Lessee Ltd., a British company operating under IFRS, leased equipment from Lessor Inc. for a period of three years. Lease payments of $100,000 are paid annually by Lessee Ltd., as well as $2,000 of other expenses including insurance, taxes and maintenance. The lessee’s incremental borrowing rate is listed at 11%, and the lessor’s implicit rate is calculated at 10%. The equipment reverts back to the lessor at the termination of the lease. The equipment has a 4-year useful life and a fair value of $265,000. Additionally, the guaranteed residual value of the equipment is $20,000 and the expected salvage value is $2,000.
Issue #1: How should Lessee Ltd.’s Lease Be Classified?
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6% Lease Payments Are “Substantially All” of the Fair Value of the Asset
Thus, the combination of the two statements defines this lease as a finance lease. The junior accountant’s analysis is void because the lease is not an operating lease. Additionally, the senior accountant’s classification of the lease is correct based off of his conclusion using IAS 17.10.c in step one and further conclusion using 17.10.d.
Issue #2: How should the present value of minimum lease payments be calculated for a finance lease?
Although the senior accountant was correct in classifying the lease as a finance lease, the rate and present value total used was incorrect. International Accounting Standard 17.20 quotes,
Lessees shall recognize finance leases as assets and liabilities in their statements of financial position at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum lease payments… The discount rate to be used in calculating the present value of the minimum lease payments is the interest rate implicit in the lease, if this is practicable to determine.
Since the present value of the minimum lease payment is lower than the fair value of the leased property, the lease recognizes assets and liabilities using the lease payments. Additionally, the rate implicit in the lease (10%) is used to calculate the present value of the guaranteed residual. Therefore, the senior accountant’s step two computation is incorrect. The correct treatment of the present value of the minimum lease payments should use the implicit rate and should include the guaranteed residual value bringing the total value of minimum lease payments to $263,896.
Issue #3: How should payments between interest and lease obligations be allocated?
Under International Accounting Standard 17.25 the finance charge should be allocated to produce a “constant periodic rate of interest” on the remaining balance of liability. The interest rate used in step three of the senior accountant’s analysis is inconsistent, and the rate is incorrect. The chart below shows the correct computations when applying a constant periodic rate at 10% interest:
Year | Cash Payment | Interest Expense (10%) | Reduction in Lease Obligation | Balance of Lease Obligation | Computation |
0 | | | | 263,896 | |
1 | 100,000 | 26,390 | 73,610 | 190,286 | 26,390 / 263,896 = 10% |
2 | 100,000 | 19,029 | 80,971 | 109,315 | 19,029 / 190,286 = 10% |
3 | 100,000 | 10,932 | 89,069 | 20,246 | 10,932 / 109,315 = 10% |
After applying a constant rate, the journal entry accounts used by the senior accountant are correct, but the amounts for interest expense and the amount for lease obligation should be updated to reflected the amounts above. The total debits and credits would still amount to $102,000. In review, the senior accountant’s classification as a finance lease...