Question

1.Describe the following terms: (a) residual value, (b) guaranteed residual value, and (c) initial direct costs.

2.Explain the following concepts: (a) bargain purchase option and (b) bargain renewal option.

3.What payments are included in the lease liability?

4.  Describe the accounting procedures involved in applying the operating lease method by a lessee.

Answer 1

1. a) Residual value is the the estimated value of a fixed asset at the end of its lease term or at the end of its useful life. In a lease, the lessor uses the residual value as one of the primary method to determine how much a lessee would pay in lease payments which ideally would be the entire value of the asset.

b) In financial accounting for leases the term guaranteed residual value is a guarantee made to the lessor that the value (or part of the value) of an underlying asset will be at least a specified amount at the end of the lease. This guarantee is made by a party unrelated to the lessor. Generally, this is an estimated fair market value of a leased property at the end of the agreement's term. If the lessee agrees to guarantee a residual value at the end of the term, this becomes an obligation for the lessee and it maybe factored in into the minimum lease payments. For example, Company A agrees to lease an equipment from Company B for a lease term of 10 years and Company A has agreed to a guaranteed residual value of $200,000. At the end of the lease term, if the actual residual value of the equipment is $100,000; Company A has to make a final cash payment of $100,000 to Company B.

c) Initial direct costs pertains to the initial incremental cost that has been incurred for obtaining a lease -like a finder's fee, upfront fees, commission etc. These costs are those which would not have been incurred if a lease had not been obtained.

2. a) Bargain purchase option in a lease agreement refers to a clause in the lease agreement that allows the lessee to purchase the leased asset at a substantially lower price than its fair value at the end of the lease term.

b) Bargain renewal option is a clause in a lease agreement that gives the lessee the option to extend the lease at a rate that is substantially lower than the current market rate.

3. At the commencement date of a lease, a lessee measures the lease liability as the present value of lease payments that have not been paid at that date. Lease liability generally consists of amount expected to be paid under a guaranteed residual value, payments for terminating a lease unless it is reasonably certain that an early termination will not occur, variable lease payment and fixed lease payments.

4. An operating lease is a contract that allows the lessee to use an asset but not convey the ownership rights of the asset. An operating lease is treated as renting - the operating lease payments are expensed in the profit and loss account and no asset is recognised in the balance sheet.