Lease Interest Calculation & Treatment

This assignment focuses on calculating the specific interest on a lease using the sum of digits method. Students are required to understand and apply this method, considering factors such as the number of instalments in arrears or advance payments. Additionally, students should analyze the financial statement treatment of assets and liabilities under operating and finance leases, discussing their advantages and disadvantages.

REPORT

Table of Contents
INTRODUCTION...........................................................................................................................1
Question 1........................................................................................................................................1
Conceptual framework for financial reporting 2010...................................................................1
Objective and qualitative characteristics of conceptual framework............................................2
Definition of assets and liability..................................................................................................2
Circumstances based on which assets are classified into assets and liabilities...........................3
Explanation to assets and liabilities and its advantages and disadvantages in financial
statements....................................................................................................................................3
Disclosures of assets and liabilities its advantage and disadvantages in financial statements....4
Question 2........................................................................................................................................4
Overview to lease under IAS17...................................................................................................4
Definition of lease under IAS17..................................................................................................5
Types of lease..............................................................................................................................5
Regulation regarding qualification of lease.................................................................................5
Disclosure and recognition of each type of lease in financial statements...................................6
Methods of calculating lease.......................................................................................................6
Various advantages and disadvantages of lease..........................................................................7
CONCLUSION................................................................................................................................7

INTRODUCTION
Financial statement plays an important role in defining the true and fair condition of the
company based on which all the decisions regarding investing and withdrawing are made by the
company. The report makes comprehensive discussion regarding conceptual framework based
upon financial reporting 2010. Assets and liabilities will also be described in detail with
appropriate accounting treatment. The report also makes discussion regarding lease. The two
types of lease, that are, operating and financial are discussed in detail.
Question 1
Conceptual framework for financial reporting 2010
Financial statements are generally prepared to assess financial position of the company. It
is presented to potential investors, lenders, other creditors and to those who need to make
financial decisions regarding buying, selling of holding equity instruments. Management’s
actions have higher dependence on current and previous year’s financial statement of the
organization. The primary users require to know regarding enterprise’s future prospects of new
cash flow and how effectively it is involved in managing it (Grant, 2016).
The IFRS framework have stated that general purpose of financial reports is not effective
enough that can provide all the information. In such cases, financial information from other
sources is also gathered at the time of decision making. Some decision that need to be made by
the board are:
 To determine taxation policies
 To regulate various ongoing activities of the business
 To determine distributed profits and dividend
Conceptual framework helps in setting the concepts that are used while preparing financial
statements. The main purposes are:
 It helps in promoting harmonization of regulations, accounting standards and procedures
related to presentation of financial statements
 It helps in interpreting the information being presented in financial statement in confined
manner
 It helps in assisting auditors in forming opinions (Higgins, 2012).
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Objective and qualitative characteristics of conceptual framework
The main objective of conceptual framework is related to setting specific concepts,
standards and policies that are required to be used by the organization in preparation of financial
statements. Conceptual framework deals with the objective of financial reporting. It helps in
defining, recognizing and measuring various elements based on which financial statements are to
be constructed. It also deals with capital and capital maintenance.
Qualitative characteristics of useful information helps in identifying various types of
information which can be useful to numerous investors, creditors and lenders. These are relevant
enough to be used in presenting financial information faithfully. Some fundamental qualitative
characteristics of conceptual framework are: Relevance: Conceptual framework states that financial information must e relevant enough
that can help management in its decision making. It helps in making a difference in a
decision. The predictive and confirmatory values help in its better formation. For instance, if
revenue information of current year and previous year is known then in that case forecasting
can be done based upon the ongoing trends (Kadous, Koonce and Thayer, 2012). Materiality: Information is material and hence any omission or misstatement can bring
adequate amount of change in decision making aspect. Hence, in such cases, it becomes
important to disclose right kind of information to people. Faithful representation: Another qualitative characteristic of conceptual framework is to
ensure that it is important to present all the actual values of organization faithfully along with
adequate amount of relevance. The values must be complete, free from errors and neutral
with maximum quality possible.
Definition of assets and liability
As per the definition of economic resource, an asset is considered to be an economic
resource. It is attached to future economic benefit embodied in it which owns the potential to
directly or indirectly contribute to cash flow of the business. The company generally involves in
employing its assets which are directly or indirectly responsible for satisfying the requirements
of customers. It has direct contribution in the case flow of the business and usually reduces cash
outflow (Louis, Lys and Sun, 2014). Some of the examples of assets can be plant, equipment,
property, etc. the assets are generally the result of past transactions and events that are normally
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obtained from purchasing and producing them. The asset must be present and the intention of
purchasing can not be considered as an asset for the company.
