Question 9.

7 Depreciation calculation

On 1 July 2016, Salt Airlines Ltd acquired a new aeroplane for a total cost of
$10 million. A breakdown of the costs to build the aeroplane was given by the
manufacturers as follows:

Aircraft body $ 3 000 000

Engines (2) 4 000 000
Fitting out of aircraft:
Seats 1 000 000
Carpets 50 000
Electrical equipment — passenger seats 200 000
— cockpit 1 500 000
Food preparation equipment 250 000

All costs include installation and labour costs associated with the relevant part.
It is expected that the aircraft will be kept for 10 years and then sold. The main value
of the aircraft at that stage is the body and the engines. The expected selling price is
$2.1 million, with the body and engines retaining proportionate value.
Costs in relation to the aircraft over the next 10 years are expected to be as follows:
• Aircraft body. This requires an inspection every 2 years for cracks and wear and tear,
at a cost of $10 000.
• Engines. Each engine has an expected life of 4 years before being sold for scrap. It is
expected that the engines will be replaced in 2020 for $4.5 million and again in 2024
for $6 million. These engines are expected to incur annual maintenance costs of
$300 000. The manufacturer has informed Salt Airlines Ltd that a new prototype
engine with an extra 10% capacity should be on the market in 2022, and that existing
engines could be upgraded at a cost of $1 million.
• Fittings. Seats are replaced every 3 years. Expected replacement costs are $1.2 million
in 2019 and $1.5 million in 2025. The repair of torn seats and faulty mechanisms is
expected to cost $100 000 p.a. Carpets are replaced every 5 years. They will be
replaced in 2021 at an expected cost of $65 000, but will not be replaced again before
the aircraft is sold in 2026. Cleaning costs amount to $10 000 p.a. The electrical
equipment (such as the TV) for each seat has an annual repair cost of $15 000. It is
expected that, with the improvements in technology, the equipment will be totally
replaced in 2022 by substantially better equipment at a cost of $350 000. The electrical
equipment in the cockpit is tested frequently at an expected annual cost of $250 000.
Major upgrades to the equipment are expected every 2 years at expected costs of
$250 000 (in 2015), $300 000 (in 2017), $345 000 (in 2019) and $410 000 (in 2024). The
upgrades will take into effect the expected changes in technology.
• Food preparation equipment. This incurs annual costs for repair and maintenance of
$20 000. The equipment is expected to be totally replaced in 2022.
Required
A. Discuss how the costs relating to the aircraft should be accounted for.
B. Determine the expenses recognised for the 2016–17 financial year.
A.
Discuss:
- the advantages of a components approach versus a simple depreciation of the $10
million dollars over the 10-year period.
- the treatment of the upgrades of cockpit equipment
- accounting for inspections

B: Expenses for the 2016-17 year:

Aircraft body:

Annual expense of $5 000 ($10 000 / 2years) for inspection for cracks
Depreciation expense = 1/10 (3 000 000 – 3/7 x $2 100 000) = $210 000

It is explained that the main value of the aircraft is the body ($3m) and engines ($4m),
a total of $7m. These two components are expected to retain their proportionate
values for when the aircraft is sold in 10 years’ time for $2.1m Therefore, the
depreciable amount for the aircraft body is adjusted by its proportionate residual
value. That is, $3m/$7m x $2.1m selling price.

Engines:

Depreciation expense = 4 000 000/4 = $1 000 000

Maintenance expense = $300 000

The depreciation calculation does not take into account the proportionate value of the
engines compared to the aircraft body. Why? The aircraft body is kept until it is
expected to be sold in 10 years’ time, whereas the engines are replaced every 4 years.

Fittings

Seats: Depreciation = 1/3 x $1 000 000 = $333 333

Annual expense = $100 000

Carpets: Depreciation = 1/5 x 50 000 = $10 000

Cleaning = $10 000

Electrical: Passenger
Annual expense = $15 000
Depreciation = 1/6 x $200 000 = $33 333
(expected to be replaced in 2020 – 6 years from date of purchase)

Electrical: Cockpit
Annual expense = $250 000
Depreciation = 1/10 x $1 500 000 = $150 000

Food preparation equipment:

Annual expense = $20 000

 Depreciation = 250 000/6 = $41 667

Total other expenses = $ 700 000

Annual depreciation = $1 778 333

Question 9.11 Revaluation of assets

On 1 July 2016, Kingdom Ltd acquired two assets within the same class of plant and
equipment. Information on these assets is as follows:

Cost Expected useful life

Machine A $100 000 5 years
Machine B 60 000 3 years

The machines are expected to generate benefits evenly over their useful lives. The class
of plant and equipment is measured using fair value.
At 30 June 2017, information about the assets is as follows:

Fair value Expected useful life

Machine A $84 000 4 years
Machine B 38 000 2 years

On 1 January 2018, Machine B was sold for $29 000 cash. On the same day, Kingdom
Ltd acquired Machine C for $80 000 cash. Machine C has an expected useful life of 4
years. Kingdom Ltd also made a bonus issue of 10 000 shares at $1 per share, using
$8000 from the general reserve and $2000 from the asset revaluation surplus created as
a result of measuring Machine A at fair value.
At 30 June 2018, information on the machines is as follows:

Fair value Expected useful life

Machine A $61 000 3 years
Machine C 68 500 1.5 years

The income tax rate is 30%.

