B301 Unit 6 Leases, provisions and contingencies

HKSSAP 14 Leases (revised 2001)                                                                                      Top

• "Off balance sheet" financing: If the lease payment were simply recorded as an expenditure, an asset and a liability would be unrecorded on the lessee's financial statements.
• Lease: an arrangement whereby one party (the lessor) retains the ownership of an asset but gives the right to use the asset to another party (the lessee) for an agreed period of time in return for specified payments.
  • E.g. in the airline industry, companies may have substantial involvement in leasing aircraft and related equipment.
  • As at 31/3/2001, 66% of fixed assets (aircraft and equipment) in Cathay Pacific Airway Ltd were leased (i.e. $32,204m of $48,548m).

• Terms
  • Minimum lease payments (MLP): the minimum payments which the lessee is legally obliged to pay to the lessor, should be discounted at the interest rate implicit in the lease.

  • Implicit interest rate: the discount rate that makes

    PV of annuity due of Minimum Lease Payment (MLP) = Fair value of the leased asset

  • Gross investment = lease payments + guaranteed residual value + unguaranteed residual value

  • Net investment = gross investment - unearned finance income (i.e. unearned interest)

  • Unearned finance income = gross investment - PV (gross investment)

Example 

Assume a company leases an asset for a term of 4 years, with monthly rental payments of HK$72,000.  The estimated residual value is HK$850,000 and the guaranteed residual value is HK$700,000.  The cost of the asset to the lessor is $3.5 million.

Calculation of the investment at the inception of the lease: 

Classification of leases                                                                                                                Top

• Finance Leases

• A much longer nature and it transfers substantially all the risks and rewards of ownership of an asset to the lessee.
• Lessee bears the risks of the leased assets (i.e. repair and maintenance) and enables the lessee to obtain its ownership at the end of the lease contract.
• Risks include the possibilities of loss from idle capacity or technological obsolescence and of variations on return due to changing economic conditions.
• Rewards include profitable operation over the asset's economic life and gain from appreciation in value or realisation of a residual value.
• Criteria to identify a finance lease:
  • ownership of the asset is transferred to the lessee by the end of the lease term;
  • existence of a bargain purchase option;
  • the lease covers the major part of the economic life;
  • the PV of MLP amounts to substantially equivalent to the fair value of the leased asset; and
  • the leased asset is specifically for the use of the lessee.
• In US, determining transfer of substantial risks and rewards is to see whether
  • the lease term equals to 75% or more of the economic life of the leased assets, or
  • 90% or more of the PV of the MLP, including any initial payment, will paid by the lessee over the term of the lease.
• However, IAS 17 (revised) & HKSSAP 14 (revised) do not give cutoff figures for these criteria, so professional judgment is needed.

• Operating Leases

• Not finance lease is an operating lease
• Usually involving land and buildings.

Accounting Treatment                                                                                                                   Top

Operating Lease

• Accounting by lessee:

• Rental payable must be charged to income statement on the straight-line basis over the lease term. Even if the monthly or annual lease payments are not the same, total lease payments should be charged to the income statement on the same monthly or yearly amounts over the lease term.

• Accounting by lessor:

• Leased assets should be recorded as fixed assets and depreciated over their useful lives.
• Initial indirect costs, e.g. legal fees, should be recognized as expenses immediately or deferred and allocated in the proportion to the recognition of the lease income over the lease term.
• Lease income should be recognised on a straight-line basis.

Finance Lease

Accounting by lessee:

• Leased asset and obligation should be recognized in the balance sheet as "Leased asset" and "Lease obligation" at the amounts equal to the fair value, or the present value of the MLP, if lower, of the leased asset at the start of the leasing arrangement.

• The leased asset has to be depreciated over the shorter of the leased term and the asset's useful life.

• There are 3 common methods of allocating the finance charge to the relevant accounting periods:

• the actuarial method: gives the most accurate result
• the rule of 78 (or sum of the Digits) method: the overall difference in result is generally not substantial
• the straight-line: simple

• The Standard suggests the finance charge may be best allocated by the actuarial method and the Rule of 78.
• Accounting entries for finance lease (on the lessee's books)

Finance lease	Accounting entries (Lessee's books)
When a lease agreement is signed	Dr. Leased asset
	Cr. Lease obligation
When lease payments are made	Dr. P/L - Finance charge
	Dr. Lease obligation
	Cr. Cash / Bank
When the depreciation expense is recorded	Dr, P/L - Depreciation
	Cr. Provision for depreciation

• If a bargain purchase option or guaranteed residual value is included, the PV of them will be regarded as part of the MLP and should be included in the leased assets and leased obligations.
• See the illustration rule78 & actuarial

