 24 315
 Dr Lease liability 31 935
Dr Executory costs 6250
Cr Cash 62 500

Dr Depreciation expense 33 020

Cr Accumulated leasehold depreciation 33 020
33 020 = (231 140) 7

11.15 (a) The implicit rate is that rate which, when used to discount the minimum lease
payments plus any unguaranteed residual, equates the discounted minimum lease
payments plus any unguaranteed residual to the fair value of the asset at the
commencement of the lease. The implicit rate is 10 per cent, proven as follows:
Periodic lease payments ($375 000 $25 000) x 4.8684 = $1 703 940
Unguaranteed residual $500 000 x 0.5132 = $256 600
Fair value of leased land and $1 960 540*
buildings
* $10 rounding error
In terms of parts (b) to (d) of this question, a number of issues need to be considered.
Firstly, when a lease includes both land and buildings elements, an entity assesses the
classification of each element as a finance or an operating lease separately. In
determining whether the land element is an operating or a finance lease, an important
considerationas indicated at paragraph 15A of AASB 117is that land normally
has an indefinite economic life.
Secondly, whenever necessary in order to classify and account for a lease of land and
buildings, the minimum lease payments (including any lump-sum upfront payments)
are allocated between the land and the buildings elements in proportion to the
relative fair values of the leasehold interests in the land element and buildings
element of the lease at the inception of the lease (see paragraph 16 of AASB 117).
Thirdly, for a lease of land and buildings in which the amount that would initially be
recognised for the land element is immaterial, paragraph 17 of AASB 117 allows the
land and buildings to be treated as a single unit for the purpose of lease classification
and classified as a finance or operating lease. However, as paragraph 18 of AASB
117 states, separate measurement of the land and buildings elements is not required if
the lessee's interest in both land and buildings is classified as an investment property
in accordance with IAS 40 and the fair value model is adopted.
(b) As indicated above, the lease payments should be allocated on the basis of the fair
values of the assets at the inception of the lease. Therefore the allocation of lease
payments is:
Land = 350 000 x (588 160/1 960 530) = $105 000
Building = 350 000 x (1 372 370/1 960 530) = $245 000
The present value of the minimum lease payments (which excludes the unguaranteed
residual) relating to the building is:
$245 000 x 4.8684 = $1 192 758
(c)
Date Lease Interest Principal Outstanding
 payment for expense reduction balance
building
1 July 2015 1 192 758
30 June 2016 245 000 119 275 125 725 1 067 030
30 June 2017 245 000 106 705 138 295 928 735
30 June 2018 245 000 92 875 152 125 776 610
30 June 2019 245 000 77 660 167 340 609 270
30 June 2020 245 000 60 925 184 075 425 195
30 June 2021 245 000 42 520 202 480 222 715
30 June 2022 245 000 22 275 222 725 (10)*
* $10 rounding error
Because the land is not being transferred to the lessee at the end of the lease term, its
life is quite indefinite and the amount paid for the lease component associated with
the land is not deemed to be immaterial, the lease of the land will be treated as an
operating lease.
1 July 2015
Dr Leased buildings 1 192 758
Cr Lease liability 1 192 758
(To record the asset and liability at the inception of the finance lease.)
30 June 2016
Dr Executory expenses 25 000
Dr Interest expense 119 275
Dr Lease liability 125 725
Dr Lease rental expense 105 000
Cr Cash 375 000
(To record the lease payment. [119 275 = 1 192 758 x 0.10])

Dr Lease depreciation expense 170 394

Cr Accumulated depreciation 170 394
(To record depreciation expense [1 192 758 7]. As the lessee does not appear likely
to retain the asset, the life of the lease is used for depreciation.)
30 June 2017
Dr Executory expenses 25 000
Dr Interest expense 106 705
Dr Lease liability 138 295
Dr Lease rental expense 105 000
Cr Cash 375 000
(To record the lease payment. [106 705 = 1 192 758 125 725 x 0.10])
 Dr Lease depreciation expense 170 394
Cr Accumulated depreciation 170 394

(d) 1 July 2015

Dr Land 588 160
Dr Buildings 1 372 370
Cr Cash 1 960 540

Dr Lease receivable 1 372 370

Cr Buildings 1 372 370
(To capitalise the present value of the minimum lease payments and the
unguaranteed residual.)
30 June 2016
Dr Cash 375 000
Cr Lease rental income 105 000
Cr Lease receivable 125 725
Cr Interest revenue 119 275
Cr Executory expenses recouped 25 000

