E14 Advanced Accounting and Financial Reporting Lecture 03

E-14 Advanced Accounting and Financial Reporting Lecture 03 IAS 17 Leases Sajid Shafiq, ACA

Overview • Objectives, Scope and Definitions • Classification of lease- Operating & Finance • Lease Accounting by LESSEE – Finance Lease – Operating Lease – Sale and Leaseback transactions • Lease Accounting by LESSOR – Finance Lease – Operating Lease – Manufacturer-Dealer cum lessor • Present Value and Annuity Tables and Formula • Class Practice Questions 03 - IAS 17 Leases 2

Objectives, Scope and Definitions Objectives • IAS 17 sets out the appropriate accounting treatment and disclosures for lease transactions in the FS of an entity; • It should be applied in accounting for all lease transactions except those that are specifically excluded. • IAS 17 sets out the accounting requirements for both lessees and lessors. Definitions • A lease is 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. • A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred. • An operating lease is a lease other than a finance lease. Scope • IAS 17 does not apply to: [IAS 17. 2] olease agreements set up for the exploration or use of minerals, oil, natural gas and similar nonregenerative resources; and olicensing agreements that are entered into for items such as motion picture films, video recordings, plays, manuscripts, patents and copyrights. • In addition, the measurement basis of IAS 17 does not apply to items which, due to their unique nature, are specifically addressed in other IASs. Examples include: oproperties that are recognised as investment properties in accordance with IAS 40; and obiological assets that are held by a lessee under finance lease arrangements or provided by a lessor under an operating lease and accounted for in accordance with IAS 41 03 - IAS 17 Leases 3

Objectives, Scope and Definitions • A non-cancellable lease is a lease that is cancellable only: a) upon the occurrence of some remote contingency; b) with the permission of the lessor; c) if the lessee enters into a new lease for the same or an equivalent asset with the same lessor; or d) upon payment by the lessee of such an additional amount that, at inception of the lease, continuation of the lease is reasonably certain. • The inception of the lease(Io. L) is the earlier of the date of the lease agreement and the date of commitment by the parties to the principal provisions of the lease. As at this date: a) a lease is classified as either an operating or a finance lease; and b) in the case of a finance lease, the amounts to be recognised at the commencement of the lease term are determined. • The commencement of the lease term is the date from which the lessee is entitled to exercise its right to use the leased asset. It is the date of initial recognition of the lease (ie the recognition of the assets, liabilities, income or expenses resulting from the lease, as appropriate). • The lease term is the non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option. • Fair value (FV)is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. 03 - IAS 17 Leases 4

Objectives, Scope and Definitions • Minimum lease payments (MLP)are o 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, o 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. o However, if the lessee has an option to purchase the asset at a price that is expected to be sufficiently lower than 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. 03 - IAS 17 Leases 5

Objectives, Scope and Definitions • Economic life is either: a) the period over which an asset is expected to be economically usable by one or more users; or b) the number of production or similar units expected to be obtained from the asset by one or more users. • Useful life is the estimated remaining period, from the commencement of the lease term, without limitation by the lease term, over which the economic benefits embodied in the asset are expected to be consumed by the entity. • Guaranteed residual value (GRV)is: 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. • Unguaranteed residual value (UGRV) is that portion of the residual value of the leased asset, the realisation of which by the lessor is not assured or is guaranteed solely by a party related to the lessor. • Initial direct costs (IDC) are incremental costs that are directly attributable to negotiating and arranging a lease, except for such costs incurred by manufacturer or dealer lessors. • Gross investment in the lease (GIL) is 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. 03 - IAS 17 Leases 6

Objectives, Scope and Definitions • Net investment in the lease (NIL) is the gross investment in the lease discounted at the interest rate implicit in the lease. • Unearned finance income (UEFI) is the difference between: a) the gross investment in the lease, and b) the net investment in the lease. • The interest rate implicit (IRR) in the lease is the discount rate that, at the inception of the lease, causes the aggregate present value of a) the minimum lease payments and b) the unguaranteed residual value to be equal to the sum of a) the fair value of the leased asset and b) any initial direct costs of the lessor. • The lessee’s incremental borrowing rate (IBR) of interest is the rate of interest the lessee would have to pay on a similar lease or, if that is not determinable, the rate that, at the inception of the lease, the lessee would incur to borrow over a similar term, and with a similar security, the funds necessary to purchase the asset. • Contingent rent is that portion of the lease payments that is not fixed in amount but is based on the future amount of a factor that changes other than with the passage of time (eg percentage of future sales, amount of future use, future price indices, future market rates of interest). 03 - IAS 17 Leases 7

