Question

JK Ltd enters into a non-cancellable five-year lease agreement with Burt Ltd on 1 July
2019.

The lease is for an item of machinery that, at the inception of the lease, has a fair value of
$647,192. The machinery is expected to have an economic life of six years, after which time
it will have an expected residual value of $105,000. There is a bargain purchase option that
JK Ltd will be able to exercise at the end of the fifth year for $140,000. There are to be five
annual payments of $175,000, the first being made on 30 June 2020. Included with $175,000
lease payments is an amount of $17,500 representing payment to the lessor for the insurance
maintenance of the equipment. The equipment is to be depreciated on a straight-line basis.

a. Determine the rate of interest implicit in the lease and calculate the present value of
the lease payments.
b. Prepare the journal entries in the books of JK Ltd for the years ending 30 June 2020
and 30 June 2021.
c. Prepare the portion of the statement of financial position for the year ending 30
June 2021 relating to the lease asset and lease liability.

Answer 1

Lease payment excluding insurance and maintenance expense = 175000 - 17500 = $ 157,500

Fair Value of Asset = $ 647,192

Lease period = 5 years

Purchase option at the end of 5 years (Unguaranteed residual value) = $ 140,000

Useful life = 6 years

Residual price at the end of 6 years = $ 105,000

(a)

The implicit rate of return is where the present value of future lease payments and ungauranteed residual value equals the fair value of the asset. We use trial method to find Present Value of Cashflows using different rates as follows:

Year	Cashflow (a)	PVIF @ 11% (b)	Present Value (a x b)	PVIF @ 12% ( c)	Present Value (a x c)
1	157500	0.900900901	141891.8919	0.892857143	140625
2	157500	0.811622433	127830.5332	0.797193878	125558.0357
3	157500	0.731191381	115162.6426	0.711780248	112105.389
4	157500	0.658730974	103750.1284	0.635518078	100094.0973
5	157500	0.593451328	93468.58417	0.567426856	89369.72978
5 (Residual Value)	140000	0.593451328	83083.18593	0.567426856	79439.7598
		Total	665186.9662	Total	647192.0117

From the above calculation we find the the implicit rate of return where the present value of future cashflows equals the fair value if asset is 12 %. Thus the Implicit rate of return on lease is 12 %.

(b)

The Lease amortization schedule for JK Ltd. is as given below:

Year	Opening Balance (a)	Lease Payment (b)	Interest @ 12 % (c = a x 12%)	Principal Paid (d = b - c)	Closing Balance (e = a - d)
2020	647192	157500	77663	79837	567355
2021	567355	157500	68083	89417	477938
2022	477938	157500	57353	100147	377790
2023	377790	157500	45335	112165	265625
2024	265625	157500	31875	125625	140000

Journal Entries in the nooks of JK Ltd.

For year ending 30 June 2020:

Right to use Asset account Dr.	647192
Lease Liability		647192
Lease Liability Dr.	79837
Interest Expense Dr.	77663
Maintenance Expense Dr.	17500
Bank Account		175000
Depreciation Account Dr.	129438.4
To Accumulated Depreciation		129438.4

For the year ending 30 June 2021:

Lease Liability Dr.	89417
Interest Expense Dr.	68083
Maintenance Expense Dr.	17500
Bank Account		175000
Depreciation Account Dr.	129438.4
To Accumulated Depreciation		129438.4

(c) Proportion of Statement of Financial Position for year ending 30 June 2021 relating to lease asset and lease liability:

Particulars	Amount	Amount
Non-Current Liabilities
Lease Liability		$ 477,937.64
Non-Current Assets
Tangible Assets
Right to use Asset
Value	$ 647,192.00
Less: Accumulated Depreciation	$ 258,876.80	$ 388,315.20