Question

Lease

PP LLC leased equipment with fair value of the vehicle was 140,000 USD. The lease agreement contained the following:

Lease term	4 years
Annual payment, payable in advance on 30 June each year	40,000 USD
Economic life of vehicle	5 years
Estimated residual value at the end of lease term	8,000 USD

The lease is cancellable, but cancellation will incur a monetary penalty equivalent to 2 years of rental payments.

The lessor incurred 1,500 USD to initiate the lease to PP LLC.

Included in the annual payment is an amount of 2,500 USD to cover reimbursement for the costs of insurance and maintenance paid by the lessor.

PP LLC has no intention to keep the property at the end of the lease term and guaranteed to return the property with residual value of $7,500.

Required:

1. Determine whether the lease is an operating or finance lease per IAS 17.

2. Calculate value at initial recognition for both lessor and lessee and show related journal entries.

Answer 1

1. Determination of type of lease:

As per IAS 17,

Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form. Situations that would normally lead to a lease being classified as a finance lease include the following:

• the lease transfers ownership of the asset to the lessee by the end of the lease term - In this case PP LLC has no intention to keep the property at the end of the lease term, hence not met.
• the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that the option will be exercised - no such information is being provided in the question
• the lease term is for the major part of the economic life of the asset, even if title is not transferred - lease term is 4 years whereas economic life of the asset is 5 years therefore it can be said that the lease term is for the major part of the economic life of vehicle.
• at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset - Total of lease rentals (before discounting) comes to $ 160,000 whereas the fair market value of vehicle is $140,000/. therefore, it seems that it will meet this condition.
• the lease assets are of a specialised nature such that only the lessee can use them without major modifications being made - no specialised nature

Other situations that might also lead to classification as a finance lease are:

• if the lessee is entitled to cancel the lease, the lessor's losses associated with the cancellation are borne by the lessee - in this case, penalty on lessee is equivalent to 2 years of rental payments therefore it doesn't look to be easily cancellable.

Considering the above analysis of finance lease conditions, the lease is a finance lease (as most of the conditions are being met).

2. Value at initial recognition for lessor and lessee:

FACTS Lease a vehicle worth 140,000 Lease term             4 yrs Annual payment     40,001 Estimated life of a computer             5 yrs Effective borrowing rate 5.57% assumed PRESENT VALUE OF PAYMENTS $140,000 ANNUAL DEPRECIATION $28,000 CAPITAL LEASE OPENING YEAR ONE YEAR TWO YEAR THREE YEAR FOUR Equipment 140,000      Cap lease obligation 140,000      Cash 40,001 40,001 40,001 Interest expense       7,791    5,999    4,106    2,109 Capital lease obligation     32,210 34,003 35,895 (2,109) Depreciation expense     35,000 35,000 35,000 35,000      Accumulated depreciation 35,000 35,000 35,000 35,000
For lessor the entry will be: Lease receivable a/c Debit 140,000 To asset a/c Credit 140,000