Classification of lease- Operating & Finance Classification of a lease as either a finance lease or an operating lease depends on the substance of the transaction. Illustration 1 P needs to buy a new item of plant which would cost CU 100, 000 if bought for cash and which has a useful life of 5 years. P has no surplus cash available and has identified the following two financing options: Option 1 Borrow CU 100, 000 from a bank. This loan is repayable in five annual instalments of CU 24, 000 each (each instalment including interest of CU 4, 000). The cash transaction will be accounted for by recording: a) an asset for the purchase of the new item of plant at CU 100, 000; b) a liability of CU 100, 000 to the bank; c) as each annual instalment is paid, a reduction in cash of CU 24, 000, a reduction in the liability of CU 20, 000 and interest of CU 4, 000 recognised in profit or loss; and d) depreciation of CU 20, 000 per annum recognised in profit or loss. Option 2 Lease plant from that leasing division of bank in return for paying five annual lease instalments of CU 24, 000 each. Without IAS 17 the transaction would involve recognising in IS the annual rental instalments of CU 24, 000. Issue The two accounting treatments are different and have a significant impact on the ‘picture’ presented by the FS. In Option 2 no asset or debt is recognised in the SFP and hence no finance cost or depreciation is recognised in IS. The substance of these two options is, however, the same, since P: • has possession and use of the asset for the whole of its five year useful life; and • is paying a total of CU 120, 000 for the use of the asset – CU 20, 000 more than its cash price, so CU 20, 000 is interest In substance, P has ‘bought’ the asset under both options, and the bank has provided the finance. The only real difference is that under Option 2 the entity never gets legal title. Option 2 would allow P to avoid showing debt in the SFP and take advantage of a form of financing that is not recognised in the FS. 03 - IAS 17 Leases 8

Classification of lease- Operating & Finance Illustration 2 A distributor of chemicals enters into a tolling agreement with a chemical producer. The producer agrees to build a customized facility to manufacture chemicals exclusively for the distributor. The useful life of the facility is estimated at ten years, which is the same period as the tolling agreement between the two parties. The facility is designed to meet only the distributor’s needs. The distributor must pay a fixed capacity charge per annum irrespective of whether it takes any of the facility’s production. It also pays a variable charge based on the actual production taken, which amounts to approximately 90% of the facility’s total variable costs. This arrangement contains a lease. The asset in the agreement is the facility and fulfillment of the agreement is dependent on that facility which is customized for the distributor’s requirements. The distributor has obtained the right to use the factory as it is customized for its needs and could not reasonably be used for another purpose. The price it will pay per unit is neither fixed nor equal to the market price at time of delivery. 03 - IAS 17 Leases 9

Classification of lease- Operating & Finance The classification of a lease is based on the extent to which ‘risks and rewards ‘ associated with ownership are transferred from the lessor to the lessee. If a lease transfers substantially all the risks and rewards normally associated with the ownership of an asset it should be classified as a finance lease; otherwise, it should be classified as an operating lease. Risk Reward Losses may arise: • where the asset stands idle for some time due to lack of sufficient demand; • from a fall in the value of the asset through technical obsolescence; and • from meeting the costs of maintaining and repairing the asset. Gains may arise from: • the generation of profits from use of the asset; • use of the asset for substantially the whole of its useful life; and • a potential gain arising on the future sale of the asset where it increases in value. 03 - IAS 17 Leases 10

Classification of lease- Operating & Finance In addition to the guidance described above, IAS 17 also sets out specific situations that, individually or collectively, would normally lead to a lease being classified as a finance lease. Such situations include where: 1. Ownership of the asset transfers to the lessee by the end of the lease term (such arrangements are sometimes known as a hire purchase); 2. The lessee has an option to purchase the asset. The price at which the option is set is such that it is reasonably certain that the option will be exercised. In other words, the price is set significantly below the fair value expected of the asset at the date the option becomes exercisable (this is sometimes referred to as a bargain purchase option); 3. The term of the lease is for the majority of the economic life of the asset. At the end of the lease, therefore, the asset will have virtually no further ability to generate future economic benefits; 4. The asset is so specialised that only the lessee can use it without major modifications; and 5. The present value of the minimum lease payments payable by the lessee under the lease is equal to substantially all of the fair value of the asset. Where this is the case, the lessee has effectively paid for the asset in full and therefore should treat the asset as if it had acquired it through a financing arrangement. 6. Losses associated with any cancellation of the lease are borne by the lessee; 7. Fluctuations in the fair value at the end of the lease term fall to the lessee; and 8. The lessee has the option to extend the lease for a secondary period at a rate that is substantially below market rate (this is often known as a ‘peppercorn rent’). 03 - IAS 17 Leases 11

