SOLUTION TO END-OF-CHAPTER EXERCISE

10.14 Implications for accounting-based contracts

(a) As the lease is non-cancellable and the lease term is for the major part of the economic life of the asset (for example, a period in excess of 75 per cent of the machinery’s useful life), the lease is a finance lease.

(b) The interest rate implicit in the lease is that which, when used to discount the minimum lease payments and any unguaranteed residual, causes the combined present value to equal the fair value of the asset at lease inception. If we use a discount rate of 10 per cent, the present value of the minimum lease payments over seven years and the unguaranteed residual are as follows:

Minimum lease payments £50,000 × 4.8684 = £243,420 Unguaranteed residual £40,000 × 0.5132 = £20,528

£263,948

As the discounted value equals the fair value of the asset at lease inception, 10 per cent must be the rate of interest implicit in the lease.

1 July 2015

Dr Leased machinery £243,420

Cr Lease liability £243,420

(to recognise the leased asset and lease liability at the commencement of the lease; the lessee does not include the unguaranteed residual) 30 June 2016 Dr Executory costs £5,000 Dr Interest expense £24,342 Dr Lease liability £25,658 Cr Cash £55,000

(to recognise the first lease payment)

Dr Depreciation expense £34,774

Cr Accumulated lease depreciation £34,774

(to recognise the period depreciation expense = £243,420 ÷ 7)

(d) Journal entries in the books of Fernster plc

1 July 2015

Dr Lease receivable £263,948

Dr Cost of goods sold £179,472

Cr Inventory £200,000

Cr Sales revenue £243,420

(to recognise the sale of inventory to Thomson plc and the related lease receivable). The cost of goods sold represents the cost of the equipment to Fernster plc less the present value of the unguaranteed residual at the end of the lease. The sales revenue represents the present value of the minimum lease payments (which by definition excludes unguar- anteed residuals).

30 June 2016

Dr Cash £55,000

Cr Lease receivable £23,605

Cr Interest revenue £26,395

Cr Recoupment of executory costs £5,000

(to recognise the receipt of the periodic lease payment)

It should be noted that, in the above exercise, owing to the existence of the unguaranteed residual, the lease liability in the books of the lessee will be different from the lease receivable in the books of the lessor. As IAS 17 specifies, where a lease is classified by the lessee as a finance lease, the lessee is to record, if material, as at the beginning of the lease term, an initial asset and liability equal in amount to the lower of the fair value of the asset and the present value of the minimum lease payments. Minimum lease payments exclude the unguaranteed residual.

In relation to lessors, where a lease is classified as a finance lease by the lessor (either a direct-finance lease or a lease involving a dealer or manufacturer), the lessor’s investment in the lease, comprising the present value of the minimum lease payments receivable plus the present value of any unguaranteed residual value expected to accrue to the benefit of the lessor at the end of the lease term, shall, if material, be brought to account as a receivable, as at the beginning of the lease term.

As the lease receivable in the financial statements of the lessor and the lease payable in the financial statements of the lessee will not be the same amount (because of the unguaranteed residual), the interest revenue recorded in the financial statements of the lessor will be different from the interest expense recorded in the financial statements of the lessee.

REVIEW QUESTIONS

1 What is a lease? LO 10.1

2 When should we capitalise a lease transaction? LO 10.3

3 If a lease transaction is to be capitalised, how do we determine the value of the leased asset and the lease liability? LO 10.3

4 Would there be circumstances in which a lessee would prefer to treat a lease as an operating lease rather than a finance lease? LO 10.5

5 As this chapter explains, the IASB and FASB are currently working on the development of a new accounting standard for leases. In this regard, you are required to answer the following: LO 10.6

(a) What are some of the major changes that might occur as a result of the new accounting standard?

(b) Is it expected that all leases will be required to be shown on the statement of financial position?

(d) Will the new leasing requirements positively or adversely impact reporting entities’ gearing ratios and reported profits?

