LESSON TWO

LEASE AND HIRE PURCHASE TRANSACTIONS

Lesson Outcome:
At the end of this lesson you should be able to:

 Record lease and hire purchase transactions in the books of the vendor and the purchaser.
 Distinguish the two classes of leases, their accounting treatment and disclosure in the financial
statements of both the lessee and the lessor in accordance with the provisions of the International
Accounting Standard No.17
 Calculate the finance charge or hire purchase interest and its apportionment over the lease term;
 Adjustments required on the repossession of goods sold on hire purchase terms.
 Distinguish, where appropriate, between the normal gross profit made on hire purchase sales, and
interest earned on outstanding instalments.

For this lesson, we shall discuss the accounts of Lease Transactions then discuss the accounts of Hire
Purchase transactions in the next Lesson (that is next week).

BBM (B100), BPM (B103) 2nd Year 2nd Semester 2020/2021 BBM 209: FA II
ACCOUNTING FOR LEASES (IAS 17)
A company may acquire the right to use a fixed asset over its useful life in a number of ways.
These include:

1. Outright purchase for cash;

2. Outright purchase on credit (or using proceeds of a secured/unsecured loan)
3. Hire purchase
4. Lease Acquisition.
In (1) and (2) the legal title to the fixed asset is obtained on the date of purchase.
In (3) title is obtained when the final instalment is paid. In a finance lease, legal title can never pass to the
lessee (person utilising the asset)

Leases are best understood as rental agreements. If a person gives out an asset that he owns - to be used by
another person in exchange for periodic rental payments, the person may be said to be leasing out his asset.
Leases are broadly classified into 2:
1. Operating leases
2. Finance leases
Operating leases in the simplest terms are short-term agreements for rentals of assets.
They are accounted as follows:

Transaction/Event Books of Lessee Books of Lessor

(user of asset) (owner of asset)
Rental Income/Expense - Debit Rent Expense - Debit Cash book
is due and remitted Credit Cash book Credit Rent Income

To record ownership of - Does not show asset in accounting - Is the rightful owner of asset and
the asset records since he does not own it. carries it in his accounting books.

To depreciate assets - Does not depreciate the asset since he - He will depreciate the asset.
does not own it.

Entries to appear in P&L - Show rent expense in P&L - Show rent income in P&L

Notes:
1) The emphasis of IAS 17 is on finance leases, and not operating leases.
2) Operating leases are just regular rental agreements covered by paragraphs 25 - 27 and 41 - 48 in IAS 17.
3) The examiner rarely expects you to carry out computations on operating leases.

Finance leases are also rental agreements; however, the rental duration is so long that the lessee (user of the
asset) ends up using the asset for most of its life. He will therefore be the sole user of the asset even though
he has rented it from someone else who is the rightful owner of such an asset. He will thus be using the asset
as if it is his own.

Under the “substance-over-form” concept, a transaction should be accounted for according to economic substance rather
than its legal form. In finance leases, the economic substance is that a person uses an asset as if it is his own. The
legal form of finance leases is that the asset is owned by a different person (lessor).

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Page 3 Advance Accountancy – Lease and Hire Purchase Transactions

Event/Transaction Books of Lessee Books of Lessor

(user of asset) (owner of asset)
Rental Income/Expense is due - Record payments as payments - Record receipts as a receipt from
and remitted to supplier of asset. debtor to whom asset is sold.

To record ownership of asset - Record asset as if it is his own - Does not record the asset as if it
even if this is not the case. is his; Instead shows a debtor to
- At the same time, shows a whom asset has been sold.
creditor whose value is equal to
the value of the asset.

Note: If the above explanations are not too clear, don’t worry; the first example (further in this chapter) will
clear it up. The important thing is to realise that the lessee (user of the asset) does not show rental payments,
but instead records the transactions as “a purchase on credit”. All rental payments are thus deemed to be
payments to a supplier of an asset.

Further Aspects of Leases

Proper Definition of a Lease
This is a contract between a lessor and a lessee, whereby the lessor conveys to the lessee, in return for the
payment of specified rentals, the right to use an asset over an agreed period of time.
The lessor retains ownership of the asset.
Types of Leases:
i) Finance leases
ii) Operating leases

Finance Leases
This is a lease that transfers substantially all the risk and reward of ownership of the asset to the lessee. Finance
leases are usually non-cancellable and the lessee enjoys substantially all the risks and rewards associated with
asset ownership. At the end of the initial lease period (primary lease period), title may or may not be passed to
the lessee.
Risks and rewards associated with asset ownership include:
Risks: i) Losses from idle capacity;
ii) Losses from technological obsolescence;
iii) The variations in return due to changing economic conditions.
Rewards: i) Expectations of profitable operations over the asset’s economic life;
ii) Gain from appreciation in value of an asset, or realisation of a residual value.

A finance lease is usually non-cancellable, but may be cancelled under the 3 following conditions:
a) Upon occurrence of some remote contingency;
b) With permission of the lessor;
c) If the lease is extended or renewed.

Operating Leases
This is any lease other than a finance lease. The lease assets are “rented out” to many different lessees (users)
over their useful economic lives. The lessee pays for the hire or use of the asset. Ownership of the asset
remains with the lessor, who assumes all the risks and rewards of the asset and takes responsibility for repairs,
maintenance and insurance expenses.

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Criteria Categorising Finance Leases

i) The lease often transfers ownership of the leased asset to the lessee by the end of the lease term, but till then
the lessor retains the title to the asset.
ii) The lease agreement contains a bargain purchase option.
iii) The lease term is equal to 75% or more of the economic or useful life of the asset.
iv) The present value of the minimum lease payments must be 90% of the fair value of the asset.
v) The lessee cannot cancel the lease without paying adequate compensation to the lessor.
vi) The lessee is responsible for repairs, maintenance and insurance of the asset.

Explanation of terms:
i) Present value: This is obtained by discounting the minimum lease payments using the interest rate
implicit in the lease as a discount factor.
ii) Minimum lease payments: The sum of all instalments payable by the lessee to the lessor. (This
excludes cost of services and taxes to be paid by or to be reimbursed by lessee to lessor). However
minimum lease payments should include residual amounts guaranteed by the lessee - if lessee had done
so when entering into lease agreement.
iii) Fair Value: This is the price for which the asset could change hands in an ‘arm’ length transaction, i.e.
its cash purchase price – normally at the lease contract commencement.

