Lease classification

Lessee Ltd., a British company that applies IFRSs, leased equipment from Lessor Inc. on

January 1, 2013, for a period of three years.  Lease payments of $100,000 are due to

Lessor Inc. each year. Other expenses (e.g., insurance, taxes, maintenance) are also to be

paid by Lessee Ltd. and amount to $2,000 per year. The lessor did not incur any initial

direct costs.  The lease contains no purchase or renewal options and the equipment reverts

back to Lessor Inc. on the expiration of the lease.  The remaining useful life of the

equipment is four years. The fair value of the equipment at lease inception is $265,000.

Lessee Ltd. has guaranteed $20,000 as the residual value at the end of the lease term.

The $20,000 represents the expected value of the leased equipment to the lessee at the end of

the lease term.  The salvage value of the equipment is expected to be $2,000 after the end of its

economic life. The lessee’s incremental borrowing rate is 11 percent (Lessor’s implicit rate is 10

percent and is calculable by the lessee from the lease agreement).  The junior accountant of

Lessee Ltd. analyzed the assets under lease, determined whether the lease was an operating lease or

capital lease, and prepared the applicable Journal entries The senior accountant of Lessee Ltd. reviewed

the junior accountant’s analysis and prepared a separate analysis. As the finance controller, you were

given both analysis to determine the correct accounting treatment. Calculations and journal entries

performed by your junior and senior accountant are below.

Present Value of the Lease Obligation

Using the rate implicit in the lease(10 percent), the present value of the guaranteed

residual value would be $15,026 ($20,000 × 0.7513), and the present value of the annual

payments would be $248,690 ($100,000 × 2.4869).

Using the incremental borrowing rate(11 percent), the present value of the guaranteed residual value

would be $14,624($20,000 × 0.7312), and the present value of the annual payments would be $244,370

($100,000 × 2.4437)

Junior accountant analysis: Since the equipment reverts back to Lessor Inc., it is an operating lease.

Entries to be posted in Years 1, 2, and 3:

Dr. Lease expense                                                           $100,000

Dr. Insurance expense                                                  $2,000

Cr. Cash                                                                                                                $102,000

(Operating lease rental paid to Lessor Inc.)

Senior accountant analysis:

Step 1

Lease classification

The lease term is for three years. The useful life of the equipment is four years. Since the

lease term is for a major part of the useful life of the equipment, it is a finance lease.

Step 2

Computation of the lease asset and obligation since the lessee’s incremental borrowing rate is greater

than the lessor’s implicit rate in the lease, compute the present value of the minimum lease payments 

using the 11 percent rate.

Present value of the minimum lease payments = $100,000 × 2.4437= $244,370.

Step 3

Allocation of payments between interest and lease obligation since interest has to be charged on

The straight - line method, the following is the allocation of the interest and the reduction in the lease

Liability.

Years           Cash Payment       Interest Expense 11%          Reduction in                       Balance of

                                                                                                       Lease Obligation                 Lease Obligation

0                                                                                                                                                                                   244,370

1                     100,000                        26,881                                 73,119                                              171,251

2                      100,000                       26,881                                  73,119                                                98,131

3                      100,000                        26,881                                  73,119                                               25,012

Journal entry in Year 1 to record the payments:

Dr. Rent expense                                                    $2,000

Dr. Interest expense                                            $26,881

Dr. Lease obligation                                             $73,119

                     Cr. Cash                                                                                     $102,000

Required:

1.  Was the junior accountant’s analysis correct? Why or why not?

2.  Was the senior accountant’s analysis correct? Why or why not?

3. How would the answer differ under U.S. GAAP?