STUDY GUIDE B4: LEASES

Acquiring non-current assets under a lease arrangement is a lifeline available to cash-starved companies.
Cash-rich companies may also opt for lease arrangements after conducting a cash outflow-benefit analysis, where
they may decide to lease because they can invest their money in something that gives a higher return than the
interest they need to pay on the lease payments.

Imagine that Cash Co ‘sells’ a building to Carry Co for Tshs100 million but in the contract it states that Cash Co
will buy the building back within 1 year for Tshs150 million.

You need to look at the ‘substance’ of the transaction, rather than its strict ‘legal form’. That means that instead
of looking at the legal document, think about whether it really looks like a sale. Here, it does not look like a sale -
why would a company agree to sell something at a low value and then agree to buy it back at a higher value?

In substance, Carry Co has given Cash loan of Tshs100 million and Cash Co has given Carry Co the building as
security. When Cash Co buys back the building, it pays Tshs150 million, which in effect is Tshs100 million for
the building, with Tshs50 million paid as interest.

Does it seem fair to derecognise the building in Cash Co’s accounts? No, it does not, as effectively the asset
was just pledged as security just like if a bank requires the deeds of a building as security against a bank loan.

This Study Guide will help you acquire the knowledge required in order to answer examination questions as well
as account for leases with ease. It will also teach you how to spot if there is a substance over form issue!

a) Understand the essential characteristics of a lease arrangement along with important terms and
definitions in accordance with International Accounting Standards on leases.
b) Classify a lease arrangement into an operating or finance lease in accordance with International
Accounting Standard on leases.
c) Show the accounting treatment of operating leases in the books of the lessor and the lessee.
d) Show the accounting treatment of finance lease in the books of the lessor and the lessee.
 © GTG Leases: 136

1. Understand the essential characteristics of a lease arrangement along with important

terms and definitions in accordance with International Accounting Standards on leases.
[Learning Outcome a]

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.
IAS 17 Para 4

In simple terms, a lease is an arrangement by which a person / entity (the lessee) can acquire the right to
use an asset from another person / entity (the lessor), without making a full payment for the asset when the
arrangement (the lease) commences.
The lessee pays for the asset in instalments, over the period of the lease.
As full payment for the use of the assets is not made by the lessee, the title of ownership of the asset
remains with the lessor.
The essential characteristics of a lease are
1. The existence of a lessor: the lessor is the person who transfers the right to use the asset for an agreed
period of time to another person.
2. The existence of a lessee: the lessee is the person who acquires the right to use the asset for an agreed
period of time from another person.
3. Transfer of the right to use an asset: the lessor transfers the right to use an asset to the lessee. Normally
the possession of the leased asset is handed over to the lessee. However, handing over the asset physically
is not compulsory, what is handed over is the right to use an asset.

Plain Co enters into an agreement with Jane Co to use a machine which remains within the factory premises of
Jane Co as the cost of dismantling and reinstalling the machine is high.
The cost of the machine is Tshs25 million.
Plain Co agrees to pay the full amount to Jane Co over 10 years, by paying Tshs3 million each year. The
ownership or title of the machine remains with Jane Co.
The agreement mentioned above is a lease agreement where:
Plain Co has the right to use the asset the lessee.
Jane Co is the lender of the asset the lessor.
The right to use the asset is with the lessee (Plain Co).
The physical possession of the machine is with the lessor (Jane Co).
The ownership of the machine is with the lessor (Jane Co).

4. Lease payments are the instalments which the lessee pays to the lessor in return for the right to use an
asset.
5. Minimum lease payments

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:
1. for a lessee, any amounts guaranteed by the lessee or by a party related to the lessee; or
2. for a lessor, any residual value guaranteed to the lessor by:
(a) the lessee;
(b) a party related to the lessee; or
(c) a third party unrelated to the lessor that is financially capable of discharging the obligations under the
guarantee.
© GTG Leases: 137

Diagram 1: Minimum lease payments for a lessee and a lessor

Other important related terms

1. The economic life of an asset

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.
IAS 17 Para 4

2. The degree / extent of transfer of risks and rewards which are incidental to the ownership of leased
asset by the lessor to the lessee.

(a) Risks incidental to ownership include

(i) the possibilities of losses from idle capacity or technological obsolescence
(ii) variations in return because of changing economic conditions

(b) Rewards incidental to ownership include:

(i) the expectation of profitable operation over the asset’s economic life
(ii) gain from appreciation in value
(iii) realisation of residual value

When the indicators are mixed the management of the reporting company has to use its discretion in deciding
the degree / extent of transfer of risks and rewards which are incidental to the ownership of leased asset
by the lessor to the lessee.

