ACCA F7 (INT) Financial Reporting - Study text - 2010

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Chapter 12: Leases

(b)

StatementoffinancialpositionatendofYear2

$

Balanceb/ffromYear1(prepayment) 37,500

LeasepaymentinYear2 50,000

 87,500

ChargedasanexpenseinYear2 (62,500)

Prepayment:assetatendofYear2 25,000

3.2 Operating leases in the financial statements of the lessor

Because the lessor has not transferred the risks and rewards of ownership of the

physical asset to the lessee, the lessor shows the leased asset as a non-current asset

in its statement of financial position.

It will be shown in an appropriate category of property, plant and equipment at its

carrying value (cost/valuation minus accumulated depreciation).

In respect of the leased asset, the lessor’s annual statement of comprehensive

income will include in profit or loss:

 depreciation on the asset as an expense, and

 rental income (as for the lessee, this is usually calculated on a straight-line basis).

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Leases: disclosure requirements

 Finance leases: disclosures in the financial statements of the lessee

 Operating leases: disclosure requirements

4 Leases: disclosure requirements

4.1 Finance leases: disclosures in the financial statements of the lessee

In the financial statements of a lessee, finance lease liabilities must be split between

their current and non-current components (as explained earlier).

 The current liability consists of the amount of the ‘capital’ obligation for the

finance lease that will be repaid in the next 12 months, plus any accrued interest.

 The non-current liability is the amount of the ‘capital’ obligation for the finance

lease that will not be repaid in the next 12 months.

Other disclosures are required in accordance with IAS16 Property, plant and

equipment, because the leased assets are treated as tangible non-current assets in

the financial statements of the lessee.

In addition, IAS17 requires the following disclosures about finance leases in notes to

the financial statements of the lessee.

 For each class of asset, the net carrying amount (net book value) of assets held

under finance leases at the end of the reporting period.

 An analysis of the total liability for finance lease obligations, divided between

amounts falling due

− within 1 year

− within 2 to 5 years

− after more than 5 years.

These amounts must be shown on both a net and a gross basis. The gross basis

is the minimum amount of lease payments that will be paid over the term of the

lease. The net basis is the amount of these minimum payments discounted to a

present value, using the interest rate implicit in the lease as the discount rate.

 A general description of the lessee’s material leasing arrangements.

 Contingent rents recognised as an expense in the period. Contingent rents are

lease rental payments that are not fixed in amount. Contingent rents payable are

not linked to the passage of time but to other factors specified in the lease

agreement and their total amount is therefore uncertain. Contingent rents are

rents in excess of the minimum rental payments.

Chapter 12: Leases

Example

The fair value of an asset, leased under a finance lease commencing on 1 January

Year 1 is $12,886. The lease is for three years with payments of $5,000 annually on 31

December Year 1, Year 2 and Year 3. The interest rate implicit in the lease is 8%.

Finance charges are allocated using the actuarial basis, and the following lease

payments table has been prepared.



Yearended31

December

Opening

balance

(OB)

Interestat8%

(I=OB×8%)

Lease

payment

(P)

Closingbalance

(CB=OB+I–P)

 $ $ $ $

Year1 12,886 1,031 (5,000) 8,917

Year2 8,917 713 (5,000) 4,630

Year3 4,630 370 (5,000) –

Required

Show the required disclosures in the financial statements in respect of the finance

lease at the end of Year 1.

Answer

 Current

liabilities

Non‐current

liabilities

 $ $

Financeleaseobligations(endofYear1current

liabilities=totalliability$8,917minusendofYear2

totalliability$4,630) 4,287 4,630



Net basis

Finance lease obligations include amounts due within:

 $

Oneyear 4,287

Twotofiveyears 4,630

Overfiveyears‐



–

–––––

 8,917



–

–––––

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Gross basis

Finance lease obligations include amounts due within:

 $

Oneyear

5,000

Twotofiveyears

5,000

Overfiveyears

‐



–

––––––



10,000

Minus:Financechargesallocatedtofutureperiods(713+370)

(1,083)



–

––––––



8,917



–

––––––

4.2 Operating leases: disclosure requirements

IAS17 requires the following disclosures about operating leases in notes to the

financial statements of the lessee:

 Lease payments charged as an expense in the period.

 An analysis of amounts payable in one, two to five and over five years. This is a

note of future commitments under operating leases, not year-end amounts due.

Example

Under an operating lease agreement, Entity F pays a non-returnable deposit of

$50,000 and then four years’ rental of $50,000 per annum on the first day of each

year (the first day of Year 1, Year 2, Year 3 and Year 4).

Total lease payments = $50,000 + ($50,000 × 4 years) = $250,000

Annual charge for the lease = $250,000 ÷ 4 years = $62,500.