Classification of lease- Operating & Finance Timing of classification & effect of subsequent changes • The examples and indicators stated earlier • Lease classification is made at the inception of the are not always conclusive. If it is clear lease. If at any time the lessee and the lessor agree from other features that the lease does to change the provisions of the lease, other than by not transfer substantially all risks and renewing the lease, in a manner that would have rewards incidental to ownership, the lease resulted in a different classification of the lease if the is classified as an operating lease. changed terms had been in effect at the inception of the lease, the revised agreement is regarded as a • For example, this may be the case if new agreement over its (new) term. ownership of the asset transfers at the end of the lease for a variable payment • However, changes in estimates (for example, changes equal to its then fair value, or if there are in estimates of the economic life or of the residual contingent rents, as a result of which the value of the leased property), or changes in lessee does not have substantially all such circumstances (for example, default by the lessee), risks and rewards. do not give rise to a new classification of a lease for accounting purposes. Further considerations Classification of Land Building • A characteristic of land is that it normally has an indefinite economic life • The land buildings elements of a lease are considered separately for the purposes of lease classification. • The minimum lease payments (including any lump-sum upfront payments) are allocated between the land 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. • If the lease payments cannot be allocated reliably between these two elements, the entire lease is classified as a finance lease, unless it is clear that both elements are operating leases, in which case the entire lease is classified as an operating lease. 03 - IAS 17 Leases 12

Lease Accounting by LESSEE Finance lease recognition Statement of financial position • Recognise a non-current asset • Recognise a liability for the lease obligation (i. e. the total payments outstanding including repayment instalments and finance charges accrued to date) Statement of comprehensive income • Recognise a charge for the depreciation of the non-current asset • Recognise a finance charge for the year Operating lease recognition Statement of financial position • Any excess or shortage of payment over rent due is shown as asset or liability (the normal prepaymentaccrual concept) Statement of comprehensive income • Recognise the rent due (lease instalment) as an expense for the year. • However, where it relates to construction/production of another asset, the amount of rent due will be included in the cost of that asset under respective IAS 03 - IAS 17 Leases 13

Lessee’s Finance Lease Initial Recognition • A lessee should recognise an asset and liability in its SFP at the commencement of the lease term. The amounts should be recorded at the FV of the asset or, if lower, the PV of the MLP, determined at Io. L. • The PV of the MLP is calculated by establishing the MLP due under the lease, as explained above, and discounting them to take account of the time value of money. • Any IDC incurred by the lessee are added to the asset’s cost. Depreciation • Since under a finance lease a non-current asset is recognised in the lessee’s SFP, IAS 17 also requires the asset to be depreciated in accordance with IAS 16. • The asset should be depreciated over its useful life or, if there is no reasonable certainty that the lessee will obtain ownership of the asset at the end of the lease term, the period of the lease if that is shorter. • The depreciation policy for leased assets should be consistent with those of legally owned assets. Illustration 3 On 1 January 2007 an entity enters into a finance lease for a photocopier with a fair value of CU 8, 000. The lease term is for 3 years, with no option to extend, and the copier will be returned to the lessor at the end of the 3 years. The present value of the minimum lease payments is CU 7, 500. The initial direct cost incurred by the lessee is CU 100. The copier should therefore be initially recognised at CU 7, 600, which is the lower of the fair value and the present value of the minimum lease payments plus initial direct cost. The useful life of the copier is estimated to be 4 years with a nil residual value. The entity operates a straight-line method of depreciation. The depreciation charge on the copier in 2007 is: CU 7, 600 / 3 years = CU 2, 533 Because the lessee will not gain ownership at the end of the 3 year period, the copier is depreciated over a 3 year period being the shorter of the lease term and the asset’s useful life. 03 - IAS 17 Leases 14

