Here we explain how to deal with a technical accounting area students sometimes struggle with.
CIPFA students need to be familiar with lease calculations for both the Business Reporting and Public Sector Financial Reporting exams. As with most technical areas in accounting, the key to success is plenty of practice. However, it is important to spend some time after completing an exercise to reflect on what you have learned.
This is highlighted in the following exercise. Consider a scenario involving leases which will require some technical accounting. After the exercise has been completed we will consider how accounting theory can be better understood.
An NHS Foundation Trust requires a new machine for one of its hospitals. The Trust has two options to lease this particular machine, inventively called Option A and Option B. Whichever option they chose, the lease agreement will begin on 1 April 20X5 and apart from the deposit, annual payments will be paid in arrears. Here are the details of the lease agreements:
From the above information, the Trust will have to enter into new lease agreements if they choose Option A and still want to use the machine for 10 years. However, by comparing how the differences between the two lease agreement affects the financial statements a better understand of the meaning of assets can be achieved.
First, compare the accounting entries for the two options for the year ending 31 March 20X6:
Step 1 – Capitalise the asset
Step 2 – Complete the lease table and calculate closing liability
Step 3 – Account for lease payment
Step 4 – Split the liabilities
Step 5 – Depreciate the asset
Under Option A because the lease does not transfer legal ownership, then the right of use asset will be depreciated over its lease term (i.e. £300,000/4) and the residual value is ignored. For Option B, as the lease does transfer legal ownership, the asset will be depreciated over its useful life and its residual value is included in the calculation (i.e. (£1,000,000 – £350,000)/10).
Now compare how the above entries affect the Statement of comprehensive income and the Statement of financial position for the Trust for the year ending 31 March 20X6.
Statement of comprehensive income for year ending 31 March 20X6 (extract)
Statement of financial position as at 31 March 20X6 (extract)
By seeing how each lease agreement affects the financial statements, it can help to better understand prior learning at a higher level. For example, notice that Option A result has a closing net book value of the asset as £225,000 (£300,000 – £75,000), whilst Option B is £935,000 (£1,000,000 – £65,000) and yet the different lease agreements are for the same machine. The lesson here is what defines an asset in accounting. Initially, many accounting students define assets as something a business owns, but an asset is defined in part, as a resource controlled by an entity.
So, what is the resource that the Trust controls? It is the right to use the machine for a period of time. Option A has a period of four years, whereas Option B has the right to use it until they plan to dispose of it (currently 10 years). They are two different resources and thus they differ in measurement.
What does this exercise teach you? It is the importance to reflect on what you have learned. It is easy to fall into the habit of just doing question after question, but by spending some time reflecting on what has been learned, will result in a greater understanding of accounting. Next time you complete an exercise, progress test or mock exam, take some time afterwards to reflect on what has been learned. Perhaps, discuss this learning with others and soon you will find that your understanding of accounting begins to accelerate.
- Thanks to CIPFA for this article
