On 1/1/16, R-U Ready leased a car with a FMV of $45,000 for 5 years with...

On 1/1/16, R-U Ready leased a car with a FMV of $45,000 for 5 years with a commitment to make 5 annual payments of $8,000 with the first payment due immediately and the remaining payments due on 12/31 of each year. R-U ready’s incremental borrowing rate is 12%. The estimated life of the car is 10 years. The car ownership does not transfer to R-U Ready at the end of the lease and there is no bargain purchase option.

Requirement: Present the accounts and dollar amounts that would appear on comparative balance sheets and income statements for the years ending 12/31/16 and 12/31/15.

Solutions

Expert Solution

A lease is a legal agreement by which the owner of a asset (lessor) allows a party (lessee) to use the asset for a specific period in exchange for periodic payments to the lessor, called lease rentals.

An operating lease is very similar to an asset rental. It lets the lessee use the leased asset for a specific period of time, which is generally less compared to the asset’s useful life. It is mostly used to lease equipment for short terms. Operating lease does not come with the option to purchase the asset at the end of lease period. There is no bargain purchase option.

An operating lease represents an off-balance sheet financing of assets, where a leased asset and associated liabilities of future rent payments are not included on the balance sheet of a company.

Current GAAP rules require companies to treat leases as capital/finance leases if they meet certain conditions:

There is an ownership transfer to the lessee at the end of the lease.(In present case - Ownership is not transferred.)
The lease contains a bargain purchase option. (There is no Bargain Purchase Option in present case.)
The lease life exceeds 75% of the economic life of the asset. (In present case 7.5 years)
The present value of the lease payments exceeds 90% of the fair market value of the asset. (In present case 88.88%)

If none of these conditions are met, the lease must be classified as an operating lease. So the question is of operating lease.

Accounting Entries in case of Operating Lease:

Accounting by Lessee

Balance Sheet: No Recording of asset.

Income Statement: Asset (Lease) Rent Expense.

Accounting by Lessor

Balance Sheet: Leased asset.

Income Statement: Interest income and Depreciation.

IFRS 16 advises an approach to record lease liability on Present Value basis of all future lease rents and record similar asset as "right to use asset". The lease liability will be reduced and the right to use asset will be amortized over the year.

ekkarill92 answered 3 months ago

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