Accounting by lessor:

Direct financing leases

• The leased assets should be eliminated from the lessor's books.
• The lease receivable from the lessee should be recognized at amounts equal to the net investment (i.e. gross investment - unearned finance income) in the lease.
• Accounting entries of direct financing lease (lessor's books)

Finance lease	Accounting entries (Lessee's books)
Lease agreement	Dr. Lease receivables (i.e., net investment in the lease)
	Cr. Asset (i.e. eliminated from lessor's books)
Lease payments received	Dr. Cash / Bank
	Cr. Lease receivables
	Cr. P/L - finance income earned

Sales-types leases

• A manufacturer or dealer lessor sells and finances leased assets.
• E.g., many taxi dealers have financing subsidiaries to provide financing to lessees of taxis.
• Types of income in sale-type finance leases

Stages	Value of leased asset	Income earned
Production	Cost or carrying value	--
Sales	Fair market value	Profit
Financing	Minimum lease payments	Finance income

• Accounting entries of sale-type finance lease (lessor's books)

Sale-type finance lease	Accounting entries (lessor's books)
In the year of lease arrangement:	Dr. Lease receivable (i.e. net investment in the lease)
Sales and financing	Cr. Sales
(Note: cost of goods sold is made up of the cost of leased assets and related initial costs.)	Dr. Cost of goods sold
	Cr. Leased asset
	Cr. Deferred initial costs (e.g. legal fees)
Each year over the lease term:	Dr. Cash
Lease income	Cr. Lease receivable
	Cr. P/L - Finance income

• If a bargain purchase option or guaranteed residual value is included, the amount should be included in the MLP (lease receivable). Therefore, sales will be increased by the PV of that amount.
• If unguaranteed residual value, the PV of the amount would be deducted from the cost of goods sold to reflect that the lessor may receive it at the end of the lease term. As unguaranteed residual value is not part of MLP, it should not be included in sales (PV of MLP).

Sale and leaseback (items 54-62)                                                                                        Top

• Sellers-lessees sell assets to other parties (purchasers-lessors) and then lease back the same assets from the parties.
• Lessees can make some cash by selling their assets and can retain their assets for use by paying lease payments.

• Accounting treatments of profit or less for "operating lease"

When sale price is:	Profit or loss should be:
at fair value	recognized profit or loss immediately
above fair value	recognized profit or loss immediately up to fair value; the excess over the fair value should be deferred and amortized over the period the asset is expected to be used.
below fair value	recognized profit or loss immediately (Exception: the loss mat be deferred and amortized over the period the asset is expected to be used if the loss is compensated by future lease payments that are below market value.)
	(The above treatment is to ensure that the normal annual lease payment is charged to the accounts.)

• Accounting treatments of profit or loss for "finance lease"
  • The substance of the transaction is that the lessor provides finance to the lessee with the asset as security.
  • The excess of sales proceeds over the carrying amount should be deferred and amortized in the seller-lessee's books overt the lease term.

Disclosures

Operating lease

• Lessee's books
  • the breakdown of future MLP under non-cancelable operating leases into within 1 year, between 2 and 5 years, and over 5 years.
  • a general description of significant leasing arrangement.
• Lessor's books
  • the carrying amount, the accumulated depreciation and accumulated impairment losses for each class of assets;
  • the aggregate and breakdown of future MLP under non-cancelable operating leases into within 1 year, between 2 and 5 years, and over 5 years.
  • contingent rents recognized in income;
  • a general description of lessor's significant leasing arrangements.

Finance lease

• Lessee's books
  • the carrying amount of each class of assets;
  • a reconciliation between the total MLP and their present value, and their breakdown of within 1 year, between 2 and 5 years, and over 5 years;
  • contingent rents recognized in income for the period;
  • a general description of significant leasing arrangements.
• Lessor's books
  • a reconciliation between the total gross investment in the lease and the present value of MLP receivable, and breakdown of within 1 year, between 2 and 5 years, and over 5 years;
  • unearned finance income;
  • the unguaranteed residual values, if any;
  • the accumulated allowance for uncollectible MLP receivable, if any;
  • contingent rents recognized in income, if any;
  • a general description of lessor's significant leasing arrangements.

