Question

The following information as at the year-end date is extracted from the Freddy Corporation's financial statements:
		December 31
	2019 ($)	2018 ($)
Cash	95,000	27,000
Accounts receivable	92,000	80,000
Allowance for doubtful accounts	(4,500)	(3,100)
Inventory	155,000	175,000
Prepaid expenses	7,500	6,800
Land	90,000	60,000
Buildings	287,000	244,000
Buildings - Accumulated depreciation	(32,000)	(13,000)
Machinery	50,000	60,000
Machinery- Accumulated depreciation	(30,000)	(25,000)
Leased equipment*	28,594	-
Leased equipment - Accumulated depreciation	(9,531)	-
	729,063	611,700
Accounts payable	90,000	84,000
Accrued liabilities	54,000	63,000
Lease payable	18,594	-
Interest payable	930	-
Bonds payable	125,000	60,000
Share capital-ordinary	100,000	92,000
Retained earnings	340,539	312,700
	729,063	611,700
For the	year 2019
Net income	$47,839
Depreciation expense - Buildings	19,000
Depreciation expense - Machinery	5,000
Depreciation expense - Leased equipment	9,531
Cash dividends declared and paid	20,000
Gain or loss on sale of Machinery	None

Additional information:

* On 1 January 2019, Freddy leased an equipment, with an economic useful life of ten years, from Flower Company for three years. The present value of the minimum lease payment and the fair value of the leased equipment were $28,594 and $95,313 respectively. Annual lease payment of $10,000 has to be made at the beginning of each period. The lease agreement offers Freddy an option of purchasing the leased equipment at $1 at the end of the lease period.

Required:

1. With reference to each of the five classification criteria, discuss why the leased equipment should be classified as the “finance lease”, instead of the “operating lease”, in the books of Freddy. [within 200 words]
2. Prepare a Statement of Cash Flows for the year ended 31 December 2019 for Freddy Corporation using the indirect method (assuming dividends and interest paid are classified as financing activities).
3. Goods, which costs $1,500, were not included in the physical count of inventory by Freddy. They were shipped from a supplier FOB shipping point on 29 December 2019, and did not arrive until 3 January 2020. Assuming that the purchase was properly recorded while the omission of the inventory could only be discovered after the 2019 financial statements were issued,
   1. analyze the effect (over/understate) of this omission on 2019 costs of goods sold, net income and retained earnings, and
   2. prepare the adjusting entries accordingly.

Answer 1

(a).Situations which individually or in combination would normally lead to financial lease:-

1.The lease transfers ownership of asset to leassee by the end of lease term:-Since the lease agreement offers feddys an option of purchasing the leased equipment at end of lease term.

So this criteria is satisfied.

2.The lessee has the option to purchase the asset at a price which is sufficiently lower than fair price at the date of exercising option:-Because lease agreement provide option to purchase at $1 which is expected to be sufficiently lower that the fair value.

So this criteria is satisfied.

3.The lease term is for major part of the economic life of the asset even of title not transfered:- In this lease term is for 3 years and economic life is 10 years.So it does not cover major part of economic life of asset.

So this criteria is not satisfied.

4.At inception present value of miniumum lease payment is substantially equal to fair value of asset:- In this fair value is $95313 which is not substantially equal to present value of minimum lease payment $28594.

So this criteria is not satisfied.

5.The leased asset is of a specialised nature that only lease can use it.since not any information regarding this it is assume that this criteria is not met or asset is not of specialsed nature.

CONCLUSION:-Because the lease agreement is met two out of five criteria of classfication of finance lease.It should be classified as financial lease and not operating lease because satisfaction of any of the above 5 conditions leads to classified as financial lease.(INDIVIDUALLY OR IN COMBINATION)

(b).Cash Flow Statement of Freddy Corporation's for the year ended December 31,2019(Indirect Method)

particulars	$	$
Cash flows from operating activities:- Net Income Add:- Reversal of effect of retained earnings Adjustments for:- Depreciation(5000+19000+9531) Dividend Changes in working capital (excluding cash and bank balnce) Increase in accounts receivable Increase in prepaid expenses Decrease in accrued liabilities Decrease in inventory Net cash flow from operating activities Cash Flow from investing activities:- Proceeds from sale of machinery Purchase of land Purchase of Building Purchase of Leased Eqipment Cash Flow from financing activities:- Proceeds from Issue of share capital Proceeds from Bond payable Payment of Dividend	47839 27839 75678 33531 20000 129209 -10600 -900 -9000 20000 5000 -30000 -25000 -19063 80000 65000 -20000	128709