Sunflower Ltd entered into a lease agreement with Olive Ltd on 1 January 2015. T

Question

Sunflower Ltd entered into a lease agreement with Olive Ltd on 1 January 2015. The following information is available: The leased asset was purchased by Olive Ltd for £200,000 on 1 January 2015. It has a useful economic life of 4 years. Sunflower Ltd pays Olive Ltd four annual installments of £60,000 each, payable at the beginning of each financial year, starting on 1 January 2015. The cost of capital for Sunflower Ltd is expected to be 5% per annum for the foreseeable future. The accounting year-end for Sunflower Ltd is 31 December. The company uses the sum of diaits method to account for finance charges from finance leases. Required a. Define what a finance lease is. State the factors for a lease to be classified as a finance lease in accordance with IAS 17- Leases (5 marks) b. Show how the above lease agreement should be accounted for, in accordance with IAS 17 - Leases, in the Income Statement for the year ended and the Statement of Financial Position of Sunflower Ltd as at 31 December 2015. gnore taxation and show your answers to the nearest £. (10 marks)

Explanation / Answer

a) Finance Lease : It is a lease which transfers substantially all of the benefits and risks & rewards inherent to ownership of the asset to the lessee. For classifying any lease as finance lease, we have to look for the substance of the transaction rather than its form. Criteria applied while classifying any lease as finance lease is:

i) Whether the ownership of the asset is being transferred to the lessee at the end of the lease tearm

ii) Whether the lessee has been given the option to purchase the leased asset at a price that is expected to be lower than the fair value at the date when the option is exercisable.

iii) Whether the lease term is for the major part of the economic ife of the asset.

iv) Whether at the inception of the lease the present value of the minimum lease payments is equal to substantially all of the fair value of the leased asset.

b) For Sunflower Ltd, in its income statement for 31 December 2015, interest expense of lease payments and Depreciation expense of the leased asset will be recognized. And, in the Statement of financial position as at 31 December 2015, an asset as well as a liability will be recognised.

Leased asset will be recognised at the Present value of minimum lease payments, calculated as below:

Present value of minimumlease payments = Present value of annuity due for 1 pound at 5% for 4 years * 60000

= 3.7232 * 60000 = 223392

Leased asset will be recognised at 223392 on 31 December 2015 in Statement of financial position.

For Depreciation expense, calculation under sum of the years' digits method;

Sum of the years digit for 4 years = 1+ 2+3+4 = 10 .

Total amount to be depreciated = 223392

Depreciation on 31 December 2015 (1st year of depreciation) = 223392*4/10 = 89357

In income statement Depreciaton expense will be recognized at 89357.

For interest expense accrual: interest expense on 31st December 2015:

Interest Expense = Interest will be calculated on the amount left after the first lease payment in the beginning

= 5% of (Carrying amount of lease obligation at the beginning - Lease instalment payment on January 1 2015)

= 5% * (223392-60000) = 5% * 163392 = 8170

Interest expense of 8170 will be recognized in income statement on 31 December 2015

Calculation of lease liability/ obligation on 31 December 2015

Carrying amount of lease obligation on 31 Decemeber 2015 = Carrying amount of lease in the beginning - lease instalment payment on 1 January 2015

= 223392-60000 = 163392

Also, an amount of 8170 will be recognized as interest payable in the liabilities section of Statement of financial position.

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