In this session we shall look at an example of a lease in order to illustrate its treatment in a company’s financial statements.
Seneca Ltd has a year end of 31st March. It has signed a lease agreement for the use of a machine:
- The cost of the right-of-use asset is £300,000
- The commencement date of the lease is 01/04/2020
- The interest rate implicit in the lease is 6% per annum
- Lease payments are made from the bank as follows:
- £67,188 on the commencement date
- £67,188 on 31/03/2021 and yearly afterwards
- The final payment will be made on 31/03/2024
- The machine will transfer to Seneca Ltd’s ownership at the end of the lease period
- The useful life of the machine is 6 years, at the end of which Seneca Ltd expects to sell it for £15,000
At the commencement date of the lease we should record the right-of-use asset at its cost and the lease liability at the present value of the lease payments yet to be made.
As the scenario provides us with the cost of the right-of-use asset (i.e. £300,000) this is straightforward; we will record the addition of a machine, which will be paid for using an immediate bank payment of £67,188 together with the lease obligation. The following journal would be recorded.
If however, it was the case that you were not given the cost of the right-of-use asset this would have to be calculated by adding the lease payments made on or before the commencement date to the present value of the lease payments yet to be made. The calculations are shown below but it is worth noting that Financial Reporting exams tend not to require students to calculate present values.
Lease payment made on the commencement date of 01/04/2020: £67,188
The present value of lease payments yet to be made at the commencement date are as follows
The above information tells us that the cost of the right-of-use asset is £300,000 and the lease liability is £232,812.
Lease liability and lease interest
Over the lease period the interest and lease liabilities would be calculated as follows:
Calculating lease interest for each year
Take the lease liability at the start of the year and multiply it by the interest rate implicit in the year to calculate the lease interest for the year.
[Note that the lease payments in the example are paid at the end of the year (i.e. in arrears). Had the lease payment been made at the start of the year (i.e. in advance) we would have taken the lease liability, deducted the lease payment for the year and then multiply the result by the interest rate in order to calculate the lease interest for the year.]
Calculating lease liabilities at the end of each year
Take the lease liability at the start of the year, add the lease interest charged in the year and deduct the lease payment.
Calculations over the lease term
Depreciation of the leased asset
As the machine will be transferred to Seneca Ltd’s ownership at the end of the lease term, it should be depreciated over the machine’s useful life of 6 years (rather than the lease term of 4 years). If Seneca Ltd depreciates the asset using the straight line method the annual charge will be calculated by deducting the residual value of £16,000 from the asset’s cost of £300,000 and then dividing the result by the useful life of 6 years.
(£300,000 – £15,000)/6yrs = £47,500 per year
The carrying values of the machine its useful life are shown below:
On 01/08/2020 a company with a financial year-end of 31st July entered into a three year lease agreement for a computer. The computer was made available to the company on the same date.
- The cost of the right-of-use asset is £10,000
- The interest rate implicit in the lease is 10% per year
- Lease payments are to be made as follows. £4,000 will be paid on 31/07/2021, £4,000 will be paid on 31/07/2022 and £4,000 will be paid on 31/07/2023 (payments will be made from the company’s bank account)
- The company will have the option of purchasing the computer at the end of the lease period for a fee £70. It is highly likely that the company will exercise this option
- The useful life of the computer is 5 years, at the end of which the company is expected to scrap the computer (i.e. there will be no disposal proceeds)