Some issues of methodology and application of

University of Agribusiness and Rural Development – Plovdiv, Bulgaria 7 – 9 October, 2015

Some issues of methodology and application of accounting for lease contracts Liliya Rangelova Abstract Lease as a kind of financial transaction that facilitates the use or acquisition of an asset has wide practical application in our country. The lack of agreement between the content of the accounting and legal categories for lease originates some problems of their accounting, which have to find an adequate solution. For this reason, issues related to clarifying the nature of the lease from legal, economic and accounting perspectives are considered, emphasizing on the perceived neutrality of the accounting compared to the legal treatment, in accordance with the application of the principle of economic substance over legal form. Guidelines are provided in the paper for the proper implementation of the requirements for initial classification of leases as finance or operating leases; the accounting treatment of the early termination of finance leases, and the treatment of financial lease contracts booked in accordance with applicable accounting standards. Key words: lease, contract, accounting. Introduction Leasing is a popular financing option for many companies. Very often in practice economic subjects resort to the rendering or receiving of assets under lease. In this way they are able to attract external sources of funding in the form of assets owned implementation of various investment projects and to satisfy the consumer needs of certain individuals. The legal framework of the lease is contained in Part Three of the Trade Act entitled "Commercial Transactions" (art. 342-347). Legal definition of operating (but with no use of this term in the law) and finance leases is given in art.342. In contrast to operating lease where the lessor is the owner of the property subject to the lease, in

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by other entities and to compensate the lack of sufficient cash funds for the

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finance lease the lessor is not owner of the property and acquires it from a third party to transfer it to the lessee. Moreover, a very important feature is that the legal ownership of the leased asset belongs to the lessor. However, in both types of lease the lessee has the option, but not the duty, to acquire the ownership of the asset during the term of the contract or after its expiry. This allows considering the leased asset as a depreciable fixed asset of the lessor to be continued and being such asset to be part of lessor’s assets. The lessee should reflect the leased asset off-balance sheet and should not calculate depreciation. Unlike commercial law viewpoint, in financial accounting treatment of the lease priority is given to the actual bearing of the risks and rewards from the use of the leased asset by the lessor and the lessee, rather than to the legal right of ownership. According to accounting standards, the main criterion for classifying the lease as a finance or operating one is the extent to which the risks and rewards of the ownership of the leased asset are transferred to the lessee. Based on the above, two types of transactions may be differentiated: −

transactions, where substantially all the risks and rewards (i.e. probability of

losses from non-utilization, perishing or obsolescence of the asset and future cash flows from its intended use) associated with the ownership of the asset are transferred from the lessor to the lessee, and it is not necessary the right of ownership to be passed on legally; in this case, the transaction should be treated as finance lease; −

transactions, in which the lessor retains all the risks and rewards incidental

to the right of ownership of the asset during the duration of the lease; in this case, Therefore, if from a commercial law point of view, the finance lease is treated just as a specific type of lease and the transfer of ownership is possible, both in finance and in operating leases, the accounting concept of "finance lease" is broader and conforms to the legal concept of the two types of lease. At the same time, conclusion can be drawn that in terms of content the accounting concept of "operating lease" is consistent with the legal term “rental contract”. This distinction is important, since the accounting treatment of lease emphasizes on its perceived neutrality compared with the legal treatment, in accordance with the application of the principle of economic substance prevalence over the legal form. These two types of transactions should be treated differently from an 233

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the transaction should be treated as operating lease.


accounting perspective. In the first type the asset subject to the lease, should be reflected as a depreciable asset and also as an obligation for future payments in the balance sheet of lessee. In the second type of transaction the leased assets should be reflected in the financial statements as required by the legal concept, i.e. as depreciable assets in the lessor’s balance sheet and off-balance sheet by the lessee. In the international practice the role of the “regulator” determining the accounting treatment of leases plays International Accounting Standard (IAS) 17 Leases. IAS 17 Leases sets out the treatment for reporting lease transactions in the financial statements. Leases are a major source of finance to a business and it is important that the financial statements disclose sufficient information to the readers of the financial statements. IAS 17, paragraph 10, states, “whether a lease is a finance lease or an operating lease depends on the transaction rather than the form of contract”. Information

in

the

financial

statements

should

represent

transactions

in

accordance with their commercial substance not merely their legal form. The accounting for leases is the application of this concept, as the classification of a lease as either a finance lease or an operating lease, depends on the substance of the transactions rather than the legal form of the contract. However, the way leasing transactions have been structured in the past has caused major variations in the presentation of financial statements. There have been two leasing options available to companies: There have been two leasing options available to companies: IAS 17 distinguishes between two types of lease transactions: 

a finance lease and;



an operating lease.

