Question

ABC is considering acquiring a machine from XYZ. It has two options; cash purchase at a cost of Rs. 14,274,890 or a lease.

The terms of the lease are as follows:

• The lease period is for four years from 1 January 2019 with an annual rental of Rs. 5,000,000 payable on 31 December each year. The lessee is required to pay all repairs, maintenance and other incidental costs. Lease term is extendable for a further one more year and ABC is uncertain about exercising this option.
• The interest rate implicit in the lease is 15% p.a.
• ABC has an option to purchase the machine at the end of lease term.

Estimated useful economic life span of the machine is five years.

Required:

a)       Prepare Lease Liability Schedule for ABC.

b)      Pass Journal Entries for the year ended 2019 in Books of ABC & XYZ.

c)       Prepare an extract of the Financial Statements for ABC for the year ended 31 December 2019.

Answer 1

First, classifying the lease,as per ASU -842 of the FASB, for purposes of accounting,

We analyse the following criteria ,for ABC, the lessee

1. Transfer of ownership at the end of the lease term--- nothing is said about that.

2.Purchase option of the leased asset at end of lease term, does exist, for the lessee---but if it is at substantially low price, is not known.

3. The lease term is for 4/5= 80% of the full economic life of the leased asset,ie. > 75% the normal threshold.

4.The present value of the lease payments ,5000000*2.85498= $ 14274900 is substantially all of the fair value of the leased asset, rather equal to its FV

5. The lease is silent about the asset's any particular specialised nature that makes it , of no alternative use to XYZ,the lessor, once the lease term ends.

As required under the new lease standard, as more than one of the above,namely,criteria 2,3& 4 are satisfied. Hence the lease is to be classifed as a FINANCE lease by ABC.

As for the lessor,

Proceeding on the same criteria , being satisfied, the lessor XYZ also needs to classify the lease as a SALE-Type lease & account as such.

a. Lease liability Schedule for ABC

Date	Annual Pmt.	Tow. Int.	Tow. Lease	Lease liability
1-Jan-19				14274900	(PV of the Lease)
31-Dec-19	5000000	2141235	2858765	11416135
31-Dec-20	5000000	1712420	3287580	8128555
31-Dec-21	5000000	1219283	3780717	4347839
31-Dec-22	5000000	652176	4347824	14
	20000000	5725114	14274886	(rounding-off error)

	b. Journal Entries				Lessor
	Books of ABC -Lessee				Books of XYZ
1-Jan-19	Right-of-use asset	14274900			Lease receivable	14274900
	Lease liability		14274900		Machinery		14274900
	P/A,5000000; i=15%,n=4
31-Dec-19	Depreciation expense	3568725
	Acc. Depn.-R-o-u asset		3568725
	(14274900/4)
	Interest expense	2141235			Cash	5000000
	Lease liability	2858765			Lease receivable		2858765
	Cash		5000000		Interest income		2141235

c. Extracts of Financial statements Of
ABC as at Dec 31, 2019
Income statement
Depreciation-R-o-u asset	3568725
Lease interest exp.	2141235
Balance sheet
Assets
R-o-u asset	14274900
Less: Acc. Depn.	3568725
R-o-u asset, net	10706175
Liabilities
Current liabilty
Lease liability(Next yr.)	3287580
Long-term liability
Lease liability (bal.)	8128555