30 June 2017
Dr Cash 375 000
Cr Lease rental income 105 000
Cr Lease receivable 138 295
Cr Interest revenue 106 705
Cr Executory expenses recouped 25 000

Optional issues
The above answers have been compiled in accordance with the Accounting Standard, AASB
117, but a number of issues may be raised.
The Standard requires that the lease payments be allocated between the land and the
buildings on the basis of their relative fair values at the inception of the lease (paragraph 16,
AASB 117). This leads to the lease payments attributed to the buildings being calculated as
$245 000 per period.
As we know, the implicit rate is that rate which causes the present value of the minimum
lease payments plus any unguaranteed residual to equal the fair value of the asset at lease
inception.
If we multiply $245 000 by 4.8684 (10%) this gives $1 192 758. If we discount the
unguaranteed residual we get $256 600. Adding these 2 numbers gives $1 449 358, which is
more than the fair value at the lease inception.
 If we allocated the lease payments on the basis of the formula (which is not suggested by the
Standard):
Total lease payment x Fair value of the component PV of unguaranteed residual
Present value of land and buildings less PV of unguaranteed residuals

The portion relating to buildings = $350 000 x 1 372 370 256 600 = $229 186
1 960 530 256 600

and the portion relating to land would be = $350 000 x 588 160 = $120 812
1 960 530 256 600

($229 186 x 4.8684) + ($500 000 x 0.5132) = $1 372 370 = the fair value of the building at
lease inception. This amount also represents the amount that would be treated as the lease
receivable in the books of the lessor. If we allocate the lease payments as described above
then in the seventh year of the lease term we would have a balance of $500 000, which
represents the unguaranteed residual for the building. This is shown below. Adopting the
method of allocation as indicated in the Standard will not lead to this result.
Lease receipt Interest Principal Closing
Date for building revenue reduction receivable
1 July 2015 1 372 370
30 June 2016 229 186 137 237 91 949 1 280 421
30 June 2017 229 186 128 042 101 144 1 179 277
30 June 2018 229 186 117 928 111 258 1 068 019
30 June 2019 229 186 106 802 122 384 945 635
30 June 2020 229 186 94 563 134 623 811 012
30 June 2021 229 186 81 101 148 085 662 927
30 June 2022 229 186 66 293 162 893 (500 034)*
* $34 rounding error

11.16 To the extent that the organisation recognised the profit on the sale, and to the extent that
they comply with accounting standards, then the lease must have been classified as an
operating lease. Otherwise, if the lease was a finance lease, the profit on the sale of the asset
would have had to be recognised over the term of the lease. As paragraph 59 of AASB 117
states:
If a sale and leaseback transaction results in a finance lease, any excess of sales
proceeds over the carrying amount shall not be immediately recognised as income by a
seller-lessee. Instead, it shall be deferred and amortised over the lease term.

Challenging questions
11.17 The IASB and FASB are planning to remove the requirement that leases be classified into
financial and operating leases. Rather, they intend to apply the asset and liability definitions
and recognition criteria incorporated within the Conceptual Framework for Financial
Reporting. Therefore, if a lease agreement provides a lessee with a legally enforceable right
to use an asset, and provides a legally enforceable obligation to make lease payments then a
leased asset and lease liability shall be recognised, regardless of whether the risks and
rewards of ownership transfer to the lessee.
Whilst we cannot be sure how (or if) managers will respond to a change in an accounting
standard it would seem likely that the attractiveness of using short-term lease arrangements
which would currently be classified as operating leases with the consequence that no asset
or liability would appear on the statement of financial positionwill diminish. Conceivably,
this could mean that managers will elect not to lease assets on a short-term basis, but rather
will lock in to longer arrangements. Also, in relation to landwhere associated leases
would, under existing rules, frequently be treated as operating leasesthere might be an
increased propensity to acquire such assets (with associated borrowings) rather than entering
into long-term lease arrangements as the effect on the financial statements would effectively
become the same under both arrangements.