6 The following was in the notes (Note 18) to the 1990 financial statements of Incitec Ltd:

On 12th October 1989 a subsidiary, Eastern Nitrogen Limited, entered into a Sale and Leaseback arrangement whereby an ammonia plant located in Newcastle with a net book value of €13,983,000 was sold for a cash con- sideration of €71,400,000 of which a deposit of €5,000,000 had been received in the previous financial year. The profit on the sale is being brought to account over the estimated useful life of the plant. The deferred gain has been disclosed in these financial statements as a deduction from the gross cost of plant and equipment.

Is the accounting policy adopted by Incitec in accordance with the current requirements of IAS 17? In answering this question, state any assumptions you are making about the sale transaction and the type of lease. LO 10.5 7 At the inception of a lease, in what circumstances would the lease receivable recorded by the lessor not be equivalent

to the lease payable recorded by the lessee? LO 10.5

8 What are minimum lease payments and what do they include? LO 10.3

9 Determine for each of the following arrangements the manner in which the relevant lease should be classified, by both the lessor and the lessee, under IAS 17. Give reasons for your answers. LO 10.2

(a) Company A enters into a non-cancellable lease with a five-year term for an item of plant, which has an expected useful life of eight years. The lease is renewable for a further two-year period at commercial rates prevailing at the time of renewal. The present value of the minimum lease payments is equal to 80 per cent of the fair value of the

leased property at the inception of the lease. The remaining 20 per cent of the fair value is represented by the guaranteed residual value. The residual value has been guaranteed by an independent third party, an insurance company, which is unrelated to either the lessor or the lessee.

(b) Company B enters into a non-cancellable lease with a seven-year term for an item of plant, which has an expected useful life of ten years. The present value of minimum lease payments is equal to 75 per cent of the fair value of the asset at the date of inception of the lease. The residual value accounts for the remaining 25 per cent. So confident is the lessor that the plant will retain its value that it is guaranteeing 50 per cent of the residual value, with the lessee being responsible for guaranteeing the remaining 50 per cent of the residual value.

(c) Company C enters into a non-cancellable lease with a five-year term for a large commercial vehicle, which has an expected useful life of eight years. The lease is renewable for a further two years at commercial rates prevailing at the time of renewal. The present value of minimum lease payments is equal to 65 per cent of the fair value of the asset at the date of inception of the lease. The residual value is not guaranteed by the lessee and the vehicle will revert to the lessor. In a separate agreement the lessee has written a put option, which entitles the lessor to put the leased vehicle to the lessee in five years’ time on payment of an amount equal to the residual value of the lease.

(d) Company D enters into a non-cancellable lease for plant with a term of eight years. The plant has a useful economic life of 12 years. Company D has an option to renew the lease with the same rental for a further four years, even though market rentals are expected to increase with inflation over the next decade. The present value of the minimum lease payments is 70 per cent of the sum of the fair value of the plant.

10 Lessee plc, on 1 July 2015, sells a tractor having a carrying amount on its books of €100,000 to Lessor plc for €140,000 and immediately leases the tractor back under the following conditions: LO 10.3

• The term of the lease is ten years, non-cancellable, and requires rental payments of €22,784 at the end of each year. • The estimated economic life of the tractor is ten years.

• There is no residual value.

• Lessee plc pays all executory costs (that is, these are not included in the lease payments). • The implicit rate of interest in the lease is 10 per cent.

(a) Classify the lease for both the lessee and the lessor.

(b) Prove the interest rate implicit in the lease is 10 per cent.

(d) Prepare the journal entries for the lessee for the second year of the lease.

11 Using the data provided in Review Question 10, answer the following questions from the perspective of the lessor. LO 10.3

(a) Prove that the rate of interest implicit in the lease is 10 per cent.

(b) Prepare the journal entries for 2015 and 2016 using the net method.

12 Rankin plc has entered into an agreement to lease an item of equipment that produces teddy bears. The terms of the lease are as follows: LO 10.3

• Date of entering lease: 1 July 2015. • Duration of lease: 10 years. • Life of leased asset: 10 years. • There is no residual value.

