Value of the Annual Lease Payments

Question: Lessor Ltd has entered into an agreement to lease a machine to ChiHerbal Ltd. The lease agreement details are as follows: Lease term 5 years Commencement date 1 July 2015 Annual lease payment, payable 30 June each year commencing 30 June 2016 $8 400 Fair value of the machine at 1 July 2015 $35 197 Estimated economic life of the machine 8 years Estimated residual value of the machine at the end of its economic life $2 000 Residual value at the end of the lease term, of which 50% is guaranteed by ChiHerbal Ltd $7 600 Interest rate implicit in the lease 9% The lease is cancellable, but a penalty equal to 50% of the total lease payments is payable on cancellation. ChiHerbal Ltd does not intend to buy the machine at the end of the lease term. Lessor Ltd incurred $1 000 to negotiate and execute the lease agreement. Lessor Ltd purchased the machine for $35 197 just before the inception of the lease. Required: a) Explain why the lease should be classified as a finance lease by both Lessor Ltd and ChiHerbal Ltd. b) Prepare a schedule of lease payments and the journal entries for ChiHerbal Ltd regarding the lease over the lease term. c) Prepare a schedule of lease receipts and the journal entries for Lessor Ltd regarding the lease over the lease term. d) Prepare an appropriate note to the financial statements for both Lessor Ltd and ChiHerbal Ltd as at 30 June 2016. Answer: The given lease would be treated as a finance lease as the present value of the annual lease payments as per the lease exceeds 90% of the assets fair market value at the time of lease agreement (AASB, 2010). This is demonstrated below. Year Lease Payment ($) PV factor (9%) PV of lease payment ($) 1 8400 0.9174 7706.42 2 8400 0.8417 7070.11 3 8400 0.7722 6486.34 4 8400 0.7084 5950.77 5 8400 0.6499 5459.42 5 3800 0.6499 2469.62 Total 35142.68 The fair value of the asset is given as $35,197. 90% of the fair value of the machine = 0.9* 35,197 = $31,677.3 Since the present value of the lease payments (including guaranteed residual value) over the lease term of five years is greater than 90% of the assets fair value, hence the requisite condition for classification of lease as financial lease has been fulfilled both on the part of the lessor as well as lessee. Additionally, the in case of cancellation of lease, 50% of the total lease payments is payable by the lessee which also implies that the given lease is finance lease (Damodaran, 2008). The schedule of lease payment for the lessee is given below (Brealey, Myers Allen, 2008). Period Date of Payment Amount of lease payment ($) Principal ($) Interest ($) Closing Balance ($) 0 35142.68 1 30th June 2016 8400 5237.16 3162.84 29905.52 2 30th June 2017 8400 5708.50 2691.50 24197.02 3 30th June 2018 8400 6222.27 2177.73 17974.75 4 30th June 2019 8400 6782.27 1617.73 11192.48 5 30th June 2020 8400 7392.68 1007.32 3799.80 5 30th June 2020 3800 3800.00 -0.20 The relevant journal entries for the lessee (i.e. ChiHerbal Ltd) during the lease term are given below (Deegan, 2014). Date Account Debit Credit 1st July 2015 Equipment Account 35142.68 Capital lease liability account 35142.68 30th June 2016 Capital lease liability account 5237.16 Interest expense account 3162.84 Accounts payable account 8400 30th June 2016 Depreciation Expense (leased) 6268.54 Accumulated Depreciation (leased) 6268.54 30th June 2017 Capital lease liability account 5708.50 Interest expense account 2691.50 Accounts payable account 8400 30th June 2017 Depreciation Expense (leased) 6268.54 Accumulated Depreciation (leased) 6268.54 30th June 2018 Capital lease liability account 6222.27 Interest expense account 2177.73 Accounts payable account 8400 30th June 2018 Depreciation Expense (leased) 6268.54 Accumulated Depreciation (leased) 6268.54 30th June 2019 Capital lease liability account 6782.27 Interest expense account 1617.73 Accounts payable account 8400 30th June 2019 Depreciation Expense (leased) 6268.54 Accumulated Depreciation (leased) 6268.54 30th June 2020 Capital lease liability account 7392.68 Interest expense account 1007.32 Accounts payable account 8400 30th June 2020 Depreciation Expense (leased) 6268.54 Accumulated Depreciation (leased) 6268.54 30th June 2020 Capital lease liability account 3800 Cash account 3800 The Lessor in this case has incurred direct cost of $ 1,000 with regards to negotiating and executing the lease agreement. Assuming that Lessor Ltd. is not a manufacturer or dealer of the machine, hence in accordance with AASB 117 (Para. 18), it can be assumed that this cost is already included in the financial lease receivable as calculated through the implicit rate (AASB, 2010). The financial lease receivable by Lessor Ltd. is shown below. PV of all the lease payments over the five years = $ 32,673.06 PV of the guaranteed residual value = $ 2,469.62 Hence, total leave receivable by Lessor = 32,673.06 + 2,469.62 = $ 35,142.68 The schedule for receipt of lease payment by Lessor Ltd. is shown below (Damodaran, 2008). Date of Receipt Lease Payment Received ($) Interest income ($) Reduction in balance ($) Lease Receivable balance 1st July 2015 35142.68 30th June 2016 8400 3162.84 5237.16 29905.52 30th June 2017 8400 2691.50 5708.50 24197.02 30th June 2018 8400 2177.73 6222.27 17974.75 30th June 2019 8400 1617.73 6782.27 11192.48 30th June 2020 8400 1007.32 7392.68 3799.80 30th June 2020 3800 0.00 3800.00 -0.20 The relevant journal entries for the lessor (i.e. Lessor Ltd) during the lease term are given below (Deegan, 2014). Date Account Debit Credit 1st July 2015 Lease Receivable 35142.68 Machine 35142.68 30th June 2016 Cash 8400.00 Lease Receivable 5237.16 Interest Receivable 3162.84 30th June 2016 Interest Receivable 3162.84 Interest Revenue 3162.84 30th June 2017 Cash 8400.00 Lease Receivable 5708.50 Interest Receivable 2691.50 30th June 2017 Interest Receivable 2691.50 Interest Revenue 2691.50 30th June 2018 Cash 8400.00 Lease Receivable 6222.27 Interest Receivable 2177.73 30th June 2018 Interest Receivable 2177.73 Interest Revenue 2177.73 30th June 2019 Cash 8400.00 Lease Receivable 6782.27 Interest Receivable 1617.73 30th June 2019 Interest Receivable 1617.73 Interest Revenue 1617.73 30th June 2020 Cash 8400.00 Lease Receivable 7392.68 Interest Receivable 1007.32 30th June 2020 Interest Receivable 1007.32 Interest Revenue 1007.32 30th June, 2020 Cash 3800.00 Lease Receivable 3800.00 Note for Lessor Ltd. Note: Trade and other Receivables Finance Lease Commitments The financial lease receivables are summarised below. June 30, 2016 Particular Gross Investment Unearned Income Payments Receivable Less than one year 8400.00 3162.84 5237.16 Between one year and fie years 37400.00 7494.28 29905.72 Total 45800.00 10657.12 35142.88 Note for ChiHerbal Ltd Note: Leases The future lease payments that the company needs to make for the existing lease agreements is mentioned below. Finance Lease FY2017 FY2018-FY2021 Total Expected lease payments in future 8400 37400 45800 Less: Interest Amount 3162.84 7494.28 10657.12 Present Value of lease payments($) 5,237.16 29,905.72 35,142.88 References AASB (2010), AASB 117-Leases, Retrieved on August 5, 2016 from: https://www.aasb.gov.au/admin/file/content102/c3/AASB117_07-04_ERDRjun10_07-09.pdf Brealey, R., Myers, S. and Allen, F. (2008), Principles of Corporate Finance (9th edition), New York: McGraw Hill PublicationsDamodaran, A. (2008), Corporate Finance (3rd edition), London: Wiley PublicationsDeegan, C.M. (2014), Financial Accounting Theory (4th edition), Sydney: McGraw-Hill Education Australia