Project #11363 - Case 11-6 Lessee Ltd.

Case 11-6

Lessee Ltd.

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:

                                 Debit            Credit

Lease expense          $100,000

Insurance expense        $2,000

Cash                                            $102,000

(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

rate.

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 

                        $                      $                                  $                               $

  0                                                                                                             244,370

  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:

                                             Debit                Credit

 Rent expense            $2,000

 Interest expense      $26,881

 Lease obligation        $73,119

     Cr. Cash                                  $102,000

 

Required:

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?

Subject Business
Due By (Pacific Time) 08/26/2013 12:00 am
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