In the Year 1 financial statements the lease payments charged as an expense are

therefore $62,500, and these should be disclosed.

At the end of Year 1, the disclosure of the minimum lease payments under non-

cancellable operating leases are as follows:

Within one year 50,000

Within two to five years 100,000

After more than five years -

–

–––––––

Total minimum lease payments 150,000

–

–––––––

A general description of the lessee’s significant leasing arrangements should also be

disclosed.

Paper F7 (INT)

Financial reporting

CHAPTER

Provisions,

contingent liabilities and

contingent assets

Contents

1 Provisions

2 Contingent liabilities and contingent assets

3 Events after the reporting period: IAS10

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Provisions

 The nature of a provision

 Definitions

 The need for an accounting standard on provisions

 Recognising a provision

 Measuring a provision

 Changes in provisions

 Uses of provisions

 Accounting for specific types of provision

 Disclosures about provisions

1 Provisions

1.1 The nature of a provision

A provision is a type of liability. However it is a liability of an uncertain amount or

uncertain timing.

The double entry in the ledger accounts to create a provision is:

Debit: Appropriate expense (when the provision is created)

Credit: Provision (included in current or non-current liabilities, as appropriate,

in the statement of financial position).

Creating a provision therefore reduces profit, by the amount of the provision that

has been created.

The provision is then adjusted annually as necessary, with any increase or decrease

in the provision being taken to profit or loss.

 An increase in a provision reduces profit.

 A reduction in a provision increases profit.

Example

An entity has been sued by a customer in Year 1. The customer is almost certain to

win the legal dispute, but the amount that will be needed to settle the claim is not

yet certain. At the end of Year 1, the entity’s solicitor advises that, in his opinion, the

cost of the settlement will be $1,000,000.

At the end of Year 1 a provision for the $1,000,000 is set up as follows.

 $ $

Dr Expenses 1,000,000

 Cr Provision 1,000,000

Chapter 13: Provisions, contingent liabilities and contingent assets

The profit in Year 1 will be reduced by the amount of the provision that has been

created.

Year 2

At the end of Year 2 the claim has still not been settled, and the solicitor now

advises that the claim will probably be settled in the customer’s favour at $1,200,000.

The provision is adjusted to $1,200,000, as follows.

  $ $

Dr Expenses 200,000

 Cr Provision 200,000

An additional $200,000 has now been charged against profit (in Year 2) and the

provision in the statement of financial position is adjusted to the revised estimate of

$1,200,000.

Year 3

At the end of Year 3 the claim has still not been settled. The solicitor now believes

that the claim will be settled at $900,000. The provision is reduced to $900,000. The

adjustment is made as follows.

  $ $

Dr Provision 300,000

 Cr Ex

enses 300,000

The excess provision of $300,000 has now been released and the total provision

reduced by $300,000. The reduction in the provision adds to profit in Year 3, and the

provision in the statement of financial position is adjusted down to the revised

estimate of $900,000.

Year 4

The claim is settled in Year 4 at $950,000. On settlement, the double entry in the

ledger accounts will be:

  $ $

Dr Expenses 50,000

Dr Provision 900,000

 Cr Cash 950,000

The charge against profit in Year 4 for settlement of the legal claim is $50,000.

The provision no longer exists. The total amount charged against profit over the

four years was the final settlement figure of $950,000.

 $

Year1 (1,000,000)

Year2

(

200,000

)



Year3 300,000

Year4

(

50,000

)



–

–––––––

–



Total

(

950,000

)



–

–––––––

–



Paper F7: Financial reporting (International)

1.2 Definitions

IAS37 gives the following definitions:

 A provision is a type of liability. It is a liability of uncertain timing or uncertain

amount.

 A liability is:

− a present obligation

− arising from past events

− the settlement of which is expected to result in an outflow of economic benefits.

An ‘ordinary’ liability is for a known amount. For example, an amount payable

under the terms of a finance lease agreement is a liability. The obligation arises from

the lease agreement. The settlement of the obligation by means of the lease

payments will result in a known outflow of cash on known dates.

A provision is a liability of an uncertain amount or uncertain timing, such as:

 amounts that an entity might have to pay under a guarantee, or

 (as in the example above) as the result of a legal claim.

An entity may know that it will have to incur expenses or will have to make a

payment under guarantees it has given to customers. It therefore has a liability – an

obligation that already exists arising from past events that will result in an outflow

of economic benefits in the future. However, it will not know for certain when

claims might be made under the guarantees and how much the claims will cost. The

entity should therefore make a provision for expenses or payments that it expects to

make under the terms of its guarantees.

1.3 The need for an accounting standard on provisions

Before IAS37 was introduced, it was common practice for entities to use different

bases for making provisions. This led to a lack of consistency between their financial

statements.