Accounting for Leases

Although the lessee never obtains legal right (entitlement), in the case of finance leases, the lessee’s rights and
obligations are such that the risks and rewards from the use of the asset are substantially similar to those of an
outright purchaser.
The lessee will therefore, in the balance sheet:
i) Include finance lease assets together with owned assets under the heading of tangible fixed assets.
However, leased assets should be distinguished from owned assets and amount disclosed.
ii) Show a liability in respect of lease payments not yet made. The liability in respect of minimum lease
payments not yet paid is split into long-term and current liabilities.

Example: Assume that an organisation leases an asset whose fair value is Sh 100,000 under terms of
“Sh 10,000 per year for 10 years”. The balance sheet immediately thereafter will be as follows:

Balance Sheet (Extract)

Fixed Assets Sh Current Liabilities Sh
Leasehold property 100,000 Amounts due on finance lease 10,000
Long term liabilities
Amounts due on finance lease 90,000

Notes: (1) The fixed asset will be subject to depreciation like any other owned asset.
(2) In the above example, the fair value of the asset is equal to the minimum lease payments; i.e. there
is no finance charge.

The lessee will, in the profit and loss account:

(i) Show the depreciation on the asset during the year.
(ii) Show the portion of finance charge allocated to the year.

Note (1)
Theoretically the amount to be capitalised and recorded in the balance sheet as an asset (as well as obligation)
should be the present value of the minimum lease rentals - discounted at the rate of interest implicit in the lease.
However, in many cases, the fair value of the asset will provide a reasonable approximation to the above.

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Note (2)
The asset should be depreciated over the shorter of
i) The lease term, and
ii) The asset’s useful life.

Here, the lease term includes:

a) The period for which the lessee has contracted to lease the asset (i.e. the non-cancellable primary period)
plus
b) Any further secondary periods under which the lessee has an option to continue leasing the asset
(possibly renewing on an annual basis)

Note (3)
The payments made by the lessee (henceforth known as rentals) should be apportioned between finance charge
and repayment obligation. The finance charge refers to the difference between the total of rentals (Minimum
lease payments) and the fair value of the asset.
Example: Assume an organisation leases an asset whose fair value is Sh 100,000 under the terms “Sh 12,000
per year for 10 years”:
Sh
Minimum lease payments = (12,000 x10) 120,000
Fair value of the asset = (100,000)
Therefore, Finance Charge = 20,000

Each payment by the lessee (in the above example Sh 12,000) is apportioned towards the asset’s fair value
repayment and the finance charge:

12000 12000 12000 12000

Fair Finance Fair Finance Fair Finance Fair Finance

value charge value charge value charge value Charge

By the end of the lease period, the total payments would have covered:
i) The full value of the asset
ii) The full finance charge

A critical question that arises is, in each payment (instalment) how much constitutes the fair value amount, and
how much constitutes the finance charge amount?

Allocation of Finance Charges

The key principle is that the total finance charge should be allocated to accounting periods during the lease
terms so as to produce a constant periodic rate of charge on the obligation outstanding.
Possible approaches are:
1) The actuarial method - This involves the use of the implicit interest rate, and accords exactly with
the above requirements, i.e. the interest charge is a fixed percentage of the liability in any given year.
For example, if the finance charge apportioned to a given year proves to be x% of the liability in that
year, then the finance charge to be apportioned to the next year should be such that it is once again x%
of the outstanding liability in that next year.
2) Sum of digits (Rule of 78) method - This is a close approximation to the actuarial method – provided the
lease terms are not very long, and the interest rates are not very high.
3) Straight line method (Level Spread method) - This does not produce a constant periodic rate of charge,
and is thus not usually acceptable. However, it may be used in practice where the total finance charge is
not material.

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Page 6 Advance Accountancy – Lease and Hire Purchase Transactions

Illustration 1
B Ltd. entered into an agreement to lease a vehicle from M Ltd.:
Cash price of the vehicle £10,000
Lease payments: 5 instalments of £2,571 paid in arrears
Required: How much of this finance charge will appear in each year’s profit and loss as an expense?

Solution £
Total lease payments = 2571 x 5 = 12,855
Fair Value = (10,000)
Therefore, Finance Charge = 2,855

i) Actuarial Method
Here the implicit rate of interest needs to be established. The cumulative factor is established by:
Fair Value = 10,000 = 3.89
Annual Rental 2,571

Using discount tables (Annuity tablets), the rate of interest may be established:

Years Interest rates (r)

(n)
1 2 3 4 5 6 7 8 9 10
1 0.9901 0.9304 0.9708 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091
2 1.8704 1.9446 1.9135 1.8861 1.8594 1.8334 1.8080 1.7833 1.7591 1.7355
3 2.9410 2.8838 2.8286 2.7751 2.7232 2.8730 2.6243 2.6771 2.5313 2.4869
4 3.8020 3.8077 3.7171 1.6299 3.5460 3.4851 3.3872 3.3121 3.2397 3.1699
5 4.8534 4.7135 4.5787 4.4518 4.3295 4.2124 4.1002 3.9927 3.889 3.7908
6 5.7955 5.8014 5.4122 5.2421 5.0757 4.8173 4.7665 4.6229 4.4859 4.3553
7 6.7282 6.4720 6.2302 6.0021 5.7864 5.5824 5.3883 5.2064 5.0330 4.8684
8 7.6517 7.3255 7.0187 7.7327 6.4832 6.2098 5.9713 5.7466 5.5348 5.3349
9 8.5880 8.1622 7.7861 7.4353 7.1078 6.8017 6.5152 6.2469 5.8952 5.7590
10 9.4713 8.9828 8.5302 8.1108 7.7217 7.3601 7.0236 6.7101 6.4177 6.1446
11 10.3676 9.7868 9.2528 8.7605 8.3084 7.8869 7.4987 7.1390 6.8052 6.4951
12 11.2551 10.5753 9.9540 9.3851 8.8633 8.3838 7.9427 7.5361 7.1607 6.8137
13 12.1337 11.3484 10.6350 9.9856 8.3836 8.8527 8.3577 7.9036 7.4869 7.1034
14 13.0037 12.1062 11.2961 10.5631 9.8986 9.2950 8.7455 8.2442 7.7862 7.3667
15 13.8651 12.8483 11.9379 11.1184 10.3797 9.7122 9.1079 8.5595 8.0607 7.6061
16 14.7179 13.5777 12.5611 11.6523 10.8378 10.1059 9.4466 8.8514 8.3126 7.8237
17 15.5623 14.2919 13.1661 12.1657 11.2741 10.4773 9.7632 9.1216 8.5436 8.0216
18 16.3983 14.9920 13.7535 12.6593 11.6896 10.8276 10.0591 9.3719 8.7556 8.2014
19 17.2260 15.6785 14.3238 13.1339 12.0853 11.1581 10.3356 9.6036 8.9501 8.3649
20 18.0456 16.3514 14.8775 13.5803 12.4622 11.4699 10.5940 9.8181 9.1285 8.5136

