High School

Q2 The following particulars are available about the lease:

Lessor's Cost of leased computer: ₹59000
Fair value of the leased computer at the inception of the lease (1-1-2004): ₹60000
The Lease term is four years. The rental is ₹35000; ₹16000; ₹8000 and ₹4500 respectively in these four years, payable in advance every year. The estimated residual value of the computer at the end of the leased term is 5% of the cost of the asset to the lessor. The lessee has the right to continue the lease at the end of the aforesaid lease term at a nominal rent. The relevant statutory WDV depreciation rate is 40%.

(a) State whether the lease should be classified as finance lease or an operating lease.

(b) Give journal entries for the finance lease in the books of lessee when financing cost transacted was 14%.

Answer :

To determine whether the lease is a finance lease or an operating lease, we need to analyze the lease terms according to the financial accounting standards.

(a) Classification of the Lease:

A lease is classified as a finance lease if it transfers substantially all the risks and rewards associated with ownership of the asset. This typically involves criteria such as:

  1. Transfer of Ownership: This lease does not specify transfer of ownership, so it does not meet this criterion.

  2. Purchase Option: The lessee has an option to continue the lease at a nominal rent, indicating a possible bargain purchase.

  3. Lease Term: The lease term covers a substantial part of the asset's economic life. For computers, typically about 5 years, 4 years is a significant portion.

  4. Present Value of Lease Payments: If the present value of lease payments amounts to at least substantially all of the fair value of the asset, it is a finance lease. We can calculate the present value using the discount rate of 14%.

  5. Residual Value: The residual value and its guarantee from the lessee vs third reflection on true economic life left.

Given that:

  • The present value of lease payments is substantial considering a 14% rate.
  • The economic life covered by the lease term along with option effectively for a nominal amount suggests a finance lease.

(b) Journal Entries for the Finance Lease:

Initial Recognition

On January 1, 2004, when the lease begins and given the lease is considered a finance lease, the lessee recognizes an asset and liability at the lower of the fair value of the leased asset and the present value of the minimum lease payments.

  1. Calculation of Present Value of Lease Payments:
    • Year 1: Payment = ₹35,000
    • Year 2: Payment = ₹16,000
    • Year 3: Payment = ₹8,000
    • Year 4: Payment = ₹4,500

Using a 14% discount rate:

  • PV Year 1 = ₹35,000 / (1 + 0.14)^1 = ₹30,701.75
  • PV Year 2 = ₹16,000 / (1 + 0.14)^2 = ₹12,313.92
  • PV Year 3 = ₹8,000 / (1 + 0.14)^3 = ₹5,337.92
  • PV Year 4 = ₹4,500 / (1 + 0.14)^4 = ₹2,769.97

Total PV (Lease Payments) = ₹30,701.75 + ₹12,313.92 + ₹5,337.92 + ₹2,769.97 = ₹51,123.56

Journal Entry at Inception:

  • [Debit] Lease Asset: ₹51,123.56
  • [Credit] Lease Liability: ₹51,123.56

Payment Entries

Each of the following years, a part of the payment would go towards interest, calculated on the outstanding liability and the rest to reduce the principal liability.

  • Year 1 Payment (₹35,000)
    • Interest Expense: ₹7,157.30 (14% on $51,123.56)
    • Liability Reduction: ₹27,842.70
      • [Debit] Interest Expense: ₹7,157.30
      • [Debit] Lease Liability: ₹27,842.70
      • [Credit] Bank/Cash: ₹35,000

Repeat similar calculations for subsequent payments. Each year, recalculate the balance, compute interest expense on the outstanding lease liability, and record a reduction on the lease liability.

This step-by-step approach provides a clear guide on how to account for a finance lease in the lessee's books of accounts.

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