4. Lessee leases asset from Lessor. Fair market value of the asset currently is
ID: 2340863 • Letter: 4
Question
4. Lessee leases asset from Lessor. Fair market value of the asset currently is $500,000. Asset is new and has a remaining economic life of 10 years, Lease term is for 7 years, implicit rate on the lease is 12% and this rate is known by Lessee. Lessor believes asset will be worth $150,000 at end of lease term (i.e., residual value-150,000) and none of the residual value is guaranteed. Lease payments of 94,691 are made annually at year-end. Lease inception date is January 1. a. Assume cost of leased asset FMV of the asset at lease inception. Classify the lease, book the lease (both Lessee and Lessor entries), and prepare journal entry (both Lessee and Lessor entries) for the first lease payment due December 31. b. Assume Lessor's cost of lease asset 400,000. Classify the lease, book the lease (both Lessee and Lessor entries), and prepare journal entry (both Lessee and Lessor entries) for the first lease payment due December 31.Explanation / Answer
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Please see the below answer
Classification of Lease
A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership.
Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract.
Situations that individually or in combination would normally lead to a lease being classified as a finance lease are:
(a) the lease transfers ownership of the asset to the lessee by the end of the lease term;
(b) the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised;
(c) the lease term is for the major part of the economic life of the asset even if title is not transferred;
(d) at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset; and
(e) the leased assets are of such a specialized nature that only the lessee can use them without major modifications.
Ans A
Lease should be recorded as assets and liability at the inception of lease.
Liability for Lease as per IAS 19 should be recorded as, (a) or (b) whichever is lower;
Case A
(a)
Fair Value of Lease
$ 500,000
(b)
Present Value of MLP Leasee (refer below working)
$ 432,147
Lease Liability
$ 432,147
Working - Present Value of Lease
Implicit Interest Rates
12%
Case A
Fair value of Leased
$ 500,000
Year
Lease Payment
Discount Facttor @ 12%
Present Value of Lease rental
1
$ 94,691.00
0.8929
$ 84,546
2
$ 94,691.00
0.7972
$ 75,487
3
$ 94,691.00
0.7118
$ 67,399
4
$ 94,691.00
0.6355
$ 60,178
5
$ 94,691.00
0.5674
$ 53,730
6
$ 94,691.00
0.5066
$ 47,973
7
$ 94,691.00
0.4523
$ 42,833
Total
$ 662,837.00
$ 432,147
Gross Investment in Lease
Present Value of Lease Rental
Finance Charge/Unearned Finance income of lease (for leseee and lessor)
Classification under lease
From the above referenced lease classification criteria it can be said that the above lease if finance lease.
In the Books of Lessee (Entries)
Date
General Journal
Debit
Credit
Jan-01
Assets on Lease
$ 432,147
To , Lessor
$ 432,147
(Being assets taken on lease recognised at lower of fair value of assets or PV of MLP Lessee and recorded)
Dec-31
lease Rental A/c …..Dr
$ 42,833
Finance Charges ….Dr
$ 51,858
To Lessor
$ 94,691
(Being lease rental under finance lease is due to the lessor and hence recorded)
Dec-31
Lessor A/c….Dr
$ 94,691
To, Bank A/c
$ 94,691
`
(Being lease rental paid to lessor)
In the Books of Lessor
Working for present value of lease rental in the books of lessor.
Implicit Interest Rates
12%
Case A
Fair value of Leased
$ 500,000
Year
Lease Payment
Discount Facttor @ 12%
Present Value of Lease rental
1
$ 94,691.00
0.8929
$ 84,546
2
$ 94,691.00
0.7972
$ 75,487
3
$ 94,691.00
0.7118
$ 67,399
4
$ 94,691.00
0.6355
$ 60,178
5
$ 94,691.00
0.5674
$ 53,730
6
$ 94,691.00
0.5066
$ 47,973
7
$ 94,691.00
0.4523
$ 42,833
7
$ 150,000.00
0.4523
$ 67,852
Total
$ 812,837.00
$ 499,999
Gross Investment in Lease
Present Value of Lease Rental
Entries in the books of lessor
Jan-01
Lease Rental Receivable A/c…Dr
$ 499,999
To, Assets A/c
$ 499,999
(Being Assets sold on Lease & Lease Rental under finance lease recorded at lower of fair value of assets or PV of MLP Lessor and recorded)
Dec-31
Lessee A/c….Dr
$ 94,691
To, Finance Income
$ 60,000
To, Lease Rental Receivable A/c
$ 34,691
(Being Lease Rental due from te lessee reorded )
Dec-31
Bank A…Dr
$ 94,691
To, Lessee A/c
$ 94,691
(Being Lease Rental Received from the lessee and recorded into the books)
Part B
Refer to above working 1 and considering the FMV $ 4,00,000
Liability for Lease as per IAS 19 should be recorded as, (a) or (b) whichever is lower;
Case A
(a)
Fair Value of Lease
$ 400,000
(b)
Present Value of MLP Leasee
$ 432,147
Lease Liability
$ 400,000
In the Books of Lessee
In the above case since the PV of MLP is less than the FMV and hence Implicit rate is to be recalculated which comes to 14.5%
Jan-01
Assets on Lease
$ 400,000
To , Lessor
$ 400,000
(Being assets taken on lease recognised at lower of fair value of assets or PV of MLP Lessee and recorded)
Dec-31
lease Rental A/c …..Dr
$ 36,712
Finance Charges ….Dr
$ 57,979
To Lessor
$ 94,691
(Being lease rental under finance lease is due to the lessor and hence recorded)
Dec-31
Lessor A/c….Dr
$ 94,691
To, Bank A/c
$ 94,691
`
(Being lease rental paid to lessor)
In the Books of Lessor
Jan-01
Lease Rental Receivable A/c…Dr
$ 400,000
To, Assets A/c
$ 400,000
(Being Assets sold on Lease & Lease Rental under finance lease recorded at lower of fair value of assets or PV of MLP Lessor and recorded)
Dec-31
Lessee A/c….Dr
$ 94,691
To, Finance Income
$ 67,814
To, Lease Rental Receivable A/c
$ 26,877
(Being Lease Rental due from te lessee reorded )
Dec-31
Bank A…Dr
$ 94,691
To, Lessee A/c
$ 94,691
(Being Lease Rental Received from the lessee and recorded into the books)
Liability for Lease as per IAS 19 should be recorded as, (a) or (b) whichever is lower;
Case A
(a)
Fair Value of Lease
$ 500,000
(b)
Present Value of MLP Leasee (refer below working)
$ 432,147
Lease Liability
$ 432,147
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