Question

(a)Lucky Limited purchased two pieces of equipment from Great Machinery and leased them to Forever Company. The details of the lease agreement are shown as below:

Equipment A: The lease was entered on 1 January 2017 for a four-year period. The rental was $6,505 per quarter payable at the end of each quarter(31 March, 30 June, 30 September, and 31 December). The equpment was brand new at the inception of the lease and the remaining useful life at the date of the agreement was seven years The fair value of the asset at the date of the contract was $70, 500. The implicit interest rate was 20%.

Equipment B: The lease was entered on 1 January 2017 for a six-year period. The rental was $6,300 per year payable at the begining of each year. The remaining useful life of he equipment is estimated to be seven years. The fair value of the asset at the date of the contract was $65,000. The implicit interest rate was 12%.

Lucky Limited considers the collectability of the lease payments is reasonably predictable, and there is no future cost to be incurred.

Required: (Answers should be rounded to the nearest dollar.)

(i)Explain how Lucky Limited should classify these TWO leases.

(ii)Prepare the appropriate entries for Lucky Limited, for the inception of these two leases for Equipment A and Equipment B on 1 January 2017.

Answer 1

Ans to part (i)

Operating Vs Finance leases :

• Title: In a finance lease agreement, ownership of the property is transferred to the lessee at the end of the lease term. But, in operating lease agreement, the ownership of the property is retained during and after the lease term by the lessor.
• Balloon/residual amount: In finance lease agreement, there is a balloon/residual option for the lessee to purchase the property or equipment at a specific price. But, under an operating lease, the lessee does not have this option. The balloon/residual on a finance lease is set using ATO asset guidelines.
• Running costs & administration: Under an operating lease all running costs (servicing, registration, tyres, insurance etc) are included in the lease within the designated term and usage km with one set monthly repayment amount. Under a finance lease these are generally not included meaning there can be greater administration and price fluctuation for the lessee.
• Account treatment: Operating lease are treated as expenses (ie off balance sheet items) where as a finance lease is included as an asset for the lessee. Edit: the tax treatment for leases will change in 2019, with operating leases appearing on the balance sheets as liabilities.

On the basis of above discussion, we can conclude as follows:

1) Equipment A will be treated as Operating lease as asset is new and having more useful life than term of lease.

2) Equipment B will be treated as Finance lease since useful life of asset is nearabout term of lease.

Ans to part ii Journal entries at inception

?Equipment A :  

       Cash A/c Dr $6,505

           To Lease Rental Income $6,505

Equipment B:

Forever Company A/c Dr $65,000

       To Equipment B A/c        $65,000

(At the time of inception)

Cash A/c Dr   $ 6,300

   To Forever Company $ 5,625 (6300 - 675)

    To Financial Income $ 675   (12% interest embedded in installment)

(First installment received)