Lessee Ltd., a British company that applies IFRSs, leased equipment from Lessor Inc. on January 1, 2013, for a period of three years. Lease payments of $100,000 are due to Lessor Inc. each year. Ot

Lessee Ltd., a British company that applies IFRSs, leased equipment from Lessor Inc. on

January 1, 2013, for a period of three years. Lease payments of $100,000 are due to

Lessor Inc. each year. Other expenses (e.g., insurance, taxes, maintenance) are also to be

paid by Lessee Ltd. and amount to $2,000 per year. The lessor did not incur any initial

direct costs. The lease contains no purchase or renewal options and the equipment reverts

back to Lessor Inc. on the expiration of the lease.

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Lessee Ltd., a British company that applies IFRSs, leased equipment from Lessor Inc. on
January 1, 2013, for a period of three years.
Lease payments of $100,000 are due to
Lessor Inc. each year. Other expenses (e.g., insurance, taxes, maintenance) are also to be
paid by Lessee Ltd. and amount to $2,000 per year. The lessor did not incur any initial
direct costs.
The lease contains no purchase or renewal options and the equipment reverts
back to Lessor Inc. on the expiration of the lease.
The remaining useful life of the
equipment is four years. The fair value of the equipment at lease inception is $265,000.
Lessee Ltd. has guaranteed $20,000 as the residual value at the end of the lease term.
The $20,000 represents the expected value of the leased equipment to the lessee at the end of
the lease term.
The salvage value of the equipment is expected to be $2,000 after the end of its
economic life. The lessee’s incremental borrowing rate is 11 percent (Lessor’s implicit rate is 10
percent and is calculable by the lessee from the lease agreement).
The junior accountant of
Lessee Ltd. analyzed the assets under lease, determined whether the lease was an operating lease
or
capital lease, and prepared the applicable Journal entries The senior accountant of Lessee Ltd.
reviewed
the junior accountant’s analysis and prepared a separate analysis. As the finance controller, you
were
given both analysis to determine the correct accounting treatment. Calculations and journal
entries
performed by your junior and senior accountant are below.
Present Value of the Lease Obligation
Using the rate implicit in the lease(10 percent), the present value of the guaranteed
residual value would be $15,026 ($20,000 × 0.7513), and the present value of the annual
payments would be $248,690 ($100,000 × 2.4869).
Using the incremental borrowing rate(11 percent), the present value of the guaranteed residual
value
would be $14,624($20,000 × 0.7312), and the present value of the annual payments would be
$244,370
($100,000 × 2.4437)
Junior accountant analysis: Since the equipment reverts back to Lessor Inc., it is an operating
lease.
Entries to be posted in Years 1, 2, and 3:
Dr. Lease expense
$100,000
Dr. Insurance expense
$2,000
Cr. Cash
$102,000
(Operating lease rental paid to Lessor Inc.)
Senior accountant analysis:
Step 1
Lease classification
The lease term is for three years. The useful life of the equipment is four years. Since the
lease term is for a major part of the useful life of the equipment, it is a finance lease.
Step 2
Computation of the lease asset and obligation since the lessee’s incremental borrowing rate is
greater

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than the lessor’s implicit rate in the lease, compute the present value of the minimum lease
payments
using the 11 percent rate.
Present value of the minimum lease payments = $100,000 × 2.4437= $244,370.
Step 3
Allocation of payments between interest and lease obligation since interest has to be charged on
The straight – line method, the following is the allocation of the interest and the reduction in the
lease
Liability.
Years
Cash Payment
Interest Expense 11%
Reduction in
Balance of
Lease Obligation
Lease Obligation
0
244,370
1
100,000
26,881
73,119
171,251
2
100,000
26,881
73,119
98,131
3
100,000
26,881
73,119
25,012
Journal entry in Year 1 to record the payments:
Dr. Rent expense
$2,000
Dr. Interest expense
$26,881
Dr. Lease obligation
$73,119
Cr. Cash
$102,000
Required:
1.
Was the junior accountant’s analysis correct? Why or why not?
2.
Was the senior accountant’s analysis correct? Why or why not?
3. How would the answer differ under U.S. GAAP?

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