Operating leases and finance leases

Published:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

SUBMISSION DATE

19th DECEMBER 2014

Table of Contents

1.0INTRODUCTION

2.0Literature Review

2.1Major Provisions of FRS 17 Leases

2.2Classification of Leases

2.3Types of Lease

2.3.1.Financial Lease

2.3.2.Operating Lease

2.3.3.Non – cancellable Lease

3.0Tasks

4.0Conclusion

5.0Reference

1.0 INTRODUCTION

A lease is a contract between two gatherings which is the “lessor” and the “lessee”. The lessor possesses a capital resource, yet lets the lessee to utilize it. The lessee makes instalments under the terms of the lease to the lessor, for a detailed period of time.

Leasing is, hence, a procedure of rental. Leased resources have typically been plant and machinery, cars and commercial vehicles, however may likewise be computers and office equipment.

There are two basic forms of lease which is “operating leases” and “finance lease”.

The lease term is the non-cancellable period for which the lessee has contracted to lease the benefit together with any further terms for which the lessee has the choice to carry on to lease the advantage, with or without further instalment, when at the beginning of the lease it is sensibly sure that the lessee will practice the alternative.

Initial direct costs are incremental expenses that are straightforwardly attributable to arranging and masterminding a lease, aside from such expenses acquired by producer or merchant lessors.

Fair value is the sum for which a benefit could be traded, or an obligation settled, between proficient, willing gatherings in and a safe distance exchange.

The interest rate implicit in the lease is the markdown rate that, at the origin of the lease, causes the total present estimation of the base lease instalments and the unguaranteed residual value to be equivalent to the aggregate of the fair value of the leased resources and any initial direct costs of the lessor.

Useful life is the estimated remaining period, from the initiation of the lease term, without control by the lease term, over which the financial profits epitomized in the advantage are required to be devoured by the substance.

Guaranteed residual value is for a lessee, that portion of the residual value that is ensured by the lessee or by a gathering associated to the lessee and for a lessor, that portion of the residual value that is ensured by the lessee or by an outsider random to the lessor that is monetarily equipped for releasing the commitments under the assurance.

2.0 Literature Review

2.1 Major Provisions of FRS 17 Leases

Leasing has become a material economic resource but the accounting treatment of the lease transaction was seen to distort the financial reports of a company so that the company did not represent a true and fair view of its commercial activities.

FRS 17, therefore, required lease agreements that transferred substantially all the risks and rewards to the lessee to be reported in the financial statements. The asset and liability were both brought onto the statement of financial position.

There was some concern that this might have undesirable economic consequences, by reducing the volume of leasing and that the inclusion of the lease obligation might affect the lessee company’s gearing adversely, possibly causing it to exceed its legal borrowing powers. However, in the event, the commercial reasons for leasing and the capacity of the leasing industry to structure lease agreements to circumvent the standard prevented a reduction in lease activity.

A standard was necessary to ensure uniform reporting and to prevent the accounting message being manipulated.

Then, the FRS 17 provisions also to require a thing that had formerly accounted its leasehold land to categorize the unamortised carrying sum as prepaid lease fee. If the thing had formerly enhanced such leasehold land, the thing will retain the unamortised increased sum as the surrogate carrying total of prepaid lease expenses.

2.2 Classification of Leases

A lease is categorised as a finance lease if it transmissions considerably all the possibilities and rewards subsidiary to proprietorship. While a lease is will categorised as an operating lease if it does not transmission considerably all the possibilities and rewards subsidiary to proprietorship.

FRS 17 provides a list of the factors that need to be considered in the decision whether risks and rewards of ownership have passed to the lessee. These factors are considered individually and in combination when making the decision, and if met would normally indicate a finance lease:

  1. The lease transmissions proprietorship of the resource to the lessee by the end of the lease term;
  2. The lessee has the choice to buying the resource at a value that is estimated to be appropriately 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;
  3. The lease term is for the main part of the economic life of the resource even if title is not transmitted;
  4. At the inception of the lease the current value of the minimum lease outgoings sums to at least substantively all of the fair value of the leased resource;
  5. The leased resources are of such a specific nature that only the lessee be able to use them without main changes

If land is leased and legal title is not expected to pass at the end of the lease, the lease will be an operating lease. The reason is that the lease can never be for the substantial part of the economic life of the asset. This means that if a land and buildings lease is entered into it should be classified as two leases, a land lease which is usually an operating lease and a buildings lease which could be operating or a finance lease. The lease payments should be allocated between the land and buildings elements in proportion to the relative fair values of the land element and the buildings elements of the lease at its inception.

2.3 Types of Lease

2.3.1. Financial Lease

Finance leases are lease contracts among the handler of the leased asset (the lessee) and a supplier of business (the lessor) for most, or all, of the resources estimated useful life.

The features of a finance lease:

  1. The lessee is in charge for the upkeep, servicing and maintenance of the asset. The lessor is not included in this at all.
  2. The lease has a primary period, which covers all or most of the economic life of the resources. At the end of the lease, the lessor could not be able to lease the resource to someone else, as the resource could be worn out. The lessor must, therefore, make sure that the lease outgoings during the primary period pay for the full cost of the resource as well as provided that the lessor with an appropriate coming back on his investment.
  3. It is usual at the end of the primary lease period to let the lessee to carry on to lease the resource for an indefinite secondary period, in coming back for a very low nominal rent. On the other hand, the lessee might be permitted to retail the resource on the lessor's behalf and to hold onto most of the sale proceeds, paying only a small percentage (maybe 10%) to the lessor.

