Chapter 11

Accounting for leases

11.1

Within 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

We should capitalise a lease transaction (meaning that the leased asset and lease liability will
be placed on the balance sheet) 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.

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

111

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.
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 balance sheet 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 balance sheet (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.

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

112

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
amortisation 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

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
balance sheet and amortised to the income statement 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.

11.6

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

Lessors shall recognise assets under a finance lease in their balance sheets 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 balance sheets at amounts equal to the fair value of the

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

113

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.
11.7

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.

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

114

11.8

(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. 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

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

115

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 market 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. In particular, the low market value that could result from obsolescence
and wear and tear.
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.

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

116

11.9

(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 2009

Dr
Cr
Cr
Dr
Cr

Cash
Tractor (net)
Deferred gain on sale of tractor
Leased asset
Lease liability

140 000
100 000
40 000
140 000
140 000

30 June 2010
Dr
Dr
Cr

Interest expense
Lease liability
Cash

14 000
8 784
22 784

(14 000 = 140 000 x 0.10)

Dr
Cr
Dr
Cr
(d)

Amortisation of leased asset

Accumulated amortisation
Deferred gain on sale of tractor
Profit on sale of leased asset (revenue)

14 000
14 000
4 000
4 000

In the books of the Lessee Company Ltd, 30 June 2011

Dr
Dr
Cr

Interest expense
Lease liability
Cash

13 122
9 662
22 784

[13 122 = (140 000 8 784) x 0.10]

Dr
Cr
Dr
Cr

Amortisation of leased asset

Accumulated amortisation
Deferred gain on sale of tractor
Profit on sale of leased asset (revenue)

14 000
14 000
4 000
4 000

It should be noted that whilst we have recorded the partial recognition of the profit on sale as
a revenue item, some organisations might treat this as an offset against the amortisation
expense. The net effect on profits will be the same.

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

117

11.10 (a)

(b)

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.
Net method
1 July 2009
Dr
Cr
Dr
Cr

Plant and equipmenttractor

Cash
Lease receivable
Plant and equipmenttractor

140 000
140 000
140 000
140 000

30 June 2010
Dr
Cr
Cr
(c)

Cash
Lease receivable
Interest revenue

22 784
8 784
14 000

Gross method
1 July 2009
Dr
Cr
Dr
Cr
Cr

Plant and equipmenttractor

Cash
Lease receivable
Unearned interest
Plant and equipmenttractor

140 000
140 000
227 840
87 840
140 000

30 June 2010
Dr
Cr
Dr
Cr

Cash
Lease receivable
Unearned interest
Interest revenue

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

22 784
22 874
14 000
14 000

118

11.11 To undertake this calculation students may use trial and error. The implicit rate is 18%,
proven as follows:
Present value of initial payment:
Present value of yearly payments:
Fair value at lease inception

$5000 x 1.0 =
($5500 $500) x 4.4941 =

$5 000
$22 470
$27 470

Alternatively, and more easily, we can divide the liability on 1 July 2009 (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.
11.12 (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:
Bargain purchase option:
Fair value at lease inception

(b)

315 000 x 3.6048 =

280 000 x 0.5674 =

1 135 512
158 872
1 294 384

1 July 2009
Dr
Cr

Leased asset
Lease liability

1 294 384
1 294 384

30 June 2010
Dr
Dr
Dr
Cr

Interest expense
Lease liability
Executory costs
Cash

155 326
159 674
35 000
350 000

(155 326 = 1 294 384 x 0.12)

Dr
Cr

Amortisation expense
Accumulated leasehold amortisation

180 731
180 731

180 731 = (1 294 384 210 000)/6

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

119

30 June 2009
Dr
Dr
Dr
Cr

Interest expense
Lease liability
Executory costs
Cash

136 165
178 835
35 000
350 000

[136 165 = (1 294 384 159 674) x 0.12]

Dr
Cr

Amortisation expense
Accumulated leasehold amortisation

180 731
180 731

(c)
Non-current assets
Leased asset
Less accumulated amortisation

30/6/2010

30/6/2011

$1 294 384
180 731
$1 113 653

$1 294 384
361 462
$932 922

$178 835

200 295

$955 875

$755 580

Current liabilities
Lease liability
Non current liabilities
Lease liability

The current portion of the lease liability ($178,835 in 2010, and $200,295 in 2008) is
the amount by which the lease liability will be reduced by the lease payments in the
following 12 months. In 2011 the current liability component would be calculated as:
$315 000 [($1 294 384 $159 674 $178 835) x 0.12]
(d)