3. The lease term

The lease term is the non-cancellable period for which the lessee has contracted to lease the asset,
together with any further terms for which the lessee has the option to continue to lease the asset, with or without
further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the
option.
© GTG Leases: 138
 © GTG Leases: 139

This basically means that when the lease term is calculated, if the lessee has the option to use the asset for a
further period for a very low payment, this extra term should be included in the lease term.

Tom took a vehicle on lease from Jerry. Tom agreed to pay Tshs12 million every year for the next 4 years. Tweety
who is related to Tom has agreed to pay the lease rental to Jerry if Tom is unable to pay any lease rent. Tweety
has also agreed to pay Tshs1.25 million for the residual value of the vehicle at the end of the lease term. Tom had
to pay Tshs250,000 for registering the lease agreement.

Required:

Determine the minimum lease payments in this transaction.

2. Classify a lease arrangement into an operating or finance lease in accordance with

International Accounting Standard on leases.
[Learning Outcome b]

2.1 Finance lease

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.
IAS 17 Para 4

If the risks and rewards incidental to ownership are transferred to the lessee, then the lease is a finance lease
regardless of whether the ownership is transferred to the lessee or not.

2.2 Operating lease

An operating lease is a lease other than a finance lease.

IAS 17 Para 4

Diagram 2: Classification of leases

2.3 Determining a lease type

The lease type has to be determined on inception of the lease because the accounting treatment for assets
acquired under the two lease types is different.

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.

It is this date on which a lease is classified as either an operating or a finance lease; and in the case of a
finance lease, the amounts to be recognised at the commencement of the lease term are determined.
© GTG Leases: 140

Determining a lease type requires determining whether the risks and rewards incidental to ownership of the
leased asset remain with the lessor or are transferred to the lessee.

While determining a lease type, it becomes essential to consider the substance of the transaction rather than
the form of the contract. A similar-sounding lease gets classified differently when we consider the substance
of the transaction rather than the strict legal form of the contract.

A lease is normally classified as a finance lease when any one or all of the following situations arise:

1. The lease transfers ownership of the asset to the lessee by the end of the lease term.

2. The lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than
the fair value of the asset, at the date the option becomes exercisable. It has to be reasonably certain
at the inception of the lease that the option will be exercised.

3. The lease term is for the major part of the economic life of the asset, even if the title is not transferred.

4. 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. The standard does not define the term ‘substantial’.
However, if the minimum lease payment is more than 90% of the fair value of the leased asset, it can be
said to be substantial.

IAS 17 does not specify the quantitative threshold for determining ‘Substantially all’ In contrast to this US
GAAP, states “the present value of minimum lease payments equaling at least 90% of leased asset fair value,”
while the corresponding language, “substantially all of the fair value of the leased asset,” is used in IAS 17.
Again, there is scope for debate as to whether “substantially all” implies a threshold lower than 90% or, less
likely, an even higher one. However the decision rests on management to determine this threshold.
5. The leased assets are of such a specialised nature that only the lessee can use them without major
modifications.

6. If the lessee can cancel the lease, then the lessor’s losses associated with the cancellation are borne
by the lessee.

7. Gains or losses from the fluctuation in the fair value of the residual accrue to the lessee.

8. The lessee has the ability to continue the lease for a secondary period at a rent that is substantially
lower than market rent.

If none of the above conditions are fulfilled then it is an operating lease.

It is important to remember that all the situations mentioned above are not conclusive in the classification of
the lease type. Each lease agreement has to be considered individually, keeping in mind that the most important
feature for classification is whether the risks and rewards incidental to ownership of the leased asset lie with
the lessor or the lessee.

1. Alpha Co takes on lease a special camera from Beta Co at an annual lease rent of Tshs6 million. Alpha Co
is to make minimum lease payments for 5 years. The present value of annual lease rents is Tshs23.956
million. The fair value of the camera is Tshs25 million.

2. Fair Co acquired a building from Deal Co on lease for 20 years. In the lease agreement itself, it is decided that
the sale proceeds of the building at the end of the lease period will remain with Deal Co.

Required:

Determine whether this lease is a finance lease or an operating lease.

 © GTG Leases: 141

Diagram 3: Determining a lease type

2.4 Method of classifying leases of land and buildings

One unique feature of land is that it cannot have an estimated economic life. Prior to the amendment to IAS 17
(2009), if the title of ownership of land was not going to be transferred to the lessee at the end of the lease term,
then the risks and rewards of owning land cannot be said to be transferred and therefore the land was classified
as an operating lease.

