Lease Q 1 Example Operating lease Flora Co

Lease

Q 1 -Example: Operating lease • Flora Co entered an operating lease agreement in order to obtain use of a photocopier for a period of three years starting on 1 October 20 X 9. The terms of the lease stated that payment of $2, 500 should be made annually in arrears for each of the three years of the lease in addition to an initial nonrefundable deposit of $1, 500. • What expense is recognised in Flora Co's financial statements for the year ended 31 December 20 X 9?

Q 1 -Example: Operating lease answer • Dr. Rent expenses 750 ((2, 500*3)+1, 500^)/3*3 m(Oct-Dec)/12 m • Cr. Cash/ Payable 750 • Remarks: 1, 500 represents non-refundable deposit( can not get back the $) • Remarks: Look at whole period first rather than 1 year (cannot: 1500/3+2500*3/12)

Q 2 - Example: Operating lease incentives • Fauna Co enters into an operating lease agreement on 1 August 20 X 8 in order to obtain use of a machine. The lease term is four years and $5, 000 is payable annually in advance. • As an incentive, the lessor has agreed a reduction of 40 per cent off the first year's rental payment. • What expense is recorded by Fauna Co in the year ended 31 December 20 X 8 in respect of this agreement?

Q 2 - Example: Operating lease incentives answer • Dr. Rent expenses 1, 250 1, 875 ((5, 000*60%4 yr-2, 000)total/4 yr*5 m(Aug. Dec)/12 m • Cr. Cash/ Payable 1, 250 1, 875 • Remarks: Look at the total “expenses” for the whole lease period first instead of focusing on 1 year only.

Q 3 - Example: Finance lease with payments in arrears • On 1 January 20 X 0, Gordon Co leased an asset with a fair value of $38 million and a useful life of five years. The lease term was five years and the interest rate implicit in the lease was 9. 9 per cent. • The company is required to make five annual instalments of $10 million on 31 December, with the first payment on 31 December 20 X 0. • Show the lease obligation working for each year of the lease and identify amounts to be recognised in income statement in 20 X 0.

Q 3 - Example: Finance lease with payments in arrears answer • • • Date Amount Interest Principal lease Expenses Obligation 1/1/20 X 0 $38 m 31/12/20 X 0 $10 m $3. 762 m $6. 238 m $31. 762 m 31/12/20 X 1 $10 m $3. 144 m $6. 856 m $24. 906 m 31/12/20 X 2 $10 m $2. 466 m $7. 534 m $17. 372 m 31/12/20 X 3 $10 m $1. 72 m $8. 28 m $9. 092 m 31/12/20 X 4 $10 m $0. 9 m $9. 1 m Finance cost $3. 762 m Amortization expenses on leased equipment $7. 6 m FV=PVM

Q 4 - Example: Finance lease with deposit and payments in arrears • On 1 January 20 X 5 Jennifer Co acquired a machine from Alice Co under a finance lease. The cash price of the machine was $7, 710 while the minimum payments in the lease agreement totalled $10, 000. The agreement required the immediate payment of a $2, 000 deposit with the balance being settled in four equal annual instalments commencing on 31 December 20 X 5. The finance charge of $2, 290 represents interest of 15 per cent per annum, calculated on the remaining balance of the liability during each accounting period. • Required • Show the breakdown of each instalment between interest and capital, using the actuarial method.

Q 4 - Example: Finance lease with deposit and payments in arrears answer • • Date Amount Interest Principal lease Expenses Obligation 1/1/20 X 5 $5710 31/12/20 X 5 $2000 $856 $1144 $4566 31/12/20 X 6 $2000 $685 $1315 $3251 31/12/20 X 7 $2000 $488 $1512 $1739 31/12/20 X 8 $2000 $261 $1739 $0

Q 5 - Example: Finance lease with payments in advance • Jesmond acquired an asset by way of a five year term finance lease on 1 July 20 X 0. The asset had a fair value of $102, 500 and a useful life of five years and the lease contract required 5 payments in advance of $25, 000. The interest rate implicit in the lease is 11%. Jesmond’s year end is 30 June. • Draw up the lease liability table for Jesmond for the whole five-year period, identifying amounts for inclusion in the income statement of the year ended 30 June 20 X 1.