Required
Prepare the journal entries in the records of Kingdom Ltd to record the described
events over the period 1 July 2016 to 30 June 2018, assuming the ends of the
reporting periods are 30 June 2017 and 30 June 2018.

1 July 2016

Machine A Dr 100 000

Machine B Dr 60 000
Cash Cr 160 000
30 June 2017

Depreciation expense – Machine A Dr 20 000

Accumulated depreciation Cr 20 000
(1/5 x $100 000)

Depreciation expense – Machine B Dr 20 000

Accumulated depreciation Cr 20 000
(1/3 x $60 000)

Accumulated depreciation- Machine A Dr 20 000

Machine A Cr 20 000
(Writing down to carrying amount)

Machine A Dr 4 000
Gain on revaluation of Machine A (OCI) Cr 4 000
(Revaluation increment: $80 000 to $84 000)

Income tax expense (OCI) Dr 1 200

Deferred tax liability Cr 1 200
(Tax effect of revaluation increment)

Gain on revaluation of Machine A (OCI) Dr 4 000

Income tax expense (OCI) Cr 1 200
Asset revaluation surplus – Machine A Cr 2 800
(Accumulation of net revaluation gain in equity))

Accumulated depreciation – Machine B Dr 20 000

Machine B Cr 20 000
(Writing down to carrying amount)

Expense – revaluation decrement (P&L) Dr 2 000

Machine B Cr 2 000
(Revaluation to fair value at 30/6/17)

1 January 2018

Machine C Dr 80 000
Cash Cr 80 000
(Acquisition of machine C)

Depreciation expense – Machine B Dr 9 500

Accumulated depreciation Cr 9 500
(($38 000 / 2years) x 1/2 year depn)

Cash Dr 29 000
Proceeds on sale of Machine B Cr 29 000
(Sale of Machine B)

Carrying amount of Machine B Sold Dr 28 500

 Accumulated depreciation Dr 9 500
Machine B Cr 38 000
(Carrying amount of machine sold)

General reserve Dr 8 000

Asset revaluation surplus – Machine A Dr 2 000
Share Capital Cr 10 000

30 June 2018

Depreciation expense – Machine A Dr 21 000

Accumulated depreciation Cr 21 000
(1/4 x $84 000)

Depreciation expense – Machine C Dr 10 000

Accumulated depreciation Cr 10 000
(1/4 x ½ x $80 000)

Accumulated depreciation – Machine A Dr 21 000

Machine A Cr 21 000
(Writing down to carrying amount)

Loss on revaluation of Machine A (OCI) Dr 2 000

Machine A Cr 2 000
(Write down of plant from $63000 to $61000)

Deferred tax liability Dr 600

Income tax expense (OCI) Cr 600
(Tax-effect on downward revaluation
subsequent to upward revaluation)

*Asset revaluation surplus – Machine A Dr 800

Income tax expense (OCI) Dr 600
Loss on revaluation of Machine A(P&L) Dr 600
Loss on revaluation of Machine A (OCI) Cr 2 000
(Accumulation of revaluation loss to equity)
*Note: in the previous year the value of the ARS account from a revaluation increment for
Machine A was $2 800. However, the entity used $2 000 of this surplus for a bonus share
issue, leaving $800 balance in this account. Therefore, when recognising a revaluation
decrement for Machine A the ARS account can only be reduced by the $800 remaining. The
balance of the loss on revaluation must now be recognised directly in P&L.

Accumulated depreciation – Machine C Dr 10 000

Machine C Cr 10 000
(Writing down to carrying amount)

Loss on revaluation (P&L) Dr 1 500

Machine C Cr 1 500
(Revaluation to fair value at 30/6/18)
Question 9.17 Acquisition, disposal and depreciation of assets
Robot Manufacturing Ltd’s post-closing trial balance at 30 June 2016 included the
following balances:

Machinery Control (at cost) $244 480

Accumulated Depreciation – Machinery Control 113 800
Fixtures (at cost) 308 600
Accumulated Depreciation – Fixtures 134 138

The Machinery Control and Accumulated Depreciation – Machinery Control

accounts are supported by subsidiary ledgers. Details of machines owned at 30 June
2016 are as follows:

Machine Purchase Cost Estimated Estimated

date useful Life residual value
1 28 Apr 2012 $74 600 5 years $3 800
2 04 Feb 2014 $82 400 5 years $4 400
3 26 Mar 2015 $87 480 6 years $5 400

Additional information
 Robot Manufacturing Ltd uses the general journal for all journal entries, records
depreciation to the nearest month, balances its accounts 6-monthly, and records
amounts to the nearest dollar.
 Robot Manufacturing Ltd uses straight-line depreciation for machinery and
diminishing balance depreciation at 20% p.a. for fixtures.
The following transactions and events occurred from 1 July 2016 onwards:

2016
03 July Exchanged items of fixtures (cost: $100 600; carrying amount at exchange date:
$56 872; fair value at exchange date: $57 140) for a used machine (Machine 4).
Machine 4’s fair value at exchange date was $58 000. Machine 4 originally cost
$92 660 and had been depreciated by $31 790 to exchange date in the previous
owner’s accounts. Robot Manufacturing Ltd estimated Machine 4’s useful life
and residual value at 3 years and $4580.
10 Oct Traded in Machine 2 for a new machine (Machine 5), that cost $90 740. A
trade-in allowance of $40 200 was received and the balance was paid in cash.
Freight charges of $280 and installation costs of $1600 were also paid in cash.
Robot Manufacturing Ltd estimated Machine 5’s useful life and residual value
at 6 years and $5500.
2017
24 Apr Overhauled Machine 3 at a cash cost of $16 910, after which Robot
Manufacturing Ltd revised its residual value to $5600 and extended its
estimated useful life by 2 years.
16 May Paid for scheduled repairs and maintenance on the machines of $2 370.
30 June Recorded depreciation and scrapped Machine 1.
Required
A. Prepare journal entries to record the above transactions and events. (Narrations are
not required.)
B. Prepare the Accumulated Depreciation Control – Machinery and Accumulated
Depreciation – Fixtures ledger accounts for the period 1 July 2016 to 30 June 2017.

1. JOURNAL ENTRIES

 M1 depreciation = [74 600 – 3 800]/60 = 1 180 per month

 M2 depreciation = [82 400 – 4 400]/60 = 1 300 per month
 M3 depreciation = [87 480 – 5 400]/72 = 1 140 per month

03/07/16 Accumulated depreciation – fixtures

(100 600 – 56 872) Dr 43 728
Carrying amount of asset sold – fixtures Dr 56 872
Fixtures Cr 100 600
(De-recognition of asset sold)

Machinery (M4) Dr 57 140

Proceeds on sale of asset – fixtures Cr 57 140
(Sale of asset and recognition of asset acquired)

M4 depreciation = [57 140 – 4 580]/36 = 1 460 per month

10/10/16 Depreciation – machinery (M2) Dr 3 900

Accumulated depreciation – machinery (M2) Cr 3 900
(Depreciation of M2 up to date of trade-in:
3 months x 1300)

Accumulated depreciation – Machinery (M2)

(1 300 x 32 months) Dr 41 600
Carrying amount of machinery sold (M2)
(82 400 – 41 600) Dr 40 800
Machinery (M2) Cr 82 400
(De-recognition of asset sold)

Machinery (M5) Dr 92 620

Proceeds on sale of machinery – (M2) Cr 40 200
Cash Cr 52 420
(Acquisition of new machinery (M5):
90 740 + 280 + 1600)
M5 depreciation = [92 620 – 5 500]/72 = 1 210 per month
24/04/17 Depreciation – Machinery (M3) Dr 11 400
Accumulated depreciation – Machinery (M3) Cr 11 400
(Depreciation on M3 up to point of overhaul:
1 140 x 10 months)
Accumulated Depreciation - machinery (M3) Dr 28 500
Machinery (M3) Cr 28 500
(write down to carrying amount prior to overhaul)
[$1 140 x 25 months]
 Machinery (M3) Dr 16 910
Cash Cr 16 910
(Cost of overhaul)

M3: new depreciable amount = 87 480 – (1 140 x 25mths) + 16 910 – 5,600

= 70 290
new useful life = 72–25+24
= 71 months
revised depreciation = 70 290/71
= 990 per month

16/05/17 Repairs and maintenance expense Dr 2 370

Cash Cr 2 370
(Repairs and maintenance expense)

30/06/17 Depreciation expense– machinery Dr 42 190

Accumulated depreciation – machinery Cr 42 190
(Depreciation charge up to end of year:
M1: 1 180 x 10 months = 11 800
M3: 990 x 2 months = 1 980
M4: 1 460 x 12 months = 17 520
M5: 1 210 x 9 months = 10 890)

Depreciation – fixtures Dr 23 518

Accumulated depreciation – fixtures Cr 23 518
(Depreciation charge up to year end:
Cost: 308 600 – 100 600 = 208,000)
Accumulated depreciation = 134 138 – 43 728
= 90 410
Depreciable amount = 117,590
Depreciation charge = 117 590 x 20%
= 23 518)

Accumulated depreciation – machinery (M1)

(1 180 x 60 months) Dr 70 800
Carrying amount of machinery scrapped (M1)
(74 600 – 70 800) Dr 3 800
Machinery (M1) Cr 74 600
(De-recognition of machinery scrapped – M1)
2. LEDGER ACCOUNTS

ACCUMULATED DEPRECIATION CONTROL - MACHINERY

10/10/16 Machinery (M2) 41 600 30/06/16 Balance b/d 113 800
31/12/16 Balance c/d 76 100 10/10/16 Depreciation (M2) 3 900
117 700 117 700
24/04/17 Machinery (M3) 28 500 31/12/16 Balance b/d 76 100
30/06/17 Machinery (M1) 70 800 24/04/17 Depreciation (M3) 11 400

Balance c/d 30 390 30/06/17 Depreciation 42 190

129 690 129 690

ACCUMULATED DEPRECIATION - FIXTURES

03/07/016 Fixtures 43 728 30/06/16 Balance b/d 134 138
31/12/16 Balance c/d 90 410 ______
134 138 134 138
31/12/16 Balance b/d 90 410
30/06/17 Fixtures 113 928 30/06/17 Depreciation 23 518
113 928 113 928

Question 10.6 Accounting for a finance lease by the lessor

On 1 July 2015, Jane Plum went to the local car yard, North Ltd, and agreed to lease a
new Ford Mustang based on an agreed price of $37 000. South Ltd, a local finance
company, set up the lease agreement. North Ltd had acquired the car from the
manufacturer for $30 000 and transferred the car to South Ltd for $37 000.
South Ltd — the lessor — wrote a lease agreement, incurring initial direct costs of
$1410 as a result. The lease agreement contained the following provisions:

Initial payment on 1 July 2015 $13 000

Payments on 1 July 2016 and 1 July $13 000
2017
Guaranteed residual value at 30 June $10 000
2018
Implicit interest rate in the lease 6%
The lease is non-cancellable.