For classifying a lease involving land and buildings, land and buildings elements are required to be separated. The
minimum lease payments are allocated between the land and buildings elements in proportion to their relative fair
values. The land element of lease is normally classified as an operating lease however, when the title of land
passes to the lessee at the end of the lease term it is classified as finance lease. However, according to
the amendment made to IAS 17 in April 2009, a long term lease of land should be classified on the basis of its
substance and not only based on its legal form. In the case of long term land agreements, the risks and rewards
would be automatically transferred to the lessee, even though the title is not transferred. In such a case, the lease
for the land should be treated as a finance lease.The buildings element is classified as an operating or finance
lease by applying the classification criteria in IAS 17.

However, if the lessee's interest in both land and buildings is classified as an investment property in accordance
with IAS 40 and the fair value model is adopted separate measurement of the land and buildings elements is not
required.

Juke Co acquired land on lease from Buke Co. for the period of 999 years. The title is not expected to pass to
Juke Co.
However, due to the long duration of the lease, significant risks and rewards associated with the land during the
lease term are to be transferred to the lessee despite there being no transfer of title.
In this situation, the lease should be treated as a finance lease and not as an operating lease.

3. Show the accounting treatment of operating leases in the books of the lessor and the
lessee.
[Learning Outcome c]
3.1 In the books of the lessee
IAS 17 states that lease rental 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 user’s benefit. An asset acquired under a lease agreement is not recognised as an asset in the books
of the lessee.

Why are assets acquired under an operating lease not recognised as an asset purchased on credit?
© GTG Leases: 142

This means that the lease rentals which the lessee pays periodically, when he acquires an asset under an
operating lease, are debited to the statement of profit or loss as an expense.

Journal entry:

Dr Lease rents paid X

Cr Bank X
Being lease rental paid

On 1 January 20X5, Earthmovers Ltd acquired on lease a bulldozer from Power Plant Ltd by paying an annual
lease rental of Tshs5 million for the next five years. The repairs and maintenance of the bulldozer are to be
undertaken by Power Plant Ltd. At the end of five years, if Earthmovers Ltd wishes to renew the lease, then it
would have to re-negotiate the terms of the lease.

Required:

State with reasons, the type of the lease and show the accounting treatment and the relevant extracts of its
financial statements in the books of Earthmovers Ltd assuming the calendar year to be the accounting year.

Answer

According to the terms of this lease agreement:

1. the risks incidental to ownership of the leased asset remain with Power Plant Ltd (lessor) has to
undertake the repairs and maintenance of the leased asset.

2. the rewards incidental to ownership of the leased asset remains with Power Plant Ltd (lessor) if the
lease is to be renewed at the end of the lease term, and then there are to be re-negotiations.

3. The title of ownership is going to remain with Power Plant Ltd (lessor).

Hence, this is an operating lease and will be accounted for in the following manner in the books of
Earthmovers Ltd.

Lease rent paid

Date Tshs’000 Date Tshs’000
31/12/20X5 Bank 5,000 31/12/20X5 Statement of profit or loss 5,000

31/12/20X6 Bank 5,000 31/12/20X6 Statement of profit or loss 5,000

31/12/20X7 Bank 5,000 31/12/20X7 Statement of profit or loss 5,000

31/12/20X8 Bank 5,000 31/12/20X8 Statement of profit or loss 5,000

31/12/20X9 Bank 5,000 31/12/20X9 Statement of profit or loss 5,000

31/12/20Y0 Bank 5,000 31/12/20Y0 Statement of profit or loss 5,000

Statement of profit or loss and OCI (extracts) for the year to 31 December (Amount in Tshs’000)

20X5 20X6 20X7 20X8 20X9 20Y0

Tshs’000 Tshs’000 Tshs’000 Tshs’000 Tshs’000 Tshs’000
Lease rent paid 5,000 5,000 5,000 5,000 5,000 5,000

The statement of financial position will not reflect any item for the bulldozer acquired under an operating lease.
 © GTG Leases: 143

Diagram 4: Accounting treatment in the books of the lessee for assets leased out under an operating
lease

3.2 In the books of the lessor

The leased asset continues to be reflected as a non-current asset in the financial statements of the lessor and is
depreciated in the normal manner. The lease rentals received are credited in the statement of profit or loss of
the lessor.

Using the information given in the example of Earthmovers Ltd above and the additional information given here
show the relevant extracts in the financial statements of Power Plant Ltd.

Additional information

The carrying amount of the bulldozer on 1 January 20X5 was Tshs200 million and the rate of depreciation was
10% on a reducing balance method.

Diagram 5: Accounting treatment in the books of the lessor for assets acquired under an operating
lease

4. Show the accounting treatment of finance lease in the books of the lessor and the lessee.
[Learning Outcome d]

4.1 Accounting treatment for finance lease in the books of the lessee

IAS 17 states that assets acquired by way of finance leases are to be accounted for in the books of the lessee
in the same manner as credit purchases are recorded.