11.18 In answering this question we will firstly consider paragraph 28 of AASB 117 as it relates to
the depreciation of a leased asset. We will also consider the definition of guaranteed
residual.
Paragraph 28 of AASB 117 states:
The depreciable amount of a leased asset is allocated to each reporting period during
the period of expected use on a systematic basis consistent with the depreciation policy
the lessee adopts for depreciable assets that are owned. If there is reasonable certainty
that the lessee will obtain ownership by the end of the lease term, the period of expected
use is the useful life of the asset; otherwise the asset is depreciated over the shorter of
the lease term and its useful life.
Paragraph 4 of AASB 117 defines a guaranteed residual value as:
(a) for a lessee, that part of the residual value that is guaranteed by the lessee or by a
party related to the lessee (the amount of the guarantee being the maximum amount
that could, in any event, become payable); and
(b) for a lessor, that part of the residual value that is guaranteed by the lessee or by a
third party unrelated to the lessor that is financially capable of discharging the
obligations under the guarantee.
(a) The guaranteed residual is included in the minimum lease payments, and hence is
included in the $250 000. If the lessee is expected to retain the asset at the end of the
lease term then the lease asset should be depreciated over the useful life of the asset.
Depreciation expense per year = ($250 000 - $10 000) 8 = $30 000
(b) If the lessee expects to return the asset to the lessee at the end of the lease term, and
to the extent that the asset has a value equal to the guaranteed residual at the end of
the lease term (meaning that the lessee can return the asset at the end of the lease
term and have no further obligation to transfer additional money) then the
depreciation would be:
Present value of minimum lease payments $250 000
 Less, present value of guaranteed residual (included in minimum
lease payments) and we will assume an implicit rate of 10 per cent:
20 000 x 0.5132
$239 736
Depreciation: $239 736 7 $34 248

11.19 (a) The seller does not lose control of the asset (if the lease is a finance lease), but is able
to free-up funds for other activities which might generate higher returns that might
be yielded from the property market. The sale might also enable the entity to
diversify into other activities. At the time of the sale, the seller is also able to lock in
any capital gains that might have occurred (although from an accounting perspective,
if the subsequent lease is a finance lease, any gains must be recognised over the lease
term).
(b) Because Lion Nathan would probably want to retain control of the properties, it
would be expected that the leases would be finance leases (thereby causing Lion
Nathan to continue to hold the risks and rewards of asset ownership).
(c) and (d) The required accounting treatment of any profit or loss on sale will depend upon
whether the subsequent lease is a finance lease or operating lease. Paragraph 59 of
AASB 117 requires:
If a sale and leaseback transaction results in a finance lease, any excess of sales
proceeds over the carrying amount shall not be immediately recognised as
income by a seller-lessee. Instead, it shall be deferred and amortised over the
lease term.
If the lease is an operating lease, paragraph 61 of AASB 117 requires:
If a sale and leaseback transaction results in an operating lease, and it is
clear that the transaction is established at fair value, any profit or loss shall
be recognised immediately. If the sale price is below fair value, any profit or
loss shall be recognised immediately except that, if the loss is compensated
for by future lease payments at below market price, it shall be deferred and
amortised in proportion to the lease payments over the period for which the
asset is expected to be used. If the sale price is above fair value, the excess
over fair value shall be deferred and amortised over the period for which the
asset is expected to be used.
Paragraph 63 further states:
For operating leases, if the fair value at the time of a sale and leaseback
transaction is less than the carrying amount of the asset, a loss equal to the
amount of the difference between the carrying amount and fair value shall be
recognised immediately.

11.20 (a) 1 July 2015

Dr Cash 4 334 700
Dr Accumulated depreciation 350 000
Cr Land 1 800 000
Cr Buildings 1 750 000
 Cr Profit on sale of land 367 350
Cr Deferred gainbuildings 767 350

Dr Leased building 2 167 350

Cr Lease liability 2 167 350

Dr Lease liability 300 000

Dr Prepaid rentland 300 000
Cr Cash 600 000
(The amount of the upfront payment that relates to the operating lease is to be treated
as prepaid rent, which will subsequently be amortised over the periods expected to
benefit from the prepayment.)
In terms of this question, a number of issues need to be considered. Firstly, when a
lease includes both land and buildings elements, an entity assesses the classification
of each element as a finance or an operating lease separately. In determining whether
the land element is an operating or a finance lease, an important considerationas
indicated at paragraph 15A of AASB 117is that land normally has an indefinite
economic life.
Secondly, whenever necessary in order to classify and account for a lease of land and
buildings, the minimum lease payments (including any lump-sum upfront payments)
are allocated between the land and the buildings elements in proportion to the
relative fair values of the leasehold interests in the land element and buildings
element of the lease at the inception of the lease (see paragraph 16 of AASB 117).
Thirdly, for a lease of land and buildings in which the amount that would initially be
recognised for the land element is immaterial, paragraph 17 of AASB 117 allows the
land and buildings to be treated as a single unit for the purpose of lease classification
and classified as a finance or operating lease. However, as paragraph 18 of AASB
117 states, separate measurement of the land and buildings elements is not required if
the lessees interest in both land and buildings is classified as an investment property
in accordance with IAS 40 and the fair value model is adopted.
In this question, because the land is not being transferred to the lessee at the end of
the lease term, its life is quite indefinite and the amount paid for the lease component
associated with the land is not deemed to be immaterial given it is 50 per cent of the
total lease payments, the lease of the land will be treated as an operating lease.
(b) 1 July 2015
Dr Building 2 167 350
Dr Land 2 167 350
Cr Cash 4 334 700