Lessee’s Finance Lease Finance charge • Each instalment made under a FL consists of a mixture of a finance charge and the repayment of capital. • The total finance charge over the total period of the lease is: CU Total lease rentals XXX Less: initial finance lease obligation being the lower of FV and PV of the MLP (XXX) Total finance charges XXX . • The total interest cost should be recognised in profit or loss over the accounting periods for which the lease liability is in existence. This is from the start of the lease until the last repayment is made. • The period over which the lease liability is in existence is not necessarily the same as the term of the lease. For example, if lease rentals are paid annually in advance, the lease finance will be paid off when the final payment is made at the start of the last year, but the lease term will include the last year, even though no liability will remain. • Different methods can be used for allocation of lease charges with the condition that it produces a constant periodic rate of interest on the outstanding lease obligation. One which is most commonly used in Pakistan is Actuarial method illustrated below. Illustration 4 An entity entered into a five year finance lease on 1 January 2007. The FV of the leased asset was CU 11, 500. Lease rentals of CU 3, 034 are payable annually in arrears on 31 December each year. The IRR is 10%. The asset is included in non-current assets at its fair value of CU 11, 500 and depreciated over the five year term. The finance charge for the year to 31 December 2007 is calculated on the outstanding balance of CU 11, 500. The finance cost will be CU 1, 150. At 31 December 2007 the lease liability of CU 9, 616 is calculated as the initial amount of CU 11, 500 plus the accrued interest of CU 1, 150 less the repayment of CU 3, 034. 03 - IAS 17 Leases 15

Lessee’s Finance Lease Disclosures • IAS 17 requires a number of disclosures to be made in relation to the effect that a finance lease has had on an entity’s financial statements during a period. • For each class of assets, for example land, buildings, plant and machinery, an entity should disclose the net carrying amount that relates to assets held under finance leases. An entity should present a reconciliation of the future minimum lease payments due at the end of the reporting period to their present value. These minimum lease payments and their present value should also be allocated over the periods in which payments will be made, as follows: – within one year; – within two to five years; and – after more than five years. • Disclosure should be made of any contingent rents that have been recognised as an expense during the period and the amount of any payments expected to be received under noncancellable subleases. • A description of an entity’s significant leasing arrangements should be presented. Such information will normally include the basis on which contingent rents are determined, the existence and terms of any options to extend the lease term or purchase the asset and any restrictions that are imposed on the lease arrangements. 03 - IAS 17 Leases 16

Lessee’s Operating Lease • • Operating Lease is a lease other than a finance lease IAS 17 requires lease payments made under an operating lease to be charged as an expense directly in profit or loss* on a systematic basis over the lease term. A straight-line basis should be used unless another basis is more representative of the timing of the benefits obtained by the user of the asset. [IAS 17. 33] Illustration 5 An entity enters into an operating lease arrangement for the use of a piece of machinery for a period of three years. The useful life of the asset is estimated as being around 15 years. The entity will pay annual rentals of CU 1, 000 over the three years. The entity expects the machinery to be used evenly over the three year period so the annual rental of CU 1, 000 should be recognised in each of the three years. * An exception applies where the use of asset is for construction-production of another asset. In that case, the amount of rent due is included in the cost of that asset. 03 - IAS 17 Leases 17

Lessee’s Operating Lease Disclosures for operating leases • An entity should disclose the outstanding payments under non-cancellable operating leases allocated between the following periods: [IAS 17. 35] – within one year; – within two to five years; and – after more than five years. • Where an entity expects to receive sub-lease rentals under an operating lease arrangement the total minimum payments at the end of the reporting period should be disclosed. • The total amount recognised in profit or loss for amounts under operating leases, including subleases, should be disclosed identifying amounts representing the minimum lease payments, contingent rents and sublease amounts. • A description of an entity’s significant leasing arrangements should be presented. Such information will normally include the basis on which any contingent rents are payable, the existence and terms of any options to extend the lease term, any escalation clauses or purchase options and any restrictions that are imposed on the lease arrangements. Illustration 6 An entity has the following outstanding non-cancellable operating lease commitments at the end of its reporting period: – rental on buildings of CU 100, 000 per annum for 15 years; – rental on plant of CU 30, 000 per annum for 3 years; and – rental on cars of CU 40, 000 for 11 months. The minimum lease payments under non-cancellable operating leases are: within 1 year (100, 000 + 30, 000 + 40, 000) within 2 – 5 years ((100, 000 x 4 yrs) + (30, 000 x 2 yrs)) after 5 years (100, 000 x 10 yrs) 03 - IAS 17 Leases CU 170, 000 460, 000 1, 630, 000 18