Q 5 - Example: Finance lease with payments in advance answer • • • Date Amount Interest Principal lease Expenses Obligation 1/7/20 X 0 11% $102, 500 1/7/20 X 0 $25000 (77, 500 -25, 000)*11% $25, 000 $77, 500 30/6/20 X 1 $25000 $8, 525 $16, 475 $61, 025 • 30/6/20 X 2 • • $25000 $6, 712. 7 $18, 287. 25 $42, 737. 7 30/6/20 X 3 $25000 $4, 701 $20, 298 $22, 438. 9 30/6/20 X 4 $25000 $2468. 28 $22, 531. 72 $ -93 Interest expenses : 8, 525 Amortization expenses: 20, 500

Q 6 - Example: Lessee disclosures • These disclosure requirements will be illustrated for Gordon Co (previous example). • We will assume that Gordon Co makes up its accounts to 31 December and uses the actuarial method, as shown in the example above, to apportion finance charges.

Q 6 - Example: Lessee disclosures answer • FP • PPE –Cost $38 • A. D. $7. 6 • N. B. V. $30. 4 Liability: Current liability $6. 856* Non-current liability $24. 906* Income statement: Finance cost $3. 762 *6. 856+24906=31762

Q 7 - Self-test question 1 • Potter leases an asset (as lessee) on 1 January 20 X 1, incurring $20, 000 of costs in setting up the agreement. Potter agrees to pay a non-refundable deposit of $58, 000 on inception together with six annual instalments of $160, 000, payable in arrears. • Potter also guaranteed to the lessor that the lessor would receive at least $80, 000 when the asset is sold in the general market at the end of the lease term. • The fair value of the asset (equivalent to the present value of minimum lease payments) on 1 January 20 X 1 is $800, 000. Its useful life to the company is five years. • The interest rate implicit in the lease has been calculated as 10 per cent. • Required • (a) Prepare the relevant extracts from the financial statements of Potter in respect of the above lease for the year ended 31 December 20 X 1. • (b) Explain what would happen at the end of the lease if the asset could be sold by the lessor: • (i) For $80, 000 (ii) For only $60, 000

• • • Q 7 - Self-test question 1 answer Date Amount Interest Principal lease Expenses Obligation 1/1/20 X 1 $742000 1/12/20 X 1 $160000 74200 $85800 $656200 31/12/20 X 2 $ 160000 $65620 $94380 $561820 • 31/12/20 X 3 $ 160000 $56182 $103818 $458002 • 31/12/20 X 4 $ 160000 $45801 $114200 $343802 • 31/12/20 X 5 $ 160000 $34381 $125620 $ 218182 • $160, 000 21, 818 $ 138, 182 $80, 000 • Interest expenses 74200 • Amortization expenses: 148, 000(800, 000+20, 000 -80, 000)/5

Q 8 - Example: Finance leases: lessor • Hire Co leased an assetaccounting to another company with effect from 1 January 20 X 8. The terms of the lease were as follows: - Lease term of eight years -Rentals of $11, 000 are payable in advance -The interest rate implicit in the lease is 12. 8 % • The fair value of the asset on 1 January 20 X 8 was $59, 500 and legal fees associated with the lease amounting to $500 were payable by Hire Co on this date. • What amounts are recognised in Hire Co's financial statements for the year ended 31 December 20 X 8 in respect of the lease?