• Lease payments: €5,000 at lease inception, €5,500 on 30 June each year (that is, ten payments). • Included within the lease payments are executory costs of €500.

• Fair value of the machine at lease inception: €27,470. Determine the interest rate implicit in the lease.

13 Burt plc enters into a non-cancellable five-year lease agreement with Earnie plc on 1 July 2015. The lease is for an item of machinery that, at the inception of the lease, has a fair value of £1,294,384.

The machinery is expected to have an economic life of six years, after which time it will have an expected residual value of £210,000. There is a bargain purchase option that Burt plc will be able to exercise at the end of the fifth year for £280,000.

There are to be five annual payments of £350,000, the first being made on 30 June 2016. Included within the

£350,000 lease payments is an amount of £35,000 representing payment to the lessor for the insurance and maintenance of the equipment. The equipment is to be depreciated on a straight-line basis. LO 10.3

(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 in the books of Burt plc for the years ending 30 June 2016 and 30 June 2017.

(c) Prepare the portion of the statement of financial position for the year ending 30 June 2017 relating to the lease asset and lease liability.

(d) Prepare the journal entries of Burt plc for the years ending 30 June 2016 and 30 June 2017 assuming that Burt plc classifies the lease an operating lease.

14 Gregory plc enters into a non-cancellable five-year lease agreement with Sanders plc on 1 July 2015. The lease is for an item of machinery that, at the inception of the lease, has a fair value of £231,140. The machinery is expected to have an economic life of seven years, after which time it will have no residual value. There is a bargain purchase option, which Gregory plc will be able to exercise at the end of the fifth year, for £50,000. LO 10.3

Sanders plc manufactures the machinery. The cost of the machinery to Sanders plc is £200,000. There are to be five annual payments of £62,500, the first being made on 30 June 2016. Included within the £62,500 lease payments is an amount of £6,250 representing payment to the lessor for the insurance and maintenance of the machinery. The machinery is to be depreciated on a straight-line basis. The rate of interest implicit in the lease is 12 per cent.

(a) 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 in the books of:

(i) Sanders plc

(ii) Gregory plc

15 On 1 July 2015 Iselin plc signs a non-cancellable agreement to lease land and a building from Weber plc. The lease agreement requires seven annual payments of €375,000, with the first payment being made on 30 June 2016. Within each of these payments €25,000 represents a payment to Weber plc for rates and maintenance of the property. The building is expected to have a life of only nine years, after which time it will have no salvage value. At 1 July 2015 the land and building have a fair value of €588,160 and €1,372,370, respectively. The building is expected to have a value (unguaranteed by the lessee) of €500,000 at the end of year 7. The rate of interest implicit in the lease is 10 per cent. LO 10.3

(a) Prove that the rate of interest implicit in the lease is 10 per cent.

(b) Allocate the lease payments between the land and building.

(d) Provide the journal entries for the years ending 30 June 2016 and 30 June 2017 for Weber plc.

16 On 2 November 2006 The Gold Coast Bulletin published an article by Chalpat Sonti entitled ‘HQ Sale Lifts Bartercard’ in which it was stated: LO 10.2

Bartercard International has posted a tidy profit on the sale and leaseback of its Southport headquarters, a bright spot in an otherwise turbulent week for the company . . . Bartercard’s Southport property, in Scarborough St, had a book value of about €3.5 million, and the sale represented a tidy profit for the company, said chairman Wayne Sharpe. Proceeds from the sale would be used to repay all long-term debt in the group, with the balance to finance Bartercard’s further expansion in Bartercard UK and the United Arab Emirates.

Determine whether you think the Southport property was leased back by Bartercard by way of a finance lease or an operating lease.

