Topic 9 Ch10 Solution - sol PDF

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Chapter 10: Leases 6, 10, 11, 12 Ex 10.4, Ex 10.5 (part 2), 10.7 Comprehension questions 6. Where a lessor incurs initial direct costs in establishing a lease agreement, how are these costs to be accounted for? Initial direct costs are incremental costs that are directly attributable to negotiating and arranging a lease, except for such costs incurred by manufacturer or dealer lessors in connection with a finance lease (AASB 16/IFRS 16, Appendix A). Examples include commission, legal fees and internal costs, but exclude general overheads such as those incurred by a sale and marketing team. Initial direct costs, other than those incurred by manufacturer or dealer lessors, are included in the initial measurement of the net investment in the lease and reduce the amount of income recognised over the lease term. The interest rate implicit in the lease is defined in such a way that the initial direct costs of the lessor are included automatically in the net investment in the lease; there is no need to add them separately. The accounting treatment for initial direct costs differs depending on whether the lease is classified as operating or finance, and if finance, whether the lessor is a manufacturer/dealer. Finance lease:  Financier lessor: initial direct costs are included in the finance lease receivable and are recovered via payments received over the lease term.  Manufacturer/dealer lessor: initial direct costs are recognised as an expense at the commencement of the lease when the profit or loss on ‘sale’ of the leased asset is recognised. Operating lease:  Any initial direct costs incurred by lessors in negotiating operating leases are added to the carrying amount of the leased asset and recognised as an expense over the lease term on the same basis as the lease income (paragraph 83).

10. How are finance leases to be accounted for by lessors? In accounting for a finance lease, the lessor derecognises the leased asset and records a lease receivable. The initial measurement of the lease receivable is at fair value of the leased asset plus initial direct costs incurred by the lessor. On receipt of lease payments from the lessee, the lessor records lease rental revenue and reduces the lease receivable, based on an application of the interest rate implicit in the lease. It is important to note that finance leases need to further be classified into (a) finance leases involving a financier lessor and (b) leases involving manufacturers or dealers, as the

accounting standard prescribes different accounting requirements for those two types of finance leases. With financier lessors, the lessor acquires the asset at fair value and then enters into a lease arrangement with the lessee and will only recognise income periodically throughout the lease term. With manufacturer/dealer lessors, the assets are normally being carried in the records of the lessor at an amount (cost) different from fair value. At the beginning of the lease, manufacturer/dealer lessors will recognise a selling profit.

11. How does the accounting treatment for a finance lease change if the lessor is a manufacturer/dealer lessor? If the lessor is a manufacturer/dealer, the lessor in a finance lease makes two profits, namely gross profit on sale and interest on the receivable over time. Accounting for the lease is identical to that required by financier lessors except for an initial entry to recognise profit or loss and the fact that initial direct costs are not included in the lease receivable amount (and not used in the calculation of the implicit rate in the lease). The manufacturer dealer lessor recognises sales revenue at the commencement of the lease equal to the present value of the lease payments, (which equals fair value minus the present value of any unguaranteed residual value). Cost of sales is recorded as the cost minus the present value of any unguaranteed residual value, which the lessor may have to recover by a future sale after the end of the lease agreement. Initial costs to establish a lease agreement do not satisfy the definition of initial direct costs in the standard. Instead, these initial establishment costs must be treated as an expense when the selling profit is recorded. As a consequence of the definition of the interest rate implicit in the lease, these costs are not included in the formula, unlike the initial direct costs incurred by a lessor as financier. Hence, the calculation of the interest rate implicit in the lease for a manufacturer/dealer lessor is different from the calculation for a financier lessor. The establishment costs of a manufacturer/dealer lessor are to be treated as an expense.

