Dalarite stheet at December 3l01B7 P2115 Lo2a fFinance and O

Dalarite stheet at December 3l,01B7 P21-15 Lo2.a) fFinance and Oerating Lease) Anthony Iincorporated leases a piece of machinery to Irving Company on r f machinery to rving Compary on January 1, 2017, under the following terms. 1. The lease is to be for 4 years with rental payments of $12471 to be made at the beginning of each year 2. The machinery\' has a fair value of $67,000, a book value of $50,000, and an econqmic life of 10 yea 3. At the end of the lease term, both parties expect the machinery to have a residdal value of $25,000. To protect against a large loss, Anthony requests Irving to guarantee $17,500 of the residual value, which Irving agrees to do. 4. The lease does not transfer ownership at the end of the lease term, does not have any bargain purchase options, and the asset is not of a specialized nature. 5. The implicit rate is 5%, which is known by Irving. 6. Collectibility of the payments is probable. Instructions (a) Evaluate the criteria for classification of the lease, and describe the nature of the lease. (b) Prepare the journal entries for Irving for the year 2017. (c) Prepare the journal entries for Anthony for the year 2017. (d) Suppose Irving did not guara ntee any amount of the expected residual value. How would your answers to parts (a) () change?

Solution

a) Leases is a contract by which one party conveys land, property, services, etc. to another for a specified time, usually in return for a periodic payment. Lease is of 2 types:

1. Operating Lease

2. Financial Lease

Financial Lease is offered to corporate customers to own and use assets such as vehicle, machinery, or other equipment (except land or houses) to expand their business for long-term financing periods without investing their own capital. You can purchase the identified asset and become its legal owner and pay monthly fees to the bank or pay at an agreed period of time.

Operating lease is a lease which is not a Financial Lease.

As per para 8 of AS 19, classification of lease into financial lease or an operating lease depends on the substance of the transaction rather than its form. Three situations which would normally lead to a lease being classified as financial lease are:

(i) the lessor transfers ownership of the asset to the lessee by the end of the lease term

(ii) the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than the fair value at the date of the option becomes exercisable such that, at the inception of the lease, it is reasonably certain that the option will be exercised,

(iii) the lease term is for the major part of the economic life of the asset even if the title is not transferred.

Since, the lease does not transfer ownership at the end of the lease term and also the aaset is not of a specialised nature and neither the lessee has the option to purchase it nor the lease term covers the major part of the economic life of the asset. The present value of lease payment is 66% ( P. V. of total minimum lease rentals is $ 44222.166 using the implicit rate i.e. 5% which 66% of the fair value i.e. $ 67000) of the fair value of the asset (less than the generally accepted threshold of 90%)

Therefore, this lease is \"OPERATING LEASE\"

b) In the Books of Irving Company

Journal Entries:

1) At the beginning of Year 1:

2) At the beginning of Year 2:

3) At the beginning of Year 3:

4) At the beginning of Year 4:

c) In the Books of Anthony Incorporated

Journal Entries:

1) At the beginning of Year 1:

2) At the beginning of Year 2:

3) At the beginning of Year 3:

4) At the beginning of Year 4:

d) If Irving did not guarantee any amount of the expected residual value then, answers to parts (a)-(c) will remain the same because in operating lease the accounting treatment is just that Lease payments (excluding costs for services such as insurance and maintenance) are recognized as an expense in the statement of profit or loss on a straight-line basis unless another systematic basis is more appropriate.

Thank you

Lease rental expense	12,471
Bank		12,471