The rate of interest is established at 9%

It can now be applied to the outstanding liability to establish the finance charge for each year.
Amount outstanding Interest charged Amount outstanding Instalment Closing
Yr at beginning of year during year at year end (principle + interest) liability
1 10,000 900 10,900 2,571 8,329
2 8,329 750 9,079 2,571 6,508
3 6,508 586 7,094 2,571 4,523
4 4,523 407 4,930 2,571 2,359
5 2,359 212 2,571 2,571 0

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Note 1. The interest charged during the year is 9% of amount outstanding at the beginning of the year
2: The amount outstanding at the yearend is arrived at by adding amounts outstanding at the beginning
of year to interest charged during the year.
3. Since the amount of finance charge for each of the years has been computed using a percentage – like
interest – it has been generally referred to as “interest charged”
The accounts of the lessee and lessor can be drawn up. The lessor’s books will be considered later. The lessee
will maintain the following accounts:
i) Lessor account
ii) Finance Charge account
iii) Asset account
iv) Provision for depreciation account

Entries are made using the following journals:

When asset is first acquired:
Dr Asset A/C with fair value or cash price
Cr Lessor A/C of asset
At the end of any year within the lease period
Dr Finance Charges with finance charges
Cr Lessor apportioned
Dr Profit and Loss with finance charges
Cr Finance Charges apportioned
When rentals are paid to lessor:
Dr Lessor
Cr Cashbook

Books of Lessee
Lessor A/C
Year 1 £ Year 1 £
Bank 2,571 Vehicle 10,000
Balance c/d 8,329 Finance Charge 900
10,900 10,900
Year 2 Year 2
Bank 2,571 Balance b/d 8,329
Balance c/d 6,508 Finance Charge 750
9,079 9,079
Year 3 Year 3
Bank 2,571 Balance b/d 6,508
Balance c/d 4,523 Finance Charge 586
7,094 7,094
Year 4 Year 4
Bank 2,571 Balance b/d 4,523
Balance c/d 2,359 Finance Charge 407
4,930 4,930
Year 5 Year 5
Bank 2,571 Balance b/d 2,359
. Finance Charge 212
2,571 2,571

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Finance Charge A/C

Year 1 £ Year 1 £
Lessor 900 Profit and Loss 900

Year 2 Year 2
Lessor 750 Profit and Loss 750

Year 3 Year 3
Lessor 586 Profit and Loss 586

Year 4 Year 4
Lessor 407 Profit and Loss 407

Year 5 Year 5
Lessor 212 Profit and Loss 212

Leasehold Vehicle
Year 1 £ Year 1 £
Lessor A/C 10,000 Balance c/d 10,000

Year 2 Year 2
Balance b/d 10,000 Balance c/d 10,000

Year 3 Year 3
Balance b/d 10,000 Balance c/d 10,000

Year 4 Year 4
Balance b/d 10,000 Balance c/d 10,000

Year 5 Year 5
Balance b/d 10,000 Balance c/d 10,000

Provision for depreciation A/C

Year 1 £ Year 1 £
Balance c/d 2,000 Profit and Loss 2,000
Year 2 Year 2
Balance b/d 2,000
Balance c/d 4,000 Profit and Loss 2,000

4,000 4,000
Year 3 Year 3
Balance b/d 4,000
Balance c/d 6,000 Profit and Loss 2,000
6,000 6,000
Year 4 Year 4
Balance b/d 6,000
Balance c/d 8,000 Profit and Loss 2,000
8,000 8,000
Year 5 Year 5
Balance b/d 8,000
Balance c/d 10,000 Profit and Loss 2,000
10,000 10,000

For balance sheet purposes, the total outstanding liability at the end of any given year should be split into:

(i) Current liabilities (amount of liability payable within 1 year from balance sheet date
(ii) Long term liabilities (amount of liability payable after expiry of one year from the balance sheet date)
Example: The total liability at the end of year 1 (£8,329) can be split into:
(i) Current Liability (£1,821)
(ii) Long term Liability (£6,508) as follows:

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Calculations of liabilities at the end of year 1

Yr 1 Yr 2 Yr 3 Yr 4 Yr 5

Instalment Instalment Instalment Instalmen Instalment

= 2571 = 2,571 = 2,571 = 2,571 = 2,571

Interest Liability Interest Liability Interest Liability Interest Liability

= 750 = 1,821 = 586 = 1,985 = 407 =2,164 = 212 = 2,359

Current Liability Long term Liability

= 1,821 = 6,508

Note:
(1) The total liability at the end of year 1 (£8,239) in balance c/d in the lessor A/C at the end of year 1.
(2) The amount of liability payable in year 2 is current liability in the balance sheet for end of year 1.
(3) The long-term liability in balance sheet for year (1) is arrived at by:
(a) Splitting all instalment payments after expiry of one year from balance sheet date
into interest (finance charges) and liability repayment.
(b) Adding all liability repayments together.

In the above diagram, payments 1 year from balance sheet date will be payments in years 3, 4, and 5.

B Ltd
Balance sheet (extract) at the end of year 1
Fixed Assets Cost Depreciation NBV
Vehicle 10,000 2,000 8,000
Current Liabilities
Obligations under
finance lease 1,821
Long term Liabilities
Obligations under
finance lease 6,508

The total liability at the end of year 2 (£6,508) can be split into:
(i) Current liability (£1,985)
(ii) Long term liability (£4,523) as follows:

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Calculations of liabilities at the end of Yr. 2

Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5

Instalment Instalment Instalment Instalment Instalment

= 2,571 = 2,571 =2,571 = 2,571 = 2,571

Interest Liability Interest Liability Interest Liability

= 586 =1,985 = 407 = 2,164 = 212 =2,359

Current Liability Long term Liability

= 1,985 = 4,523
Note:
(1) The total liability at the end of year 2 (£6,508) is balance c/d in the lessor A/C at the end of year 2
(2) The amount of liability payable in year 3 is current liability in the balance sheet for end of year 2.
(3) The long-term liability in balance sheet for year (2) is arrived at by:
(a) Splitting all instalment payments after expiry of one year from balance sheet date into interest
(finance charges) and liability repayment
(b) Adding all liability payments together.
In the above diagram, payments 1 year from balance sheet date will be payments in years 4 and 5.

