ACCA F7 Financial Reporting

Fino (12/07) Question

On 1 April 2007, Fino increased the operating capacity of its plant. Due to a lack of liquid funds it was unable to buy the required plant which had a cost of $350,000. On the recommendation of the finance director, Fino entered into an agreement to lease the plant from the manufacturer. The lease required four annual payments in advance of $100,000 each commencing on 1 April 2007. The plant would have a useful life of four years and would be scrapped at the end of this period. The finance director, believing the lease to be an operating lease, commented that the agreement would improve the companys return on capital employed (compared to outright purchase of the plant). Required (i) (ii) (1) (2) Discuss the validity of the finance directors comment and describe how IAS 17 Leases ensures that leases such as the above are faithfully represented in an entitys financial statements. (4 marks) Prepare extracts of Finos income statement and statement of financial position for the year ended 30 September 2007 in respect of the rental agreement assuming: It is an operating lease (2 marks) It is a finance lease (use an implicit interest rate of 10% per annum). (4 marks)

Answer
Text references: Chapter 16. Top tips: Only 5 marks were available for calculations here. Intelligent comment on faithful representation and its application to leasing would have earned the greater part of the marks. Examiner's comments. Answers to this question were very mixed. Weaker answers did not pinpoint the importance of the commercial substance of transactions in part (a) or identify effect on ROCE in part (b). In the last part some candidates failed to treat the payments under the finance lease as being in advance and so based the finance costs on $350,000 rather than $250,000.

Marking scheme
Marks

(i) (ii) (1)

1 mark per valid point to operating lease income statement charge prepayment finance lease income statement: depreciation and finance costs statement of financial position: non-current asset non-current liabilities current liabilities interest and capital

Maximum

4 1 1 2 1 1 1 1 4 10

Maximum

(2)

Maximum Total for question

(i)

The finance director is correct in that, if the plant is regarded as being held under an operating lease, it will not be capitalised. In this case the cost of the plant will not be included in capital employed and so will not have an adverse effect on ROCE. However, the finance directors comments betray an ignorance of IAS 17. Under IAS 17 leases are classified according to the substance of the transaction, on the basis of whether or not the risks and rewards of ownership have been transferred. The standard gives examples of situations where a lease would normally be classified as a finance lease, including: where the lease transfers ownership to the lessee at the end of the lease term where an option to purchase exists on terms which make it reasonably certain that the option will be exercised where the lease term is for the major part of the assets economic life where the present value of the minimum lease payments amounts to at least substantially all of the fair value of the asset In this case the lease term is for the whole of the assets economic life and the present value of the minimum lease payments (four payments of $100,000 over three years) amounts to substantially all of the fair value of the plant. This must therefore be regarded as a finance lease and consequently will impact the ROCE.

(ii)

1 Operating lease Income statement Payment under operating lease (100,000 6/12) Statement of financial position Current assets Prepayment (100,000 6/12)

$ 50,000

50,000 $

Finance lease Income statement Depreciation (350,000/4 6/12) Finance costs (W) Statement of financial position Non-current assets Leased plant (350,000 43,750) Non-current liabilities Amount due under finance lease (W) Current liabilities Amount due under finance lease (262,500 175,000)

43,750 12,500

306,250 175,000

87,500 $

Working Cost 1.4.07 1.4.07 deposit Balance 1.4.07 Interest to 30.9.07 (250,000 10% 6/12) Balance 30.9.07 Interest to 1.4.08 (250,000 10% 6/12) 1.4.08 payment Capital balance due 30.9.08

350,000 (100,000) 250,000 12,500 262,500 12,500 (100,000) 175,000