Sale and Lease Back Transactions • • An entity may enter into a financing arrangement to improve its liquidity through what is commonly referred to as a sale and leaseback transaction. In such circumstances, the entity sells the asset to a third party, receives proceeds for the sale and then leases the asset back and pays rentals for its use. A sale and leaseback transaction can result in a finance or operating lease, depending on the substance of the transaction. If the lease is identified as a finance lease, finance has been provided and the asset has been given as security for that finance. Any profit made on the sale of the asset is deferred. The excess of sale proceeds over the carrying amount of the asset at the date of the transaction is deferred in the SFP and amortised through profit or loss over the period of the lease. If the lease is identified as an operating lease and the lease payments and the sale price are established at FV, any profit made on the sale should be recognised immediately in profit or loss for the period. If, however, the sale price is below FV, then any loss arising should be deferred to the extent that future rental payments are below market value ( a compensation from lessor). The loss will be recognised in profit or loss as the rentals are recognised. If the sale price was above FV, the excess profit over FV should be deferred and recognised in the period over which the asset is expected to be utilised. Where an operating lease results and the fair value of the asset is less than its carrying amount at the time of the sale, then this loss should be recognised immediately. A loss arising in such circumstances is essentially an impairment of the asset (i. e. a decrease in the recoverable amount of the asset) 03 - IAS 17 Leases 19

Sale and Lease Back Transactions Illustration 7 An entity had two sale and leaseback transactions during the year. 1) It sold a non-current asset with a carrying amount of CU 20, 000 for its fair value of CU 24, 000 under a finance leaseback arrangement. The lease period was for five years at an annual rental of CU 7, 000. The machine has a useful life of five years. 2) It sold a property under an operating leaseback arrangement for its fair value of CU 40, 000 when the property had a carrying amount of CU 36, 000. The annual operating leaseback payments are CU 10, 000 per annum for three years, which reflect market rentals. Transaction 1 Although the machine has been sold at fair value, no profit is recognised as the machine remains a non-current asset. The proceeds are recognised as a liability and the finance charge of CU 11, 000 ((CU 7, 000 x 5) less CU 24, 000) is allocated over the five year period. Transaction 2 The gain on disposal of the property of CU 4, 000 (CU 40, 000 less CU 36, 000) is recognised immediately, because the sale price and the rentals are at fair value. The operating lease rentals are recognised as an expense. 03 - IAS 17 Leases 20

Sale and Lease Back Transactions Operating Lease, further illustrations SP equals FV SP FV Action 120 No gain/loss 120 Gain of 10 to IS 120 Loss of 10 to IS CA 120 110 130 SP less than FV CA 120 85 130 SP 100 100 FV 120 120 Action Loss of 20 to IS. If compensated, over LT Gain of 15 to IS IL of 10 to IS. Loss of 20 to IS. If compensated, over LT CA 100 SP more than FV SP FV Action 120 100 Gain of 20 over LT 110 120 100 90 120 100 IL of 10 to IS Gain of 20 over LT Gain of 10 to IS Gain of 20 over LT 03 - IAS 17 Leases SP– Sale Price FV– Fair Value CA– Carrying Amount IS– Income Statement LT– Lease Term IL– Impairment Loss 21

Lease Accounting By the Lessor Finance leases • Just as a lessee accounts for the substance, not form, of a finance lease, so should a lessor. • Under a finance lease the lessor is entitled to a stream of leasing receipts, so it should recognise as an asset the amounts receivable, rather than the leased item as a non-current asset. The receivables should be measured at the net investment in the lease. • The net investment in the lease is defined as being the “gross investment in the lease discounted at the interest rate implicit in the lease”. This gross investment is calculated as the lessee’s minimum lease payments (which includes any residual value guaranteed by the lessee) plus any unguaranteed amount accruing to the lessor. • The interest rate implicit in the lease is the same as that explained in relation to the lessee and the way that it is calculated automatically includes any initial direct costs incurred by the lessor in the amounts receivable from the lessee, so they should not be added separately. • The income receivable under a finance lease arrangement should be recognised based on “a pattern reflecting a constant period rate of return on the lessor’s net investment in the finance lease”. Again method used in Pakistan is ‘actuarial method’. Disclosure by a lessor finance lease arrangements • A lessor should provide a general description of its significant leasing arrangements. • A lessor should present a reconciliation of the GIL to the PV of the future MLP due under them at the end of the reporting period. The GIL and the PV of the MLP for each of the following periods should also be disclosed: – within one year; – within two to five years; and – after more than five years. • In addition, a lessor should disclose any UEFI , any UGRV that accrue to the lessor (the amount that the asset will be worth at the end of its useful life) and contingent rents received during the period. • A lessor should also identify any allowance that has been made for uncollectable lease payments receivable 03 - IAS 17 Leases 22