12.How are operating leases to be accounted for by lessors? Paragraph 81 of AASB 16/IFRS 16 requires lessors to account for receipts from operating leases as income on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern in which the benefit derived from the underlying asset is diminished. According to paragraph 83 of AASB 16/IFRS 16, any initial direct costs incurred by lessors in negotiating operating leases are to be added to the carrying amount of the underlying asset and recognised as an expense over the lease term on the same basis as the lease income. Given that the underlying asset is to be depreciated over the useful life (which in operating leases is normally longer that the lease term), while the initial direct costs are to be recognised as an expense over the lease term, the initial direct costs are capitalised into a separate deferred costs account; however, the balance of that account is nevertheless included in the calculation of the carrying amount of the underlying asset, just like the balance of the accumulated depreciation is taken into consideration when calculating that carrying amount. According to paragraph 84 of AASB 16/IFRS 16, depreciation of underlying assets provided under operating leases should be consistent with the lessor’s normal depreciation policy for

similar assets, and should be calculated in accordance with AASB 116/IAS 16 Property, Plant and Equipment and AASB 138/IAS 38 Intangible Assets. Exercise 10.4 Finance lease If a lease has been capitalised as a finance lease by the lessor, identify circumstances in which the lease receivable raised by the lessor will differ from the right-of-use asset raised by the lessee. (LO3 and LO5) The lessee will value the right-of-use asset at the present value of the lease payments plus any directly attributable costs (including the initial direct costs incurred by the lessee), whereas the lease receivable will be valued at the net investment in the lease by the lessor, which is the present value of the lease payments plus the present value of the unguaranteed residual value, all discounted at the interest rate implicit in the lease. One circumstance is where there is an unguaranteed residual value in the lease contract. A second circumstance is where the lessee has incurred initial direct costs or may incur any other directly attributable costs.

Exercise 10.5 Accounting by lessee and lessor On 1 July 2023, Sherlock Ltd leased a processing plant to Holmes Ltd. The plant was purchased by Sherlock Ltd on 1 July 2023 for its fair value of $348 942. The lease agreement contained the following provisions: Lease term Economic life of plant Annual rental payment, in arrears (commencing 30/6/24) Residual value at end of the lease term Residual guaranteed by lessee Interest rate implicit in lease The lease is cancellable only with the permission of the lessor.

3 years 5 years $120 000 $50 000 $30 000 8%

Holmes Ltd intends to return the processing plant to Sherlock Ltd at the end of the lease term. The lease has been classified as a finance lease by Sherlock Ltd.

2. Prepare: (a) the lease receipts schedule for Sherlock Ltd (show all workings) (b) the journal entries in the records of Sherlock Ltd for the year ended 30 June 2025.

10.3

2. *PV of LP

= $120 000 x 2.5771 [T2 8% 3yrs] + $30 000 x 0.7938 [T1 8% 3yrs] = $309 252 + $23 814 = $333 066 PV of UGRV = $20 000 x 0.7938 [T1 8% 3yrs] = $15 876 Lease receivable at 1 July 2023 = PV of LP + PV of UGRV = $348 942 (a) Lease receipts schedule.

Date $ 1 July 2023 30 June 2024 30 June 2025 30 June 2026

SHERLOCK LTD Lease receipts schedule Lease Interest revenue Reduction in receipts (8%) receivable $ $ $ 120 000 120 000 170 000 410 000

27 915 20 549 12 594 61 058

92 085 99 451 157 406 348 942

Balance of receivable $ 348 942* 256 857 157 406 —

2. (b) Journal entries for the year ended 30 June 2025. 30 June 2025 Cash Interest revenue Lease receivable (Second lease receipt)

Dr Cr Cr

120 000 20 549 99 451

Exercise 10.7 Lease classification; accounting by lessor (SEE also Exercise 10.3 Accounting by lessee) On 1 July 2022, Monkey Ltd leased a plastic-moulding machine from Wise Ltd. The machine cost Wise Ltd $65 000 to manufacture and had a fair value of $77 055 on 1 July 2022. The lease agreement contained the following provisions. Lease term years Annual rental payment, in advance on 30 June each year Residual value at end of the lease term 500 Residual guaranteed by lessee

