Lessee Ltd., the British company which applies IFRSs, leased equipment from Lessor Inc. on January 1, 2007, for period of three years. Lease payments of $100,000 are due to Lessor Inc. each year. Other expenses (like insurance, taxes, maintenance) are also to be paid by Lessee Ltd. and amount to $2,000 per year. Lessor did not incur any initial direct costs. Lease contains no purchase or renewal options and equipment reverts back to Lessor Inc. on expiration of the lease. The remaining useful life of the equipment is four years. 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 lease term. $20,000 represents the expected value of the leased equipment to the lessee at the end of a lease term. Salvage value of an equipment is expected to be $2,000 after the end of its economic life. Lessee’s incremental borrowing rate is 11 percent (Lessor’s implicit rate is 10 percent and is calculable by lessee from the lease agreement).
Junior accountant of Lessee Ltd. analyzed assets under lease and prepared the computation. The senior accountant of Lessee Ltd. reviewed the analysis and the computation and prepared a separate analysis. As the finance controller, you were given both of the computations 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 rate implicit in lease (10 percent), present value of a guaranteed residual value would be $15,026 ($20,000 × 0.7513), and present value of annual payments would be $248,690 ($100,000 × 2.4869).
Using incremental borrowing rate (11 percent), present value of the guaranteed residual value would be $14,624 ($20,000 × 0.7312), and present value of the annual payments would be $244,370 ($100,000 × 2.4437).
Computations by junior accountant:
As the equipment reverts back to Lessor Inc., it is the operating lease.
Entries to be posted in Years 1, 2, and 3:
Dr. Lease expense: $100,000
Dr. Insurance expense: $2,000
Cr. Cash: $102,000
(Operating lease rental paid to Lessor Inc.)
Computations by senior accountant:
Step 1: Lease classification
Lease term is for three years. The useful life of the equipment is four years. As the lease term is for a major part of the useful life of the equipment, it is a finance lease.
Step 2: Computation of lease asset and obligation
As 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.
Year Cash Payment Interest Expense (11%) Reduction in Lease Obligation Balance of Lease 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:
Dr. Rent expense: $2,000
Dr. Interest expense: $26,881
Dr. 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?