Dr Lease receivable 2 167 350

Cr Building 2 167 350

Dr Cash 600 000

 Cr Lease receivable 300 000
Cr Rent received in advance 300 000
(c) 30 June 2025
To determine the interest expense for the year ended 30 June 2025 we need to
consider what the present value of the liability was at the beginning of the financial
year. That is, as at 1 July 2024. As at 1 July 2024 there were 11 payments of
$250 000 remaining. The $500 000 lease payments are divided equally between the
land and buildings given that both have the same fair value at the inception of the
lease. At an implicit rate of 12 per cent, the present value of these 10 payments is
$250 000 x 5.9377 = $1 484 425. The interest expense will, therefore, be $1 484 425
x 12 per cent = $178 131.
Dr Lease payable 71 869
Dr Interest expense 178 131
Dr Rental expense 250 000
Cr Cash 500 000

Dr Lease depreciation expense 108 368

Cr Accumulated lease depreciation 108 368
(2 167 350 20 = 108 368)
Dr Deferred gainbuilding 38 368
Cr Profit on sale of leased asset 38 368
(38 368 = 767 350 20)
Dr Rental expenseland 15 000
Cr Prepaid rent 15 000
(15 000 = 300 000 20)
(d) 30 June 2025
Dr Cash 500 000
Cr Interest revenue 178 131
Cr Lease receivable 71 869
Cr Rental incomeland 250 000

Dr Revenue received in advance 15 000

Cr Rental income 15 000

11.21(a) Flyer Ltd

Firstly, although not required by the question, we can prove that the interest rate
implicit in the lease is 10 per cent:
$300 000 x 1.0 = $300 000
$250 000 x 8.5136 = $2 128 400
$2 428 400
 1 July 2015
Dr Leased plantaeroplane 2 428 400
Cr Lease liability 2 428 400

Dr Lease liability 300 000

Cr Cash 300 000
(b) Finance Ltd
1 July 2015
Dr Plant and machineryaeroplane 2 428 400
Cr Cash 2 428 400

Dr Lease receivable 2 428 400

Cr Plant and machineryaeroplane 2 428 400

Dr Cash 300 000

Cr Lease receivable 300 000
(c) Flyer Ltd
To determine the entry for the final lease payment we must determine the present
value of one payment of $250 000 in one year discounted at 10 per cent. The present
value is $250 000 x 0.9091 = $227 275.
Dr Interest expense 22 725
Dr Lease liability 227 275
Cr Cash 250 000

Dr Lease depreciation expense 121 420

Cr Accumulated depreciation 121 420
(121 420 = 2 428 400 20)
(d) Finance Ltd
Dr Cash 250 000
Cr Interest revenue 22 725
Cr Lease receivable 227 275

11.22 (a)
Present value of lease payments $100 000 n = 4, i = 10 $316 990
Present value of unguaranteed
residual $50 000 n = 4, i = 10 34 150
Fair value of truck at 1 July 2015 $351 140
(b)
Year Beginning Lease Interest Lease Closing lease
 lease
ended investment receipt revenue reduction receivable
06/16 351 140 100 000 35 114 64 886 286 254
06/17 286 254 100 000 28 625.4 71 374.6 214 879.4
06/18 214 879.4 100 000 21 487.94 78 512.06 136 367.3
06/19 136 367.34 150 000 13 636.734 136 363.3 4

The lease receipt in June 2019 includes unguaranteed residual on the basis that there
is an expectation that the lessee will decide to make this payment and take ownership
of the truck (meaning that the lessee will pay $50 000 to the lessee rather than
returning an asset that is expected to have a value of $50 000). In any case, the
unguaranteed residual would still be included within the present value of the lease
receivable as the lessor expects to have a truck returned to it with a value of $50 000
at the end of the lease even if the lessee does not elect to take ownership. On the
basis that there is an expectation that the lessee will elect to buy the asset at the end
of the lease, then no repainting will be required and therefore the repainting costs of
$40 000 have not been considered.

