IAS 17 paragraph 13 states that “Lease classification is made at the inception of the lease…..”
Sishi Ltd entered into a lease agreement in terms of which a machine with a fair value of R250 450 was acquired in exchange for five annual lease payments of R69 600 in arrears. In addition, Sishi Ltd will pay R20 000 at the end of year 5 to take ownership of the machine. The machine is expected to have a total useful life of 5 years. The interest rate implicit in the lease is 13.82% p.a. This is the rate that discounts the future minimum lease payments of R69 600 and the guaranteed payment of R20 000 at the end of year 5 to equal to the fair value of R250 450.
REQUIRED:
2.1.1
What class of lease is this (Finance OR Operating)? Support your answer.
(3)
2.1.2
Prepare the journal entries to account for the lease in the books of Sishi Ltd
(17)
NOTE: For annual lease payments on the first year journal is required
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2.1.1
To determine the class of lease, we need to consider the criteria set out in IAS 17:
a) Ownership transfer: If ownership of the asset is transferred to the lessee by the end of the lease term, it is a finance lease. If ownership is not transferred, it is an operating lease.
b) Bargain purchase option: If the lessee has the option to purchase the asset at a price significantly lower than its fair value, it is a finance lease. If the option price is close to the fair value or the lessee does not have the option to purchase, it is an operating lease.
c) Lease term: If the lease term covers the major part of the economic life of the asset, it is a finance lease. If the lease term is significantly shorter than the economic life, it is an operating lease.
d) Present value of minimum lease payments: If the present value of the minimum lease payments equals or exceeds substantially the fair value of the asset, it is a finance lease. If the present value is significantly lower than the fair value, it is an operating lease.
Based on the information given, we can determine the class of lease:
- Ownership transfer: Sishi Ltd will take ownership of the machine by paying R20,000 at the end of year 5.
- Bargain purchase option: There is a bargain purchase option as the R20,000 payment at the end of year 5 is significantly lower than the fair value of R250,450.
- Lease term: The lease term is for 5 years, which is the total useful life of the machine.
- Present value of minimum lease payments: The future minimum lease payments of R69,600 per year for 5 years plus the guaranteed payment of R20,000 at the end of year 5, discounted at the implicit interest rate of 13.82%, equals the fair value of R250,450.
Based on these criteria, this lease is considered a FINANCE LEASE.
2.1.2
Now, let's prepare the journal entries to account for the lease in the books of Sishi Ltd:
Year 1:
1. At the inception of the lease:
Leased Machine (Asset) - Dr. R250,450
Lease Liability - Cr. R250,450
2. Recording the annual lease payment:
Lease Liability - Dr. R69,600
Bank/Cash - Cr. R69,600
Year 2 to Year 4:
1. Recording the annual lease payment:
Lease Liability - Dr. R69,600
Bank/Cash - Cr. R69,600
Year 5:
1. Recording the annual lease payment:
Lease Liability - Dr. R69,600
Bank/Cash - Cr. R69,600
2. Recording the guaranteed payment and transfer of ownership:
Lease Liability - Dr. R20,000
Bank/Cash - Cr. R20,000
Leased Machine (Asset) - Dr. R231,850
Gain on Lease Settlement - Cr. R231,850
At the end of year 5, the lease liability is fully settled, and ownership of the machine is transferred to Sishi Ltd. The gain on lease settlement arises because the fair value of the machine at the end of year 5 is R231,850 (R250,450 - R20,000), which is lower than the remaining lease liability.
Note: The present value calculations for the lease liability should be done based on the implicit interest rate given (13.82% p.a.).
To determine the class of lease (Finance or Operating), we need to consider the criteria outlined in IAS 17.
1. Transfer of Ownership: If the lease agreement includes a transfer of ownership to the lessee at the end of the lease term, it is considered a Finance lease. If ownership remains with the lessor, it is an Operating lease.
2. Bargain Purchase Option: If the lease agreement includes a bargain purchase option, allowing the lessee to purchase the leased asset at a price significantly below its fair value, it is considered a Finance lease. If there is no such option, it is an Operating lease.
3. Lease term: If the lease term covers a major part of the economic life of the asset, it is considered a Finance lease.
4. Present Value of Lease Payments: If the present value of lease payments amounts to substantially all of the fair value of the asset, it is considered a Finance lease. If it does not, it is an Operating lease.
Now let's apply these criteria to determine the class of lease for Sishi Ltd:
1. Transfer of Ownership: Sishi Ltd has an option to purchase the machine at the end of the lease term for R20,000. This indicates a transfer of ownership, suggesting a Finance lease.
2. Bargain Purchase Option: The R20,000 purchase option price is significantly lower than the fair value of the machine (R250,450). This further supports the Finance lease classification.
3. Lease term: The lease term is equal to the total useful life of the machine (5 years), indicating a Finance lease.
4. Present Value of Lease Payments: The interest rate implicit in the lease (13.82%) is used to discount the future minimum lease payments and the guaranteed payment at the end of year 5 to equal the fair value of the machine. This suggests that the present value of lease payments is substantially all of the fair value, indicating a Finance lease.
Based on these criteria, we can conclude that the lease is classified as a Finance lease.
Now, let's prepare the journal entries to account for the lease in the books of Sishi Ltd:
2.1.2 Journal Entries:
Year 1:
Leased Machine Dr. 250,450
Lease Liability Cr. 183,523
Cash Cr. 66,927 (R69,600 - R2,673 finance cost [R183,523 * 13.82%])
Year 2-4:
Interest Expense Dr. 25,386 (R183,523 * 13.82%)
Lease Liability Dr. 41,214 (R69,600 - R28,386 finance cost)
Cash Cr. 69,600
Year 5:
Interest Expense Dr. 4,764 (R34,301 * 13.82%)
Lease Liability Dr. 34,301 (R20,000 + R14,301 principal repayment)
Cash Cr. 20,000
Machine Dr. 34,301
Lease Liability Cr. 68,602
At the end of year 5 when the ownership is transferred, the machine will be recognized on the balance sheet as a non-current asset, and the lease liability will be fully settled.
Note: Please consult with a professional accountant to ensure the accuracy of the journal entries and to comply with any specific reporting requirements.