Topic 7

Accounting for lease contract

7.1 overview

Lease contract 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. The
lessor is the legal owner of the asset while lessee is the party granted right of use over a
specific asset.

Different lease contracts may have different salient characteristics such that the
obligations for maintenance may be assumed by the lessor or the lessee. Equally the tittle
over the asset may be transferred at the end of the primary lease term or not.
7.2 Previous lease classification

Lease contract are currently accounted for under IFRS 16 which introduced significant
reforms on accounting for lease contracts. Before IFRS 16 lease contract were classified
as either finance or operating.

A Finance Lease transfer substantially all of the benefits and risks of ownership from
lessor to lessee. Transfer of benefits and risks of ownership can be assumed only if there
is a high degree of performance to the transfer, that is, the lease is non-cancelable, and
lease is liable for non-performance of the asset. The leased assets are of such a specialized
nature that only the lessee can use them without major modifications.

Leases that do not substantially transfers benefits and risks of ownership are operating
leases. Contract that would be classified as finance lease must meet at least one of the
following characteristics;

 Leases that transfers ownership at end of lease term

 Leases with bargain purchase options
 Leases with lease terms/duration covering substantially most of the economic life
of the leased property
 Leases where the present value of lease payments is equal or approximate to the
fair market value.

7.3 Accounting by lessee under IFRS 16

The lessee records an asset (leased equipment or right of use) and a liability (lease
obligation) equal to the present value of the lease instalments including any premium
paid upfront for all long-term lease exceeding one year (contingent rents charged as
expenses in the periods in which they are incurred.) The lease instalments include the
guaranteed residual value of the asset at the end of the lease period

On 1 April 2020 a company entered into a lease for an item of plant which had an
estimated life of five years. The lease period is also five years with annual rentals of Ksh
22 million payable in advance from 1 April 2020. The plant is expected to have a nil
residual value at the end of its life. If purchased this plant would have a cost of Ksh 92
million and be depreciated on a straight-line basis. The lessor includes a finance cost of
10% per annum when calculating annual rentals.

Accounting by lessee

Recognize long-term leases as assets and liabilities in the statements of financial position
at amounts equal to the fair value of the leased property or, if lower, the present value of
the minimum lease payments, each determined at the inception of the lease.

The discount rate to be used in calculating the present value of the minimum lease
payments is the interest rate implicit in the lease, if this is practicable to determine; if not,
the lessee’s incremental borrowing rate shall be used.

Any initial direct costs of the lessee are added to the amount recognised as an asset.

Subsequent measurement

Minimum lease payments apportioned between the finance charge and the reduction of
the outstanding liability.

The finance charge 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 (effective rate
of interest).

Contingent rents charged as expenses in the periods in which they are incurred.

Accounting by lessee

Depreciate the asset over the shorter of the lease term and its useful life.
The depreciable amount of a leased asset is allocated to each accounting 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.

Short term leases by lessee

Lease contract that are less than one year

Lease payments under a short-term lease are recognised as an expense on a systematic

basis representative of the time pattern of the user’s benefit.

Accounting by lessor

Accounting by lessor did not change

Recognise assets held under a finance lease as a receivable at an amount equal to the net
investment in the lease.

The net investment in a lease is the lessor’s gross investment in the lease discounted at
the interest rate implicit in the lease.

The gross investment in the lease is the aggregate of:

the minimum lease payments receivable by the lessor under a finance lease, and

any unguaranteed residual value accruing to the lessor.

Accounting by lessor

Initial direct costs are included in the initial measurement of the finance lease receivable

Costs incurred by manufacturer or dealer lessor in connection with negotiating and

arranging a lease are recognised as an expense when the selling profit is recognised

Implicit rate of interest

The lessee computes the present value of the lease payments using the lessee’s
incremental borrowing rate

If the lessee knows the lessor’s implicit interest rate and it is less than the lessee’s
incremental rate, then such implicit rate must be used.

The lessor’s implicit rate produces the following result:

present value of (minimum lease payments and unguaranteed residual value) = fair value
of the asset to lessor
Minimum lease payments

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:

for a lessee, any amounts guaranteed by the lessee or by a party related to the lessee; or

for a lessor, any residual value guaranteed to the lessor by the lessee or a party related to
the lessee.

Minimum Lease Payments

They include:

Minimum rental payments (which may or may not be equal to the minimum lease
payments)

Guaranteed residual value end of the lease term (guaranteed the lessor by the lessee or a
third party)

Any penalty required of the lessee for failure to extend or renew the lease

Any bargain purchase option given to lessee

Example

A Manufacturing Company Ltd. has entered into an agreement with a finance company,
to lease a machine for a four year period. Under the terms of the agreement, the machine
is to be made available to the Manufacturing Company Ltd. on 1 January 2020, when an
immediate payment of Sh.2,550,000 will be made, followed by seven semi-annual
payments of an equivalent amount.
The fair market price of the machine on 1 January 2020 is expected to be Sh.16,320,000.
The estimated life of this type of machine is four years. The implicit rate of interest in the
transaction is 6.94% payable semi-annually. The machine is depreciated over a four years
period on the straight line basis.
Required:
a) Extracts of the profit and loss
b) Extracts of statement of financial position
Solution
Fair value of Asset 16,320
Initial payment -2,550
Balance 13,770

Repayment Schedule
 Bal Bal
Year Interest Total Rental
b/f c/f
2020 1 13,770 478 14,248 -2,250 11,998
2 11,998 416 12,414 -2,250 10,164
2021 3 10,164 353 10,517 -2,250 8,267
4 8,267 287 8,554 -2,250 6,304
2022 5 6,304 219 6,523 -2,250 4,273
6 4,273 148 4,421 -2,250 2,171
2023 7 2,171 79 2,250 -2,250 -

Profit & Loss Extracts

2020 2021 2022 2023

Gross profit XX XX XX XX
Finance charge -894 -640 -367 -79
Depreciation (1) -4,080 -4,080 -4,080 -4,080
Deferred tax (2)

Manufacturing Ltd.
Extracts of statement of financial position
Non-current asets 2020 2021 2022 2023
Cost 16,320 16,320 16,320 16,320
-
Depreciation -4,080 -8,160 -12,240
16,320
Net book value 12,240 8,160 4,080 -

Equity and
Liabilities:
Current lease
3,860 2,177
obligations
Non-current lease
6,304 4,133
obligations
Calculations:
Remaining 7
Assuming interest is quoted on an instalments at 3.47%
annual basis: i.e 6.94% ÷ 2

13770 = 2250 X
 Depreciation = 16,320 x ¼ = 4,080

Exercise 1

Lear Ltd is a manufacturer of ladies hand bags. The company has adopted a policy of
leasing long term assets to finance the growth. The company leased leather processing
equipment on 1st January 2015. The lease provided for three annual lease rental of Ksh
18 million payable in arrears. The equipment has a cash price of Ksh 40 million and useful
life of four years and a nil residual value. Ownership will be transferred at the end of
the third year.

Required:

i) Prepare the finance lease obligation amortization schedule

ii) Prepare the journal entries to record all the transactions

Exercises 2

Mines Ltd leased industrial plant on 1st January 2016. The lease provided for four annual
lease rental of Ksh 10 million payable in arrears at the end of the year. The equipment
has a useful life of four years and a nil residual value. The cash selling price of the
equipment is Ksh 32.1 million.
Required:

i) Compute the implicit rate of interest

ii) Prepare the finance lease obligation amortization schedule
iii) Prepare journal entries to record the transaction for the year to 31st Dec 2017