Question

On 1 July 2021 Fairval Ltd (the lessee) contracts a lease equipment for five years at an annual rental of $20,000, with the first payment payable immediately and subsequent annual payments due on 30 June. The equipment could have been purchased from the supplier for $80,747 on 1 July 2021 if leasing was not chosen instead. The rate of interest implicit in the lease is 12% and the end of the reporting period is 30 June. Assume the equipment is returned to the lessor at the end of the lease, when the residual value of the equipment is nil.

1）Prepare the general journal entries for the lessee for the remaining term of the lease (not covered by part (1) of this question) up until 30 June 2023.

2）Based on the case, explain the motivation for the standard setter to release the new lease standard (AASB 16).

Answer 1

1…..Fairval Ltd.(Lessee)

Testing for operating lease or a capital lease?

1. Transfer of ownership? No

2. Bargain purchase option? No

3. Length of lease term > or equal to 75% of total life? Not very clear

4. Present value of MLP > or equal to 90% of asset’s current FMV? Yes, PV of the 5 beginning of year Lease payments at 12% =80747 (as calculated below)= 100% of FMV

PV of beginning of term lease payments -- Using PV of Annuity-due formula--

(20000*(1-1.12^-5)/0.12)*(1.12)=

80747

As atleast 1 of the above criteria is met (here, 4 th ), the lessee Fairval Ltd. should account this as a CAPITAL LEASE.

Lease amortisation schdeule for the Lessee
Lease Amortisation schedule			Lessee
Date	Annuity	Tow.Int. at 12%	Tow.Principal	Principal Balance
				80747
1-Jul-21	20000	0	20000	60747
1-Jul-22	20000	7290	12710	48037
1-Jul-23	20000	5764	14236	33801
1-Jul-24	20000	4056	15944	17857
1-Jul-25	20000	2143	17857	0
	100000	19253	80747

	Lessee Journal entries
Date	Account Titles & explanations	Debit	Credit
1-Jul-21	Leased Equipment(right-of-use)	80747
	Capital Lease liability		80747
	(To record inception of Lease)
	Capital Lease liability	20000
	Cash		20000
	(To record initial lease payment)
30-Jun-22	Interest expense	7290
	Interest payable		7290
	(To accrue interest expense on lease)
	Depreciation	16149
	Accumulated depn.on leased equipment		16149
	(80747/5)
1-Jul-22	Capital Lease liability	12710
	Interest payable	7290
	Cash		20000
30-Jun-23	Interest expense	5764
	Interest payable		5764
	(To accrue interest expense on lease)
30-Jun-23	Depreciation	16149
	Accumulated depn.on leased equipment		16149
	(80747/5)

2. The motivation for the standard setter to release the new lease standard (AASB 16).

is that the lessee has to record in his books, even the right-of-use asset & the liabilities that arise due to it, in a very clear manner.

The standard setter is motivated so that the lessee(Here, Fairval) will recognise assets and liabilities for the rights and obligations created, even it be only an operating leases.

AS the asset, in the above case,is reverting to the lessor after use for 5 yrs., the right-of-use is only amortised over the 5 yrs. Of its use.

Also the users of financial statements get to have a comprehensive knowledge about the company's leasing activities & their nature, implications & can judge about the correctness of their disclosure in the said statements.

Ultimately, the aim of the setter is that no type of lease is left, out of the books, as it is a type of financing activity for the business.