Lessee Ltd., a British company that applies IFRSs, leased equipment from Lessor Inc. on
January 1, 2013, for a period of three years. Lease payments of $100,000 are due to
Lessor Inc. each year. Other expenses (e.g., insurance, taxes, maintenance) are also to be
paid by Lessee Ltd. and amount to $2,000 per year. The lessor did not incur any initial
direct costs. The lease contains no purchase or renewal options and the equipment reverts
back to Lessor Inc. on the expiration of the lease. The remaining useful life of the
equipment is four years. The fair value of the equipment at lease inception is $265,000.
Lessee Ltd. has guaranteed $20,000 as the residual value at the end of the lease term. The
$20,000 represents the expected value ofthe leased equipment to the lessee at the end of
the lease term. The salvage value of the equipment is expected to be $2,000 after the end
of its economic life. The lessee’s incremental borrowing rate is 11 percent (Lessor’s
implicit rate is 10 percent and is calculable by the lessee from the lease agreement).
The junior accountant of Lessee Ltd. analyzed the assets under lease, determined whether
the lease was an operating lease or capital lease, and prepared the applicable journal
entries. The senior accountant of Lessee Ltd. reviewed the junior accountant’s analysis
and prepared a separate analysis. As the finance controller, you were given both analysis
to determine the correct accounting treatment. Calculations and journal entries performed
by your junior and senior accountant are below.
Present Value of the Lease Obligation
Using the rate implicit in the lease (10 percent), the present value of the guaranteed
residual value would be $15,026 ($20,000 × 0.7513), and the present value of the annual
payments would be $248,690 ($100,000 × 2.4869).
Using the incremental borrowing rate (11 percent), the present value of the guaranteed
residual value would be $14,624 ($20,000 × 0.7312), and the present value of the annual
payments would be $244,370 ($100,000 × 2.4437).
Junior accountant analysis:
Since the equipment reverts back to Lessor Inc., it is an operating lease.
Entriesto be posted in Years 1, 2, and 3:
Lease expense $100,000
Insurance expense $2,000
(Operating lease rental paid to Lessor Inc.)
Senior accountant analysis:
Step 1 —Lease classification
The lease term is for three years. The useful life of the equipment is four years. Since the
lease term is for a major part of the useful life of the equipment, it is a finance lease.
Step 2 —Computation of the lease asset and obligation
Since the lessee’s incremental borrowing rate is greater than the lessor’s implicit rate in
the lease, compute the present value of the minimum lease payments using the 11 percent
Present value of the minimum lease payments = $100,000 × 2.4437 = $244,370.
Step 3 —Allocation of payments between interest and lease obligation
Since interest has to be charged on the straight-line method, the following is the
allocation of the interest and the reduction in the lease liability.
Reduction in Balance of
cash Interest Lease Lease
Year Cash Payment Expense (11%) Obligation Obligation
$ $ $ $
1 100,000 26,881 73,119 171,251
2 100,000 26,881 73,119 98,131
3 100,000 26,881 73,119 25,012
Journal entry in Year 1 to record the payments:
Rent expense $2,000
Interest expense $26,881
Lease obligation $73,119
Cr. Cash $102,000
1. Was the junior accountant’s analysis correct? Why or why not?
2. Was the senior accountant’s analysis correct? Why or why not?
3. How would the answer differ under U.S. GAAP?
|Due By (Pacific Time)||08/26/2013 12:00 am|
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