1. Recognition of an asset and a liability

The journal entry to capitalise the asset is:

Dr Asset X
Cr Lessor X
Being asset acquired by a finance lease

The amount to be recorded is the lower of the fair value of the asset and the present value of the minimum
lease payments.
© GTG Leases: 144

Alpha Ltd acquired a machine on lease from Beta Ltd. Alpha Ltd has to bear the repairs and maintenance
charges of the machine and can also realise the residual value at the end of its economic life. The fair value of
the machine is Tshs50 million and the present value of the minimum lease payments is Tshs48.5.
In this example:
The lease is a finance lease as both the risks (repairs and maintenance charges of the machine) and the
rewards (realisation of the residual value at the end of the economic life) of ownership of the machine lie with
Alpha Ltd (the lessee).
The journal entry in the books of Alpha Ltd (the lessee) is:
Dr Machine Tshs48.50
Cr Lessor Tshs48.50
Being machine acquired by a finance lease

2. Depreciating an asset
The depreciation policy for depreciable leased assets should be consistent with the normal depreciation
policy of the lessee for similar assets (according to the requirements of IAS 16 and IAS 38).
If there is no reasonable certainty that the lessee will obtain ownership by the end of the lease term, the asset
shall be fully depreciated over the shorter of:
the life of the lease; and
the useful life of the asset.

Laurel acquired a film projector from Hardy on a 5-year finance lease. The fair value of the projector is Tshs75
million and the present value of the minimum lease payments is Tshs76 million. The useful life of the projector is
10 years and the estimated residual value is Tshs2.5 million.
In this example:
Laurel will capitalise the projector in his books for Tshs75 million (the lower of the fair value of the asset
and the present value of the minimum lease payments).
The projector will be depreciated over 5 years [the shorter of the life of the lease and the useful life of the
asset.
The amount of depreciation charged each year will be Tshs14.5 million ((Tshs75 million – Tshs2.5 million) /
5 years).
Estimated residual value

Why is an asset acquired by a finance lease recorded as a credit purchase in the books of the lessee?

3. Accounting for repayment

The journal entries to record the lease rental payment are
For the lease rental repayment (inclusive of both the interest and capital repayment portion):
Dr Lessor X
Cr Cash/bank X
Being the total rental payment paid to the lessor
For recording the interest
Dr Lease interest X
Cr Lessor X
Being the interest accrued outstanding on the total lease amount

(The lease rental payment is split into the capital portion and the interest portion by using one of the two
© GTG Leases: 145
methods mentioned above).
 © GTG Leases: 146

Diagram 6: Treatment in the books of the lessee for assets acquired under a finance lease

SOPL – Statement of profit or loss

4.2 Accounting treatment in the books of the lessor

IAS 17 requires the leased asset to be recognised in the lessor’s statement of financial position as a receivable
and not as a non-current asset. The lessor will recognise receivables and derecognise the leased asset.

The journal entry for recording this transaction is:

Dr Receivable (lessee) X
Cr Non-current asset X
Being asset transferred by a finance lease

The amount to be recognised is the present value of minimum lease payments.

The journal entries to record the lease instalments received are:

For the lease instalment received (inclusive of both the interest and capital repayment portion)
Dr Cash/bank X
Cr Lessee X
Being the total lease instalment received from the lessee

For recording the interest

Dr Lessee X
Cr Lease interests received X
Being the interest received on the total lease amount outstanding

(The lease rental payment is split into the capital portion and the interest portion by using one of the two
methods mentioned above).
© GTG Leases: 147

Diagram 7: Treatment in the books of the lessor for assets leased out under a finance lease

SOPL – Statement of profit or loss

Treatment of initial direct costs incurred by the lessor

Lessors often incur initial direct costs like commissions, legal charges, professional fees etc. In the case of lessors
other than manufacturer or dealer lessors, the initial direct costs incurred are to be capitalised and recognised
over the lease term. The interest rate implicit in the lease is defined in such a manner that initial direct costs
are automatically included in finance lease receivables. Thus, there is no need to add these costs separately.
However in case of manufacturer or dealer lessors the initial direct costs are recognised as expenses as and
when the selling profits are recognised.
4.3 Determination of the interest portion and the capital portion of the lease instalment
In order to account for the finance lease the lease rental has to be split into
The interest portion; and
The capital portion

The two methods which can be used for apportioning the lease rental payments are:
The actuarial method; and
The sum-of-digits method

It should be noted that, whichever method is followed, the total interest paid remains the same.