South Ltd agreed to pay for the insurance and maintenance of the vehicle, the latter to
be carried out by North Ltd at regular intervals. The required lease payments included
the costs for these services at $3000 p.a.
The vehicle had an expected useful life of 4 years. The expected residual value of the
vehicle at 30 June 2018 was $12 000.
Costs of maintenance and insurance incurred by South Ltd over the years ended 30
June 2016 to 30 June 2018 were $2810, $3020 and $2750 respectively. On 30 June 2018,
Jane returned the vehicle to South Ltd. On 5 July 2018, South Ltd sold the car to a
third party for $9000 and Jane agreed to pay the balance of the guaranteed residual.
The lease is classified as a finance lease by South Ltd.

Required
A. Calculate the net investment in the lease for South Ltd
B. Prepare a lease receipts schedule for South Ltd.
C. Prepare the journal entries of South Ltd in relation to the lease from 1 July 2015
to 5 July 2018.
D. In relation to finance leases, explain why the balance of the lease receivable asset
raised by the lessor at the inception of the lease may differ from the balance of the
lease liability raised by the lessee.

SOUTH LTD (LESSOR)

South Ltd is a financier lessor rather than a manufacturer/dealer lessor. The significance of
this classification is that:
 there is no selling profit to South Ltd on entering into the lease arrangement
 initial indirect costs are included the initial recognition of the lease receivable

PART A

The annual lease receipts that relate to the use of the asset amount to $10 000, that is, the full
amount of $13 000 less reimbursement for executory costs $3 000. The guaranteed residual at
the end of the lease is $10 000 and the unguaranteed is $2 000 giving a total of $12 000 at the
end of the lease.

The lease receivable is initially measured at $38 410 calculated as follows:

(1) Fair Value + Initial Direct Costs = $37 000 + $1 410

(2) Net investment in lease = PV of MLP + PV of Unguaranteed Residual Value (UGRV)

PV of MLP = 10 000 + 10 000 x 1.8334 [T2 6% 2 yrs] + 10 000 x 0.8396 [T1 6% 3 yrs]
= 10 000 + 18 334+ 8 396
=36 730

PV of UGRV = 2 000 x 0.8396 [T1 6% 3 yrs]

= 1 679

Net investment in lease = 36 730 + 1 679 = $38 409 (difference due to rounding)
PART B – LEASE RECEIPTS SCHEDULE

South Ltd (lessor)

Schedule of lease receipts

MLR Interest Receivable Receivable

revenue reduction balance

$ $ $ $
1 July 2015 38 410
1 July 2015 10 000 - 10 000 28 410
1 July 2016 10 000 1 705 8 295 20 115
1 July 2017 10 000 1 207 8 793 11 322
30 June 2018 12 000 678* 11 322 --
42 000 3 590 38 410

*Includes adjustment for the effect of rounding

PART C – JOURNAL ENTRIES

South Ltd (lessor)

Journal entries

1 July 2015

Vehicle Dr 37 000
Cash Cr 37 000
(Purchase of vehicle by lessor)

Lease Receivable Dr 38 410

Cash Cr 1 410
Vehicle Cr 37 000
(Lease of vehicle and payment of initial
direct costs)

Cash Dr 13 000
Unearned Revenue Cr 3 000
Lease Receivable Cr 10 000
(First lease receipt in advance)

30 June 2016

Unearned Revenue Dr 3 000

Reimbursement Revenue Cr 3 000
(Adjusting entry for unearned revenue)

Insurance and Maintenance Expense Dr 2 810

Cash Cr 2 810
(Executory costs incurred for the year)
 Interest Receivable Dr 1 705
Interest Revenue Cr 1 705
(Accrual of interest for the year)

1 July 2016

Cash Dr 13 000
Unearned Revenue Cr 3 000
Interest Receivable Cr 1 705
Lease Receivable Cr 8 295
(Second lease receipt in advance)

30 June 2017

Unearned Revenue Dr 3 000

Reimbursement Revenue Cr 3 000
(Adjusting entry for unearned revenue)

Insurance and Maintenance Expense Dr 3 020

Cash Cr 3 020
(Executory costs incurred for the year)

Interest Receivable Dr 1 207

Interest Revenue Cr 1 207
(Accrual of interest for the year)

1 July 2017

Cash Dr 13 000
Reimbursement Revenue Cr 3 000
Interest Receivable Cr 1 207
Lease Receivable Cr 8 793
(Third lease receipt in advance)

30 June 2018

Unearned Revenue Dr 3 000

Reimbursement Revenue Cr 3 000
(Adjusting entry for unearned revenue)

Insurance and Maintenance Expense Dr 2 750

Cash Cr 2 750
(Executory costs incurred for the year)

Vehicle Dr 12 000
Interest Revenue Cr 678
Lease Receivable Cr 11 322
(Return of vehicle at end of lease)
5 July 2018

