Question

Max Ltd is involved in furniture business and runs furniture stores successfully in Victoria. Due to the detrimental impact of Covid 19 sales began to drop sharply and company is facing a severe liquidity problems. Management consultant, who advices the company on business matters, proposed them to sell off all shops owned by them and leased out shop to ease off the liquidity issue and run the business profitability. The chairman of Max Ltd is keen on the plan but is puzzled by the consultant’s insistence that all lease agreements for the shops be ‘operating’ rather than ‘finance’ leases.

Meantime, Johnson Ltd agreed to lease 5 shops to Max ltd under the following conditions.

The lease agreements details are as follows:

Length of lease	10 Years
Commencement date	1 July 2020
Annual lease payment, payable 1 July each year commencing 1 July 2020($100000*5)	$500000
Estimated economic life of the building	10 Years
Annual interest rate implicit in the lease	10%

Chairman of the board directed company accountant to submit a detailed report on the above project.

Required:

1. Explain the difference between a finance lease and an operating lease.
2. Show how to record the lease of the buildings in the books of the Max Ltd in accordance with AASB16 as at 30 June 2021.

Answer 1

a. Difference between Finance lease and Operating lease

Finance lease:

A lease agreement shall be treated as finance lease if any of the following conditions are fulfilled

1. Significant economic life is covered by lease term

2. Asset is subject to buy out at the end of the lease

3. The lease payments cover significant value of the asset

In such cases, the lessee should recognize the leased asset and lease liability in it’s books. And he shall be eligible for depreciation for the lease asset and shall simultaneously charge interest expense on the lease liability, which is nothing but the present value of the minimum lease payments and payments should be reduced from the lease liability

Operating lease:

A lease agreement which is not a finance lease is called operating lease. Here the lessee shall recognize the rental expense over the term of the lease as agreed. There is no other impact apart from this.

b. Max ltd has taken the lease of 5 shops for 10 years

Lease term 10 years

Commencement July 01, 2020

Annual lease payments $500000 ($100000 per shop per year for 10 years)            

Annual interest rate is 10%

Initial recognition on july 01, 2020:

Leased asset and lease liability at Present value of annual lease payments

Years	Lease payments	Present value factor @10%	Present value
1	500000	1	5,00,000.00
2	500000	0.909090909	4,54,545.45
3	500000	0.826446281	4,13,223.14
4	500000	0.751314801	3,75,657.40
5	500000	0.683013455	3,41,506.73
6	500000	0.620921323	3,10,460.66
7	500000	0.56447393	2,82,236.97
8	500000	0.513158118	2,56,579.06
9	500000	0.46650738	2,33,253.69
10	500000	0.424097618	2,12,048.81
			33,79,511.91

                               

Leased asset and lease liability will be recognised at $33,79,512.

Effect during July, 2020 to June 2021:

Depreciation of lease asset = 33,79,512/10 = 3,37,951

Interest on lease liability = (33,79,512-500000) *10% = 287,951

Lease payment = 500000

Lease asset and lease liability as on June 30, 2021:

Leased asset:

                Leased asset as on July 01, 2020 =$33,79,512

                Depreciation during the period = ($3,37,951)

                Leased asset as on June, 30 2021 = $30,41,561

Lease liability:

                Lease liability as on July 01,2020 = $ 33,79,512

                Interest on lease liability               = $ 287,951

                Lease payment made                    = ($ 500000)