Question

X Ltd is asset rich but cash poor. In an attempt to alleviate its liquidity problems, it entered into an agreement on 1 June 2014 to sell its processing plant to Y Ltd for £467,100. At the date of sale, the plant had a carrying amount of £400,000 and a future useful life of 5 years. Y Ltd immediately leased the processing plant back to X Ltd. The terms of the lease agreement were:

·  Lease term - 3 years

·  Economic life of plant - 5 years

·  Annual rental payment, in arrears (commencing 30/5/15) - £165,000

·  Residual value of plant at end of lease term - £90,000

·  Residual value guaranteed by Ultramarine Ltd - £60,000

·  Interest rate implicit in the lease - 6%

·  The lease is cancellable, but only with the permission of the lessor.

At the end of the lease term, the plant is to be returned to Y Ltd. In setting up the lease agreement Y Ltd incurred £9,414 in legal fees and stamp duty costs. The annual rental payment includes £15,000 to reimburse the lessor for maintenance costs incurred on behalf of the lessee.

Required

Classify the lease for both lessor and lessee and justify your answer accordingly. Prepare a lease payments schedule in the records of X Ltd and a lease receipts schedule and the journal entries in the records of Y Ltd for the year ending 30 May 2015. Show all workings. Finally, explain how and why your answers would change if the lease agreement could be cancelled at any time without penalty. Discuss this with regard to both companies involved in this transaction.

Answer 1

Classification of lease:

For classifying the lease in this case, both lessee and lessor need to determine that whether the agreement of lease effectively transfer all the reward and risk to the lessee from the owner. In the given case, such transfer is made which shows that the lease is a finance lease because such lease is non-cancellable; also, the term of the lease is almost 60% which is a major portion of the economic life of asset.

Minimum lease payment = (£165,000 – £15,000)*3(Rental net of the executory cost) + £60,000 (GRV)

Interest rate = 6%

PV of MLP = £150,000*2.6730 [T2, 6%, 3 years] + £60,000*0.8396 [T1, 6%, 3 years]

= £400,950 + £50,376

= £451,326

PV/FV = £451,326/£467,100

            = 96.60%

The schedule for lease payment for X Ltd is made as follows in the excel sheet by using the following formulas:

The schedule for lease payment for X Ltd is as follows by using the above formulas in the excel sheet:

The journal entries in the books of X Ltd is made as follows:

1. On 1^st June 2014

Cash A/c                                             Dr. £467,100

      To Deferred gain on sale A/c                                            Cr. $67,100

      To Processing plant A/c                                                    Cr. £400,000

(Being sale of plant under lease)

2. On 1^st June 2014

Leased plant A/c                                 Dr. £451,326

             To Lease liability A/c                                                     Cr. $451,326

(Being lease agreement recognized)

3. On 30^th May 2015

Lease liability A/c                   Dr. £122,920

Interest A/c                             Dr. £27,080

Executory cost A/c                 Dr. £15,000

             To Cash A/c                                                   Cr. £165,000

(Being first lease payment made)

4. On 30^th May 2015

Depreciation A/c                                             Dr. £130,442

         To Accumulated depreciation A/c                                             Cr. £130,442

(Being depreciation charged on lease asset)

Note:

Depreciation = (£451,326 – £60,000)/3

                     = £130,442

5. 30^th May 2015

Deferred gain on sale A/c       Dr. £22,367

           To Sale A/c                                          Cr. £22,367

(Being Amortization of deferred profit)

Note:

Deferred gain = £67,100/3

                       = £22,367

Now,

The schedule for lease receipt for Y Ltd is made as follows in the excel sheet by using the following formulas:

The schedule for lease payment for Y Ltd is as follows by using the above formulas in the excel sheet:

The journal entries in the books of X Ltd is made as follows:

1. On 1^st June 2014

Processing plant A/c   Dr. £467,100

            To Cash A/c                                        Cr. £467,100

(Being plant purchased from X Ltd)

2. On 1^st June 2014

Lease receivable A/c                           Dr. £467,100

            To Processing plant A/c                                     Cr. £467,100

(Being lease agreement made)

3. On 1^st June 2014

Lease receivable A/c               Dr. £9,414

            To Cash A/c                                        Cr. £9,414

(Being legal fees paid)

4. On 30^th May 2015

Cash A/c                                             Dr. £165,000

         To Lease receivable A/c                                                            Cr. £121,409

         To Interest Revenue A/c                                                Cr. £28,591

         To Reimbursement revenue A/c                                    Cr. £15,000

(Being lease payment received)

5. On 30^th May 2015

Maintenance expense A/c                   Dr. £15,000

                  To Cash A/c                                              Cr. £15,000

(Being payment made for maintenance cost)

Now,

If the lease agreement can be cancelled at any time without imposing any penalty then such lease cannot be said as finance lease and thus need to classify as operating lease. Thus, the lessee i.e. X Ltd will not capitalized the lease asset and thus no liability or asset is raised on 1^st June 2014. Also, the payment of lease will be treated as expense item when it is paid and also X Ltd will not record depreciation expense. The profit earned by the X Ltd on the sale of such plant will be recognized in the P&L A/c.