4 $20 750 $7 nil

Interest rate implicit in lease

8%

The lease is cancellable only with the permission of the lessor. The expected useful life of the machine is 5 years. Monkey Ltd intends to return the machine to the Wise Ltd at the end of the lease term. Included in the annual rental payment is an amount of $750 to cover the costs of maintenance and insurance paid for by the lessor. Use the information contained in exercise 10.3 to complete the following: 1. Classify the lease for Wise Ltd. Justify your answer. 2. Prepare (a) the lease receipts schedule for Wise Ltd (show all workings) and (b) the journal entries in its books for the year ended 30 June 2023. 1. (a) Determine whether the lessor is a financier or a manufacturer/dealer. This is essential as it changes the accounting treatment for initial direct costs paid by the lessor and the impacts on the determination of the interest rate implicit in the lease. Wise Ltd is a manufacturer lessor. Accordingly, the initial direct costs are treated as part of expenses and are not included in calculating the interest rate implicit in the lease (they are not considered as part of the lessor’s investment in the lease). (b) Determine whether substantially all of the risks and rewards associated with ownership of the machine have been transferred to the lessee; that is, whether the lease is a finance lease or an operating lease. (i) Cancellability test: The lease is cancellable, but only with the permission of the lessor. Arguably, this condition implies that the lease transferred some risks, but probably not the rewards to the lessee. (ii) Transfer of ownership test: The machine will be returned to the lessor at the end of the lease term. Moreover, the lessee does not guarantee any part of the residual value at the end of the lease, which may imply that the lease did not transfer some risks and rewards to the lessee. (iii) Lease term test: The lease term at 4 years is 80% of the machine’s economic life. Arguably, this represents a major part of that economic life, which may imply that the lease transferred some risks and rewards to the lessee. (iv) Present value test: Applying the provided implicit rate in the lease to the lease payments, we find the present value of those payments to be 92.85% of the fair value of the machine (i.e. substantially all of that fair value). PV of LP = $20 000 + $20 000 x 2.5771 [T2 8% 3yrs] = $20 000 + $51 542 = $71 542 PV of LP/FV = $71 542/$77 055 = 92.85% Given the above evidence, the lessor will classify the transaction as a finance lease by a manufacturer lessor. 2. (a) Lease receipts schedule.

10.5

PV of LP = $20 000 + $20 000 x 2.5771 [T2 8% 3yrs] = $20 000 + $51 542 = $71 542 PV of UGRV = 7 500 x 0.7350 [T1 8% 4yrs] = 5 513 Thus, lease receivable = PV of LP + PV of UGRV = $77 055

Date $ 1 July 2022 1 July 2022 30 June 2023 30 June 2024 30 June 2025 30 June 2026

WISE LTD Lease receipts schedule Lease Interest revenue Reduction in receipts (8%) receivable $ $ $ 20 000 20 000 20 000 20 000 7 500 87 500

— 4 564 3 330 1 996 555 10 445

Balance of receivable $ 77 055 57 055 41 619 24 949 6 945 —

20 000 15 436 16 670 18 004 6 945 77 055

2. (b) Journal entries for the lessor prepared for the year ended 30 June 2030. 1 July 2022 Lease receivable Cost of sales Sales revenue Inventory

Dr Dr Cr Cr

77 055 59 487* 71 542** 65 000

(Inception of lease) (* Cost less PV of UGRV [$7 500 x 0.7350 [T1 8% 4yrs]]) (** Lower of PV of LP and FV, in this case, PV of LP) Cash Reimbursement in advance Lease receivable (First lease receipt) Reimbursement in advance Reimbursement revenue (Reversal of accrual) 30 June 2023 Insurance and maintenance expense Cash (Payment of executory costs) Cash Lease receivable Interest revenue Reimbursement in advance

Dr Cr Cr

20 750

Dr Cr

750

Dr Cr

750

Dr Cr Cr Cr

750 20 000

750

750

20 750 15 436 4 564 750

(Interest revenue accrued at balance date) Exercise 10.11 (Online tutorial) Accounting by lessee and lessor Albert Ltd entered into an agreement on 1 July 2022 to lease a processing plant with a fair value of $569 230 to Einstein Ltd. The terms of the lease agreement were: Lease term Economic life of plant Annual rental payment, in arrears (commencing 30/6/23)

3 years 5 years $225 000

Residual value of plant at end of lease term

$50 000

Residual value guarantee by Einstein Ltd Interest rate implicit in the lease The lease is cancellable, but only with the permission of the lessor.