Cash Dr 9 000
Accounts Receivable/J Plum Dr 1 000
Proceeds on Sale of Vehicle Cr 10 000
(Revenue from sale of vehicle)

Carrying Amount of Vehicle Sold Dr 12 000

Vehicle Cr 12 000
(Expense from sale of vehicle)

PART D – FINANCE LEASE RECEIVABLE V FINANCE LEASE LIABILITY

Two situations in which the lease receivable recorded by lessor is not the same as lease asset
recorded by lessee are:

1. There is an unguaranteed residual value. The lessor records as a lease receivable its
net investment in the lease (present value of the minimum lease payments receivable
and the present value of any unguaranteed residual value). The lessee, however,
records as a leased asset (and lease liability) the present value of the minimum lease
payments. The amount recorded by the lessee does not include any unguaranteed
residual value.

and/or

2. If the lessor or lessee has incurred initial direct costs. If lessor (other than a
manufacturer/dealer lessor) has incurred initial direct costs then its lease receivable
balance is equal to the fair value of the asset plus costs. If the lessee has incurred initial
direct costs they are added to the value of the leased asset.

Question 10.7 Accounting for a finance lease by the lessee and lessor

On 1 July 2015, Lions Den Ltd leased a plastic-moulding machine from Jersey City Ltd.
The machine cost Jersey City Ltd $130 000 to manufacture and had a fair value of
$154 109 on 1 July 2015. The lease agreement contained the following provisions:

Lease term 4 years

Annual rental payment, in advance on 1 July each year $41 500
Residual value at end of the lease term $15 000
Residual guaranteed by lessee nil
Interest rate implicit in lease 8%
The lease is cancellable only with the permission of the
lessor.

The expected useful life of the machine is 6 years. Lions Den Ltd intends to return the
machine to the lessor at the end of the lease term. Included in the annual rental
payment is an amount of $1500 to cover the costs of maintenance and insurance paid for
by the lessor.
Required
A. Explain why the lease should be classified as a finance lease by both lessee and
lessor based on the guidance provided in AASB 117.
B. Prepare (1) the lease payment schedule for the lessee (show all workings); and (2)
the journal entries in the accounting records of the lessee for all years of the lease.
C. Prepare (1) the lease receipt schedule for the lessor (show all workings); and (2)
the journal entries in the accounting records of the lessor for all years of the lease.

PART A – CLASSIFICATION OF LEASE

The lease would be classified by both lessee and lessor as a finance lease as substantially all of the
risks and rewards incidental with ownership have been transferred as a result of the lease
arrangement.

This is evidenced by the fact that:

 the lease is non-cancellable (by definition),
 the lease term, at 67%, could be argued to represent a major part of the economic life of
the machine, and
 the present value of the minimum lease payments is substantially all of the fair value of
the machine at the inception of the lease:

PV of MLP = 40 000 + 40 000 x 2.5771 [T2 8% 3 yrs]

= 40 000 + 103 084
= 143 084/154 109
= 93%

The lease payments for the use of the asset are $40 000 per annum, that is, $41 500 total less $1 500
for reimbursement of executory costs.

PART B – ACCOUNTING BY LESSEE

(1) Lease payment schedule

Lions Den Ltd (Lessee)

Schedule of lease payments\

MLP Interest Liability Liability

expense reduction balance
$ $ $ $

1 July 2015 143 084

1 July 2015 40 000 - 40 000 103 084
1 July 2016 40 000 8 247 31 753 71 331
1 July 2017 40 000 5 706 34 294 37 037
1 July 2018 40 000 2 963 37 037 -
160 000 16 916 143 084
(2). Journal entries
Lions Den Ltd (Lessee)

1 July 2015

Leased Machine Dr 143 084

Lease Liability Cr 143 084
(Inception of lease)

Lease Liability Dr 40 000

Prepaid Ins & Maintenance Dr 1 500
Cash Cr 41 500
(First lease payment in advance)

30 June 2016

Ins & Maintenance Expense Dr 1 500

Prepaid Ins & Maintenance Cr 1 500
(Adjusting entry for prepayment)

Interest Expense Dr 8 247

Interest Payable Cr 8 247
(Interest accrued at year end)

Depreciation Expense Dr 35 771

Accumulated Depreciation Cr 35 771
(Depreciation for year 1, $143 084 ÷ 4)

1 July 2016

Lease Liability Dr 31 753

Interest Payable Dr 8 247
Prepaid Ins & Maintenance Dr 1 500
Cash Cr 41 500
(Second lease payment in advance)

30 June 2017

Ins & Maintenance Expense Dr 1 500

Prepaid Ins & Maintenance Cr 1 500
(Adjusting entry for prepayment)

Interest Expense Dr 5 706

Interest Payable Cr 5 706
(Interest accrued at year end)

Depreciation Expense Dr 35 771

Accumulated Depreciation Cr 35 771
(Depreciation for year 2, $143 084 ÷ 4)
1 July 2017

Lease Liability Dr 34 294

Interest Payable Dr 5 706
Prepaid Ins & Maintenance Dr 1 500
Cash Cr 41 500
(Third lease payment in advance)

30 June 2018

Ins & Maintenance Expense Dr 1 500

Prepaid Ins & Maintenance Cr 1 500
(Adjusting entry for prepayment)