CHALLENGING QUESTIONS

17 The IASB and FASB have been developing a revised accounting standard for leasing which will act to eliminate the concept of financial leases versus operating leases. If their proposals (some of which have been described in this chapter) are incorporated within a revised accounting standard, then how do you think the management of reporting entities will respond to the new accounting requirements? Do you think it will impact how or whether they lease assets and, if so, why? LO 10.6

18 Mark Richards plc enters a finance lease to lease an asset from Michael Petersen plc. The lease term is for seven years and the leased asset is initially recorded in Mark Richards plc’s financial statements for £250,000 at the date of lease inception. The asset is expected to have a useful life of eight years. The lease terms include a guaranteed residual of £20,000, and that the asset is expected to have a residual value of £10,000 at the end of its useful life. LO 10.4

Determine the lease depreciation expense assuming that:

(a) Mark Richards plc is expected to get ownership of the asset at the end of the lease term.

(b) Mark Richards plc is not expected to get ownership of the asset at the end of the lease term.

19 Owing to low liquidity, Lisa plc decides on 1 July 2015 to sell its land and buildings to Anderson plc. The carrying values of the land and buildings in the books of Lisa plc, at 1 July 2015, are: LO 10.3

Land, at cost €1,800,000 Buildings, at cost €1,750,000 Accumulated depreciation €350,000

The land and buildings are sold for €4,334,700 (their fair value), with the amount being allocated equally as follows:

Land €2,167,350

Buildings €2,167,350

Immediately following the sale, Lisa plc decides to lease back the land and buildings from Anderson plc. The term of the lease is 20 years. The implicit interest rate in the lease is 12 per cent. It is expected that the buildings will be demolished at the end of the lease term. The lease is non-cancellable, returns the land and buildings to Anderson plc at the end of the lease and requires the following lease payments:

Payment on inception of the lease on 1 July 2015 €600,000 Payment on 30 June each year starting 30 June 2016 €500,000 There is no residual payment required.

(a) Provide the entries for the sale and lease in the books of Lisa plc as at 1 July 2015.

(b) Provide the entries for the purchase and lease in the books of Anderson plc as at 1 July 2015.

(d) Provide the entries in the books of Anderson plc as at 30 June 2025.

20 On 1 July 2015 Flyer plc decides to lease an aeroplane from Finance plc. The term of the lease is 20 years. The implicit interest rate in the lease is 10 per cent. It is expected that the aeroplane will be scrapped at the end of the lease term. The fair value of the aeroplane at the commencement of the lease is €2,428,400. The lease is non-cancellable, returns the aeroplane to Finance plc at the end of the lease and requires a lease payment of €300,000 on inception of the lease (on 1 July 2015) and lease payments of €250,000 on 30 June each year (starting 30 June 2016). There is no residual payment required. LO 10.3

(a) Provide the entries for the lease in the books of Flyer plc as at 1 July 2015.

(b) Provide the entries for the lease in the books of Finance plc as at 1 July 2015.

(c) Provide the journal entries in the books of Flyer plc for the final year of the lease (that is, the entry in 20 years’ time).

(d) Provide the journal entries in the books of Finance plc for the final year of the lease (that is, the entry in 20 years’ time).

21 Deliveries plc leased a truck from a truck dealer, City Vans plc. City Vans plc acquired the truck at a cost of £180,000. The truck will be painted with Deliveries plc’s logo and advertising and the cost of repainting the truck to make it suitable for another owner four years later is estimated to be £40,000. Deliveries plc plans to keep the truck after the lease but has not made any commitment to the lessor to purchase it. The terms of the lease are as follows: LO 10.3

• Date of entering lease: 1 July 2015. • Duration of lease: four years.

• Life of leased asset: five years, after which it will have no residual value. • Lease payments: £100,000 at the end of each year.

• Interest rate implicit in the lease: 10 per cent. • Unguaranteed residual: £50,000.

• Fair value of truck at inception of the lease: £351,140.

(a) Demonstrate that the interest rate implicit in the lease is 10 per cent.

(b) Prepare the journal entries to account for the lease transaction in the books of the lessor, City Vans plc, at 1 July

In document Chapter. Accounting for Leases. Learning objectives Introduction to accounting for leases (Page 36-41)