SOLUTION: exchange for lease payments | My Assignment Tutor

Week 4 Tutorial Questions and solutions QUESTIONS 1. Define a lease. Identify five key provisions that are likely to be included in a lease agreement. Answer: Leases are agreements which, in exchange for lease payments, convey to one party (the lessee) the right to possess and to use an asset owned by another party (the lessor) for a stated period of time. In all lease agreements, the lessee acquires the right to use the asset during the term of the lease. Hence, lease term is one of the five key provisions found in all leases. The amount and timing of lease payments, the term of the lease and whether the lease is cancellable by either party (and, if so, under what conditions) are three additional key provisions. What happens at the end of the lease is another key provision. In some leases, the lessor retains the right to use or dispose of the asset at the end of the lease term, in other leases ownership is passed to the lessee on payment of a guaranteed residual value or payment of a ‘bargain purchase’ price. In still other leases, the lessee has the option to make a further additional payment to acquire the leased asset. During the lease term, the lessor continues to own the asset but does not have possession or the right to use it. 2. From the point of view of the lessee, outline the advantages and disadvantages of leasing. Answer: The advantages of leasing from the lessee’s point of view are that leases provide a mechanism whereby lessees can obtain the use of a resource without having to own it and pay for it at the time of acquisition. Leases are sufficiently flexible to allow short-term rental-type agreements (operating lease) or long-term finance leases that allow the lessee to use and then acquire the resource. Leases may also provide tax advantages to lessees who can claim the full amount of the lease payments as a tax deduction. The cost of leasing may be greater than other sources of bank funding which may be a disadvantage. Further, for leases classified as finance leases, the leased asset and lease liability is recognised in the statement of finance position and therefore has an effect on leverage. 3. Distinguish between an operating lease and a finance lease. Answer: The essential difference between an operating and a finance lease is that in the former the benefits and costs of ownership remain with the lessor but with the latter they pass to the lessee. In other words, an operating lease is a hiring arrangement while a finance lease is a financing arrangement. The essential difference may be illustrated in another way. An operating lease is likely to exist if acquiring legal ownership of the property is not a viable option, for example, because the lessee’s need for the resource is short-term. On the other hand, a finance lease is likely to exist if acquiring legal ownership is regarded as a possible way of obtaining the services provided by the property. 4. ‘The critical characteristic of a lease in deciding whether it should be capitalised is its “cancellability”.’ Discuss. Answer: The essential characteristic of a lease which determines whether it should be capitalised is whether the lease transfers substantially all the risks and rewards incidental to ownership to the lessee.If the risks and rewards of ownership remain with the lessor, the transaction is an operating lease which need not be capitalised. If the risks and rewards of ownership pass to the lessee, then the transaction is a finance lease which should be capitalised. Note that ‘ownership’ is not a component of the Framework 2010 definition of assets. The question of cancellability arises only because it may provide evidence of the disposition of the risks and rewards of ownership. If the lease is non-cancellable, this is an indication that the risks and rewards have passed to the lessee and that the transaction is a finance lease. There would usually also have to be some minimum term for the lease (relative to the total life of the asset) or the present value of total lease payments would have to be a significant proportion of the property’s purchase price. On the other hand, a cancellable lease would nearly always be an operating lease because there would be no certainty that substantially all the risks and rewards of ownership had passed to the lessee. 5. Managers are not indifferent to the differences between the capitalisation and expense methods of accounting for leases. Outline management’s incentives to favour one form of lease accounting over the other. Answer: In summary, the capitalisation treatment will result in an increased debt ratio (implying higher financial risk, an increase in the rates of interest on debt, and a reduced credit rating) and lower return on total assets (implying inferior operating performance and possibly reduced management incentives such as bonuses). Managers will not be indifferent to the choice between these treatments. They have strong incentives to favour the expense treatment and to ensure that leases are classified as operating leases. Empirical accounting research shows that following the introduction of accounting standards that mandated the operating/finance lease distinction, many lessees restructured their leases to ensure that they could be classified as operating leases and