WORKED EXAMPLE 11.
5: Comprehensive example of accounting for leases
by a lessee
Trigger Ltd enters into a non-cancellable five-year lease agreement with
Brothers Ltd on 1 July 2015. The lease is for an item of machinery that, at the
inception of the lease, has a fair value of $369 824.
The machinery is expected to have an economic life of six years, after which
time it will have an expected salvage value of $60 000. There is a bargain
purchase option that Trigger Ltd will be able to exercise at the end of the fifth
year for $80 000.
There are to be five annual payments of $100 000, the first being made on
30 June 2016. Included within the $100 000 lease payments is an amount of
$10 000 representing payment to the lessor for the insurance and
maintenance of the equipment. The equipment is to be depreciated on a
straight-line basis.
A review of the appendices to this book shows that the present value of an
annuity in arrears of $1 for five years at 12 per cent is $3.6048, while the
present value of an annuity of $1 for five years at 14 per cent is $3.4331.
Further, the present value of $1 in five years discounted at 12 per cent is
$0.5674, while the present value of $1 in five years discounted at 14 per cent is
$0.5194.
REQUIRED
(a) Determine the rate of interest implicit in the lease and calculate the present
value of the minimum lease payments.
(b) Prepare the journal entries for the years ending 30 June 2016 and 30 June
2017.
(c) Prepare the portion of the statement of financial position (balance sheet)
relating to the leased asset and lease liability for the years ending 30 June
2016 and 30 June 2017.
(d) Prepare the journal entries for the years ending 30 June 2016 and 30 June
2017, assuming (for purposes of illustration) that the lessee classifies the
lease an operating lease.
SOLUTION
(a) First, as the lease is non-cancellable and the present value of the minimum
lease payments amounts to at least substantially all of the fair value of the
leased asset (calculations provided below), the lease is a finance lease.
The interest rate implicit in the lease agreement is the interest rate that
results in the present value of the minimum lease payments, and any
unguaranteed residual value, being equal to the fair value of the leased
property at the inception of the lease. The minimum lease payments
include any bargain purchase option. If we use a rate of interest of 12 per
cent, the discounted value of the payments is $369 824, determined as:
Present value of five lease payments
of $90 000
discounted at 12 per cent (we
eliminate the executory costs) = $90 000 3.6048
= $324
432
Present value of the bargain purchase
option
= $80 000 0.5674 = $45
392
$369 824
As the amount of the minimum lease payments discounted at 12 per
cent equates to the fair value of the asset at lease inception, the interest
rate implicit in the lease is 12 per cent.
(b) When preparing the journal entries it is often convenient to produce a table
such as that provided below. Interest expense in the table is determined by
multiplying the opening liability for a period by the rate of interest implicit in
the lease.
Date
Lease payment
(exclusive of
executory costs)
Interest
expense
Principal
reduction
Outstanding
balance
01 July 2015 369 824
30 June 2016 90 000 44 379 45 621 324 203
30 June 2017 90 000 38 904 51 096 273 107
30 June 2018 90 000 32 773 57 227 215 880
30 June 2019 90 000 25 906 64 094 151 786
30 June 2020 170 000* 18 214 151 786 0
*Includes bargain purchase option
1 July 2015
Dr Leased machinery 369 824
Cr Lease liability 369 824
(to record the leased asset and liability at the inception of the finance lease)
30 June 2016
Dr Executory expenses 10 000
Dr Interest expense 44 379
Dr Lease liability 45 621
Cr Cash 100 000
(to record the lease payment of $100 000)
Dr Lease depreciation expense 51 637
Cr Accumulated lease depreciation 51 637
(to record depreciation expense [(369 824 60 000) 6])
As the lessee will most probably retain the asset after the lease period as a
result of the bargain purchase option, the economic life of the asset, and
not the lease term, is used for depreciation purposes.
30 June 2017
Dr Executory expenses 10 000
Dr Interest expense 38 904
Dr Lease liability 51 096
Cr Cash 100 000
(to record the lease payment of $100 000)
Dr Lease depreciation expense 51 637
Cr Accumulated lease depreciation 51 637
($369 824 less $60 000 divided by six years)
(c) Portion of the statement of financial position for years ending 30 June 2016
and 30 June 2017
2016 ($) 2017 ($)
Assets
Leased asset 369 824 369 824
less Accumulated depreciation 51 637 103 274
318 187 266 550
2016 ($) 2017 ($)
Current liabilities
Lease liability 51 096 57 227
Non-current liabilities
Lease liability 273 107 215 880
As at 30 June 2016, the present value of the outstanding lease liability is
$324 203. The current portion of the liability ($51 096) is the amount by
which the lease liability will be reduced by the lease payments in the next
12 months (from the lease payments schedule).
(d) Journal entries for years ending 30 June 2016 and 30 June 2017, assuming
that the lease is an operating lease
30 June 2016
Dr Executory expenses 10 000
Dr Lease expenses 90 000
Cr Cash 100 000
(to record lease payment for 2016)
30 June 2017
Dr Executory expenses 10 000
Dr Lease expenses 90 000
Cr Cash 100 000
(to record lease payment for 2017)