Question

a.) When should a leased asset (perspective of lessee) be depreciated over its lease term ? Over it's economic life?

b.) And when should a leased asset be amortized ? What is the difference between amortizing the leased asset and depreciating it ?

Answer 1

Answer:-

A)

Depreciation
Following the initial capitalisation of the leased asset, depreciation should be charged on the asset over the shorter of the lease term or the useful economic life of the asset. The accounting for this will be:

Dr Depreciation expense
Cr Accumulated depreciation

Lease rental/interest
When you look at a lease agreement it should be relatively easy to see that there is a finance cost tied up within the transaction. For example, a company could buy an asset with a useful economic life of four years for $10,000 or lease it for four years paying a rental of $3,000 per annum.

If the leasing option is chosen, over a four-year period the company will have paid $12,000 in total for use of the asset ($3,000 pa x 4 years) – ie the finance charge in this example totals $2,000 (the difference between the total lease cost ($12,000) and the purchase price of the asset ($10,000)).

When a company pays a rental, in effect it is making a capital repayment (ie against the lease obligation) and an interest payment. The impact of this will need to be shown within the financial statements in the form of a finance cost in the statement of profit or loss and a reduction of the outstanding liability in the statement of financial position. In reality there are several ways that this can be done, but the Paper F7 examiner has stated that he will examine the actuarial method only.

Example:–
On 1 October 2009 Alpine Ltd entered into an agreement to lease a machine that had an estimated life of 10 years. The lease period is for four years with annual rentals of $5,000 payable in advance from 1 October 2009. The machine is expected to have a nil residual value at the end of its life. The machine had a fair value of $50,000 at the inception of the lease.

How should the lease be accounted for in the financial statements of Alpine for the year end 31 March 2010?

Solution
In the absence of any further information, this transaction would be classified as an operating lease as Alpine does not get to use the asset for most of/all of the assets useful economic life and therefore it can be argued that they do not enjoy all the rewards from this asset.

In addition to this, the present value of the minimum lease payments, if calculated (you are not required to do this in the exam, only use if the examiner gives to you) would be substantially less than the fair value of the asset.

The accounting for this lease should therefore be relatively straightforward and is shown below:

Rental of $5,000 paid on 1 October:

Dr Lease expense (statement of profit or loss)	5,000
Cr Bank	5,000

This rental however spans the lease period 1 October 2009 to 30 September 2010 and therefore $2,500 (the last six-months’ rental) has been prepaid at the year end 31 March 2010.

Dr Prepayments	2,500
Cr Lease expense	2,500

Statement of profit or loss extract
Lease expense	2,500
Statement of financial position extract
Current assets
Prepayments	2,500

B) A proposed accounting standard issued jointly by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) would require firms to recognize many more lease assets than are currently required and to amortize those assets on a straight-line basis. A number of respondents to the exposure draft argue that the “front-loading” of lease expense resulting from straight-line amortization would not reflect the economics of the lease assets. This study compares straight-line amortization with the most-often cited alternative, present value amortization. First, we illustrate by example that under stylized conditions, present value amortization provides information that more faithfully represents the future cash flows of lease assets than straight-line amortization. Second, for a large subset of firms that are more likely to conform to the stylized conditions in our example, we find that investors value those firms as though the lease assets are capitalized and amortized on a present value basis. Finally, we find that financial ratio comparability is substantially increased when operating leases are constructively capitalized and amortized using straight-line amortization, and further increased when using present value amortization. Taken together, these results provide no evidence for favoring straight-line amortization over present value amortization as the default method for amortizing capitalized operating leases.

The difference between amortization and depreciation are as follows:-

The key difference between amortization and depreciation is that amortization charges off the cost of an intangible asset, while depreciationdoes so for a tangible asset.

Another difference between the two concepts is that amortization is almost always conducted on a straight-line basis, so that the same amount of amortization is charged to expense in every reporting period. Conversely, it is more common for depreciation expense to be recognized on an accelerated basis, so that more depreciation is recognized during earlier reporting periods than later reporting periods.

Yet another difference between amortization and depreciation is that the calculation of amortization does not usually incorporate any salvage value, since an intangible asset is not typically considered to have any resale value once its useful life has expired. Conversely, a tangible asset may have some salvage value, so this amount is more likely to be included in a depreciation calculation.

The two concepts also share several similar traits. For example:

• Non-cash. Both depreciation and amortization are non-cash expenses - that is, the company does not suffer a cash reduction when these expenses are recorded.
• Reporting. Both depreciation and amortization are treated as reductions from fixed assets in the balance sheet, and may even be aggregated together for reporting purposes.
• Impairment. Both tangible and intangible assets are subject to impairment, which means that their carrying amounts can be written down. If so, the remaining depreciation or amortization charges will decline, since there is a smaller remaining balance to offset.