Liability in company’s obligation that can arise during the course of business operations. It
can be settled down with the transfer of economic benefits which can be in the form of money or
goods and services. Since, it is an obligation for the company, it has to met in certain way. The
settlement of present obligation involves in giving up of certain economic benefit. Hence, the
payment can be made by way of cash, provision of services, transfer of other assets, converting
obligation into equity and replacing the current obligation with other one. Liabilities can be the
result of short term loan, long term loan, debt, payment to be made to creditors etc (Tukdeo,
2015).
Circumstances based on which assets are classified into assets and liabilities
Future economic benefit is one main concept based on which assets and liabilities are
actually divided. It is considered to be the synonym of notion of service potential. If the company
have to pay in future for a particular good or service then it is liabilities for it. However, in other
case, if the organization will enjoy future economic benefits then they are put in the category of
assets.
Another important aspect of division of asset and liability is based upon disclosing the
component when one criteria are not met and hence to be divided based upon the other one. The
future sacrifices of economic benefits can be in the form of transfer of goods, cash and cash
equivalents to be used to buy plants and machinery. These issues are generally resolved in other
accounting concepts being issues by IFRS (Vasarhelyi, Chan and Krahel, 2012).
The example of asset can be accrued rent. The services have already been delivered but
money is yet to be transferred to the account. It shows that a probable future benefit to the
organization will occur. An example for liability can be, payment that is to be made to creditors.
It shows that probable future economic sacrifice is to be made by organization to cope up with
generated liabilities.
Explanation to assets and liabilities and its advantages and disadvantages in financial statements
A specific criterion is followed where assets and liabilities can be recognised. category of
assets.
Criteria of recognizing an asset
 It must be a probable future economic benefit
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 Asset must possess a cost or other value that can reliably be measured in terms of money.
The main advantage of recognizing asset is that the company can use it in settling down the
expenses to be made to pay out present liabilities of the company. It acts as a cash inflow to the
company. However, the main disadvantage related to asset is that, some of them which are fixed
asset may not be directly converted into cash and hence require some time to get them converted
into liquid asset.
Criteria of recognizing a liability
 It must be probable that a future sacrifice of economic benefit is required to be made.
 The amount of liability can be measured in a reliable format (Weygandt, Kimmel and Kieso,
2015).
The main advantage of recognizing liability is that it helps in assessing that how much
amount is required to be paid by the company in totality. Based on this recognition, assets can be
arranged for payment. However, in comparison to this, the main disadvantage of having
liabilities is that the organization have to waive off its cash inflow which are in the form of asset
so as to pay the obligation.
Disclosures of assets and liabilities its advantage and disadvantages in financial statements
It is important to disclose assets and liabilities in the financial statement of the company. As
per the financial reporting 2010, the conceptual framework has effectively defined the
requirements of disclosing assets and liabilities to the company. Based upon the criteria of
division of assets and liabilities, the components are put in their respective heads. However, there
are certain cases where recognition criteria are not met by the components. It such cases,
disclosure for the same is mentioned in notes under the head contingent assets and liabilities.
These are the probable gain or loss that can take place in near future (Arnold, 2013).
The main advantage of disclosing asset and liabilities is that the investors, creditors and the
other stakeholders directly or indirectly linked to company are able to generate true and fair view
of the organization. It discloses assets and obligations held by the organization and investing and
managing decision can be made by the board. However, the main disadvantage is that if the
conditions of company’s finances is not effective enough, in such cases, the investors may not
want to invest in the organization looking at the condition of financial statements.
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Question 2
Overview to lease under IAS17
IAS 17 is responsible for addressing accounting treatments and disclosures that are directly
linked to financing and operating lease for both lessor and lessee. It is limited to where IAS 40
where application is made to investment property which is held by lessee and hence it is not
applicable there. Hence, it can be ascertained that it helps in providing accounting treatment that
are related to financial and operating lease to the organization.
Definition of lease under IAS17
As per IAS 17, a financial lease is related to substantial transfer of all type of risk and
rewards, related to the asset, of ownership. However, any lease that is not financial lease is
termed as operating lease.
Lease is generally related to transferring the ownership of any asset under a contract being
set for minimum period. Lessee is the individuals who gets the ownership after contract and
lessor in such cases is the individual who have transferred the ownership to other individual. The
contract of lease is made for the minimum possible term. However, the same can be extended
after mutual discussion between the two parties (Caglayan and Demir, 2014).
Minimum lease payments mean lessee have to pay a certain amount to the lessor. It is
excluding service costs, contingent rents and taxes. It is the amount guaranteed by the lessee in
the form of exercise price. Any residual value is required to be return back by the lessor to
lessee.
Types of lease
There are basically two types of lease under IAS 17. These are:
 Financial lease: In case of financial lease, the risk and rewards related to the leased asset is
generally transferred to lessee. There is an option to transfer the ownership as well. However,
it totally depends on both the parties that the title of the asset will be transferred to lessee at
the end of lease period or not. Financial lease Is generally treated like loan. The examples of
financial lease are, office building, land, plant and machinery.