Lease Accounting By the Lessor Operating leases • A lessor should recognise assets that are leased under operating leases in its SFP according to the nature of the asset. Where it is the lease of a photocopier, for example, it would be presented as a non-current asset as part of property, plant and equipment. [IAS 17. 49] • The lessor will recognise depreciation on depreciable non-current assets under operating lease arrangements in accordance with IAS 16. The depreciation policy for leased assets should be consistent with that for other non-current assets held by the lessor that are not subject to lease arrangements. [IAS 17. 53] • Initial direct costs, as described above, should be added to the carrying amount of the asset and will therefore be recognised as an expense over the period of the useful life of the asset as it is depreciated. [IAS 17. 52] • The income received under an operating lease should be recognised in the lessor’s profit or loss based on a straight-line basis over the lease term. A different systematic basis of recognition should be used where it represents more fairly the timing of the benefits derived from the asset as the lessee uses it. [IAS 17. 50] Disclosure by a lessor for operating lease arrangements • Disclosures should include a general description of the entity’s leasing arrangements and the amount of contingent rents received in the period. [IAS 17. 56] • A lessor should disclose the future minimum receipts under non-cancellable operating leases allocated between the following periods: [IAS 17. 56] – within one year; – within two to five years; and – after more than five years. 03 - IAS 17 Leases 23

Lease Accounting By the Lessor • A manufacturer or dealer lessor effectively has income arising from two sources, being: – the profit or loss that would have arisen from an outright sale of an asset; and – the finance income over the lease term. • The selling profit or loss should be recognised in the same period as it would have been recognised in had the asset been sold without the financing arrangements, so a consistent policy is adopted for the recognition of selling profit or losses. • If the interest rate charged by a manufacturer or dealer lessor on the financing of the purchase of an asset is artificially low, then the selling profit should be adjusted so that a market rate of interest is charged. This will result in a deferral of some of the selling profit. • Any incremental costs incurred in negotiating a lease by a manufacturer or dealer lessor should be recognised as an expense when the selling profit is recognised. 03 - IAS 17 Leases 24

1% 2% 3% 4% 5% 6% 7% 8% 9% 1 2 3 4 5 0. 990 0. 980 0. 971 0. 961 0. 951 0. 980 0. 961 0. 942 0. 924 0. 906 0. 971 0. 943 0. 915 0. 888 0. 863 0. 962 0. 925 0. 889 0. 855 0. 822 0. 952 0. 907 0. 864 0. 823 0. 784 0. 943 0. 890 0. 840 0. 792 0. 747 0. 935 0. 873 0. 816 0. 763 0. 713 0. 926 0. 857 0. 794 0. 735 0. 681 0. 917 0. 842 0. 772 0. 708 0. 650 10% 0. 909 1 0. 826 2 0. 751 3 0. 683 4 0. 621 5 6 7 8 9 10 0. 942 0. 933 0. 923 0. 914 0. 905 0. 888 0. 871 0. 853 0. 837 0. 820 0. 837 0. 813 0. 789 0. 766 0. 744 0. 790 0. 760 0. 731 0. 703 0. 676 0. 746 0. 711 0. 677 0. 645 0. 614 0. 705 0. 665 0. 627 0. 592 0. 558 0. 666 0. 623 0. 582 0. 544 0. 508 0. 630 0. 583 0. 540 0. 500 0. 463 0. 596 0. 547 0. 502 0. 460 0. 422 0. 564 6 0. 513 7 0. 467 8 0. 424 9 0. 386 10 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 2 3 4 5 0. 901 0. 812 0. 731 0. 659 0. 593 0. 893 0. 797 0. 712 0. 636 0. 567 0. 885 0. 783 0. 693 0. 613 0. 543 0. 877 0. 769 0. 675 0. 592 0. 519 0. 870 0. 756 0. 658 0. 572 0. 497 0. 862 0. 743 0. 641 0. 552 0. 476 0. 855 0. 731 0. 624 0. 534 0. 456 0. 847 0. 718 0. 609 0. 516 0. 437 0. 840 0. 706 0. 593 0. 499 0. 419 0. 833 0. 694 0. 579 0. 482 0. 402 6 7 8 9 10 0. 535 0. 482 0. 434 0. 391 0. 352 0. 507 0. 452 0. 404 0. 361 0. 322 0. 480 0. 425 0. 376 0. 333 0. 295 0. 456 0. 400 0. 351 0. 308 0. 270 0. 432 0. 376 0. 327 0. 284 0. 247 0. 410 0. 354 0. 305 0. 263 0. 227 0. 390 0. 333 0. 285 0. 243 0. 208 0. 370 0. 314 0. 266 0. 225 0. 191 0. 352 0. 296 0. 249 0. 209 0. 176 0. 335 6 0. 279 7 0. 233 8 0. 194 9 0. 162 10 03 - IAS 17 Leases 1 2 3 4 5 25