B Ltd.
Balance sheet (Extract) at the end of Year 2
Fixed Assets Cost Depreciation NBV
Vehicle 10,000 4,000 6,000
Current Liabilities
Obligations under
finance lease 1,985
Long term Liabilities
Obligations under
finance lease 4,523

The total liability at the end of year 3 (£4,523) can be split into:
(i) Current liability (£2,164)
(ii) Long term liability (£2,359) as follows:
Calculation of liabilities at the end of Year 3
Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5

Instalment Instalment Instalment Instalment Instalment

=2,371 = 2,571 = 2,571 = 2, 571 = 2,571

Interest Liability Interest Liability

= 407 = 2,164 = 212 = 2,359
Current Liability Long term liability
2164 2359
Note:
(1) The total liability at the end of year 3 (£4.523) is balance c/d in the lessor A/C at the
end of year.
(2) The amount of liability payable in year 4 is current liability in the balance sheet for end
of year 3.
(3) The long-term liability in balance sheet for year (3) is arrived at by:
(a) Splitting all instalment payments after expiry of one year from the balance sheet date into interest

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(finance charges) and liability repayment.

(b) adding all liability repayments together.
In the above diagram, repayments one year from balance sheet date will be payments in years 5.

B Ltd
Balance sheet (Extract) at the end of Year. 3
Fixed Assets Cost Depreciation NBV
Vehicle 10,000 6,000 4,000
Current Liabilities
Obligations under
finance lease 2,164
Long term Liabilities
Obligations under
finance lease 2,359

Note:
At the end of year 4, there will be only current liabilities and no long term liabilities. This is because there will
be no outstanding liability at end of year 5.

B Ltd
Balance sheet (Extract) at the end of Year. 4
Fixed Assets Cost Depreciation NBV
Vehicle 10,000 8,000 2,000
Current Liabilities
Obligations under
finance lease 2,359
Long term Liabilities
Obligations under
finance lease -

(ii) Sum of digits method (Also known as “rule of 78” method)

This approximates to the actuarial method - splitting the total interest without reference to a rate of interest in
such a way that a greater proportion falls in the earlier years.

Steps to follow:
(a) Number the instalments giving the highest digit to the 1st instalment, and digit N1 to the last instalment.
(b) Add up the digits
(c) Apportion to each accounting period a proportion of the finance charge for each instalment paid in the
period.
The sum of the digits may be obtained by N (N+1)
2
Where N is the number of financial periods
In the above N of financial periods = 5
sum of digits = 5(5+1) = 15
2

Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5

5 4 3 2 1
Int= 5 x 2885 Int= 4 x 2885 Int= 3 x 2885 Int= 2 x 2885 Int= 1 x 2885
15 15 15 15 15
= 952 = 761 = 571 = 381 = 190

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Lessor A/C
Year 1 £ Year 1 £
Bank 2,571 Vehicle 10,000
Balance c/d 8,381 Finance Charge 952
10,952 10,952
Year 2 £ Year 2 £
Bank 2,571 Balance b/d 8,381
Balance c/d 6,571 Finance Charge 761
9,142 9,142
Year 3 £ Year 3 £
Bank 2,571 Balance b/d 6,571
Balance c/d 4,571 Finance Charge 571
7,142 7,142
Year 4 £ Year 4 £
Bank 2,571 Balance b/d 4,571
Balance c/d 2,381 Finance Charge 381
4,952 4,952
Year 5 £ Year 5 £
Bank 2,571 Balance b/d 2,381
. Finance Charge 190
2,571 2,571

Leasehold vehicle
Year 1 £ Year 1 £
Lessor 10,000 Balance c/d 10,000
Year 2 £ Year 2 £
Balance b/d 10,000 Balance c/d 10,000
Year 3 £ Year 3 £
Balance b/d 10,000 Balance c/d 10,000
Year 4 £ Year 4 £
Balance b/d 10,000 Balance c/d 10,000
Year 5 £ Year 5 £
Balance b/d 10,000 Balance c/d 10,000
Year 6 £ Year 6 £
Balance b/d 10,000

Finance Charge A/C

Year 1 £ Year 1 £
Lessor 952 Profit and Loss 952
Year 2 £ Year 2 £
Lessor 761 Profit and Loss 761
Year 3 £ Year 3 £
Lessor 571 Profit and Loss 571
Year 4 £ Year 4 £
Lessor 381 Profit and Loss 381
Year 5 £ Year 5 £
Lessor 190 Profit and Loss 190

The provision for depreciation account is as per the previous method (see earlier working)

B Ltd.
Balance Sheet (Extract) at the end of Yr. 1
Fixed Assets Cost Depreciation NBV
Leasehold vehicle 10,000 2,000 8,000
Current Liabilities
Obligations under finance lease 1,810
Long term Liabilities
Obligations on finance lease 6,571

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B Ltd.
Balance Sheet (Extract) at the end of Yr. 2
Fixed Assets Cost Depreciation NBV
Leasehold vehicle 10,000 4,000 6,000
Current Liabilities
Obligations under finance lease 2,000
Long term Liabilities
Obligations on finance lease 4,571

B Ltd.
Balance Sheet (Extract) at the end of Yr. 3
Fixed Assets Cost Depreciation NBV
Leasehold vehicle 10,000 6,000 4,000
Current Liabilities
Obligations under finance lease 2,190
Long term Liabilities
Obligations on finance lease 2,381

B Ltd.
Balance Sheet (Extract) at the end of Yr. 4
Fixed Assets Cost Depreciation NBV
Leasehold vehicle 10,000 8,000 2,000
Current Liabilities
Obligations under finance lease 2,381
Long term Liabilities
Obligations on finance lease -

Calculations of liabilities at the end of Yr. 1 (For balance sheet purposes)

Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5
Instalment Instalment Instalment Instalment Instalment
=2,571 = 2,571 = 2,571 = 2,571 = 2,571

Interest Liability Interest Liability Interest Liability Interest Liability

= 761 = 1,810 = 571 = 2,000 = 381 = 2,190 = 190 = 2,381

Current Liability Long term Liability

= 1,810 = 6,571

Calculations of liabilities at the end of Yr. 2 (For balance sheet purposes)

Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5

Instalment Instalment Instalment Instalment Instalment

=2,571 = 2,571 = 2,571 = 2,571 = 2,571

Interest Liability Interest Liability Interest Liability

= 571 = 2,000 = 381 = 2,190 = 190 = 2,381

Current Liability Long term Liability

= 2,000 = 4,571

BBM (B100), BPM (B103) 2nd Year 2nd Semester 2020/2021 BBM 209: FA II
Page 14 Advance Accountancy – Lease and Hire Purchase Transactions

Calculations of liabilities at the end of Yr. 3 (For balance sheet purposes)

Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5 Instalment
Instalment Instalment Instalment Instalment
=2,571 = 2,571 = 2,571 = 2,571 = 2,571

Interest Liability Interest Liability

= 381 = 2,190 = 190 = 2,381

Current Liability Long term Liability

= 2,190 = 2,381

Note: At the end of year 4, there will only be current liabilities (£2,381) and no long term liabilities. This is
Because there will be no outstanding liability at the end of year 5.