$20 000 6%

At the end of the lease term, the plant is to be returned to Albert Ltd. In setting up the lease agreement Albert Ltd incurred $7350 in legal fees and stamp duty costs. The annual rental payment includes $25 000 to reimburse Albert Ltd for maintenance costs incurred on behalf of Einstein Ltd. Required 2. Classify the lease from Albert Ltd perspective. 3. Prepare a lease receipts schedule and the journal entries in the records of Albert Ltd for the year ending 30 June 2023. Show all workings. 4. Explain how and why your answers to requirements 1 and 2 would change if the lease agreement could be cancelled at any time without penalty. (LO3, LO4 and LO7) 2. (a) Determine whether the lessor is a financier or a manufacturer/dealer. This is essential as it changes the accounting treatment for initial direct costs paid by the lessor and the impacts on the determination of the interest rate implicit in the lease. Albert Ltd is a financier lessor. Accordingly, the initial direct costs are treated as part of the lessor’s investment in the lease). (b) Determine whether substantially all of the risks and rewards associated with ownership of the processing plant have been transferred to the lessee; that is, whether the lease is a finance lease or an operating lease. (i) Cancellability test: The lease is cancellable, but only with the permission of the lessor. Arguably, this condition implies that the lease transferred some risks, but probably not the rewards to the lessee. (ii) Transfer of ownership test: The processing plant will be returned to the lessor at the end of the lease term (i.e., fail to pass the test). However, the lessee guarantees a part of the residual value at the end of the lease, which may imply that the lease transferred some risks and rewards to the lessee.

10.7

(iii) Lease term test: The lease term at 3 years is 60% of the plant’s economic life. Arguably, this represents a major part of that economic life, which may imply that the lease transferred some risks and rewards to the lessee. (iv) Present value test: Applying the provided implicit rate in the lease to the lease payments, we find the present value of those payments to be 96.87% of the fair value of the processing plant (i.e. substantially all of that fair value). PV of LP = $200 000 x 2.6730 [T2 6% 3yrs] + $20 000 x 0.8396 [T1 6% 3yrs] = $534 600 + $16 792 = $551 392 PV of LP/FV = $551 392/$569 230 = 96.87%. Given the above evidence, the lessor will classify the transaction as a finance lease by a financier lessor. 3. Accounting for the lease in the books of Albert Ltd. PV of LP = $200 000 x 2.6730 [T2 6% 3yrs] + $20 000 x 0.8396 [T1 6% 3yrs] = $534 600 + $16 792 = $551 392

PV of UGRV = 30,000 x 0.8396 [T1 6% 3yrs] = 25 188

Date $ 1 July 2023 30 June 2024 30 June 2025 30 June 2026

ALBERT LTD Lease receipts schedule Lease Interest revenue Reduction in receipts (6%) receivable $ $ $ 200 000 200 000 250 000 650 000

34 595 24 670 14 151 73 416

165 405 175 330 235 845 576 580

Balance of receivable $ 576 580 411 175 235 845 —

1 July 2022 Processing plant Dr 569 230 Cash Cr 569 230 (Purchase of plant)* *Note: In this example, this journal entry for the acquisition of the plant is not required as there is no information about when the plant is purchased. If the plant is purchased at the commencement date of the lease contract (like Illustrative Example 10.6), a journal entry for the plant purchase must be included. Lease receivable Processing plant

Dr Cr

569 230 569 230

(Recognition of lease agreement) Lease receivable Cash (Payment of initial direct costs) 30 June 2023 Cash Lease receivable Interest revenue Reimbursement revenue (First lease receipt) Maintenance expense Cash (Payment of maintenance costs)

Dr Cr

7 350

Dr Cr Cr Cr

225 000

Dr Cr

25 000

7 350

165 405 34 595 25 000

25 000

4. As the lease is now cancellable without penalty it could be argued that the lease can no longer be classified by the lessor as a finance lease and thus should be treated as an operating lease. There are no consequences from Einstein Ltd’s perspective.

10.9...