HKSSAP 28 Provisions & contingencies (revised Dec 2001)                           Top

• Terms
  • Provision: a liability with uncertain timing or amount, such as provision for closure of a division, e.g. a provision for doubtful debts
  • Liability: a present obligation of the enterprise arising from past events, and an outflow of resources for settlement is expected, e.g. trade payables.
  • Legal obligation: an event that creates a legal or constructive obligation.
  • Constructive obligation: an obligation derived from an enterprise's actions. Through past practice or published policies, the enterprise creates a valid expectation to other parties that it will accept certain responsibilities.  E.g., a company that promises to raise employee's salaries and make this known to its employees creates a constructive obligation.
  • Accruals: liabilities to be paid for goods or services sometime in the future with the amount already determined, e.g. accrued rental payments.
  • Contingent liability: a possible obligation (depending on the occurrence or non-occurrence of one or more uncertain future events, e.g. litigation) or present obligation arising from past events (an outflow of resources is uncertain or cannot be measured reliably, e.g. warranty for products).
  • Contingent asset: a possible asset arising from past events, e.g. legal claim against others for compensation.
• Recognition criteria
  • Provision: all 3 criteria should be met
    • it is the present obligation arising from a past event;
    • an outflow of resources is probable; and
    • the amount of the obligation can be measured reliably.
  • In HK, "probable" defines as "more likely than not": chance > 50%; however in US, define as "likely to occur": chance =>70%.
  • If any of the above 3 conditions cannot be satisfied, the liability should be disclosed only as a contingent liability.

Provision

• Once established, it should be used only to settle the obligation originally intended and should not be used for any other purposes.
• Review annually and to be adjusted to reflect any changes by a best estimate.
• Reversed if an outflow of resources to settle the obligation is not anticipated.
• Disclosures: for each class of provisions, the carrying amount & movement during the period
  • opening & closing balance,
  • additional provisions,
  • amount used,
  • unused amounts reversed,
  • the increase in the discounted amount arising from the passage of time.

Contingencies                                                                                                                                     Top

• Contingent assets:
  • A possible gain arising from past events.
  • Depends on the occurrence or non-occurrence of one or more future uncertain events that are not within the control of the enterprise, e.g. a legal claim against suppliers for supplying inferior goods.
• Contingent liabilities: a possible obligation or present obligation arising from past events.
• Accounting treatment: "prudence" applied

• Contingent assets: not recognized unless the realization of income is virtually certain.
• Contingent liabilities: not recognized unless the payment or loss is virtually certain or probable.

Degree of probability	Contingent assets	Contingent liabilities
Remote (slight)	Ignored	Ignored
Unlikely (more than slight but not likely)	Ignored	Disclosed
Probable (more likely than not)	Disclosed	Recognized
Virtually certain	Recognized	Recognized

• Disclosures: for each class of contingent liabilities
  • an estimate of its financial effect;
  • the uncertainties about the amount or timing of any outflow; and
  • any expected reimbursement.

Measurement rules:

• Provision should be the best estimate of the amount required to settle the present obligation at the balance sheet date. So professional judgment and opinion from outside independent experts may be required.
• Risks and uncertainties are always inherent in the estimation of figures.
• The estimated amount of a provision should be discounted to PV if the effect of the time value of money is material.
• In estimating the amount of provision, expected future events may need to be taken into consideration, e.g. the cost of cleaning up a site at the end o its use would be reduced by the anticipated change in future technology.
• Reimbursement should be recognized as a separate asset up to the amount of the provision if it is virtually certain that the amount would be reimbursed.

Application of the recognition criteria and measurement rules:

• Future operating losses: not provision as there is no past obligation event or present obligation involved.
• Onerous contracts:
  • If a signed contract cannot be cancelled and additional costs are expected to fulfill this contract, the present obligation of this contract should be recognized.
  • Provisions should be made for the unavoidable costs, which is the lower of the cost of fulfilling the contract and any compensation or penalties arising from not fulfilling it.
• Restructuring:
  • Termination of a line of business, the closure of a part of the business, changes in management structure, or even more fundamental reorganization.
  • A provision recognized only if there is a constructive obligation where the enterprise has committed itself to do something and it is expected to do so by those affected.
  • If the constructive obligation of restructuring exists before the B/S date, provision recognized; otherwise, only a disclosure.
  • Provision includes only the expenditures directly related to the restructuring. Other indirect costs (retraining or relocating staff, marketing, and investment in new systems) should not be included as they relate to future conduct of business rather than to the restructuring program itself.

Some controversial views

• Before the issue of HKSSAP28, there was no consistent accounting treatment for provisions
• Now a provision can be recognized only if it is a liability that has actually happened (i.e. it is derived from a past event). Anticipated future expenditures cannot be recognized as provisions any more.
• A number of provision such as future repairs and maintenance do not meet the recognition criteria and thus should not be recognized now.
• Wright worries that the standard will produce unexpected results for similar transactions or situations. E.g., a provision for future repairs and maintenance for the owned premises that would not be allowed under the new standard, but could be recognized in the lease of the leased premises.