30 June 2010
Dr
Dr
Cr

Executory expenses
Lease expense
Cash

35 000
315 000
350 000

To record lease payment for 2010

30 June 2011
Dr
Executory expenses
Dr
Lease expense
Cr
Cash
To record lease payment for 2011
11.13 (a)

(62 500 6250) x 3.6048 =

50 000 x 0.5674 =
Present value of minimum lease payments

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

35 000
315 000
350 000

202 770
28 370
231 140

1110

(b)

(i)

Books of Sanders using the net method

1 July 2009
Dr
Dr
Cr
Cr

Lease receivable
Cost of sales
Inventory
Sales

231 140
200 000
200 000
231 140

30 June 2010
Dr
Cr
Cr
Cr

Cash
Executory expense recoupment (income
statement)
Interest revenue
Lease receivable

62 500
6 250
27 737
28 513

(27 737 = 231 140 x 0.12)

30 June 2011
Dr
Cr
Cr
Cr

Cash
Executory expense recoupment (income
statement)
Interest revenue
Lease receivable

62 500
6 250
24 315
31 935

[24 315 = (231 140 28 513) x 0.12]

(ii)

Books of Gregory Ltd

1 July 2009
Dr
Cr

Leased machinery
Lease liability

231 140
231 140

30 June 2010
Dr
Dr
Dr
Cr
Dr
Cr

Interest expense
Lease liability
Executory costs
Cash
Amortisation expense
Accumulated leasehold amortisation

27 737
28 513
6 250
62 500
33 020
33 020

33 020 = (231 140) 7

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

1111

30 June 2011
Dr
Dr
Dr
Cr
Dr
Cr

Interest expense
Lease liability
Executory costs
Cash
Amortisation expense
Accumulated leasehold amortisation

24 315
31 935
6 250
62 500
33 020
33 020

33 020 = (231 140) 7

11.14 (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:
Unguaranteed residual:
Fair value of leased land and
buildings

($375 000 $25 000) x 4.8684 =

$500 000 x 0.5132 =

$1 703 940
$256 600
$1 960 540*

* $10 rounding error

(b)

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)

Lease
payment
for building

Interest
expense

Principal
reduction

245 000
245 000
245 000
245 000
245 000
245 000
245 000

119 275
106 705
92 875
77 660
60 925
42 520
22 275

125 725
138 295
152 125
167 340
184 075
202 480
222 725

Date
1 July 2009
30 June 2010
30 June 2011
30 June 2012
30 June 2013
30 June 2014
30 June 2015
30 June 2016
* $10 rounding error

Outstanding
balance
1 192 758
1 067 030
928 735
776 610
609 270
425 195
222 715
(10)*

Because the land is not being transferred to the lessee at the end of the lease term,
and as its life is quite indefinite, the lease of the land will be treated as an operating
lease.
1 July 2009

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

1112

Dr
Cr

Leased buildings
Lease liability

1 192 758
1 192 758

(To record the asset and liability at the inception of the finance lease.)
30 June 2010
Dr
Dr
Dr
Dr
Cr

Executory expenses
Interest expense
Lease liability
Lease rental expense
Cash

25 000
119 275
125 725
105 000
375 000

(To record the lease payment. [119 275 = 1 192 758 x 0.10])
Dr
Cr

Lease amortisation expense

Accumulated amortisation

170 394
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 amortisation.)
30 June 2011
Dr
Dr
Dr
Dr
Cr

Executory expenses
Interest expense
Lease liability
Lease rental expense
Cash

25 000
106 705
138 295
105 000
375 000

(To record the lease payment. [106 705 = 1 192 758 125 725 x 0.10])
Dr
Cr
(d)

Lease amortisation expense

Accumulated amortisation

170 394
170 394

1 July 2009
Dr
Dr
Cr
Dr
Cr

Land
Buildings
Cash
Lease receivable
Buildings

588 160
1 372 370
1 960 540
1 372 370
1 372 370

(To capitalise the present value of the minimum lease payments and the unguaranteed
residual.)