1% 2% 3% 4% 5% 6% 7% 8% 9% 1 2 3 4 5 6 7 8 9 10 0. 990 1. 970 2. 941 3. 902 4. 853 0. 980 1. 942 2. 884 3. 808 4. 713 0. 971 1. 913 2. 829 3. 717 4. 580 0. 962 1. 886 2. 775 3. 630 4. 452 0. 952 1. 859 2. 723 3. 546 4. 329 0. 943 1. 833 2. 673 3. 465 4. 212 0. 935 1. 808 2. 624 3. 387 4. 100 0. 926 1. 783 2. 577 3. 312 3. 993 0. 917 1. 759 2. 531 3. 240 3. 890 5. 795 6. 728 7. 652 8. 566 9. 471 5. 601 6. 472 7. 325 8. 162 8. 983 5. 417 6. 230 7. 020 7. 786 8. 530 5. 242 6. 002 6. 733 7. 435 8. 111 5. 076 5. 786 6. 463 7. 108 7. 722 4. 917 5. 582 6. 210 6. 802 7. 360 4. 767 5. 389 5. 971 6. 515 7. 024 4. 623 5. 206 5. 747 6. 247 6. 710 4. 486 5. 033 5. 535 5. 995 6. 418 11% 1 2 3 4 5 0. 901 1. 713 2. 444 3. 102 3. 696 12% 0. 893 1. 690 2. 402 3. 037 3. 605 13% 0. 885 1. 668 2. 361 2. 974 3. 517 14% 0. 877 1. 647 2. 322 2. 914 3. 433 15% 0. 870 1. 626 2. 283 2. 855 3. 352 16% 0. 862 1. 605 2. 246 2. 798 3. 274 17% 0. 855 1. 585 2. 210 2. 743 3. 199 18% 0. 847 1. 566 2. 174 2. 690 3. 127 19% 0. 840 1. 547 2. 140 2. 639 3. 058 10% 0. 909 1. 736 2. 487 3. 170 3. 791 1 2 3 4 5 4. 355 6 4. 868 7 5. 335 8 5. 759 9 6. 145 10 20% 0. 833 1. 528 2. 106 2. 589 2. 991 6 7 8 9 10 1 2 3 4 5 4. 231 4. 712 5. 146 5. 537 5. 889 4. 111 4. 564 4. 968 5. 328 5. 650 3. 998 4. 423 4. 799 5. 132 5. 426 3. 889 4. 288 4. 639 4. 946 5. 216 3. 784 4. 160 4. 487 4. 772 5. 019 03 - IAS 17 Leases 3. 685 4. 039 4. 344 4. 607 4. 833 3. 589 3. 922 4. 207 4. 451 4. 659 3. 498 3. 812 4. 078 4. 303 4. 494 3. 410 3. 706 3. 954 4. 163 4. 339 3. 326 6 3. 605 7 3. 837 8 4. 031 9 4. 192 10 26