qualify for off-balance sheet treatment. Where the lease arising from the sale-and-leaseback transaction is classified as an operating lease – that is, substantially all the risks and rewards of ownership are retained by the lessor, who is the purchaser of the asset – AASB 117 requires different treatments that are determined by the relationship between the asset’s carrying amount, its fair value and the sale price. Problem 1 On 1 July 2013, Tasman Ltd contracts to lease equipment for five years at an annual rental of $20 000 with the first payment payable immediately. The equipment could have been purchased from the supplier for $80 747. The rate of interest implicit in the lease is 12% and the end of the reporting period is 30 June. Required (a) Prepare general journal entries for the year ended 30 June 2014, assuming the lease is an operating lease. (b) Prepare general journal entries for the year ended 30 June 2014, assuming the lease is a finance lease. (c) Prepare a schedule showing the division of the lease rental into interest and principal components for the first two years. Answer: (a) Tasman Ltd – operating lease in the books of the lessee __________________________________________________________________ 1 July Prepaid lease expense Dr $20 000 2013 Cash at bank Cr $20 000 __________________________________________________________________ 30 June Lease expense Dr $20 000 2014 Prepaid lease expense Cr $20 000 ___________________________________________________________________ (b) Tasman Ltd – finance lease in the books of the lessee The finance lease is initially recognised at an amount equal to the fair value of leased property or, if lower the present value of minimum lease payments (PV of MLP). The PV of MLP is determined as: 20 000 + () = $80 746. (Using the PV tables provided in the back of the textbook, the calculation is 20 000 + (20 000 × 3.0373) = $80 746. The factor of the annuity of $20 000 at 12% for 4 periods is 3.0373.) The PV of MLP equals the fair value. ___________________________________________________________________ 1 July Lease rights Dr $80 747 2013 Lease liability Cr $80 747 Lease liability Dr $20 000 Cash at bank Cr $20 000 ___________________________________________________________________ 30 June Lease interest expense Dr $7 290 2014 Lease interest payable Cr $7 290 Depreciation expense Dr $16 149 Accumulated depreciation Cr $16 149 (depreciation of leased asset over 5 year useful life and zero residual value $80 747/5) ___________________________________________________________________ (c) Schedule of lease payments PeriodLease paymentInterest – 12%Principal repaymentBalance1 July 2013 $80 747$80 7471 July 201320 000–20 00060 74730 June 201420 0007 29012 71048 03730 June 201520 0005 76414 23633 801 Problem 2. a) ‘If lease rights and obligations are not shown in the statement of financial position of the lessee, information concerning future financial obligations may be omitted, and to this extent the statement of financial position is incomplete and could be misleading.’ Discuss. (b) Compak Finance Ltd acquires equipment at a cost of $65 343. On 1 July 2013 it enters a contract to lease this equipment to DRD Ltd for four years at an annual rental of $20 000 with the first payment payable on 30 June 2014. The contract provides for an unguaranteed residual at the end of the lease term of $5000. The rate of interest implicit in the lease is 11% and the end of the reporting period is 30 June. Required (a) Prepare general journal entries in the books of Compak Finance Ltd for the year ended 30 June 2014, assuming the lease is an operating lease. (b) Prepare general journal entries in the books of Compak Finance Ltd for the year ended 30 June 2014, assuming the lease is a finance lease. (c) Prepare a schedule showing the division of the lease rental into interest and principal components. Answer: (a) The statement of financial position presents the firm’s financial position a given date. The liabilities presented in the statement of financial position should reflect all financial obligations of the firm that meet the definition of and recognition criteria for liabilities. The application of AASB 117 does not necessarily lead to this outcome. Some operating leases meet the definition of liabilities but are not represented on the firm’s statement of financial position; similarly with the assets created by operating leases. Although amounts owing under non-cancellable operating leases must be disclosed, this does not ensure that all financial statement users are aware of these commitments. (b) Compak Finance Ltd (a) Operating lease in the books of the lessor ___________________________________________________________________ 30 June Cash at bank Dr $20 000 2014 Lease revenue Cr $20 000 Depreciation expense Dr $15 086 Accumulated depreciation Cr $15 086 (depreciation of leased asset over 4 years’ useful life and $5 000 residual value $65 334 – 5 000 = 60 334/4 = $15 086) ___________________________________________________________________ (b) Finance lease in the books of the lessor For the lessor, the unguaranteed residual must be included in the calculation of the net investment in the lease. PV of lease payments = + 5 000 (1 + 0.11)-4= $65 343. ___________________________________________________________________ 1 July Lease receivable