Entities also used provisions as a method of ‘moving’ profits between accounting

periods (profit smoothing). A provision could be created or increased if an entity

wanted to reduce the reported profit for one year, and then a provision could be

reduced in a subsequent year, when the entity wanted to report a higher profit.

For example, at the end of Year 1 a company might be planning a reorganisation

that will take place over the next four years (Years 2 – 5) at an expected cost of

$2,000,000. Before IAS37, the company might have chosen any of the following

accounting policies:

 To treat the costs of reorganisation as an expense in the year when the expense

occurs. In this way, profit in each of Years 2 – 5 is reduced by the actual costs of

the organisation in each year.

 To create a provision of $2,000,000 at the end of Year 1, but spread the creation of

the provision over four years (Years 1 – 4) at $500,000 in each year. The provision

Chapter 13: Provisions, contingent liabilities and contingent assets

is created as $500,000 in Year 1, then increased to $1 million in Year 2, $1.5

million in Year 3 and $2 million in Year 4. In each of the Years 1 - 4, the net

expense for the reorganisation will be $500,000 minus the actual reorganisation

costs incurred.

 To take all the ‘bad news’ in Year 1 by creating a full provision for $2,000,000

immediately. This will reduce profit by $2,000,000 in Year 1. If actual

reorganisation costs are $2,000,000, there will be no further charge against profit

in any of the Years 2 – 5.

In many cases, management would choose to create a large provision, and ‘take all the

bad news’ immediately. Although this would reduce profits by a large amount in the

first year, when the provision was made, profits in future years would be ‘protected’.

There were other problems with accounting for provisions.

 Entities often made provisions for future expenditure that management planned

to incur, but to which it was not yet fully committed. For example, at the end of

Year 1 an entity might recognise a provision for the expense of replacing plant

during Year 2. However, in Year 2 management might then decide not to replace

the plant after all and to release the provision. Sometimes ‘management

intentions’ were used deliberately to distort reported profits and losses and to

mislead users of the financial statements.

 Several different items could be combined into one large all-purpose provision

(sometimes called ‘the big bath’). This was then available to be released to

income to improve profits in poor-performing years.

IAS37 brought to an end this ability for entities to use provisions as a method of

‘manipulating’ profits between different years.

1.4 Recognising a provision

Under IAS37, a provision should only be recognised when:

 an entity has a present obligation as a result of a past event

 it is probable that an outflow of economic benefits will be required to settle the

obligation, and

 a reliable estimate can be made of the amount of the obligation.

Note: These ‘rules’ are the ‘recognition criteria’ for provisions.

Present obligation

There must be an obligation already in existence. The obligation may be legal or

constructive.

 A legal obligation is one arising from a contract, or some other aspect of the

law.

Paper F7: Financial reporting (International)

 A constructive obligation is one arising from the entity’s actions, whereby

− through established past practice, published policies, or a specific current

statement, the entity has indicated to other parties that it will accept certain

responsibilities, and

− as a result, the entity has created a valid expectation that it will discharge

those responsibilities.

For example, a clothing retailer may have a policy of taking back items of clothing

that customers have purchased, and refunding the purchase price, simply because

the purchaser has changed his or her mind after purchase and wants to return the

purchased item and obtain a refund. The retailer night not be under a legal

obligation to take back purchased items in this way, so there is no legal obligation.

However, if this is the usual practice of a particular retailer, and the retailer’s policy

is well-known or has been made known to customers, then a constructive obligation

arises.

Obligation arising out of a past event

The event leading to the obligation must be past, and must have occurred before the

end of the reporting period when the provision is first recognised. No provision is

made for costs that may be incurred in the future but where no obligation yet exists.

For example, if an entity is planning a reorganisation but does not yet have an

obligation (legal or constructive) to undertake the reorganisation, it cannot create a

provision for reorganisation costs.

Probable outflow of economic benefits

The outflow of benefits must be probable. ‘Probable’ is defined by IAS37 as ‘more

likely than not to occur’. For example, an entity may have given a guarantee but

may not expect to have to honour it. In such a situation, it cannot create a provision

for the cost of expenses that it may have to incur under the terms of the guarantee.

This is because a payment under the guarantee is not probable.

1.5 Measuring a provision

The amount recognised as a provision should be the best estimate, as at the end of

the reporting period, of the future expenditure required to settle the obligation.

Risks and uncertainties should be taken into account in reaching the best estimate.

Events after the reporting period will provide useful evidence. (Events after the

reporting period are dealt with in more detail later.)

However, entities should:

 avoid creating excessive provisions (which could be used as a way of

manipulating profits between financial years), or

 avoid underestimating provisions.

ACCA F7 (INT) Financial Reporting - Study text - 2010 - Emile Woolf Publishing

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