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

1113

Net method
30 June 2010
Dr
Cr
Cr
Cr
Cr

Cash
Lease rental income
Lease receivable
Interest revenue
Executory expenses recouped

375 000
105 000
125 725
119 275
25 000

30 June 2011
Dr
Cr
Cr
Cr
Cr

Cash
Lease rental income
Lease receivable
Interest revenue
Executory expenses recouped

375 000
105 000
138 295
106 705
25 000

OPTIONAL ISSUES
The above answers have been compiled in accordance with the Accounting Standard, 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

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

1 372 370 256 600

1 960 530 256 600

and the portion relating to land would be = $350 000

588 160
1 960 530 256 600

$229 186
= $120 812

($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

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

1114

the building. This is shown below. Adopting the method of allocation as indicated in the Standard
will not lead to this result.
Date
1 July 2009
30 June 2010
30 June 2011
30 June 2012
30 June 2013
30 June 2014
30 June 2015
30 June 2016
* $34 rounding error

Lease receipt
for building

Interest
revenue

Principal
reduction

229 186
229 186
229 186
229 186
229 186
229 186
229 186

137 237
128 042
117 928
106 802
94 563
81 101
66 293

91 949
101 144
111 258
122 384
134 623
148 085
162 893

Closing
receivable
1 372 370
1 280 421
1 179 277
1 068 019
945 635
811 012
662 927
(500 034)*

11.15 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.

11.16 In answering this question we will firstly consider paragraph 28 of AASB 117 as it relates to
the amortisation 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

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

1115

the lease asset should be amortised over the useful life of the asset. Amortisation 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 amortisation would be:
Present value of minimum lease payments:
Less, present value of guaranteed residual (included in minimum lease
payments) and we will assume an implicit rate of 10 percent:
20,000 x 0.5132
Amortisation: $239,736 7:

$250,000
10,264
$239,736
$34,248

11.17 (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
Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

1116

amount of the difference between the carrying amount and fair value shall be
recognised immediately.

11.18 (a)

1 July 2009
Dr
Dr
Cr
Cr
Cr
Cr
Dr
Cr
Dr
Dr
Cr

Cash
Accumulated depreciation
Land
Buildings
Profit on sale of land
Deferred gainbuildings
Leased building
Lease liability
Lease liability
Prepaid rentland
Cash

4 334 700
350 000
1 800 000
1 750 000
367 350
767 350
2 167 350
2 167 350
300 000
300 000
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.)
(b)

1 July 2009
Dr
Dr
Cr
Dr
Cr
Dr
Cr
Cr

(c)

Building
Land
Cash
Lease receivable
Building
Cash
Lease receivable
Rent received in advance

2 167 350
2 167 350
4 334 700
2 167 350
2 167 350
600 000
300 000
300 000

30 June 2019
To determine the interest expense for the year ended 30 June 2019 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 2018. As at 1 July 2018 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.

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

1117

Dr
Dr
Dr
Cr
Dr
Cr

Lease payable
Interest expense
Rental expense
Cash
Lease amortisation expense
Accumulated lease amortisation

71 869
178 131
250 000
500 000
108 368
108 368

(2 167 350 20 = 108 368)

Dr
Cr

Deferred gainbuilding
Profit on sale of leased asset

38 368
38 368

(38 368 = 767 350 20)

Dr
Cr

Rental expenseland
Prepaid rent

15 000
15 000

(15 000 = 300 000 20)

(d)

30 June 2019
Dr
Cr
Cr
Cr
Dr
Cr

11.19(a)

Cash
Interest revenue
Lease receivable
Rental incomeland
Revenue received in advance
Rental income

500 000
178 131
71 869
250 000
15 000
15 000

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 =
$250 000 x 8.5136 =

$300 000
$2 128 400
$2 428 400

1 July 2009
Dr
Cr
Dr
Cr

Leased plantaeroplane
Lease liability
Lease liability
Cash

2 428 400
2 428 400
300 000

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

300 000

1118

(b)

Finance Ltd
1 July 2009
Dr
Cr
Dr
Cr
Dr
Cr

(c)

Plant and machineryaeroplane

Cash
Lease receivable
Plant and machineryaeroplane
Cash
Lease receivable

2 428 400
2 428 400
2 428 400
2 428 400
300 000
300 000

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
Dr
Cr
Dr
Cr

Interest expense
Lease liability
Cash
Lease amortisation expense
Accumulated amortisation