Dr $65 343 2013 Equipment Cr $65 343 30 June Cash at bank Dr $20 000 2014 Lease interest revenue Cr $7 188 Lease receivable Cr 12 812 (receipt of lease payment) ___________________________________________________________________ (c) Lease schedule for lessor DateRent receivedInterest Revenue 11%Principal recoveryBalance of Lease receivable1 July 2013 $65 34330 June 201420 0007 18812 81252 53130 June 201520 0005 77814 22238 30930 June 201620 0004 21415 78622 52330 June 201720 0002 47717 5235 00030 June 20175 00005 000 $85 000$19 657 Problem 3 Box Ltd entered into a finance lease with GEC Ltd to obtain the services of a forklift truck. The term of the lease is four years and in return Box Ltd has agreed to make an initial payment of $4000 followed by 47 monthly payments of $2000. The rate of interest charged by the lessor is found to be 1% per month, and the lessor acquired the forklift truck for $78 707. Required (a) Record the lease of the forklift truck, including the initial payment of $4000 and the first lease instalment of $2000, in the books of the lessor. (b) Record the lease of the forklift truck, including the initial payment of $4000 and the first lease instalment of $2000, in the books of the lessee. Answer: (a) GEC Ltd PV of lease payments = $4 000 + = $78 707 The journal entries at the commencement of the lease would be as follows: ___________________________________________________________________ Lease receivable Dr $78 707 Property Cr $78 707 Cash at bank Dr $4 000 Lease receivable Cr $4 000 ___________________________________________________________________ At the end of the first month: ___________________________________________________________________ Cash at bank Dr $2 000 Lease receivable Cr $1 253 Interest revenue Cr 747 __________________________________________________________________ (b) Box Ltd At the commencement of the lease: ___________________________________________________________________ Machine under lease Dr $78 707 Lease liability Cr $78 707 Lease liability Dr $4 000 Cash at bank Cr $4 000 ___________________________________________________________________ At the end of the first month: ___________________________________________________________________ Interest expense Dr $747 Lease liability Dr 1 253 Cash at bank Cr $2 000 ___________________________________________________________________ Problem 4: On 1 July 2013, ABC Company leased a machine from XYZ Company for a period of six years. The machine has an estimated useful life of six years and a residual value of zero. The normal selling price of the machine is $71 861 and the carrying amount in XYZ’s books was $52 000. ABC agreed to make annual payments of $15 000, commencing from the inception of the lease; in addition, ABC undertook to pay all associated costs, including maintenance and insurance. The interest rate implicit in the lease is 10%. Required Show general journal entries to record the lease transaction for the first two years in the books of both the lessor and the lessee. Identify any assumptions underlying your entries. Answer: Lessor’s Books: XYZ Company PV of lease payments = $15 000 + = $71 861 Given that this is a dealer or manufacturer lease, we assume that 10% is the market rate of interest, and there is no unguaranteed residual. Based on these assumptions, the journal entries would be as follows: ___________________________________________________________________ 1 July Lease receivable Dr $71 861 2013 Cost of goods sold Dr 52 000 Sales revenue Cr $71 861 Inventory Cr 52 000 Cash at bank Dr $15 000 Lease receivable Cr $15 000 ___________________________________________________________________ 30 June Interest receivable Dr $5 686 2014 Interest revenue Cr $5 686 ___________________________________________________________________ 1 July Cash at bank Dr $15 000 2014 Lease receivable Cr $9 314 Interest receivable Cr $5 686 ___________________________________________________________________ 30 June Interest receivable Dr $4 755 2015 Interest revenue Cr $4 755 ___________________________________________________________________ 1 July Cash at bank Dr $15 000 2015 Lease receivable Cr $10 245 Interest receivable Cr $4 755 ___________________________________________________________________ Lessee’s Books: ABC Company ___________________________________________________________________ 1 July Machine under lease Dr $71 861 2013 Lease liability Cr $71 861 Lease liability Dr $15 000 Cash at bank Cr $15 000 ___________________________________________________________________ 30 June Interest expense Dr $5 686 2014 Accrued interest expense Cr $5 686 Depreciation expense Dr $11 977 Accumulated depreciation Cr $11 977 (straight-line depreciation over term of lease 6 years) ___________________________________________________________________ 1 July Lease liability Dr $9 314 2014 Accrued interest expense Dr $5 686 Cash at bank Cr $15 000 ___________________________________________________________________ 30 June Interest expense Dr $4 755 2015 Accrued interest expense Cr $4 755 Depreciation expense Dr $11 977 Accumulated depreciation Cr $11 977 ___________________________________________________________________ 1 July Lease liability Dr $10 245 2015 Accrued interest expense Dr $4 755 Cash at bank Cr $15 000 ___________________________________________________________________