4.4 The actuarial method

(1) At the inception of the lease (when the lease starts), the lessor is credited with an amount equal to the fair
value of the asset.
(2) Any deposit paid to the lessor is then deducted from this amount.
(3) The amount of capital repaid is deducted from the credit balance of the lessor’s account every time a lease
rental is paid.
(4) The interest portion is calculated by applying the rate of interest to the balance in lessor’s account each year
(reducing balance method).

The interest rate used is called the interest rate implicit in the lease. This rate spreads income derived from
the lease over the period of the lease. This interest rate will be mentioned in the question.

As the reducing balance method is followed to calculate the amount of interest, the interest is highest in the
early part of the lease term, and gradually reduces as capital is repaid.
 © GTG Leases: 148

Right Ltd leases an item of a plant from Left Ltd on 1 January 20X5. Tshs12.5 million is payable immediately,
followed by four annual payments starting on 1 January 20X6. The agreed fair value of the plant is Tshs44.868
million and the interest rate implicit in the lease is 20% per annum.
Right Ltd has the right to continue to use the plant after the end of the five-year period for as long as it wishes to
without further payment. The expected useful life of the plant is ten years, at the end of which the residual value
is estimated to be nil.
Required:
Split the lease rental payments into the interest and capital portions by using the actuarial method.

4.5 The sum-of-digits method

1. A digit is assigned to each interest bearing instalment.
If there is a down payment followed by 3 instalments then the number of interest bearing instalments is 3. The
number of interest bearing instalments is not 4 - there is no interest inherent in a down payment.
2. The last instalment is assigned the digit 1, the second last one 2, and so on.
3. Add all the digits, using the formula:
Sum of digits = n (n+1) / 2,
where n is the number assigned to the interest bearing instalments
4. Calculate the interest portion included in each interest bearing instalment by using the formula:
Interest portion = Total interest (to be paid or received) over lease term x digit applicable to the
instalment / sum of digits
In this method also, the interest is highest in the early part of the lease term, and gradually reduces as capital is
repaid. This is consistent with what happens in reality, where the first instalments have a higher interest element
as there is more capital outstanding at that point.

Using data and figures from Test Yourself 6 - Right Ltd, calculate interest under the sum-of-digits method.

Diagram 8: Treatment of interest using the actuarial method

© GTG Leases: 149

Using information given in Test Yourself 6, show the relevant extracts of the financial statements (interest
apportionment using the actuarial method) of Right Ltd, the lessee, for the years 20X5 to 20Y0.

For Test Yourself 6 show the relevant extracts of the financial statements of Left ltd

Answers to Test Yourself

Answer to TY 1

In this case minimum lease payments for both Tom (lessee) and Jerry (lessor) are:

Tshs’000
Lease rent (Tshs12,000 x 4) 48,000
Plus amount guaranteed to be paid by Tweety 1,250
Minimum lease payments 49,250

Tshs250,000 paid for registering the lease agreement does not become a part of the minimum lease payments.

Answer to TY 2

(a) A lease is classified as a finance lease if the present value of the minimum lease payments amounts to at
least substantially all of the fair value of the leased asset.
In this lease
the present value of the minimum lease payments is Tshs23.956 million
the fair value of the camera is Tshs25 million.
As the present value of the minimum lease payments amounts to substantially all of the fair value of
the leased camera, this lease is classified as a finance lease.
(b) As gains or losses arising from the fluctuation in the fair value of the leased building remain with the lessor
this is an operating lease.

Answer to TY 3

The risks and rewards incidental to ownership of the leased asset remain with the lessor under an
operating lease.

They are not transferred to the lessee.

This means that the lessee does not acquire a non-current asset, even after making the minimum lease
payments under the lease agreement: he is only paying rent for operating the asset.

Hence, assets acquired under an operating lease are treated not as a credit purchase of asset but as a lease
(rental) expense in the statement of profit or loss.

Answer to TY 4

Statement of profit or loss and OCI (extracts) of Power Plant Ltd for the year to 31 December (Amounts
in Tshs’000)

Income 20X5 20X6 20X7 20X8 20X9 20Y0

Lease rent received 5,000 5,000 5,000 5,000 5,000 5,000

Expenses 20X5 20X6 20X7 20X8 20X9 20Y0

Depreciation (W1) 20,000 18,000 16,200 14,580 13,122 11,810
 © GTG Leases: 150

Statement of financial position (extracts) of Power Plant Ltd as on 31 December (Amounts in Tshs’000)

Assets 20X5 20X6 20X7 20X8 20X9 20Y0

Non-current assets (W1) 180,000 162,000 145,800 131,220 118,098 106,288

Workings

W1 Carrying amount of non-current assets and depreciation (Amounts in Tshs’000)

20X5 20X6 20X7 20X8 20X9 20Y0

Carrying amount on 1 January 200,000 180,000 162,000 145,800 131,220 118,098
Depreciation @ 10% (RBM) (20,000) (18,000) (16,200) (14,580) (13,122) (11,810)
Carrying amount on 31 December 180,000 162,000 145,800 131,220 118,098 106,288

Answer to TY 5

The risks and rewards incidental to ownership of the leased asset are transferred to the lessee in a finance
lease. This means that the lessee has acquired a non-current asset, regardless of whether the title of ownership
eventually passes over to him or not.

