Question

Thomas forms a company, Thomson Ltd to manufacture motorised roller blades. To make the roller blades, Thomson Ltd needs to acquire specialised machinery from Fernster Ltd, which designs and manufactures the machinery. To manufacture the equipment, which has an estimated economic life of eight years, costs Fernster Ltd $200 000. Fernster Ltd sells the equipment to parties such as Thomson Ltd for $263 948. Thomson Ltd decides to lease the equipment from Fernster Ltd for a period of seven years, by way of a non-cancellable lease. The lease commences on 1 July 2019. The lease payments are made at the end of each year and amount to $55 000. The lease payments include reimbursement of Fernster Ltd’s costs for servicing the machinery at an amount of $5 000 per annum. There is an unguaranteed residual at the end of the lease term of $40 000, which represents expectations of what the lessee and lessor expect the machinery to be worth at the end of the lease term. The rate of interest implicit in the lease is 10 per cent.

REQUIRED:

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

2. Provide the journal entries in the books of Thomson Ltd as at 1 July 2019 and 30 June 2020. Provide the journal entries in the books of Fernster Ltd as at 1 July 2019 and 30 June 2020.

Answer 1

Fair value of asset = $263,948

Implicit rate in the lease = 10%

Reimbursement of $5,000 towards cost of servicing of the machinery should not be part of calculation of present value of minimum lease payments.

Hence lease installment is $50,000 (55,000-5,000)

Calculation of present value minimum lease payments
Date	Type	Amount	PF Factor @10%	PV of MLP (Amount*PF factor)
30-Jun-20	Installment	$ 50,000	0.90909	$     45,455
30-Jun-21	Installment	$ 50,000	0.82645	$     41,323
30-Jun-22	Installment	$ 50,000	0.75132	$     37,566
30-Jun-23	Installment	$ 50,000	0.68302	$     34,151
30-Jun-24	Installment	$ 50,000	0.62093	$     31,047
30-Jun-25	Installment	$ 50,000	0.56448	$     28,224
30-Jun-26	Installment	$ 50,000	0.51316	$     25,657
30-Jun-26	Unguranteed Residual value	$ 40,000	0.51316	$     20,525
Total	Total present value of MLP			$ 2,63,948

Since present value of minimum lease payment equal to fair value of lease asset, interest rate implicit in the lease is 10%.

2) Journal entries:

Amortization schedule
Date	Installment	Interest @ 10%	Reduction in liability	Balance of lease liability
30-Jun-20				$ 2,63,948
30-Jun-20	$ 50,000	$        26,395 (263948*10%)	$       23,605 (50000-26395)	$ 2,40,343
30-Jun-21	$ 50,000	$        24,034 (240343*10%)	$       25,966 (50000-24034)	$ 2,14,377
30-Jun-22	$ 50,000	$        21,438 (214377*10%)	$       28,562 (50000-21438)	$ 1,85,815
30-Jun-23	$ 50,000	$        18,581 (185815*10%)	$       31,419 (50000-18581)	$ 1,54,396
30-Jun-24	$ 50,000	$        15,440 (154396*10%)	$       34,560 (50000-15440)	$ 1,19,836
30-Jun-25	$ 50,000	$        11,984 (119836*10%)	$       38,016 (50000-11984)	$     81,819
30-Jun-26	$ 50,000	$          8,182 (81819*10%)	$       41,818 (50000-8182)	$     40,001

In the books Thomson ltd

01-Jul-19	Right of use asset	$ 2,63,948
	Lease liability		$ 2,63,948
	(To record leased asset and lease liability)
30-Jun-20	Lease liability	$     23,605
	Interest expense	$     26,395
	Maintenance expense
	Cash		$     55,000
	(To record payment of first installment)
30-Jun-20	Amortization expense(263948/7)	$     37,707
	Right of use asset		$     37,707
	(To record amortization)

In the books of Fernster Ltd:

01-Jul-19	Lease receivable	$ 2,63,948
	Asset		$ 2,63,948
	(To record lease receivable)
30-Jun-20	Cash	55,000
	Lease receivable		$     23,605
	Interest income		$     26,395
	Maintenance charges receivable		$       5,000
	(To record receipt of lease rentals)