Question

On 1 April 2007, Fino increased the operating capacity of its plant. Due to a lack of liquid funds it was unable to buy the required plant which had a cost of $350,000. On the recommendation of the finance director, Fino entered into an agreement to lease the plant from the manufacturer. The lease required four annual payments in advance of $100,000 each commencing on 1 April 2007. The plant would have a useful life of four years and would be scrapped at the end of this period. The finance director, believing the lease to be an operating lease, commented that the agreement would improve the company’s return on capital employed (compared to outright purchase of the plant).

Required:

(i) Discuss the validity of the finance director’s comment and describe how IAS 17 Leases ensures that leases such as the above are faithfully represented in an entity’s financial statements.

(ii) Prepare extracts of Fino’s income statement and balance sheet for the year ended 30 September 2007 in respect of the rental agreement assuming:

(1) It is an operating lease

(2) It is a finance lease (use an implicit interest rate of 10% per annum).

Answer 1

Fino
Let us find the PV of the minimum lease payments to find
if the Lease is operating of financial lease.
Implict interest rate is 10%
PV annuity factor for 3 years @10%=(1-1.10^-3)/10%=	2.48685
Let us find the PV of Min lease payments as on Apr 1,2017

Cash flow	Amt $	PV annuity factor	PV of Cash flow
Lease payment on Apr 1,2017	$         100,000.00	1	$             100,000.00
Lease payments on three years Apr 1, 2018/2019/2020	$         100,000.00	2.48685	$             248,685.20
Total PV of Lease Payments			$             348,685.20

PV of Lease Payment s as on Apr 1,2017	$         348,685.20
Fair Value of Asset as on Apr 1,2017	$         350,000.00
So PV of Lease value/Fair value of asset=	99.6%
Useful life of Asset in years	4
Lease tenure with Fino in years.	4

If we consider IAS 17 conditions,
The PV of minimum lease payments is substantially equal
to the fair value of the asset, and the lease covers the full
useful life of the asset.
Therefore this lease will be treated as Financial lease, not
operating leaase.
Therefore, the Finance Director's comment is not valid
in this aspect.	Ans i.

Ans ii.
Value of Right to use asset	$         348,685.20
No of years of useful life	4
Salvage value	0
Annual depreciation	$            87,171.30
Depreciation expense for 6 months in 2017=	$            43,585.65

1. Considering Operating Lease.
Fino
Income Statement extract
for the year ending Sep 30,2017.
Particulars	Amt $
Operating Expense
Lease Rental Expense	100,000

Fino
Balance Sheet Extract
As on Sep 30,2017
Particulars	Amt $
Cash	(100,000)
Total Assets	(100,000)
No Impact on Liability
Shareholders' Equity
Retained Earning	(100,000)
Total Liabilities & Shareholders'Equity	(100,000)

2. Considering Financial Lease

Fino
Income Statement extract
for the year ending Sep 30,2017.
Particulars	Amt $
Depreciation expense	$            43,585.65

Fino
Balance Sheet Extract
Particulars	Amt $
Cash	$        (100,000.00)
Right to Use Asset	$         348,685.20
Accumulated Depreciation	$          (43,585.65)
Total Assets	$        205,099.55
Lease Liability =	$         248,685.20
Shareholders' Equity
Retained Earning	(43,585.65)
Total Liabilities & Shareholders'Equity	$        205,099.55

As lease payment in 2017 has been made at the start of the lease, full lease payment will be

set off against lease liability.