In order to apply the principle of economic substance an asset acquired by a finance lease is recorded as a
credit purchase in the books of the lessee.

The substance of the transaction is: the asset is being used and benefits are being received by the lessee.
The legal form of the transaction is: the ownership documents are owned by the lessor.

Answer to TY 6
The lease rental payments are split into the interest and capital portions, by using the actuarial method in
the following manner:
Left Ltd Lease Rental Left Ltd Left Ltd
Interest
Year Balance on Paid on Reducing Balance on
Portion
1 January 1 January Balance 31 December
Tshs’000 Tshs’000 Tshs’000 Tshs’000 Tshs’000

20X5
44,868 (12,500) 32,368 6,474 38,842
20X6
38,842 (12,500) 26,342 5,268 31,610
20X7
31,610 (12,500) 19,110 3,822 22,932
20X8
22,932 (12,500) 10,432 2,068 12,500
20X9
12,500 (12,500) -
17,632

Answer to TY 7
The following calculation shows the allocation of the lease rental payments into the interest and capital
portions by using the sum of digits method:

Year Formula Interest portion

Tshs’000
20X5 4/10 x 17,632 7,053
20X6 3/10 x 17,632 5,290
20X7 2/10 x 17,632 3,526
20X8 1/10 x 17,632 1,763
Total interest 17,632
© GTG Leases: 151

Workings (Amounts in Tshs’000)

W1 Sum of digits

Sum of digits = n (n+1)/2

= 4(4+1)/2
= 4 x 5/2
= 10

n = number of interest bearing instalments - 4

W2 Total interest

Total interest = Total of instalments – fair value of asset

= (12,500 x 5) – 44,868
= 62,500 – 44,868
= 17,632

Answer to TY 8

Right Ltd has the right to continue to use the plant after the end of the five year period for as long as it wishes
without further payment. This shows that Right Ltd has acquired the plant under a finance lease because the risks
and rewards of ownership have been transferred from the lessor (Left Ltd) to the lessee (Right Ltd).

It is assumed that Right Ltd charges depreciation at 10% on a straight-line basis as the estimated useful life of
the machine is estimated to be 10 years.

Statement of profit or loss and OCI (extracts)

20X5 20X6 20X7 20X8 20X9

Tshs'000 Tshs'000 Tshs'000 Tshs'000 Tshs'000
Lease interest (W1) 6,474 5,268 3,822 2,068
Depreciation - plant (W2) 4,487 4,487 4,487 4,487 4,487

Statement of financial position (extracts)

20X5 20X6 20X7 20X8 20X9

Tshs'000 Tshs'000 Tshs'000 Tshs'000 Tshs'000
Non-current assets
Plant: at cost 44,868 44,868 44,868 44,868 44,868
Depreciation (W3) (4,487) (8,974) (13,461) (17,948) (22,435)

40,381 35,894 31,407 26,920 22,433

Current Liabilities
Left Ltd (Instalment - interest portion) (W4) 12,500 12,500 12,500 12,500
Non-current liabilities
Left Ltd (closing balance - current liability) (W4) 26,342 19,110 10,432 -

Note

The asset will be depreciated for a further period of 5 years, hence the WDV at the end of the 5 year is not nil.
However, the lease payment is to be made only for 5 years, so the liability to the lessor will be nil.
 © GTG Leases: 150

Workings

W1 Lease interest

Left Ltd Lease Rental Left Ltd Left Ltd

Interest
Year Balance on Paid on Reducing Balance on
Portion
1 January 1 January Balance 31 December
Tshs'000 Tshs'000 Tshs'000 Tshs'000 Tshs'000

20X5
44,868 (12,500) 32,368 6,474 38,842
20X6
38,842 (12,500) 26,342 5,268 31,610
20X7
31,610 (12,500) 19,110 3,822 22,932
20X8
2
2,932 (12,500) 10,432 2,068 12,500
20X9
12,500 (12,500) - - -
62,500 17,632

W2 Depreciation on plant (Amounts in Tshs’000)