Interest Expense Dr 2 963

Interest Payable Cr 2 963
(Interest accrued at year end)

Depreciation Expense Dr 35 771

Accumulated Depreciation Cr 35 771
(Depreciation for year 3, $143 084 ÷ 4)

1 July 2018

Lease Liability Dr 37 037

Interest Payable Dr 2 963
Prepaid Ins & Maintenance Dr 1 500
Cash Cr 41 500
(Fourth lease payment in advance)

30 June 2019

Ins & Maintenance Expense Dr 1 500

Prepaid Ins & Maintenance Cr 1 500
(Adjusting entry for prepayment)

Depreciation Expense Dr 35 771

Accumulated Depreciation Cr 35 771
(Depreciation for year 4, $143 084 ÷ 4)

Accumulated Depreciation Dr 143 084

Leased Machine Cr 143 084
(De-recognition of lease asset)
PART C – ACCOUNTING BY LESSOR

Jersey City Ltd is a manufacturer/dealer lessor. The significance of this classification is that:
 there is a selling profit to Jersey City Ltd on entering into the lease arrangement
 initial indirect costs are not included the initial recognition of the lease receivable but
treated as part of the sale transaction

The lease receivable is initially measured at the fair value of $154 109 calculated as follows:

Net investment in lease = PV of MLP + PV of Unguaranteed Residual Value (UGRV)

PV of MLP = 40 000 + 40 000 x 2.5771 [T2 8% 3 yrs]

= 40 000 + 103 084
=143 084

PV of UGRV = 15 000 x 0.7350 [T1 8% 4 yrs]

= 11 025

Net investment in lease = 143 084 + 11 025 = $154 109

(1) Lease receipts schedule

Jersey City Ltd (Lessor)

Lease receipts schedule

MLR Interest Receivable Receivable

revenue reduction balance
$ $ $ $

1 July 2015 154 109

1 July 2015 40 000 - 40 000 114 109
1 July 2016 40 000 9 129 30 871 83 238
1 July 2017 40 000 6 659 33 341 49 897
1 July 2018 40 000 3 992 36 008 13 889
30 June 2019 15 000 1 111 13 889 -
175 000 20 891 154 109

(1) Journal Entries

Jersey City Ltd (Lessor)
1 July 2015

Lease Receivable Dr 154 109

Inventory Cr 130 000
Cost of Sales Dr *118 975
Sales Revenue Cr **143 084
(Inception of lease)
(* Cost less PV of UGRV [15 000 x 0.735])
(** PV of MLP)
 Cash Dr 41 500
Unearned Revenue Cr 1 500
Lease receivable Cr 40 000
(First lease receipt in advance)

30 June 2016

Unearned Revenue Dr 1 500

Reimbursement Revenue Cr 1 500
(Adjusting entry for unearned revenue)

Interest Receivable Dr 9 129

Interest Revenue Cr 9 129
(Interest revenue accrued at year end)

1 July 2016

Cash Dr 41 500
Interest Receivable Cr 9 129
Unearned Revenue Cr 1 500
Lease receivable Cr 30 871
(Second lease receipt in advance)

30 June 2017

Unearned Revenue Dr 1 500

Reimbursement Revenue Cr 1 500
(Adjusting entry for unearned revenue)

Interest Receivable Dr 6 659

Interest Revenue Cr 6 659
(Interest revenue accrued at year end)

1 July 2017

Cash Dr 41 500
Interest Receivable Cr 6 659
Unearned Revenue Cr 1 500
Lease receivable Cr 33 341
(Third lease receipt in advance)

30 June 2018

Unearned Revenue Dr 1 500

Reimbursement Revenue Cr 1 500
(Adjusting entry for unearned revenue)
 Interest Receivable Dr 3 992
Interest Revenue Cr 3 992
(Interest revenue accrued at year end)

1 July 2018

Cash Dr 41 500
Interest Receivable Cr 3 992
Unearned Revenue Cr 1 500
Lease receivable Cr 36 008
(Fourth lease receipt in advance)

30 June 2019

Unearned Revenue Dr 1 500

Reimbursement Revenue Cr 1 500
(Adjusting entry for unearned revenue)

Inventory Dr 15 000
Interest Revenue Cr 1 111
Lease Receivable Cr 13 889
(Return of equipment at lease end)

The lessor would also record insurance and maintenance expenses during the lease term for
the insurance and maintenance costs it incurs in relation to the plastic moulding machine.

Question 10.8 Accounting for a finance lease by the lessee and the lessor

On 1 July 2015, Standing Ltd leased a processing plant to Fell Ltd. The plant was
purchased by Standing Ltd on 1 July 2015 for its fair value of $467 112. The lease
agreement contained the following provisions:

Lease term 3 years

Economic life of plant 5 years
Annual rental payment, in arrears (commencing $150 000
30/6/2016)
Residual value at end of the lease term $90 000
Residual guaranteed by lessee $60 000
Interest rate implicit in lease 7%
The lease is cancellable only with the permission
of the lessor.