Q 8 - Example: Finance leases: lessor accounting answer

Sales and Leaseback

Q 9 - Example: Sale and “finance” lease that transfers leaseback. Asubstantially Major part of economic life of asset all the risks and rewards of Ownership to the lease. • Osborne Co owned an asset with a carrying amount of $840, 000 on 1 March 20 X 8. On this date Osborne Co sold the asset to a bank for $1, 320, 000, being the present value of the minimum lease payments, and then undertook to lease it back under a 40 -year finance lease. • The annual rental is $39, 000 payable in advance. End of reporting period for Osborne Co is 28 February. • Required • How should the transaction be accounted for by Osborne Co?

Q 9 - Example: Sale and finance leaseback answer • • Dr. Cash 1, 320, 000 Cr. Asset 840, 000 Cr. Deferred income 480, 000 Dr. Asset 1, 320, 000 Cr Cash 1, 320, 000 Dr. Finance lease payable 39, 000 Cr Cash 39, 000 Dr. Deferred income 480, 000/40 yr • Cr income statement 480, 000/40 yr

Q 10 - Example: Sale & “operating” leaseback • On 1 January 20 X 2 Cable Co owned an asset with a carrying amount of $80, 000. The fair value of the asset on that date was $90, 000. • In order to improve its liquidity position, Cable Co has negotiated possible agreements to sell the asset and lease it back under an operating lease for seven years. The financial controller is assessing 4 agreements. • The agreements are as follows: • 1 - Sale for $90, 000 with annual future lease payments at a market rate of $15, 000 • 2 - Sale for $75, 000 with annual future lease payments of $15, 000 • 3 - Sale for $50, 000 with annual future lease payments of $10, 000 (x 15, 000) 4 -Sale for $110, 000 with annual future lease payments of $17, 500 • How would each of these agreements be accounted for in Cable Co's financial statements?

Q 10 - Example: Sale and operating leaseback answer • • • A) Dr. Cash 90, 000 Cr. NBV 80, 000 Cr 10, 000 –I/S B) Dr. Cash 75, 000 Cr. NBV 80, 000 Dr 5, 000 –I/S C) Dr. Cash 50, 000 Cr. NBV 80, 000 Dr Deferred expenses 30, 000 D) Dr. Cash 110, 000 Cr. NBV 80, 000 Cr 10, 000 –I/S Cr. Deferred income 20, 000

Q 11 - Past exam paper (HKICPA September 2008) • On 1 January 20 X 7, lessor, entered into a non-cancellable lease agreement for equipment with SRC, the lessee. • Annual lease payment due at the beginning of each year, beginning on 1 January 20 X 7 $53, 069 Option to purchase at the end of lease term $10, 000 • Lease term 5 years, economic useful life of leased equipment 8 years • Lessor's manufacturing cost $200, 000 • Fair value of leased equipment at 1 January 20 X 7 $227, 500 estimated unguaranteed residual value of leased equipment at the end of lease term $30, 000 • Lessor's implicit rate 12. 93%, Lessee's incremental borrowing rate 10% • (a) Discuss how the purchase option at the end of the lease term offered by TMI to SRC will affect the classification of this lease by SRC. • (b) Prepare an amortisation schedule that would be suitable for TMI for the lease term. • (c) Prepare all the journal entries that company should make for each of the years ended 31 December 20 X 7 and 20 X 8.

Q 11 - Past exam paper answer • Date • Amount Interest Principal lease Expenses Obligation $227, 500 • 1/1/20 X 7 $53069 $22, 554 $196, 985 • 1/1/20 X 8 $53069 $18, 608 $162, 524 • 1/1/20 X 9 $ 53069 $14, 153 $123, 608 • 1/1/2010 $53069 $9, 121 • 1/1/2011 $53069 $3, 438 $79, 660 $30, 029

• Dr. F. L. Receivable 227, 500 • Cr. Revenue 227, 500 • Dr. cost of sales 200, 000 • Cr. Inventory 200, 000 • Dr Cash 53, 069 • Cr. F. L. Receivable 53, 069 • Dr. F. L. Receivable 22, 554 • Cr. Interest income 22, 554