A finance lease is a lease that transfers substantially all the risks and rewards inherent to ownership of the asset. An operating lease is a lease other than a finance lease. The classification of a lease is crucial, as different accounting Indicators to be considered, individually or in combination, when classifying a lease as a finance lease includes: 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 at the date of the option exercisability. It is reasonably certain, at the inception of the lease, that the option will be exercised. 234


approaches are required for the different types of leases.


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. 5.

The leased assets are of such a specialized nature that only the lessee can use

them without major modifications. 6.

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

the lessee. 7.

The lessee has the ability to continue the lease for a secondary period at a rent

that is substantially lower than market rent. 8.

If the lessee can cancel the lease, the lessor’s associated losses are borne by

the lessee. Accounting treatment of a Finance lease Leases in the Financial Statements of Lessees Finance leases are recognized as an asset and liability in lessees’ financial statements at the start of the lease term. The amount recognized is the fair value of the asset or if lower, the present value of the minimum lease payments. The present value is calculated by establishing the minimum lease payments due and discounting to take into account the time value of money. Lease payments are apportioned between finance charges and reduction of liability. The finance charge is recognized in the income statement of each period of the lease liability. Property, plant and equipment. The main difference in the booking of finance lease in the lessee financial statement, as required by national accounting standard (SS 17) Leasing in comparison with IAS 17 Leases, is in connection with the presentment of the finance expenses. According to IAS 17, the lessee does not reflect these costs (at the beginning of the lease term) in the amount of the obligation to the lessor. The finance expense is booked on continuous basis, in each period during the lease contract term, and is distributed according to a repayment plan, in order to obtain a constant periodic interest rate on the remaining balance of the liability for each period. This approach allows companies to skip establishing and booking of the 235

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The asset, which is a non-current asset, needs to be depreciated in line with IAS 16


specific "asset" deferred expenses, thus skip increasing the carrying amount of its assets. NAS 17 requires the lessee to include, as early as the initial date of the lease contract, in the sum of its obligation to the lessor also the total amount of finance expenses, which are generally recognized as deferred expenses. Deferred finance expenses reflect the difference between the total amount of the agreed lease payments (lease price) and the fair value of the asset. In particular, the lessee reflects the leased asset as its own asset and books it at fair value. At the same time, it reflects a long-term liability to the lessor in the amount of contractual lease payments. The lease price is higher than the fair value of the asset. The excess represents the remuneration paid during the lease period to the lessor in exchange of lessor’s service of the providing the asset. In this approach the obtained tangible fixed asset and the deferred finance expense (expense for a future period) will be reflected as assets in the balance sheet of the lessee, while the incurred liability to the lessor – as a liability. Leases in the Financial Statements of Lessors The following rules are applied to the financial statements of lessors: •

Derecognize a tangible asset and recognize resultant gain/loss; the leased

asset is not recognized in the statement of financial position; •

Recognize a receivable equal to the net investment of the lease;

•

Recognize finance income based on a pattern reflecting a constant periodic

rate of return on the lease. According to IAS 17 Leases, accounting for leases in the lessor’s financial statement is differentiated in two patterns depending on the type of income that the lessor may realize from the lease, as well as on the parties participating in the leasing process: a) direct (regular) finance lease. In the direct finance lease, the lessor, usually a leasing company or a bank, buys the respective asset from a manufacturer or dealer and immediately leases it to the lessee. Therefore, the lessor does not post profit in direct finance lease, because the carrying amount of the leased asset is equal to its fair value. The only income for the lessor is the interest he/she receives from the lessee during the term of the

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b) sales-type finance leases (finance leases of manufacturers and dealers).


lease contract. Hence, direct finance leases in its function can be treated as equivalent to the granting of a loan. In sales-type finance leases lessors are manufacturers or dealers who provide the leased asset to the lessee. Under this option of finance lease profit or loss is recorded, since the carrying value of the leased asset is not equal to its fair value at inception of the contract. It is used by manufacturers and dealers who use the leasing as a form of sale of assets. In Bulgarian SS 17 Leases only sales type lease is adopted. According to the provisions of IAS 17, the finance income paid to the lessor, which is a compensation for its investment and services, is not included in the beginning of the rental period in the amount receivable from the lessee, but is recognized and booked on continuous basis after receipt of each lease payment. As per the stipulations of SS 17, the finance income should be recognized in full amount even at the date of the lease contract initiation, however as a deferred finance income. In the current period the lessor books deferred finance income proportionally to the relative shares of the amounts to be received in the period as per the contract in respect of the total of the agreed lease payments. Accounting treatment of an Operating Lease Leases in the Financial Statements of Lessees The following rules are applied to the financial statements of lessees: •

Lease contract is treated as an executory contract;

•

No leased asset is recognized in the statement of financial position;

•

Lease expense is recognized on a straight line basis over the lease term.