Fell Ltd intends to return the processing plant to the lessor at the end of the lease
term. The lease has been classified as a finance lease by both the lessee and the lessor.
Required
A. Prepare (1) the lease payment schedule for the lessee (show all workings); and (2)
the journal entries in the records of the lessee for all years of the lease.
B. Prepare (1) the lease receipt schedule for the lessor (show all workings); and (2)
the journal entries in the records of the lessor for all years of the lease.
PART A – ACCOUNTING BY THE LESSEE

FELL LTD
1. Lease payment schedule

Fell Ltd (Lessee)

Schedule of lease payments

MLP Interest Liability Liability

expense reduction balance
$ $ $ $

1 July 2015 *442 623

30 June 2016 150 000 30 984 119 016 323 607
30 June 2017 150 000 22 652 127 348 196 259
30 June 2018 150 000 13 741 136 259 60 000
30 June 2018 60 000 - 60 000 -
510 000 67 377 442 623

Workings

PV of MLP = $150 000 x 2.6243 [T2 7% 3y] + $60 000 x 0.8163 [T1 7% 3y]
= $393 645 + $48 978
= $442 623*

2. Journal entries
Fell Ltd (Lessee)

1 July 2015

Leased Processing Plant Dr 442 623

Lease Liability Cr 442 623
(Initial recognition of finance lease)

30 June 2016

Lease Liability Dr 119 016

Interest Expense Dr 30 984
Cash Cr 150 000
(First lease payment in arrears)

Depreciation Expense Dr 127 541

Accumulated Depreciation Cr 127 541
(Depreciation for year 1)
[(442 623 – 60 000)/3]
30 June 2017

Lease Liability Dr 127 348

Interest Expense Dr 22 652
Cash Cr 150 000
(Second lease payment in arrears)

Depreciation Expense Dr 127 541

Accumulated Depreciation Cr 127 541
(Depreciation for year 2)
[(442 623 – 60 000)/3]

30 June 2018
Lease Liability Dr 136 259
Interest Expense Dr 13 741
Cash Cr 150 000
(Third lease payment in arrears)

Depreciation Expense Dr 127 541

Accumulated Depreciation Cr 127 541
(Depreciation for year 3)
[(442 623 – 60 000)/3]

Lease Liability Dr 60 000

Leased Processing Plant Cr 60 000
(Return of plant to lessor)

Accumulated Depreciation Dr 382 623

Leased Processing Plant Cr 382 623
(De-recognition of leased asset)

PART B – ACCOUNTING BY THE LESSOR

STANDING LTD
1. Lease receipts schedule
Standing Ltd (Lessor)
Lease receipts schedule

MLR Interest Receivable Receivable

revenue reduction balance
$ $ $ $

1 July 2015 467 112

30 June 2016 150 000 32 698 117 302 349 810
30 June 2017 150 000 24 487 125 513 224 297
30 June 2018 150 000 15 703 134 297 90 000
30 June 2018 90 000 - 90 000 -
540 000 72 888 467 112
Net investment in lease = P.V. of MLP + P.V of unguaranteed residual value (UGRV)
= $442 623 + 30 000 x 0.8163 [T1 7% 3y]
= $467 112
2. Journal entries
Christchurch Ltd (Lessor)
Journal entries

1 July 2015

Processing Plant Dr 467 112

Cash Cr 467 112
(Acquisition of plant)

Lease Receivable Dr 467 112

Plant Cr 467 112
(Initial recognition of finance lease)

30 June 2016

Cash Dr 150 000

Interest revenue Cr 32 698
Lease receivable Cr 117 302
(First lease receipt in arrears)

30 June 2017

Cash Dr 150 000

Interest Revenue Cr 24 487
Lease Receivable Cr 125 513
(Second lease receipt in arrears)

30 June 2018

Cash Dr 150 000

Interest Revenue Cr 15 703
Lease Receivable Cr 134 297
(Third lease receipt in arrears)

Processing Plant Dr 90 000

Lease Receivable Cr 90 000
(Return of plant at end of lease)

Question 10.11 Accounting for a sale and leaseback transaction by the

lessee and lessor

Squeal Ltd is asset rich but cash poor. In an attempt to alleviate its liquidity problems,
it entered into an agreement on 1 July 2015 to sell its processing plant to Tyres Ltd for
$467 100. At the date of sale, the plant had a carrying amount of $400 000 and a future
useful life of 5 years. Tyres Ltd immediately leased the processing plant back to Squeal
Ltd. The terms of the lease agreement were:
 Lease term 3 years
Economic life of plant 5 years
Annual rental payment, in arrears (commencing $165 000
30/6/16)
Residual value of plant at end of lease term $90 000
Residual value guaranteed by Squeal Ltd $60 000
Interest rate implicit in the lease 6%
The lease is cancellable, but only with the permission
of the lessor.

At the end of the lease term, the plant is to be returned to Tyres Ltd. In setting up the
lease agreement Tyres Ltd incurred $9414 in legal fees and stamp duty costs. The
annual rental payment includes $15 000 to reimburse the lessor for maintenance costs
incurred on behalf of the lessee.

Required
A. Explain why the lease should be classified as a finance lease by both the lessor and
lessee.
B. Prepare a lease payments schedule and the journal entries in the records of Squeal
Ltd for the lease. Show all workings.
C. Prepare a lease receipts schedule and the journal entries in the records of Tyres
Ltd for the lease. Show all workings.
D. Explain how and why your answers to requirements A and B would change if the
lease agreement could be cancelled at any time without penalty.
E. Explain how and why your answer to requirements A, B and C would change if
the processing plant had been manufactured by Tyres Ltd at a cost of $400 000.