Lessors intend to disclose the subsequent for finance leases:

  1. A resolution among the gross investment in the lease at the end of the reporting period, and the current value of minimum lease outgoings receivable at the end of the reporting period. Other than that, an entity intend to disclose the gross investment in the lease and the current value of minimum lease outgoings receivable at the end of the reporting period, for each of the subsequent periods:
  1. not more than one year;
  2. More than one year and not more than five years;
  3. More than five years.
  1. Unearned finance income.
  2. The unguaranteed residual values accruing to the advantage of the lessor.
  3. The accumulated allowance for uncollectible minimum lease outgoings receivable.
  4. Contingent rents known as income in the period.
  5. A general description of the lessor’s material leasing arrangements.

2.3.2. Operating Lease

Operating leases are rental contracts among the lessor and the lessee whereby:

  1. the lessor provisions the equipment to the lessee
  2. the lessor is in charge for servicing and maintaining the leased equipment
  3. the period of the lease is fairly short, less than the economic life of the resource, then at the end of the lease agreement, the lessor can also
  1. lease the equipment to others, and gain a good rent for it, or
  2. Trade the equipment second-hand.

The advantages of operating leases:

  • The leased equipment no need to be exposed in the lessee's published balance sheet, so that the lessee's balance sheet not showing rise in its gearing ratio.
  • The equipment is leased for a shorter period than its predictable useful life. In the case of high-technology equipment, if the equipment becomes obsolete afore the end of its predictable life, the lessee does not have to hold onto on using it, and it is the lessor who must stand the possibility of having to trade out-of-date equipment recycled.

Lessors intend to disclose the subsequent for operating leases:

  1. the upcoming minimum lease outgoings under non-cancellable operating leases in the total and for each of the subsequent periods:
  1. not more than one year;
  2. more than one year and not more than five years;
  3. More than five years.
  1. Aggregate contingent rents known as income in the period.
  2. A general description of the lessor’s leasing provisions.

2.3.3. Non – cancellable Lease

A non-cancellable lease is a lease that is cancellable only:

  1. upon the manifestation of some remote contingency;
  2. with the authorisation of the lessor;
  3. if the lessee move in into a new lease for the same or an the same resource with the same lessor;
  4. Upon expense by the lessee of such an extra sum that, at inception of the lease, extension of the lease is reasonably certain.

3.0 Tasks

Date

Gross Yearly Rental

Tax Paid

9% Interest

Net Rental

Total Lease Liability

1/1/2014

1/1/2014

1/1/2015

1/1/2016

1/1/2017

1/1/2018

Journal Entries:

Year 1

Particulars

Debit

Credit

Equipment a/c Dr.

Lease liability a/c Cr.

(To record equipment lease obtained)

Tax on leasing a/c Dr.

Lease liability a/c Cr.

Cash a/c Cr.

(To record first payment)

Year 2

Tax on leasing a/c Dr.

Interest expense a/c Dr.

Lease liability a/c Dr.

Cash a/c Cr.

(To record second payment)

Year 3

Tax on leasing a/c Dr.

Interest expense a/c Dr.

Lease liability a/c Dr.

Cash a/c Cr.

(To record third payment)

Year 4

Tax on leasing a/c Dr.

Interest expense a/c Dr.

Lease liability a/c Dr.

Cash a/c Cr.

(To record fourth payment)

Year 5

Tax on leasing a/c Dr.

Interest expense a/c Dr.

Lease liability a/c Dr.

Cash a/c Cr.

(To record fifth payment)

4.0 Conclusion

5.0 Reference

1

Writing Services

Essay Writing
Service

Find out how the very best essay writing service can help you accomplish more and achieve higher marks today.

Assignment Writing Service

From complicated assignments to tricky tasks, our experts can tackle virtually any question thrown at them.

Dissertation Writing Service

A dissertation (also known as a thesis or research project) is probably the most important piece of work for any student! From full dissertations to individual chapters, we’re on hand to support you.

Coursework Writing Service

Our expert qualified writers can help you get your coursework right first time, every time.

Dissertation Proposal Service

The first step to completing a dissertation is to create a proposal that talks about what you wish to do. Our experts can design suitable methodologies - perfect to help you get started with a dissertation.

Report Writing
Service

Reports for any audience. Perfectly structured, professionally written, and tailored to suit your exact requirements.

Essay Skeleton Answer Service

If you’re just looking for some help to get started on an essay, our outline service provides you with a perfect essay plan.

Marking & Proofreading Service

Not sure if your work is hitting the mark? Struggling to get feedback from your lecturer? Our premium marking service was created just for you - get the feedback you deserve now.

Exam Revision
Service

Exams can be one of the most stressful experiences you’ll ever have! Revision is key, and we’re here to help. With custom created revision notes and exam answers, you’ll never feel underprepared again.