(iii) Straight line (level spread) method.

Under this method, the finance charge is divided uniformly among the accounting periods. However, this goes
against the requirements of IAS 18, and is not commonly used. In the above example, the interest would be:
2855 = 571
5
Lessor
Year 1 £ Year 1 £
Bank 2,571 Vehicle 10,000
Balance c/d 8,000 Finance Charge 571
10,571 10,571
Year 2 £ Year 2 £
Bank 2,571 Vehicle 8,000
Balance c/d 6,000 Finance Charge 571
8,571 8,571
Year 3 £ Year 3 £
Bank 2,571 Vehicle 6,000
Balance c/d 4,000 Finance Charge 571
6,571 6,571
Year 4 £ Year 4 £
Bank 2,571 Vehicle 4,000
Balance c/d 2,000 Finance Charge 571
4,571 4,571
Year 5 £ Year 5 £
Bank Vehicle 2,000
2,571 Finance Charge 571
.
2,571 2,571

Finance Charge
Year 1 £ Year 1 £
Lessor 571 Profit and Loss 571
Year 2 £ Year 2 £
Lessor 571 Profit and Loss 571
Year 3 £ Year 3 £
Lessor 571 Profit and Loss 571
Year 4 £ Year 4 £
Lessor 571 Profit and Loss 571
Year 5 £ Year 5 £
Lessor 571 Profit and Loss 571

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Page 15 Advance Accountancy – Lease and Hire Purchase Transactions

Vehicle A/C
Year 1 £ Year 1 £
Lessor 10,000 Balance c/d 10,000
Year 2 £ Year 2 £
Balance b/d 10,000 Balance c/d 10,000
Year 3 £ Year 3 £
Balance b/d 10,000 Balance c/d 10,000
Year 4 £ Year 4 £
Balance b/d 10,000 Balance c/d 10,000
Year 5 £ Year 5 £
Balance b/d 10,000 Balance c/d 10,000

The provision for depreciation account is the same as before

B Ltd. B Ltd.
Balance Sheet (Extract) at the end of Yr. 1 Balance Sheet (Extract) at the end of Yr. 2
Fixed Assets Cost Depre. NBV Fixed Assets Cost Depre. NBV
Leasehold vehicle 10,000 2,000 8,000 Leasehold vehicle 10,000 4,000 8,000
Current Liabilities Current Liabilities
Obligations under finance Obligations under finance
lease 2,000 lease 2,000
Long term Liabilities Long term Liabilities
Obligations on finance lease 6,000 Obligations on finance lease 4,000

B Ltd. B Ltd.
Balance Sheet (Extract) at the end of Yr. 1 Balance Sheet (Extract) at the end of Yr. 2
Fixed Assets Cost Depre. NBV Fixed Assets Cost Depre. NBV
Leasehold vehicle 10,000 6,000 4,000 Leasehold vehicle 10,000 8,000 6,000
Current Liabilities Current Liabilities
Obligations under finance Obligations under finance
lease 2,000 lease 2,000
Long term Liabilities Long term Liabilities
Obligations on finance lease Obligations on finance lease
2,000 -

Accounting for leases - the lessors books

The books of the lessor are almost a perfect mirror image of the lessee’s books except that:
(i) The lessor does not keep a fixed asset account - it is “owned” by the lessee.
(ii) The debtor’s account maintained by the lessor is called “net investment in finance lease”
(iii) The debtors in the balance sheet are divided into:

a) Debtors due in one year

b) Debtors due after more than one year.

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Page 16 Advance Accountancy – Lease and Hire Purchase Transactions

Illustration:
For the illustration discussed previously, the lessor’s books will be as follows:
Net Investment in Finance Lease
Actuarial Sum-of Straight Actuarial Sum-of Straight
method Digits Line method Digits Line
Year 1 £ £ £ Year 1 £ £ £
Bank 10,000 10,000 10,000 Bank 2,571 2,571 2,571
P&L Income 900 952 571 Balance 8,329 8,381 8,000
c/d
10,900 10,952 10,571 10,900 10,952 10,571
Year 2 Year 2
Balance b/d 8,329 8,381 8,000 Bank 2,571 2,571 2,571
P&L Income 750 761 571 Balance 6,508 6,571 6,000
c/d
9,079 9,142 8,571 9,079 9,142 8,571
Year 3 Year 3
Balance b/d 6,508 6,571 6,000 Bank 2,571 2,571 2,571
P&L Income 586 571 571 Balance 4,523 4,571 4,000
c/d
7,084 7,142 6,571 7,094 7,142 6,571
Year 4 Year 4
Balance b/d 4,523 4,571 4,000 Bank 2,571 2,571 2,571
P&L Income 407 381 571 Balance 2,359 2,381 2,000
c/d
4,930 4,952 4,571 4,930 4,952 4,571
Year 5 Year 5
Balance b/d 2,359 2,381 2,000 Bank 2,571 2,571 2,571
P&L Income 212 190 571 . . .
2,571 2,571 2,571 2,571 2,571 2,571

M Ltd.
Balance sheet extract at the end of Year 1
Current Assets Actual Sum-of-digits Straight-line
Net investment in finance
lease 8329 – 6508 8381 – 6571 8000 – 6000
- Debtors due in one year =1821 = 1810 = 2000
- Debtors due after one
year 6508 6571 6000

M Ltd.
Balance sheet extract at the end of Year 2
Current Assets Actual Sum-of-digits Straight-line
Net investment in finance
lease 6508-4523 6571-4571 6000-4000
- Debtors due in one year =1985 = 2000 =2000
- Debtors due after one
year 4523 4571 4000

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Page 17 Advance Accountancy – Lease and Hire Purchase Transactions

M Ltd.
Balance sheet extract at the end of Year 3
Current Assets Actual Sum-of-digits Straight-line
Net investment in finance
lease 4523 - 2359 4571 - 2381 4000 - 2000
- Debtors due in one year =2164 =2190 =2000
- Debtors due after one
year 2359 2381 2000

Comprehensive example on both lessee’s and lessor’s books:

On Jan 19X8, Scruff PLC acquired an item of plant on a finance lease agreement with Kingsway PLC. The
agreement provided that Scruff PLC would pay Kingsway PLC 5 annual lease payments of £62,500
commencing from 1Jan 19X8. Kingsway PLC paid £250,000 for the plant in question.
Scruff PLC accounts for the interest charge; on the actuarial method and depreciates the plant at 20% per
annum on original cost. Kingsway PLC deals with the interest on the rule of 78 method.