Plant at cost Tshs44,868

Depreciation at 10% on straight line basis (Tshs44,868 x 10%) Tshs4,487

W3 Provision for depreciation

20X5 20X6 20X7 20X8 20X9

Tshs'000 Tshs'000 Tshs'000 Tshs'000 Tshs'000
Opening balance - 4,487 8,974 13,461 17,948
Depreciation for the year (4,487) (4,487) (4,487) (4,487) (4,487)
Closing balance 4,487 8,974 13,461 17,948 22,435

W4 Non-current liabilities

Non-current liability portion = Amount payable to Left Ltd – Current liability portion

As at 31 December 20X5 20X6 20X7 20X8 20X9

Tshs'000 Tshs'000 Tshs'000 Tshs'000 Tshs'000
Amount payable to Left 38,842 31,610 22,932 12,500 -
Less: Current portion (12,500) (12,500) (12,500) (12,500) -
Non-current portion (26,342) (19,110) (10,432) -

Answer to TY 9

Statement of profit or loss and OCI (EXTRACTS) (amounts in Tshs’000)

20X5 20X6 20X7 20X8 20X9 20Y0

Lease interest received (W1) 6,474 5,268 3,822 2,068

Statement of financial position (EXTRACTS) (amounts in Tshs’000)

20X5 20X6 20X7 20X8 20X9 20Y0

Receivable from Right Ltd 38,842 31,610 22,932 12,500 -
© GTG Leases: 151

Workings

W1 Lease interest received and receivable from Right Ltd

Lease
Right Ltd instalment Right Ltd Right Ltd
Year
Balance on received on Reducing Interest Balance on
1 January 1 January Balance Portion 31 December
Tshs’000 Tshs’000 Tshs’000 Tshs’000 Tshs’000

20X5 44,868 (12,500) 32,368 6,474 38,842

20X6 38,842 (12,500) 26,342 5,268 31,610

20X7 31,610 (12,500) 19,110 3,822 22,932

20X8 22,932 (12,500) 10,432 2,068 12,500

20X9 2,500
1 (12,500) - - -
17,632

Quick Quiz

(1) Name the two different types of leases.

(2) What are the two components of a lease rental and which are the two methods by which these components
are identified?

(3) Is an asset acquired under an operating lease capitalised and brought into the books of accounts of the
lessee?

(4) What is the principle of substance over form?

Answers to Quick Quiz

(1) The two different types of leases are:

Finance lease
Operating lease

(2) The lease rental comprises of two portions:

The interest portion

The capital portion

The two methods by which these components can be identified are:

The actuarial method

The sum of digits method

(3) An asset acquired under an operating lease is not brought into the books of accounts of the lessee at all.
Only the lease rental payments made are debited to the statement of profit or loss.

(4) Substance over form is the principle that transactions and events are accounted for and presented in
accordance with their substance and economic reality, and not just their legal form.
 © GTG Leases: 152

Self Examination Questions

Question 1

Play Inc has leased land and buildings to Clay Inc. The terms of the lease say that:

The title of land will not be transferred to Clay Inc.

Clay Inc has to pay an annual lease rent of Tshs50 million for a minimum number of 10 years. The fair value
of the building is Tshs480 million.

Required:

Determine the lease type.

Question 2

Fox Enterprises bought four helicopters at a price of Tshs20 million each as a part of business expansion. Fox
Enterprises entered into a finance lease agreement with Monk Flights Co for the same on 1 January 20X5. The
agreement stated that Fox Enterprises would pay a deposit of Tshs10 million on 1 January 20X5, annual
instalments on 31 December 20X5 and 31 December 20X6 of Tshs25 million each and a final instalment on 31
December 20X7 of Tshs79.04 million.

Interest was charged at 30% on the outstanding balance at 1 January and paid on 31 December each year. Fox
Enterprises writes off its vehicles over a period of three years using the straight-line method. The value of scrap
of the vehicle is assumed to be Tshs1.5 million each.

Required:

Prepare

(i) The relevant accounts to show how the above transactions would be recorded in the books of Fox
Enterprises and;

(ii) Extracts from the statement of profit or loss and statement of financial position for the years ending 31
December 20X5, 20X6, 20X7.

Question 3

On 1 October, 20X5 Red Inc leased one of its machines to White Inc for 3 years, at an annual lease rental of
Tshs4 million. The estimated economic life of the machine was 10 years. Show the accounting entries in the books
of White Inc for these transactions.

Answers to Self Examination Questions

Answer to SEQ 1

The land portion of the lease: This portion is an operating lease because the title of land will not be
transferred to Clay Inc and the estimated economic life of land cannot be ascertained.

Furthermore, this is not the long term lease agreement where the significant risks and rewards associated with
the land during the lease term would be transferred to the lessee, despite there being no transfer of title. Therefore
this will be an operating lease.