1 July 2015
Dr Cost of goods sold 180 000
Cr Inventory 180 000

Dr Lease receivable 351 140

Cr Sales 351 140

30 June 2016
Dr Cash 100 000
Cr Interest revenue 35 114
Cr Lease receivable 64 886

(c) Lessee PV of lease liability is $316 990 per part (a), excludes unguaranteed residual
Beginning
lease Lease Interest Lease Closing lease
liability payment expense reduction liability
Y/E 06/16 316 990 100 000 31 699 68 301 248 689
Y/E 06/17 248 689 100 000 24 868.9 75 131.1 173 557.9
Y/E 06/18 173 557.9 100 000 17 355.79 82 644.21 90 913.69
Y/E 06/19 90 913.69 100 000 9091.369 90 908.63 5.059*
* rounding error
1 July 2015
 Dr Leased truck 316 990
Cr Lease liability 316 990

30 June 2016
Dr Interest expense 31 699
Dr Lease liability 68 301
Cr Cash 100 000

Dr Depreciation expense 63 398

Cr Accumulated depreciationleased truck 63 398
Depreciation is $316 990/5 years as there is intention is to keep the truck at the end
of the lease term
 (d) 30 June 2019
Dr Interest expense 9091
Dr Lease liability 90 909
Cr Cash 100 000

Dr Depreciation expense 63 398

Cr Accumulated depreciationleased truck 63 398

Dr Accumulated depreciationleased truck 253 592

Cr Accumulated depreciationtruck 253 592

Dr Truck 316 990

Cr Leased truck 316 990

Dr Truck 50 000
Cr Cash 50 000
The third and fourth set of entries undertaken above are done because the truck is no
longer leased but is owned and there is a requirement that leased assets be disclosed
separately from owned (freehold) assets. We have simply moved all existing leased
truck balances across to truck balances.

11.23 (a) fair value + nil initial direct costs = PV minimum lease payments + any unguaranteed
residual
Initial payment on 1 July 2015 payment $50 000
$50 000 paid at the beginning of each
year (meaning that the final payment
is in three years and not four years as
would be the case if the lease
payments were made at the end of
each lease year), number of year =3,
PV of remaining lease rental interest rate =8% 128 855
40 000, number of years = 4
PV of guaranteed residual interest rate =8% 29 400
$208 255
Because the residual value is guaranteed it is included in the lease liability. This
means that at the conclusion of the lease the lessee shall return to the lessor a leased
asset which is expected to have a fair value of $40 000. If the leased asset has a value
of less than $40 000 at the end of the lease term then the lessee is obliged to pay an
amount to the lessor equal to the difference between the expected fair value of
$40 000 and its actual value.
(b) Initial payment reduces the liability
Beginning Lease Closing
lease Lease Interest Accrued liability lease
liability payment expense interest reduction liability
1 June 2015 208 255 50 000 158 255
30 June 2016 158 255 12 660 0 158 255
1 July 2016 158 255 50 000 12 660 37 340 120 915
30 June 2017 120 915 9 673 0 0 120 915
1 July 2017 120 915 50 000 9 673 40 327 80 589
30 June 2018 80 589 6 447 0 0 80 589
1 July 2018 80 589 50 000 6 447 43 553 37 036
30 June 2019 37 036 2 964 0 0 37 036
1 July 2019 37 036 40 000 2 964 37 036 0
Lease payment on 1 July 2019 is the guaranteed residual.
(c) 1 July 2015
Dr Leased studio 208 255
Cr Cash 50 000
Cr Lease liability 158 255

30 June 2016
Dr Interest expense 12 660
Cr Accrued interest 12 660

Dr Depreciation expense 42 064

Cr Accumulated depreciation 42 064
Depreciation: ($208 255 $40 000)/4)
Note that the accrued interest expense is recognised because the lease payment is not
made until 1 July and therefore at the end of the reporting period (30 June) it is
necessary to recognise the unpaid (accrued) interest expense for the year.
1 July 2016
Dr Lease liability 37 340
Dr Accrued interest 12 660
Cr Cash 50 000
The above entry is to accrued interest (a liability) and not interest expense as the
interest expense of $12 660, and the accrued liability of $12 660, was recognised on
30 June 2016.
(d) Hopeful Ltd must pay $15 000, being the difference between the fair value of the
studio and the guaranteed residual.
1 July 2019
Dr Accumulated depreciation 168 255
Cr Leased studio 168 255

Dr Lease liability 37 036

Dr Accrued interest 2964
Cr Leased studio 40 000

Dr Loss on guaranteed residual 15 000

Cr Cash 15 000
Alternatively the $15 000 loss would have been recognised on 30 June 2019, if
known. The final payment might occur later, when the fair value of the vehicle has
been assessed.