Required:
(i) State the key factors that differentiate a finance lease from an operating lease.
(ii) Show how the leasing transactions will appear in the financial statements of Scruff Ltd.
(iii) Show how the leasing transactions will appear in the financial statements of Kingsway PLC.
Extract from Annuity Table
12% 13%
Yr. 1 0.893 0.885
Yr. 2 1.690 1.668
Yr. 3 2.402 2.361
Yr. 4 3.037 2.974
Yr. 5 3.605 3.517

Solution
i) (See page 3)
ii) Books of the Lessee
Since actuarial method is being used, the rate of interest implicit in the lease needs to be computed.
** Payments are made in advance, thus the instalments for which interest will apply are 4 (not 5), i.e. the
duration is 4 years.
implicit rate of interest = (250,000 - 62500) = 3.000
62500
In the table above: (check year 4)
12% 3.037
13% 2.974
X 3.000, where x is between 12% and 13%

 12% -----------------------------X---------------------------13%
----------------------------3.000
0.037
3.037--------------------------------------------------------2.974
0.063
12% + 0.037 X (13% - 12%) ]
0.063
=12% + 0.6% = 12.6%

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Page 18 Advance Accountancy – Lease and Hire Purchase Transactions

Yr. Amount at Instalment Balance after Interest @ 12.6% Amount at year

commencement instalment end
1 250 000 62 500 187 500 23 625 211 125
2 211 125 62 500 148 625 18 727 167 352
3 167 352 62 500 104 852 13 211 118 063
4 118 063 62 500 55 563 7 001 62 564
5 62 564 62 564 - - -

Due to rounding errors  amount is not 62 500
Note: The accounts were not necessary in this question, but they will be as follows:

Lessor A/C
19X8 £ 19X8 £
1 Jan Bank 62 500 1 Jan Plant and machinery 250000
31 Dec. Balance c/d 211,125 31 Dec. Finance Charge 23 625
273 625 273 625
19X9 19X9
1 Jan Bank 62 500 1 Jan Balance b/d 211 125
31 Dec. Balance c/d 167 352 31 Dec. Finance Charge 18 727
229 852 229 852
19Y0 19Y0
1 Jan Bank 62 500 1 Jan Plant and machinery 167 352
31 Dec. Balance c/d 118 063 31 Dec. Finance Charge 13 211
180 563 180 563
19Y1 19Y1
1 Jan Bank 62 500 1 Jan Balance b/d 118063
31 Dec. Balance c/d 62 564 31 Dec. Finance Charge 7 001
125 064 125 064
19Y2 19Y2
1 Jan Bank 62,564 1 Jan Balance b/d 62,564

Finance Charge
19X8 £ 19X8 £
31 Dec. Lessor 23,625 31 Dec. Profit and Loss 23,625
19X9 19X9
31 Dec. Lessor 18,727 31 Dec. Profit and Loss 18,727
19Y0 19Y0
31 Dec. Lessor 13,211 31 Dec. Profit and Loss 13,211
19Y1 19Y1
31 Dec. Lessor 7,001 31 Dec. Profit and Loss 7,001
19Y2 19Y2
31 Dec. Lessor -. 31 Dec. Profit and Loss - .

Plant A/C
19X8 £ 19X8 £
1 Jan Lessor A/C 250,000 31 Dec. Balance c/d 250,000
19X9 19X9
1 Jan Balance b/d 250,000 31 Dec. Balance c/d 250,000
19Y0 19Y0
1 Jan Balance b/d 250,000 31 Dec. Balance c/d 250,000
19Y1 19Y1
1 Jan Balance b/d 250,000 31 Dec. Balance c/d 250,000
19Y2 19Y2
1 Jan Balance b/d 250,000 31 Dec. Balance c/c 250,000
19Y3 19Y3
1 Jan Balance b/d 250,000

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Page 19 Advance Accountancy – Lease and Hire Purchase Transactions

Provision for depreciation

19X8 £ 19X8 £
31 Dec. Balance c/d 50,000 31 Dec. Profit and Loss 50,000
19X9 19X9
1 Jan Balance b/d 50 000
31 Dec. Balance c/d 100 000 31 Dec. Profit and Loss 50 000
100,000 100,000
19Y0 19Y0
1 Jan Balance b/d 100 000
31 Dec. Balance c/d 150 000 31 Dec. Profit and Loss 50 000
150,000 150,000
19Y1 19Y1
1 Jan Balance b/d 150 000
31 Dec. Balance c/d 200 000 31 Dec. Profit and Loss 50 000
200,000 200,000
19Y2 19Y2
1 Jan Balance b/d 200 000
31 Dec. Balance c/d 250 000 31 Dec. Profit and Loss 50 000
250,000 250,000
P & L (extract) for the year ended 31 Dec. 19X8 P & L (extract) for the year ended 31 Dec. 19X9
Expenses £ Expenses £
Finance charge on leasehold plant 23 625 Financecharge on leasehold plant 18 727
Depreciation on plant 50 000 Depreciation on plant 50 000

P & L (extract) for the year ended 31 Dec. 19Y0 P & L (extract) for the year ended 31 Dec. 19Y1
Expenses £ Expenses £
Finance charge on leasehold plant 13 211 Finance charge on leasehold plant 7 001
Depreciation on plant 50 000 Depreciation on plant 50 000

P & L (extract) for the year ended 31 Dec. 19Y2

Expenses £
Finance charge on leasehold plant 0
Depreciation on plant 50 000

Balance Sheet (extract) as at 31 Dec. 19X8

Fixed Assets Cost Depreciation NBV
Lease Vehicle 250 000 50 000 200 000
Current Liabilities
Finance lease obligations 43,773
Long term liabilities
Finance lease obligations 167,352

