Question

Accounting for leases

Kapiti Ltd runs a successful chain of fashion boutiques, but has been experiencing significant cash flow problems. The directors are examining a proposal made by an accounting consultant that all the shops currently owned by the company be sold and either leased back or the businesses moved to alternative leased shops. The directors are keen on the plan but are puzzled by the consultant’s insistence that all lease agreements for the shops be ‘operating’ rather than ‘finance’ leases.

Meanwhile, Scarlett Ltd agreed to lease their 5 buildings to Kapiti Ltd.

The lease agreement details are as follows:

Length of lease	10 years
Commencement date	1 July 2020
Annual lease payment, payable 1 July each year commencing 1 July 2020 ($120000 x 5)	$600 000
Estimated economic life of the building	10 years
Annual Interest rate implicit in the lease	10%

The Chairman of the Board directed the Company Accountant to submit a detailed report on the above project.

Required

1. Explain the difference between a finance lease and an operating lease.               
2. Explain, by reference to the requirements of AASB 117, why the consultant prefers operating to finance leases.                                                                                                

Show how to record the lease of the buildings in the books of the Kapiti in accordance with AASB 6 as at 30 June 2021.         

Answer 1

A. Explain the difference between a finance lease and an operating lease.

Finance lease is a transfers substantially all the risks and rewards incidental to ownership of an asset to the lessee by the lessor . Its an intermediate term loan to long term arrangement. During the primay lease period, the lease cannot be cannelled and also cost of Insurance,taxes,Maintenance are the responsibility of the lessee unless the contract proivdes otherwise. The lessee is required to take the risk of obsolence where as "opaerating lease" does not transfer all the risks and rewards incidental to ownership. Operating lease importantly less than the economic life of the asset.It can be cancelled by the lessee prior to its expiration date.The lease rental is general not sufficient to fully amortize the cost of the asset. cost of Insurance,taxes,Maintenance are the responsibility of the lessor. Lessee is procted against the risk of obsolescence. The lessor has the option to recover the cost of the asset from another party on cancellation of the lease by leasing out the assets.

B. Explain, by reference to the requirements of AASB 117, why the consultant prefers operating to finance leases.

the consultant prefers operating to finance leases due to all the risks and rewards incidental to ownership of an asset to the lessee by the lessor and also cost of Insurance,taxes,Maintenance are the responsibility of the lessee and claim these expenses.

C. Show how to record the lease of the buildings in the books of the Kapiti in accordance with AASB 6 as at 30 June 2021.

Lease Rent A/c Dr $600000

To Bank a/c $600000

(Being payment of lease rent)

Profit and loss a/c Dr $600000

To Lease rent a/c $600000

(Transfer to P & L)