Question

On 1 April 2019, Brilliant Ltd leased an equipment to Smart Ltd. The lease agreement is non-cancellable with a lease term of three years. The equipment is expected to have an economic life of five years, after which time it will have an expected salvage value of $30,000. There are to be three annual payments of $125,000, the first to be made on 31 March 2020 (i.e. at the end of the year).
Included in the $125,000 is $5,000 representing payment for insurance and maintenance. The interest rate implicit in the lease is 3%. The fair value of the equipment at the inception of the lease is $339,433.  Smart Ltd intends to return the equipment to Brilliant Ltd at the end of the lease term. Assume straight line depreciation is used for depreciation of the leased equipment.
a) If Smart Ltd decides to take over the ownership of the leased equipment at the end of the lease term, explain the effect of this arrangement on the net profit of Smart Ltd, in comparison to the arrangement in which the leased asset is returned to Brilliant Ltd.

Answer 1

If the ownership is transferred to Smart Ltd at the end of the lease term:

Smart Ltd. will consider the asset in the balance sheet as the ownership rights will be transferred. The lease is said to be as loan. So, it will expense the interest on the lease liability, depreciation on the value recorded in the balance sheet and the insurance and maintenance expenditure. The portion paid for the installment or lease liability will be treated as the cash outflow for the financing activity. The net profit of the company will be higher as compared to other arrangement.

Depreciation = (Net Capitalized cost - Residual Value)/ Term of lease

= (339,433 - 30,000)/ 5 = $61,886.60 per year

Financing cost = (Net Capitalized cost + Residual Value)* Money Factor

Money factor = Interest rate/ 24 = 3%/24 = 0.00125

Therefore, financing cost = (339,433 + 30,000)*0.00125 = $461.80

Total expenses per year will be Depreciation + Financing cost + insurance and maintenance

= $61,886.60 + $461.80 + $5,000

= $67,348.40

If the ownership is not transferred to Smart Ltd at the end of the lease term:

Smart Ltd. will not record the asset in the balance sheet. The lease is said to be as paying the rent for the use of the asset. So, it will expense the lease liability as rent in the income statement, interest on lease liability and the insurance and maintenance expenditure. This will reduce the net profit of the company as all the payments are considered as expense under the income statement.

Toatl expenses will be lease payment i.e. $125,000

which includes lease liability, interest expense and insurance and maintenance.