Balance Sheet (extract) as at 31 Dec. 19X9

Fixed Assets Cost Depreciation NBV
Lease Vehicle 250 000 100 000 150 000
Current Liabilities
Finance lease obligations 49,289
Long term liabilities
Finance lease obligations 118,063

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Page 20 Advance Accountancy – Lease and Hire Purchase Transactions

Balance Sheet (extract) as at 31 Dec. 19Y0

Fixed Assets Cost Depreciation NBV
Lease Vehicle 250 000 150 000 100 000
Current Liabilities
Finance lease obligations 55,499
Long term liabilities
Finance lease obligations 62,564

Balance Sheet (extract) as at 31 Dec. 19Y1

Fixed Assets Cost Depreciation NBV
Lease Vehicle 250 000 200 000 50 000
Current Liabilities
Finance lease obligations 62,564

Solution: Books of the lessor

Since the lessor will be recording his income after apportionments on the “rule of 78” method, the income
will be apportioned over the 4 years of financing as follows:
19X8 19X9 19Y0 19Y1
4 3 2 1
10 10 10 10
4 X 62 500 3 X 62 500 2 X 62 500 1 X 62 500
10 10 10 10
= 25 000 = 18 750 = 12 500 = 6 250

Investment in finance lease

19X8 £ 19X8 £
1 Jan Bank 250 000 1 Jan Bank 62 500
31 Dec. Profit and Loss (Income) 25 000 31 Dec. Balance c/d 212 500
275,000 275,000
19X9 19X9
1 Jan Balance b/d 212 500 1 Jan Bank 62 500
31 Dec. Profit and Loss (Income) 18 750 31 Dec. Balance c/d 168 750
231,250 231,250
19Y0 19Y0
1 Jan Balance b/d 168 750 1 Jan Bank 62 500
31 Dec. Profit and Loss (Income) 12 500 31 Dec. Balance c/d 118 750
181,250 181,250

19Y1 19Y1
1 Jan Balance b/d 118 750 1 Jan Bank 62 500
31 Dec. Profit and Loss (Income) 6 250 31 Dec. Balance c/d 62 500
125,000 125,000
19Y0 19Y0
1 Jan Balance b/d 62,500 1 Jan Bank 62,500

Bank (extract)
19X8 £ 19X8 £
1 Jan Investment in finance lease 62 500 1 Jan Investment in finance lease 250 000
19X9 19X9
1 Jan Investment in finance lease 62 500
19Y0 19Y0
1 Jan Investment in finance lease 62 500
19Y1 19Y1
1 Jan Investment in finance lease 62 500
19Y2 19Y2
1 Jan Investment in finance lease 62 500

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Page 21 Advance Accountancy – Lease and Hire Purchase Transactions

P and L (extract) for the year ended 31 Dec. 19X8 P and L (extract) for the year ended 31 Dec. 19X9
Income £ Income £
Gross earnings from finance lease 25 000 Gross earnings from finance lease 18 750

P and L (extract) for the year ended 31 Dec. 19Y0 P and L (extract) for the year ended 31 Dec. 19Y1
Income £ Income £
Gross earnings from finance lease 12 500 Gross earnings from finance lease 6 250

Balance Sheet (extract) as at 31 Dec. 19X8 Balance Sheet (extract) as at 31 Dec. 19X9
Current Assets £ Current Assets £
Investment in finance lease:-- Investment in finance lease:-
-Debtors due in one year 43 750 -Debtors due in one year 50 000
-Debtors due after one year 168 750 -Debtors due after one year 118 750

Balance Sheet (extract) as at 31 Dec. 19Y0 Balance Sheet (extract) as at 31 Dec. 19Y1
Current Assets £ Current Assets £
Investment in finance lease:-- Investment in finance lease:-
-Debtors due in one year 56 250 -Debtors due in one year 62 500
-Debtors due after one year 62 500 -Debtors due after one year 0

Alternative method of arriving at balance sheet values:

Lessse’s books.
In the lessor A/C, the balance c/d at the end of any given year makes up the total liability for the end of that
year. If this amount is to be split into current and long term liabilities, the amount of balance c/d, at the end
of the following year is deemed to be the long term liability.

Lessor A/C__________________________________
Yr. 1 £ Yr. 1 £
Cashbook X Asset A/C X
(2) Balance c/d X Finance Charges X
XX XX
Yr. 2 £ Yr. 2 £
Cashbook X Balance b/d X This is the end of yr 1; a balance
(1) Balance c/d X Finance Charges X sheet is required as at this date.
XX XX It will be as follows:

Balance Sheet extract (year 1)

Current Liabilities: £ £
Obligations under finance lease
(2) - (1) XX
Long term liabilities
Obligations under finance lease XX
(1)

BBM (B100), BPM (B103) 2nd Year 2nd Semester 2020/2021 BBM 209: FA II
Page 22 Advance Accountancy – Lease and Hire Purchase Transactions

REINFORCEMENT QUESTION
(a) Define a finance lease and state the criteria, which distinguish it from an operating lease.
(4 marks)
(b) Two companies entered into an agreement whereby the lessor (ABC Ltd.) leased on finance lease to the
lessee (XYZ Ltd.) an item of capital, which cost the lessor Sh.100,000 on 1 September 1993. The lease
was to run for five years from 1 September 1993. The plant to be depreciated on a straight line basis, is
considered to have nil residual value at the end of the agreement. The agreement specifies that a rental of
Sh.7,400 per quarter is payable in advance.

It is proposed that, in the lessor’s account, profit should only be taken pro rata to the interest received and
that the total interest elements included in the rentals should be allocated over the period of the lease using
the actuarial method. It is further proposed that in the lessee’s accounts, the lease should be capitalised.
The interest rate implicit in the lease is 5% per quarter.

Required:
(i) The necessary ledger accounts in the books of both ABC Ltd. and XYZ Ltd. to record the above
transactions for the year ended 31 August 1994.

(ii) Show how the above transactions would appear in the financial statements of both ABC Ltd. and XYZ
Ltd for the year ended 31 August 1994. (Assume interest is paid after it is incurred and round all
workings where applicable to the nearest whole number.)

