Drago Ltd enters into a three-year lease agreement with Ultra Finance Ltd on 1 J

Question

Drago Ltd enters into a three-year lease agreement with Ultra Finance Ltd on 1 June 2015 for an item of machinery. The lease term commences on 30 June 2015. According to the lease agreement, Drago Ltd must make three annual payments of $15,000 with the first payment being made on 30 June 2016. Drago Ltd incurs costs of $218 in negotiating the lease agreement and in preparing the lease documentation.
The item of machinery has an expected economic life of four years and a residual value at the end of the lease term of $5,000. Drago Ltd has guaranteed $4,000 of the residual value. Drago Ltd intends to return the item of machinery to Ultra Finance Ltd at the end of the lease term.
The terms of the lease agreement specify that Drago Ltd can only cancel the lease agreement with the written permission of Ultra Finance Ltd and must pay an amount equal to the remaining outstanding lease payments and the guaranteed portion of the residual value to Ultra Finance Ltd.
The policy of Drago Ltd is to depreciate items of machinery using the straight-line method.
The interest rate implicit in the lease cannot be determined by Drago Ltd as, at the inception of the lease, they cannot determine the fair value of the item of machinery. However, Drago Ltd’s incremental borrowing rate is 4%.
Required
(a) Explain how, in accordance with the requirements of AASB 117 Leases, Drago Ltd should classify this lease agreement.
(b) Prepare the lease payments schedule for Drago Ltd.
(c) Prepare the appropriate journal entries for Drago Ltd from 30 June 2015 to 30 June 2018. Assume that, at the end of the lease term on 30 June 2018, Ultra Finance Ltd estimates that the residual value of the item of machinery is $4,500.

Explanation / Answer

This lease can be classiffied as finance lease.

As per AASB 117, below are the points basis which, the lease can be classified as finance lease.

Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract.1 Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease are:

(a) the lease transfers ownership of the asset to the lessee by the end of the lease term;

(b) the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised;

(c) the lease term is for the major part of the economic life of the asset even if title is not transferred;

(d) at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset; and

(e) the leased assets are of such a specialised nature that only the lessee can use them without major modifications.

Indicators of situations that individually or in combination could also lead to a lease being classified as a finance lease are:

(a) if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee;

(b) gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (for example, in the form of a rent rebate equalling most of the sales proceeds at the end of the lease); and

(c) the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent

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