Class Practice Questions 03 - IAS 17 Leases 27

Class Practice Questions 03 - IAS 17 Leases 28

Class Practice Questions 03 - IAS 17 Leases 29

Class Practice Questions 03 - IAS 17 Leases 30

Class Practice Questions 03 - IAS 17 Leases 31

Class Practice Questions 03 - IAS 17 Leases 32

Class Practice Questions 03 - IAS 17 Leases 33

Class Practice Questions Question 15 Following are the transactions of sale and lease back arrangement: i. LMN Limited sold one of its three years old plants costing Rs. 25 million on June 30, 2005 to XYZ Leasing Limited for Rs. 20 million. It was leased back to LMN for a term of two years at monthly installment of Rs. 941, 500 payable at the end of each month. Borrowing rate of LMN is around 12% per annum. Depreciation rate for plant is 10%. ii. LMN Limited sold a two years old motor vehicle costing Rs. 1. 50 million on June 30, 2005 to XYZ Leasing Limited for Rs. 1. 00 million. It was taken back on lease for six months at a lease rental of Rs. 30, 000 payable at the end of each month. Depreciation rate for motor vehicle is 20%. Required: What accounting treatment do you suggest for LMN Limited for the above transactions? (06) Question 16 The Pure Limited leased plant and machinery having fair value of Rs. 125, 000 from Leasing Corporation Limited. The lease agreement contains a bargain purchase option and requires 15 annual minimum lease payments of Rs. 15, 000 payable at the end of each year. The economic life of the plant and machinery is 20 years. Implicit rate of Leasing Corporation Limited is 8%. Required: a) Calculate present value of minimum lease payments payable in 15 years. (03) b) Prepare a statement showing repayment of principal and mark- up for the firs 5 years. (10) c) In the light of IAS-17, what are the criteria, which attract capitalization of leased plant and machinery in above case? (03) d) In the absence of bargain purchase option, will the Pure Limited capitalize the leased plant and machinery? Briefly explain reasons. (02) 03 - IAS 17 Leases 34

Class Practice Questions Question 17 Munir Niazi Corporation, a lessor, purchased a new machine for Rs 1, 200, 000 on December 31, 2001, which was delivered the same day (prior arrangement) to Ahmad Nadeem & Company, the lessee. Following information relating to lease transaction is available: The Lease Asset has an estimated useful life of 5 years which coincides with the Lease term. i. At the end of lease term, Machine will revert to Munir Niazi Corporation, at which time it is expected to have a residual value of Rs 100, 000. (None of which is guaranteed by Ahmad Nadeem & Company). ii. Munir Niazi Corporation’s implicit interest rate is 8% which is known to Ahmad Nadeem & Company. iii. Ahmad Nadeem & Company’s incremental borrowing rate is 10% at December 31, 2001. iv. Lease rentals consist of five equal annual payments, the first of which was paid on Dec 31, 2001. v. Both the lessor and the lessee use calendar year as their accounts period and depreciate all fixed assets on straight line basis. Required: a) Compute the annual rental under the lease. (05) b) Compute the amounts of Gross lease rental receivable and unearned interest revenue that Munir Niazi Corporation should disclose at the inception of the lease December 31, 2001. (05) c) What expense should Ahmad Nadeem & Company record for the year ended Dec 31, 2002. (05) 03 - IAS 17 Leases 35

Class Practice Questions Question 18 Bowtock has leased an item of plant under the following terms: Commencement of the lease was 1 January 2002 Term of lease 5 years Annual payments in advance Rs 120, 000 Cash price and fair value of the asset – Rs 520, 000 at 1 January 2002 Implicit interest rate within the lease (as supplied by the lessor) 8% per annum (to be apportioned on a time basis where relevant). The company’s depreciation policy for this type of plant is 20% per annum on cost (apportioned on a time basis where relevant). Required: Prepare extracts of the Statement of Comprehensive Income and Statement of Financial Position for Bowtock for the year to 30 September 2003 for the above lease. 03 - IAS 17 Leases 36

Class Practice Questions Question 19 Mars Limited (ML) is engaged in the manufacturing of chemicals. On July 1, 2008 it obtained a motor vehicle on lease from a bank. Details of the lease agreement are as follows: i. Cost of motor vehicle is Rs. 1, 600, 000. ii. Installments of Rs. 480, 000 are to be paid annually in advance. iii. The lease term and useful life is 4 years and 5 years respectively. iv. The interest rate implicit in the lease is 13. 701%. ML follows a policy of depreciating the motor vehicles over their useful life, on the straight-line basis. The tax department allows only the lease payments as a deduction from taxable profits. The tax rate applicable to the company is 30%. ML’s accounting profit before tax for the year ended June 30, 2009 is Rs. 4, 900, 000. There are no temporary differences other than those evident from the information provided above. Required: a) Prepare journal entries in the books of Mars Limited for the year ended June 30, 2009 to record the above transactions including tax and deferred tax. b) Prepare a note to the financial statements related to disclosure of finance lease liability, in accordance with the requirements of International Accounting Standards. 03 - IAS 17 Leases 37