Question

On 1 July 2019, Fisher Ltd decides to lease a cargo ship from XFinance Ltd. The term of the lease is 20 years. The implicit interest rate in the lease is 10 per cent. The fair value of the cargo ship at the commencement of the lease is $2,215,560. The lease is non-cancellable, and requires a lease payment of $300,000 on inception of the lease (on 1 July 2019) and lease payments of $250,000 on 30 June each year (starting 30 June 2020). Included within the $250,000 lease payments is an amount of $25,000 representing payment to the lessor for the insurance and maintenance of the cargo ship. There is no residual payment required. Annuity factor, n=20; r = 10% is 8.5136. Required: a) Prove that the interest rate implicit in the lease is 10 per cent. b) Provide the entries for the lease in the books of Fisher Ltd as at 1 July 2019, and 30 June 2020. c) Provide the entries for the lease in the books of X Finance Ltd as at 1 July 2019, and 30 June 2020.

Answer 1

On 1 July 2019, Fisher Ltd decides to lease a cargo ship from XFinance Ltd.

The term of the lease is 20 years.

The implicit interest rate in the lease is 10 per cent.

The fair value of the cargo ship at the commencement of the lease is $2,215,560.

The lease is non-cancellable

, and requires a lease payment of $300,000 on inception of the lease (on 1 July 2019)

lease payments of $250,000 on 30 June each year (starting 30 June 2020). Included within the $250,000 lease payments is an amount of $25,000 representing payment to the lessor for the insurance and maintenance of the cargo ship.

Annuity factor, n=20; r = 10% is 8.5136

a) Prove that the interest rate implicit in the lease is 10 per cent.

We can prove it through calculating the Present value of lease payment, and just verify it is equal or not to fair value of the lease at commencement date

The fair value of the cargo ship at the commencement of the lease is $2,215,560.

PV of lease payment = 300000 + 225000 * ( 1 + 20%)20GT

Only take yearly lease payment as 225000 ( 250000 - 25,000 representing payment to the lessor for the insurance and maintenance of the cargo ship.)

( 1 + 20%)20GT  = Annuity factor, n=20; r = 10% is 8.5136 (already given )

PV of lease payment = 300000 + 225000 * 8.5136

PV of lease payment = 300000 + 1915560 = 2215560

Here you can see that

PV of lease payment = The fair value of the cargo ship at the commencement of the lease = $ 2215560

*The lessee’s implicit interest rate is the rate of interest the lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.

**the $25,000 representing payment to the lessor for the insurance and maintenance of the cargo ship is not included in the calculation. It is an expenses of the lessee like maintenance cost and insurance cost etc..

b) Provide the entries for the lease in the books of Fisher Ltd as at 1 July 2019, and 30 June 2020

It is the finance lease

A finance lease results in recognition of both an asset and a liability in the books of the lessee at the inception of the lease at amount equal to present value of lease payments.

Journal entry on 1st July 2019

Dr Leased asset	$2215560
Cr Lease liability		$2215560

Entry for lease payment $ 300000 beginning of the year

Dr Lease liability	$300000
Cr cash		$300000

Entry on 30th june 2020

:

	Dr Lease liability	$202500
	Dr interest 22500 * 10%	$ 22500
			$225000

And also record depreciation expense on leased asset on usual way at the end of period

c) Provide the entries for the lease in the books of X Finance Ltd as at 1 July 2019, and 30 June 2020.

journal entry on 1st july 2019

Dr Leased receivable	$2215560
Cr Asset		$2215560

Journal entry when the time of first payment of $300000

Dr Cash	$300000
Cr Leased receivable		$300000

journal entry on 30th  June 2020

Dr Cash	$225000
Cr Lease receivable		$202500
Cr finance income		$ 22500