 Operating lease: It is a type of lease where all the risk and rewards related to the leased asset
remain with lessor. The asset has to be returned back by lessee after the completion of
specific term for which the contract was made. The ownership of asset remains with lessor
for entire lease period. Operating lease generally treated as rent. The examples of operating
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lease are, computers, projectors, coffee dispensers’ laptops, etc (Lanis and Richardson,
2012).
Regulation regarding qualification of lease
It actually depends upon the substance of transaction that whether it is to be considered as
an operating lease or financial lease rather than the form in which contract has been formed.
Hence, certain terms that are to e considered in this context are:
 Ownership of transfer of asset at the end of term of lease.
 The contract of lease term and what it covers substantially have high dependence on
economic life of the asset.
 The present value in the form of minimum lease payments and fair value of the asset that is
going to be taken or given on lease.
 Transfer of ownership
 Gain or loss through the fluctuation in market value of the asset.
Disclosure and recognition of each type of lease in financial statements
It is important to effectively disclose the lease and its payments. However, the accounting
treatment for both the parties, that is lessor and lessee is quite different.
Accounting treatment for lessee to be made in financial statements
 During the lease term commencement, the financial lease must be disclosed as assets and the
liability of lower fair value and the present value of minimum lease.
 Ascertaining depreciation policy of the asset. However, it should be consistent for entire
lease period.
 Lease payments made in operating lease must be recognized as expense in income statement
over straight line basis.
Accounting treatment for lessor to be made in financial statements
 Lessor should record it as a financial lease in the balance sheet as receivables. The amount
mentioned must be equal to net investment made in the lease.
 The rate of return mentioned in the income statement at the income side must be constant
enough (Needles, Powers and Crosson, 2013).
 Assets that are held in operating lease must be mentioned in the nature of asset and income
for the same must be based upon straight line basis.
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Methods of calculating lease
As per the lease mentioned in IAS 17, there are two methods of calculating the interest that
are applicable as lease interest. These two methods are: Actuarial method: It actually uses actuarial or interest tables in order to calculate the specific
interest on lease. The rate generally applied to opening balance of the liability of lease at the
starting of accounting period and is considered as financial charge for other reporting
purposes. The sum of digits method: This method considers the total interest charge that is mentioned
in the lease agreement. The same is distributed over lease life of the asset and the outstanding
balance is divided in proportion. The result is generally approximate to actuarial method
only. The formula for the same is:
N (n+1) / 2
N is the number of instalments in arrears. However, if the payment has already been made
in advance, then in that case, 1 is subtracted from n.
Various advantages and disadvantages of lease
Advantages of lease
 Lack of restrictive covenants
 Conservation of capital
 Tax saving
 Avoidance of risk of obsolescence
Disadvantages
 Expensive
 Leasing agreement more complex
CONCLUSION
From the above report, it can be concluded that, it is important to assess financial statement
treatment so that true and fair representation of financial statements can be presented. The report
outlines financial treatment of assets and liabilities and provisions based on which the two are
divided. It also makes discussion regarding accounting treatment of operating and financial lease.
Moreover, its advantages and disadvantages are also being discussed in the report.
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REFERENCES
Books and Journals
Arnold, G., 2013. Corporate financial management. Pearson Higher Ed.
Caglayan, M. and Demir, F., 2014. Firm productivity, exchange rate movements, sources of
finance, and export orientation. World Development.54. pp.204-219.
Grant, R. M., 2016. Contemporary strategy analysis: Text and cases edition. John Wiley & Sons.
Higgins, R. C., 2012. Analysis for financial management. McGraw-Hill/Irwin.
Kadous, K., Koonce, L. and Thayer, J. M., 2012. Do financial statement users judge relevance
based on properties of reliability?. The Accounting Review. 87(4). pp.1335-1356.
Lanis, R. and Richardson, G., 2012. Corporate social responsibility and tax aggressiveness: An
empirical analysis. Journal of Accounting and Public Policy. 31(1). pp.86-108.
Louis, H., Lys, T. Z. and Sun, A. X., 2014. Conservatism, analyst ability, and forecast error:
evidence on financial statement users' ability to account for conservatism.
Needles, B. E., Powers, M. and Crosson, S. V., 2013. Principles of accounting. Cengage
Learning.
Tukdeo, R., 2015. Analysis of financial statements.
Vasarhelyi, M. A., Chan, D. Y. and Krahel, J. P., 2012. Consequences of XBRL standardization
on financial statement data. Journal of Information Systems. 26(1). pp.155-167.
Weygandt, J. J., Kimmel, P. D. and Kieso, D. E., 2015. Financial & managerial accounting.
John Wiley & Sons.
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