22 725
227 275
250 000
121 420
121 420

(121 420 = 2 428 400 20)

(d)

Finance Ltd
Dr
Cr
Cr

11.20 (a)
Present value of lease
payments
Present value of
unguaranteed residual

Cash
Interest revenue
Lease receivable

250 000
22 725
227 275

$100 000 n = 4, I = 10

$316 990

$50 000 n = 4, I = 10

34 150
$351 140

(b)
Beginning
Year
lease
Lease
ended
investment
payment
06/10
351 140
100 000
06/11
286 254
100 000
06/12
214 879.4
100 000
06/13
136 367.34
150 000
Payment 06/13 includes residual

Interest
35 114
28 625.4
21 487.94
13 636.734

Lease
reduction
64 886
71 374.6
78 512.06
136 363.3

Closing
liability
286 254
214 879.4
136 367.3
4.074

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

1119

1 July 2009
Dr
Cr
Dr
Cr
30/06/201
0
Dr
Cr
Cr

Cost of goods sold

Inventory
Lease Receivable
Sales

180 000

Cash
Interest revenue
Lease Receivable

100 000

180 000
351 140
351 140

35 114
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 06/10 316 990
100 000 31 699
68 301
248 689
Y/E 06/11 248 689
100 000 24 868.9
75 131.1
173 557.9
Y/E 06/12 173 557.9
100 000 17 355.79
82 644.21
90 913.69
Y/E 06/13 90 913.69 100 000
9 091.369 90 908.63
5.059
1/07/2009
Dr
Cr

Leased Truck
Lease Liability

316 990
316 990

30/06/2010
Dr
Dr
Cr
Dr
Cr

Interest exp
Lease Liability
Cash
Amortisation exp
Acc. Amortisation

31 699
68 301
100 000
63 398
63 398

Amortisation is $316 990/5yrs as intention is to keep.

(d)
30/06/2013
Dr
Dr
Cr
Dr
Cr
Dr
Cr

Interest exp
Lease liability
Cash
Amortisation
exp
Acc.
amortisation

9 091
90 909

Truck
Cash

50 000

100 000
63 398
63 398
50 000

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

1120

11.21
(a)
fair value + nil initial direct costs = PV minimum lease payments + any unguaranteed residual
Initial payment on 1-Jul-09
PV of remaining lease rental
PV of guaranteed residual

payment
50 000, n=3, i=8
40 000, n=4, i=8

$50 000
128 855
29 400
$208 255

(b)

Initial payment reduces the liability

Beginning Lease
Interest
Accrued
Closing
LL
paymt
exp.
int.
Lease red. LL
1/07/2009
208 255
50 000
158 255
30/06/201
0
158 255
12 660
0
158 255
1/07/2010
158 255
50 000
12 660
37 340
120 915
30/06/2011
120 915
9 673
0
0
120 915
1/07/2011
120 915
50 000
9 673
40 327
80 589
30/06/201
2
80 589
6 447
0
0
80 589
1/07/2012
80 589
50 000
6 447
43 553
37 036
30/06/201
3
37 036
2 964
0
0
37 036
1/07/2013
37 036
40 000
2 964
37 036
0

Lease payment on 1/7/2013 is the guaranteed residual.

(c) 1/7/09
Dr
Cr
30/6/10
Dr
Cr
Dr
Cr

Leased studio
Cash
Lease liability
Interest expense
Accrued interest
Amortisation exp
Acc. amortisation

208 255
50 000
158 255
12 660
12 660
42 064
42 064

Amortisation: ($208 255 $40 000)/4

1/07/2010
Dr
Dr
Cr

Lease liability
Accrued interest
Cash

37 340
12 660

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

50 000

1121

(d)

Hopeful Ltd must pay $15 000, being the difference between the fair value of the studio and
the guaranteed residual.
1/07/2013
Dr
Accum. amort.
168 255
Cr
Leased studio
168 255
Dr
Lease liability
37 036
Dr
Accrued interest
2 964
Cr
Leased studio
40 000
Dr
Loss on gtee residual
15 000
Cr
Cash
15 000
Alternatively the $15 000 loss would have been recognised on 30 June 2013, if known. The final
payment might occur later, when the fair value of the vehicle has been assessed.

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

1122