ACC204 Introduction To Financial Accounting II

Introduction

Lease is regarded as the specific contract that puts the obligation on one party to transport land, property and others to some other party for a specific time and another party is required to pay some money on periodical basis (Barone, Birt and Moya 2014). There are two types of leases; they are finance lease and operating lease. Finance lease is regarded as the specific lease that puts the obligation for the transfer of all the incidental risks and rewards associated to the assets to the lessees. In order to carry on the finance lease, the requirement for lessees is to follow certain accounting standards and principles. Thus, this study aims to discuss about the accounting of finance lease from the side of the lessees.

Accounting of Finance Leases by Lessee

The earlier part of the study indicates towards the requirement of the lessees to comply with certain accounting principles to carry out the finance lease accounting. While carry out the accounting for the finance lease, the primary job of the lessees is to properly classify the finance leases (Vernimmen et al. 2014). For this reason, it is required for the lessees at the time of doing classification of the finance leases to take into consideration all the information associated with the leases.

While classifying the leases, it is required for the lessees to put focus on the risk and ownership related to the lease assets; and at the same time, the lessees are required to ascertain whether the risk and ownership is stayed with the lessees or the lessors. For this reason, one can consider a lease as the finance lease if the risk and reward of ownership related to the lease asset stays with the lessees (Tai 2013). Thus, there is large importance of the classification of finance lease. In order to classify a lease as finance lease, the lessees take into consideration the fulfillment of the following discussed factors.

Ownership associated with the lease asset is the first criteria. In case the risk and reward related to the lease asset transfers to the lessees at the end of the lease term, one can classify this lease as the finance lease. Purchas option of the lease asset is the next classification criteria. If the lessees have the right for the purchase of the lease asset and get the right for the use of that purchased asset, that lease will be classified as finance lease. Economic life of the underlying lease asset can be considered as the third criteria for classification. If the term of the lease covers the maximum portion of the economic life of the lease asset, the lease will be considered as the finance lease. For this reason, the agreement of lease must cover more than 75 percent of the economic life of the asset (Schallheim, Wells and Whitby 2013).

Fair value of the associated lease asset is the next criteria. If the present value of the lease payment sums and the residual value of the lease asset match or exceeds the fair value of the associated lease asset, then the lessees are needed to treat the lease as the finance lease. Specialization of the associated lease asset is the last classification criteria. In order to be classified as the finance lease, the associated lease asset needs to be too specialized to use it for the other purposes (Spencer and Webb 2015). On the satisfaction of the above-discussed classification criteria, it is needed for the lessees to treat a lease as the finance lease.

After the completion of the finance lease classification process, the next job of the lessees is to correctly measure the lease liability and the right-of-use asset related to the lease asset. As per the standards and principles of accounting for lease, it is needed for the lessees to correctly measure the lease liability and right-of-use asset of the leases. Thus, the responsibility of the lessees is to comply with certain accounting regulations (Henraat et al. 2013).

In order to conduct the calculation of the lease liabilities, it is the requirement of the lessees to consider the present value of the lease payment after discounting it at the discount rate of the lease. The lessees are to consider this discounting rate as the implicit rate of the lease due to the reason of its easy determination by the lessees. In case the lessees are not able to determine this discount rate, the obligation on them is to use the incremental borrowing rate.

In term of the right-of-use asset calculation, the obligation for the lessees is to consider the initial amount of the lease liability; after that, they are required to make the addition of the lease payment by the lessors before the lease commencement date; then, it is required for them to add the initial direct cost associated with the lease and then to deduct the received lease incentives, if any (Mitu, Tduor and Pali-Pista 2014).

After the completion of the recognition and classification process of finance leases, the obligation on the lessees is the identification of certain aspects associated with the finance leases. The first aspect is the recognition of the amortization related to the right-of-use assets. After this procedure, the obligation on the lessees is the recognition of the amortization of the lease liability interest. After that, the obligation is on the lessees to consider the variable lease payment that are not included in the lease liability, if any. At the same time, the lessees are needed to take into consideration the payment of the right-of-use assets (Xu, Davidson and Cheong 2017). The journal entry for lease accounting for the lessees is as follow:

Conclusion

The above discussion indicates towards the specific regulations and rules of lease accounting that the lessees need to consider. The classification of the finance leases is the first criteria for the lessees. The next process involves in the calculation of lease liability as well as right-of-use assets. Apart from all these, the recognition of amortization and impairment related to the lease assets is needed to take into consideration.

References

Barone, E., Birt, J. and Moya, S., 2014. Lease accounting: a review of recent literature. Accounting in Europe, 11(1), pp.35-54.

Henraat, D., Georgakopoulos, G., Kalantonis, P. and Rodosthenous, M., 2013. A comparative empirical study for the different approaches of the operational leases capitalization. Journal of Computational Optimization in Economics and Finance, 5(1), p.51.

Mitu, I., Tduor, A.T. and Pali-Pista, S.F., 2014. Accounting for Leases: Differences between Romanian Regulations and IAS 17. Procedia Economics and Finance, 15, pp.1310-1315.

Schallheim, J., Wells, K. and Whitby, R.J., 2013. Do leases expand debt capacity?. Journal of Corporate Finance, 23, pp.368-381.

Spencer, A.W. and Webb, T.Z., 2015. Leases: A review of contemporary academic literature relating to lessees. Accounting Horizons, 29(4), pp.997-1023.

Tai, B.Y., 2013. Constructive capitalization of operating leases in the Hong Kong fast-food industry. International Journal of Accounting and Financial Reporting, 3(1), p.128.

Vernimmen, P., Quiry, P., Dallocchio, M., Le Fur, Y. and Salvi, A., 2014. Corporate finance: theory and practice. John Wiley & Sons.

Xu, W., Davidson, R.A. and Cheong, C.S., 2017. Converting financial statements: operating to capitalised leases. Pacific Accounting Review, 29(1), pp.34-54.