Question

International Accounting Standards (IFRS) 16 Leases standardizes the accounting treatment and disclosure requirements of assets held under lease. The approach to lessor accounting classifies leases into two types, Operating lease and Finance lease.

Required:

1. Discuss any five indications that may provide evidence that a particular lease agreement may be:

1. An operating lease                                                                 
2. A finance lease                                                                      

2. Briefly explain the effect of treating a finance leased asset as though it was an operating leased asset on assets, liabilities, ROCE and Gearing ratios.

3. On 1 October 2019, Botha Ltd, a company specialized in leasing non current assets to business houses in Choma leased an item of plant to Musho Ltd,. The terms of the agreement were that Musho would pay 5 rentals of K36,000 annually in advance commencing on 1 October 2019. Musho would continue, at its option, to use the plant for a nominal rental considered not material.

The present value of the lease payments is K184,710 and the asset has a useful life of 10 years. The rate of interest implicit in the lease is 8% per annum.

Required:

Discuss, with relevant computations how the above transaction will be accounted for in the financial statements of Botha Ltd for the years ended 30 September 2020, 2021, and 2022.                                                                                 

                                                                                                           

Answer 1

Note: As question contains multiple question answered for the 1 only

1. (a) indications that may provide evidence that a particular lease agreement may be:

Fiance Lease :

• Lease term is more the major part of the economic life of the asset even if title of the asset is not transferred
• at Inception of lease; present value of the minimum lease payment amounts to all or substantial all of fair value of leased asset
• leased asset is of specialized nature that only lessee can use without major modification
• leaser will transfer ownership of the lease asset to lessee at end of the lease term
• Lessee has the option to purchase lease asset at the end of the lease term at price which will be lower than fair value of the asset on the date option become exercisable
• lessee can cancel the lease before expiry of the lease term and expense for the same will be born by lessee

Operating Lease :

• Risk and reward incidental to nature of the ownership is vest with lessor
• Not for major economic life of the asset
• Lessor only have option or right to cancel the lease before its expiry
• At the end of the period ownership is not transferred to lessee; however lessee can enter into secondary lease term at mutual consent
• present value of minimum lease payment is less than fair value of the lease asset

1(b) effect of treating a finance leased asset as though it was an operating leased asset on assets, liabilities, ROCE and Gearing ratios.

• Leads to creation of Asset and liablity
• Rent expense in income and expenditure statement is substituted by depreciation and interest exp lead to lower of earning i.e. lowers' ROCE
• Financial ratios and peformance indicators such as EPS, ROCE, capital gearing etc negatively impacted while operating cash flows, EBT EBIT may improves leads to negative credit rating due to increase of debt and interest expense

1(c)

As Botha Ltd has leased for the 5 years while economic useful life of the asset is 10 year; it's operating lease. Botha ltd will required to recognize Lease asset in financial statement according to nature of asset. Operating lease rentals are charged to income and expenditure statement on straight line basis. i.e 36000 p.a.

However as Musho would continue, at its option, to use the plant for a nominal rental considered not material;  if we consider that and treat this as financial lease then Asset will be recognize in Mushos' financial statement and de-recognized from the Botha.

date	Opening balance	principal repayment	closing principal	interest	closing
01-10-19	184710	36000	148710	0	148710
30-09-20	148710	0	148710	11897	160607
01-10-20	160607	36000	124607	0	124607
30-09-21	124607	0	124607	9969	134575
01-10-21	134575	36000	98575	0	98575
30-09-22	98575	0	98575	7886	106461
01-10-22	106461	36000	70461	0	70461
30-09-23	70461	0	70461	5637	76098
01-10-23	76098	36000	40098	0	40098
30-09-24	40098	0	40098	3208	43306

30-09-2020

• Long term lease receivable = 36000*3=108000
• Short Term Lease Receivable = 36000

30-09-2021

• Long term lease receivable = 36000*2=72000
• Short Term Lease Receivable = 36000

30-09-2022

• Long term lease receivable = 36000*1=36000
• Short Term Lease Receivable = 36000