The building portion of the lease:

The minimum lease payments amount to Tshs500 million (Tshs50 million x 10).
The fair value of the building is Tshs480 million.

This portion of the lease is a finance lease, because at the inception of the lease the present value of the
minimum lease payments seems to cover substantially all of the fair value of the leased asset.
© GTG Leases: 153

Answer to SEQ 2

Books of Fox Enterprises

Helicopter Account

Date Tshs’000 Date Tshs’000

01/01/20X5 Monk Flights (Tshs20,000 x 4) 80,000 31/12/20X5 Balance c/d 80,000

01/01/20X6 Balance b/d 80,000 31/12/20X6 Balance c/d 80,000

01/01/20X7 Balance b/d 80,000 31/12/20X7 Balance c/d 80,000

Accumulated depreciation on helicopter

Date Tshs’000 Date Tshs’000

Statement of profit or loss
31/12/20X5 Balance c/d 24,667 31/12/20X5 33.33% x (Tshs80,000- (4 x 24,667
Tshs1,500)

31/12/20X6 Balance c/d 49,334 01/01/20X6 Balance b/d 24,667

31/12/20X6 Statement of profit or loss 24,667
49,334 49,334

31/12/20X7 Balance c/d 74,000 01/01/20X7 Balance b/d 49,334

31/12/20X7 Statement of profit or loss 24,666
74,000 74,000

Lease interest

Year Tshs’000 Date Tshs’000

31/12/20X5 Monk Flight Co *21,000 31/12/20X5 Statement of profit or loss 21,000
31/12/20X6 Monk Flight Co *19,800 31/12/20X6 Statement of profit or loss 19,800
31/12/20X7 Monk Flight Co *18,240 31/12/20X7 Statement of profit or loss 18,240

Workings (Amounts in Tshs’000)

*(Tshs20,000 x 4 helicopters) = total Tshs80,000 – deposit Tshs10,000 = cost Tshs70,000 x interest 30% =
21,000

*(cost Tshs70,000 + lease interest 21,000 – 1st instalment Tshs25,000) = Tshs66,000 x interest 30% = 19,800
nd
*(cost Tshs66,000 + lease interest 19,800 – 2 instalment Tshs25,000) = Tshs60,800 x interest 30% = 18,240

Statement of profit or loss and OCI (extracts) for the year to 31 December

Amounts in Tshs’000
Expenses 20X5 20X6 20X7
Lease interest 21,000 19,800 18,240
Depreciation on helicopters 24,667 24,667 24,666
154 : Elements of Financial Statements © GTG

Statement of financial position (extracts) as at 31 December

20X5 20X6 20X7

Tshs’000 Tshs’000 Tshs’000
Non-current assets
Helicopters: at cost 80,000 80,000 80,000
Less: Depreciation (24,667) (49,334) (74,000)
55,333 30,666 6,000

Non-current liabilities
Finance lease obligations
(Closing balance – Current liability) 66,000 60,800 -

Current liabilities Finance

lease obligations (Instalment - - -
– Interest portion)

Monk Flight Co

Year Tshs’000 Year Tshs’000

01/01/20X5 Bank- deposit 10,000 01/01/20X5 Helicopter 80,000
31/12/20X5 Bank 25,000 31/12/20X5 Interest 21,000
Balance c/d 66,000
101,000 101,000
31/12/20X6 Bank 25,000 01/01/20X6 Balance b/d 66,000
Balance c/d 60,800 31/12/20X6 Interest 19,800
85,800 85,800
31/12/20X7 Bank 79,040 01/01/20X7 Balance b/d 60,800
31/12/20X7 Interest 18,240
79,040 79,040

Answer to SEQ 3

According to the terms of this lease agreement:

The rewards incidental to ownership of the leased asset remains with Red Inc (lessor): the asset has been
leased for only 3 years out of its estimated economic life of 10 years.

The title of ownership is going to remain with Red Inc (lessor).

Hence, this is an operating lease and will be accounted for in the following manner, in the books of White Inc.

Lease interest

Year Tshs’000 Date Tshs’000

31/12/20X5 Bank 1,000 31/12/20X5 Statement of profit or loss 1,000
31/12/20X6 Bank 4,000 31/12/20X6 Statement of profit or loss 4,000
31/12/20X7 Bank 4,000 31/12/20X7 Statement of profit or loss 4,000
31/12/20X8 Bank 3,000 31/12/20X8 Statement of profit or loss 3,000

Statement of profit or loss (extracts)

(Amount in Tshs’000)
20X5 20X6 20X7 20X8
Lease rent 1,000 4,000 4,000 3,000
155 : Elements of Financial Statements © GTG