FRS 117 ACCOUNTING FOR LEASES

Introduction FRS 117

All paragraphs have equal authority FRS 117 should be read in the context of its objective, the Foreword to FRS and the Framework for the Preparation and Presentation of Financial Statements FRS 108 Accounting Policies, Changes in Accounting Estimates and Errors provides a basis for selecting and applying accounting policies in the absence of explicit guidance
2 2

Objective

To prescribe, for lessees and lessors, the appropriate accounting policies and disclosure to apply in relation to leases

3 3

Scope
This Standard shall be applied in accounting for all leases other than:
(a) leases to explore for or use minerals, oil, natural gas and similar nonregenerative resources; and (b) licensing agreements for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights.
4 4

Scope (contd)
This Standard shall not be applied as the basis of measurement for: a) property held by lessees that is accounted for as investment property (see FRS 140 Investment Property); b) investment property provided by lessors under operating leases (see FRS 140); c) biological assets held by lessees under finance leases (see MASB ED 50 Agriculture); or d) biological assets provided by lessors under operating leases (see MASB ED 50).
5

Scope (contd)
This Standard applies to agreements that transfer the right to use assets even though substantial services by the lessor may be called for in connection with the operation or maintenance of such assets. This Standard does not apply to agreements that are contracts for services that do not transfer the right to use assets from one contracting party to the other.

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.
7

Definitions (contd)
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.

Definitions (contd)
The inception of the lease 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).
9

Definitions (contd)
Minimum lease payments are 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. 10

Definitions (contd)
(contd from previous page) 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. Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arms length transaction. 11

Definitions (contd)
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.
12

Definitions (contd)
Guaranteed residual value 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 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.
13

Definitions (contd)
Initial direct costs 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 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. Net investment in the lease is the gross investment in the lease discounted at the interest rate implicit in the lease. Unearned finance income is the difference between: a) the gross investment in the lease, and b) the net investment in the lease.
14

Definitions (contd)
The interest rate implicit 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 (i) the fair value of the leased asset and (ii) any initial direct costs of the lessor. The lessees incremental borrowing rate 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.
15

Definitions (contd)
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).
16

Classification of Leases
FRS 117 classified leases into 2 broad categories: finance leases and operating leases A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership

17

Classification of Leases (contd)

5 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. 18 (This list is not exhaustive)

Classification of Leases (contd)

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 All other leases that cannot be classified as a finance lease shall be treated as operating leases.

19

Leases in the financial statements of lessees Finance Lease

In the case of a finance lease, although the lessee may obtain no legal title to the asset, the substance over form consideration requires that the lessee capitalises the leased asset and recognises the related finance lease obligation At the commencement of the lease term, a lessee shall recognise a finance lease as an asset and a corresponding liability in its balance sheets at an amount that is equal to the fair value of the leased assets or, if lower, at the present value of the minimum lease payments, each determined at the inception of the lease. In calculating the present value of the minimum lease payment, the discount factor is the interest rate implicit in the lease, if this rate is practicable to determine, if not, the rate shall be the lessees incremental borrowing cost. (see example 1)
20

Leases in the financial statements of lessees Finance Lease (contd)

Example 1 On 1 January 20X1, Manja Bhd entered into a finance lease agreement with Alpha leasing for the use of a machine. The agreement called for 5 yearly instalments of RM25,000 each, with the firs payment due on 31 December 20X1. The machine could be bought outright for cash of RM100,000. Manja Bhds incremental borrowing cost is 10% per annum. Required Calculate the amount that Manja Berhad shall record at the inception.
21

Leases in the financial statements of lessees Finance Lease (contd)

Solution 1 the fair value of the lease asset in this case is RM100,000, the equivalent cash purchase price. The present value of the minimum lease payment (PVMLP) is calculated as follows: PV = RM25,000/(1+1.1)1 + RM25,000/(1+1.1)2 RM25,000/(1+1.1)3 + RM25,000/(1+1.1)4 + RM25,000/(1+1.1)5 = RM94,775 Since the (PVMLP) is lower than the fair value of the leased asset, the asset shall be recorded at RM94,775.
22

Leases in the financial statements of lessees Finance Lease (contd)

In practice, and in the absence of grants and tax credits available by the lessor, the equivalent cash purchase price can normally be taken as the fair value of the leased asset. Also in a straight finance lease where only lease rentals are involved, the present value of lease rentals shall normally be equal to the cash purchase price if the implicit rate of interest in the lease is used in the discounting. For a lease of machinery or equipment, it is quite common to capitalise the leased assed based on the cash purchase price without having to test for the lower of fair value and present value.

23

Leases in the financial statements of lessees Finance Lease (contd)

Minimum lease payments shall be apportioned between the finance charge and the reduction of the outstanding liability. The finance charge shall be allocated to each period during the lease term so as to produce a constant periodic rate of interest on the remaining balance of the liability. Contingent rents shall be charged as expenses in the periods in which they are incurred. (Para 25) Effective interest rate method shall be used applied in the recognition of interest expense in a finance lease. Approximation eg. Sum of digit may be used, provided results approximate effective interest rate (See example 2) Straight line method unlikely to produce a constant periodic rate.