BBM (B100), BPM (B103) 2nd Year 2nd Semester 2020/2021 BBM 209: FA II
Solution to the above problem
(a) Books of Lessee (XYZ Ltd)

Lessor A/C (ABC Ltd)

1993 Shs 1993 Shs
1 Sept Cashbook 7,400 1 Sep Plant 100 000
1 Dec Cashbook 7,400 30 Nov Finance charges 4,630
1994 1994
1 March Cashbook 7,400 28 Feb Finance charges 4,492
1 June Cashbook 7,400 31 May Finance charges 4,346
31 Aug Balance c/d 88,061 31 Aug Finance charges 4,193
117,661 117,661
1 Sept Cashbook 7,400 1 Sept Balance b/d 88,061
1 Dec Cashbook 7,400 30 Nov Finance charges 4,033
1995 1995
1 March Cashbook 7,400 28 Feb Finance charges 3,865
1 June Cashbook 7,400 31 May Finance charges 3,688
31 Aug Balance c/d 73,549 31 Aug Finance charges 3,502
103,149 103,149

Finance Charges A/C

1993 Shs 1993 Shs
30 Nov Lessor 4,630
1994 1994
28 Feb Lessor 4,492
31 May Lessor 4,346
31 Aug Lessor 4,193 31 Aug Profit and Loss 17,661
17,661 17,661
30 Nov Lessor 4,033
1995 1995
28 Feb Lessor 3,865
31 May Lessor 3,688
31 Aug Lessor 3,502 31 Aug Profit and Loss 15,088
15,088 15,088

Plant A/C
1993 Shs 1993 Shs
1 Sept Lessor 100,000
1994 1994
31 Aug Balance c/d 100,000
100,000 100,000

Provision for depreciation

1994 Shs 1994 Shs

31 Aug Balance c/d 20,000 31 Aug Profit and Loss 20,000

20,000 20,000

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Page 24 Advance Accountancy – Lease and Hire Purchase Transactions

Books of Lessor (ABC Ltd)

Net Investment in Finance Lease (Lessee)
1993 Shs 1993 Shs
1 Sept Cashbook 100,000 1 Sep Cashbook 7,400
30 Nov GEOFL 4,630 1 Dec Cashbook 7,400
1994 1994
28 Feb GEOFL 4,492 1 March Cashbook 7,400
31 May GEOFL 4,346 1 June Cashbook 7,400
31 Aug GEOFL 4,193 31 Aug Balance c/d 88,061
117,661 117,661
1 Sept Balance b/d 88,061 1 Sept Cashbook 7,400
30 Nov GEOFL 4,033 1 Dec Cashbook 7,400
1995 1995
28 Feb GEOFL 3,865 1 March Cashbook 7,400
31 May GEOFL 3,688 1 June Cashbook 7,400
31 Aug GEOFL 3,502 31 Aug Balance c/d 73,549
103,149 103,149

Gross Earnings on Finance Leases (GEOFL)

1993 Shs 1993 Shs
30 Nov Lessor
4,630
1994 1994
28 Feb Lessor 4,492
31 May Lessor 4,346
31 Aug Profit and Loss 17,661 31 Aug Lessor 4,193
17,661 17,661
30 Nov Lessor 4,033
1995 1995
28 Feb Lessor 3,865
31 May Lessor 3,688
31 Aug Profit and Loss 15,088 31 Aug Lessor 3,502
15,088 15,088

Note:
The finance charges at any point are computed by taking the balance on the Lessee/Lessor A/C 3 months
prior to date of finance charges and multiplying this by 5%. E.g.:
(i) The finance charges of Sh.4,630 (30 Nov 1993) were arrived at:
(100,000 – 7,400) x 5%
(ii) Finance charges of Sh.4,492 (28 Feb 1994) were arrived at by:
(100,000 + 4,630 – 7,400 – 7,400) x 5%
(iii) Finance charges of Sh.4,346 (31 may 1994) were arrived at by:
(100,000 + 4,630 + 4,492 – 7,400 – 7,400 – 7,400) x 5%
(iv) Finance charges of Sh.4,193 (31 Aug 1994) were arrived at by:
(100,000 + 4,630 + 4,492 + 4,346 – 7,400 – 7,400 – 7,400 – 7,400) x 5%

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Page 25 Advance Accountancy – Lease and Hire Purchase Transactions

b (ii) Balance sheet of Lessee (XYZ Ltd)

Balance Sheet (Extract) as at 31 August 1994.
Sh. Sh. Sh.
Fixed Assets Cost Depr. NBV
100,000 20,000 80,000

Current Liabilities
Obligation on finance leases (88,061 – 73,549) 14,512
Long-term Liabilities
Obligation on finance leases 73,549

Balance Sheet of Lessor (ABC Ltd)

Sh. Sh. Sh.
Current Assets
Net investment in finance lease:
Debtors due in year 14,512
Debtors due after 1 year 73,549

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Page 26 Advance Accountancy – Lease and Hire Purchase Transactions

ACCOUNTING FOR LEASEHOLD LAND

Under IAS 17, Leasehold land requires a separate accounting treatment as compared to the other assets acquired
on lease. This is because whereas the ownership of the other assets like buildings, plant and machinery can pass
to the lessee after the expiry of the lease period, ownership of land cannot pass. Land in most cases is owned
by the government or the local authorities and ownership can therefore not pass to the lessee.
IAS 17 therefore requires that land on lease should in all cases be accounted for as an operating lease.
The accounting treatment will therefore be summarized as follows:

1. If the firm paid a lump sum amount at the commencement of the lease to acquire the land on lease,
then this amount is transferred to a new account called prepaid operating lease rental. This account is
shown as a non-current asset in the balance sheet separate from the other Property plant and
equipment. The standard requires that the prepaid operating lease rental should be amortised over the
lease period (the amortization being charged as an expense) and the amount shown in the balance sheet
should be net of the amortization to date. Not that the land on lease is not shown in the accounts.
2. If the firm pays an annual rental relating to the use of land on lease, then the annual rentals are
expensed just like in the operating leases. Land is not shown in the accounts as an asset.

Example
A ltd paid £100,000 for the acquisition of land on lease. A ltd was to use the land for the next 100 years
commencing 01.01.2000.

Required:
Prepare the final accounts extracts for each of the next five years to show how the land would be accounted
for.

Income statement extract:

2000 2001 2002 2003 2004

£ £ £ £ £
Amortisation of
Prepaid operating
Lease rentals 1,000 1,000 1,000 1,000 1,000

Balance sheet extract

2000 2001 2002 2003 2004

£ £ £ £ £
Non Current assets
Prepaid operating
Lease rental
(Net of amortization) 99,000 98,000 97,000 96,000 95,000

BBM (B100), BPM (B103) 2nd Year 2nd Semester 2020/2021 BBM 209: FA II