The rules applicable to the financial statements of lessors are: •

Lease contract is treated as an executory contract;

•

Leased asset is retained in the statement of financial position;

•

Lease income is recognized on a straight line basis over the lease term.

The main difference in comparison to SS 17 Leasing is in the amount of the recognized expenses/revenues in operating leases. According to IAS 17 Leases, in line with the principle of accrual, lease payments from an operating lease shall be recognized as an expense in the statement of comprehensive income of the lessee and as an income in the lessor’s statement of comprehensive income, on a straight

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Leases in the Financial Statements of Lessors


line basis for the entire period of the lease contract, unless another systematic basis is more representative with regard of the time during which the lessee has obtained the benefits of the leased asset(IAS 17, para. 33 and 50). This requirement does not apply to payments in respect of expenses for services such as insurance and maintenance. Application of the linear method for recognition of lease expense/ revenue is related to some peculiarities in the presence of various clauses in the lease contract, which result in uneven cash flows over the lease term. Examples of such clauses are presence of an initial grace period or a reduced rent at the beginning of the contract. In case of incentives they have to be recognized as an integral part of the agreed remuneration. Lessee deducts the amount of the incentive from the lease expense over the contract period on a straight line basis. The same is also valid for the lessor: it must deduct the amount of the incentive from the lease income during the contract period on a straight line basis, according to SIC 15 "Operating Leases Incentives". In particular, the application of this requirement means that for example, if the lease contract is for six years, but the first year is a grace period and lease fee will not be paid as an incentive for the lessee to conclude the contract, and in the remaining five years BGN 12 000 are due per year, in each year of the lease period (including the first year) the lessee should recognize an expense of BGN 10 000 [(BGN 12 000 x 5 installments) / 6 years]. The difference between the accrued lease amount and the paid one in this case is booked on a suspense account (obligation). In the first year the lessee will only accrue the lease expenses without paying them. In the next years the lessee will accrue and will transfer the remaining expenses, as well as will pay the amount of the deferred payments. Conclusion Leases and its Bulgarian analogue SS 17 Leases a mixed approach of accounting for leases is adopted based on the extent of the transfer of the significant risks and rewards from the ownership of the leased asset from the lessor to the lessee, in which two approaches are used: booking of finance lease and booking of operating lease. Prior to IAS 17, one of the major attractions of leasing agreements for the lessee was the off-balance sheet nature of the transaction. This means that if a lease can be structured such that it can be classified as an operating lease, then 238


In summary, it can be stated that at this stage in the accounting standard IAS 17


the lease will act as a form of off-balance sheet financing. Currently there are proposals to remove the distinction between the operating and finance leases to require the capitalization of all leases. In the joint project on accounting for leases undertaken by the International Accounting Standards Board (IASB) and the American Financial Accounting Standards Board (FASB), which is still under discussion, this approach based on posting in the balance sheet is adopted. It is centered on the idea that in all lease contracts, regardless of their economic and legal differences, the right of use of the leased asset is transferred. Therefore, if a lease would be classified as an operating lease then the lessees will recognize both assets and liabilities as a result of the lease contracts in their financial statements (balance sheet). In conclusion, application of the balance sheet approach will impose radical changes in the accounting for leases and will have a significant effect on the financial indicators calculated on the basis of data from the financial statements of the lessees. References 1.

Башева, Сн., Миланова, Е., Йонкова, Б., Петрова, Д., Пожаревска, Р.,

Основи на счетоводството, Университетско издателство “Стопанство”, 2009. 2.

Брезоева, Б., Подходи и модели на счетоводно третиране на лизинга,

издателски комплекс-УНСС, 2012. 3.

Брезоева, Б., Балансов подход за отчитане на всички лизингови

4.

Найденов, Б., Лизингът, финансов и правен аспект, Сиела,С., 1996.

5.

Национални стандарти за финансови отчети за малки и средни

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договори, сп. Счетоводна политика, 7-8/2011.


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