(e) Lucky Limited purchased two pieces of equipment from Great Machinery and lea
ID: 2513713 • Letter: #
Question
(e) Lucky Limited purchased two pieces of equipment from Great Machinery and leased them to Forever Company. The details of the lease agreement are shown as below: Equipment A: The lease was entered on 1 January 2017 for a four-year period. The rental was $6,505 per quarter payable at the end of each quarter (31 March, 30 June, 30 September, and 31 December). The equipment was brand new at the inception of the lease and the remaining useful life at the date of the agreement was seven years. The fair value of the asset at the date of the contract was $70,500. The implicit interest rate was 20%. Equipment B: The lease was entered on 1 January 2017 for a six-year period. The rental was $6,300 per year payable at the beginning of each year. The remaining useful life of the equipment is estimated to be seven years. The fair value of the asset at the date of the contract was $65,000. The implicit interest rate was 12%. Lucky Limited considers the collectability of the lease payments is reasonably predictable, and there is no future cost to be incurred. Required: (Answers should be rounded to the nearest dollar.) (i) Explain how Lucky Limited should classify these TWQ leases. (ii) (10 marks) Prepare the appropriate entries for Lucky Limited, for the inception of these two leases for (5 marks) Equipment A and Equipment B on 1 January 2017.Explanation / Answer
A finance lease is a way of providing finance – effectively a leasing company (the lessor or owner) buys the asset for the user (usually called the hirer or lessee) and rents it to them for an agreed period.
The lessor charges a rent as their reward for hiring the asset to the lessee. The lessor retains ownership of the asset but the lessee gets exclusive use of the asset (providing it observes the terms of the lease).
The lessee will make rental payments that cover the original cost of the asset, during the initial, or primary, period of the lease. There is an obligation to pay all of these rentals, sometimes including a balloon payment at the end of the contract. Once these have all been paid, the lessor will have recovered its investment in the asset.
The customer is committed to paying these rentals over this period and, technically, a finance lease is defined as non-cancellable although it may be possible to terminate early.
At the end of the lease
What happens at the end of the primary finance lease period will vary and depends on the actual agreement but the following are possible options:
– the lessee sells the asset to a third party, acting on behalf of the lessor
– the asset is returned to the lessor to be sold
– the customer enters into a secondary lease period
whereas
Operating Lease
In contrast to a finance lease, an operating lease does not transfer substantially all of the risks and rewards of ownership to the lessee. It will generally run for less than the full economic life of the asset and the lessor would expect the asset to have a resale value at the end of the lease period – known as the residual value.
This residual value is forecast at the start of the lease and the lessor takes the risk that the asset will achieve this residual value or not when the contract comes to an end.
An operating lease is more typically found where the assets do have a residual value such as aircraft, vehicles and construction plant and machinery. The customer gets the use of the asset over the agreed contract period in return for rental payments. These payments do not cover the full cost of the asset as is the case in a finance lease.
Operating leases sometimes include other services built into the agreement, e.g. a vehicle maintenance agreement.
Ownership of the asset remains with the lessor and the asset will either be returned at the end of the lease, when the leasing company will either re-hire in another contract or sell it to release the residual value. Or the lessee can continue to rent the asset at a fair market rent which would be agreed at the time.
Ans to (i) Based on above mentioned definitions and explainations
Equipment A: will be comes under Operating lease since its useful life is more than lease tenure.
Equipment B: will be classified as Finance lease as its useful life is near about to lease tenure
Ans to (ii)
Equipment A – Inception Entry. At year end Lucky Limited will be charging depreciation to asset in his books
Cash A/c Dr $6,505
To Lease rental A/c $6,505
(Being Equipment A leased out )
Equipment B – Inception Entry. Lucky Limited won’t be charging depreciation at year end.
Forever Company A/c Dr $65,000
To Equipment B A/c $65,000
(being equipment leased out)
Cash A/c Dr $6300
To Forever Company $5625 (Principal Amount viz 6300-675)
To Financial Income $ 675 (6300*12/112 = 675, 12 % interest)
(being first installment received)
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