24

Leases in the financial statements of lessees Finance Lease (contd)

Please keep in mind the following: Where a lease contains a bargain purchase option and at the inception of the lease it is reasonable certain that the purchase option will be exercised, the minimum lease payment shall comprise the payment or rentals over the lease term plus the payment required to exercise the purchase option (see example 3)

25

Leases in the financial statements of lessees Operating Lease

Under operating lease, a lessee shall not capitalise assets. Lease payments under an operating lease shall be recognised as an expense on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern of the users benefit.* (Para 33)

26

Disclosure in lessees financial statements

Disclosure - Finance lease
Lessees shall, in addition to meeting the requirements of FRS 7, make the following disclosures for finance leases: (a) for each class of asset, the net carrying amount at the end of the reporting period. (b) a reconciliation between the total of future minimum lease payments at the end of the reporting period, and their present value. In addition, an entity shall disclose the total of future minimum lease payments at the end of the reporting period, and their present value, for each of the following periods: (i) not later than one year; (ii) later than one year and not later than five years; (iii) later than five years. (c) contingent rents recognised as an expense in the period.
27

Disclosure in lessees financial statements (contd)

Disclosure - Finance lease (contd)
(d) the total of future minimum sublease payments expected to be received under non-cancellable subleases at the end of the reporting period. (e) a general description of the lessees material leasing arrangements including, but not limited to, the following: (i) the basis on which contingent rent payable is determined; (ii) the existence and terms of renewal or purchase options and escalation clauses; and (iii) restrictions imposed by lease arrangements, such as those concerning dividends, additional debt, and further leasing.

28

Disclosure in lessees financial statements (contd)

Disclosure - Operating lease (contd) Lessees shall, in addition to meeting the requirements of FRS 7, make the following disclosures for operating leases: (a) the total of future minimum lease payments under noncancellable operating leases for each of the following periods: (i) not later than one year; (ii) later than one year and not later than five years; (iii) later than five years. (b) the total of future minimum sublease payments expected to be received under non-cancellable subleases at the end of the reporting period.
29

Disclosure in lessees financial statements (contd)

Disclosure - Operating lease (contd)
(c) lease and sublease payments recognised as an expense in the period, with separate amounts for minimum lease payments, contingent rents, and sublease payments. (d) a general description of the lessees significant leasing arrangements including, but not limited to, the following: (i) the basis on which contingent rent payable is determined; (ii) the existence and terms of renewal or purchase options and escalation clauses; and (iii) restrictions imposed by lease arrangements, such as those concerning dividends, additional debt and further leasing.

30

Leases in the financial statements of lessors Finance Lease

Lessors are normally leasing companies or banks that provide financing to purchase assets of lease arrangements. Lessors shall recognise assets held under a finance lease in their statements of financial position and present them as a receivable at an amount equal to the net investment in the lease (Para 36). (See example 4) Net investment = Gross investment in the lease Unearned finance income, where, Gross investment = Aggregate of minimum lease payment plus any unguaranteed residual payment Minimum lease payment = lease rentals or payments plus any guaranteed residual payment Unearned finance income = Gross investment in the lease less its present value 31 refer definitions (para 4)

Leases in the financial statements of lessors Finance Lease (contd)

The recognition of finance income shall be based on a pattern reflecting a constant periodic rate of return on the lessors net investment in the finance lease (para 39). Effective interest rate method shall be used applied in the recognition of interest expense in a finance lease. Approximation eg. Sum of digit may be used, provided the method is applied consistently. Straight line method shall not be used.

32

Leases in the financial statements of lessors Finance Lease (contd)

Initial Direct Costs of Arranging a Lease assets Costs directly attributable to negotiating and arranging a lease. Eg. Commissions, agency and legal fees and other directly attributable costs incurred by lessors in negotiating and arranging a finance lease. Initial direct costs shall be included in the initial measurement of the finance lease receivables.

33

Leases in the financial statements of lessors Operating Lease

Lessors shall present assets subject to operating leases in their statements of financial position according to the nature of the asset. (Para 49) PPE shall be capitalised in the books of the lessor. These assets shall be accounted for in accordance with FRS 116. Lease payments shall be recognised as income on the straight line basis.
34

Disclosures in Lessors financial statements

Finance lease: a) a reconciliation between the gross investment in the lease at the end of the reporting period, and thepresent value of minimum lease payments receivable at the end of the reporting period. In addition, an entity shall disclose the gross investment in the lease and the present value of minimum lease payments receivable at the end of the reporting period, for each of the following periods: (i) not later than one year; (ii) later than one year and not later than five years; (iii) later than five years. b) unearned finance income. c) the unguaranteed residual values accruing to the benefit of the lessor. d) the accumulated allowance for uncollectible minimum lease payments receivable. e) contingent rents recognised as income in the period. f) a general description of the lessors material leasing arrangements.

35

Disclosures in Lessors financial statements

Operating lease a) the future minimum lease payments under noncancellable operating leases in the aggregate and for each of the following periods: i. not later than one year; ii. later than one year and not later than five years; iii. later than five years. b) total contingent rents recognised as income in the period. c) a general description of the lessors leasing arrangements.
36

Finance leases by Manufacturers or Dealers

In some leaseing transactions, lessors are themselves manufacturers or dealers. Often termed sales-type leases In the lessees books, there is no difference in accounting, however in the manufacturer cum lessors books there are slight differences in accounting. 2 types of income for the manufacturer or dealer. normal gross profit on sale; and Finance income over lease term Unlike direct finance and operating lease lessor, direct costs in negotiating and arranging lease shall be 37 recognised as an expense

Sale and Leaseback Transactions

Ownership transferred to lessor. Original owner becomes the lessee. No accounting complication in lessors books. In lessees books, if the leaseback is a finance lease, in substance, there is no sales transaction (no transfer of risk and rewards). Thus, any excess of sales proceeds over carrying amount of asset shall be deferred and amortised. If the leaseback is an operating lease, please refer to next slide.
38