SALE AND LEASEBACK TRANSACTION

Squeal Ltd (Seller)

Squeal Ltd (Lessee) and Tyres Ltd (Lessor)

If a sale and leaseback transaction results in a finance lease any excess of proceeds over the
carrying amount shall not be immediately recognised as income by a seller-lessee. Instead, it
shall be deferred and amortised over the lease term.

PART A - CLASSIFICATION OF THE LEASE

Both the lessor and the lessee must determine whether the lease agreement effectively
transfers substantially all of the risks and rewards from the owner to the lessee.

In this case, based on the following evidence, both parties should conclude that such a
transfer is achieved and the lease should be classified as a finance lease:

 the lease is non-cancellable (by definition)

 the lease term at 60% which, arguably, is for a major part of the asset’s economic life, and
 the PV of the MLP at 96.6% represents substantially all of the asset’s fair value (see
calculation below)

PV of MLP

Minimum Lease Payments = ($165 000 – $15 000) x 3 [rentals net of executory costs] + $60
000 [GRV]

Interest Rate 6%

Pattern of Payments - Arrears

PV of MLP = $150 000 x 2.6730 [T2 6% 3 years]

+ $60 000 x 0.8396 [T1 6% 3 years]
= $400 950 + $50 376
= $451 326

PV/FV = $451 326/$467 100

= 96.6%

PART B – LEASE PAYMENTS SCHEDULE AND JOURNALS

1. Lease repayment schedule

Squeal Ltd (Lessee)

Lease Payments Schedule

Date MLP Interest Reduction of Balance of

Expense liability lease liability
$ $ $ $
1 July 2015 451 326
30 June 2016 150 000 27 080 122 920 328 406
30 June 2017 150 000 19 704 130 296 198 110
30 June 2018 150 000 11 890 138 110 60 000
30 June 2018 60 000 - 60 000
510 000 58 674 451 326 -

2. Accounting for the lease in the books of Squeal Ltd (lessee)

Journal Entries
1 July 2015

Cash Dr 467 100

Deferred gain on sale Cr 67 100
Processing plant Cr 400 000
(Sale of plant under sale
and leaseback agreement)
 Leased plant Dr 451 326
Lease liability Cr 451 326
(Recognition of lease agreement)

30 June 2016
Lease liability Dr 122 920
Interest expense Dr 27 080
Executory costs expense Dr 15 000
Cash Cr 165 000
(First lease payment in arrears)

Depreciation expense Dr 130 442

Accumulated depreciation Cr 130 442
(Depreciation of leased asset
[($451 326 – 60 000)/3]

Deferred gain on sale Dr 22 367

Revenue on sale Cr 22 367
(Amortisation of deferred gain - $67 100/3)

30 June 2017

Lease liability Dr 130 296

Interest expense Dr 19 704
Executory costs expense Dr 15 000
Cash Cr 165 000
(Second lease payment in arrears)

Depreciation expense Dr 130 442

Accumulated depreciation Cr 130 442
(Depreciation of leased asset
[($451 326 – 60 000)/3]

Deferred gain on sale Dr 22 367

Revenue on sale Cr 22 367
(Amortisation of deferred gain - $67 100/3)

30 June 2018
Lease liability Dr 138 110
Interest expense Dr 11 890
Executory costs expense Dr 15 000
Cash Cr 165 000
(Third lease payment in arrears)

Depreciation expense Dr 130 442

Accumulated depreciation Cr 130 442
(Depreciation of leased asset
[($451 326 – 60 000)/3]
 Deferred gain on sale Dr 22 367
Revenue on sale Cr 22 367
(Amortisation of deferred gain - $67 100/3)

Lease liability Dr 60 000

Leased plant Cr 60 000
(Return of leased asset to lessor)

Leased plant Dr 391 326

Accumulated depreciation Cr 391 326
(De-recognition of leased asset)

PART C – LEASE RECEIPTS SCHEDULE AND JOURNALS

Lessor is a financier lessor (i.e. non-maufacturer/non-dealer) therefore:

Net investment in the lease = fair value of leased asset + initial indirect costs
= 467 100 + 9 414 = $476 514

Net investment in the lease = PV of MLP + PV of UGRV

= 451 326 + 30 000 x 0.8396 [T1 6% 3 years]
= $476 514

1. Lease receipts schedule

Tyres Ltd (Lessor)

Lease Receipts Schedule

Date MLR Interest Reduction in Balance of lease

Revenue Receivable Receivable
$ $ $ $
1 July 2015 476 514
30 June 2016 150 000 28 591 121 409 355 105
30 June 2017 150 000 21 306 128 694 226 411
30 June 2018 150 000 13 589 136 411 90 000
30 June 2018 90 000 90 000 -
540 000 63 486 476 514 -

2. Accounting for the lease in the books of Tyres Ltd (lessor)

Journal Entries

1 July 2015

Processing plant Dr 467 100

Cash Cr 467 100
(Purchase of plant from Squeal Ltd)
 Lease receivable Dr 467 100
Processing plant Cr 467 100
(Recognition of lease agreement)

Lease receivable Dr 9 414

Cash Cr 9 414
(Payment of initial direct costs)

30 June 2016

Cash Dr 165 000

Lease receivable Cr 121 409
Interest revenue Cr 28 591
Reimbursement revenue Cr 15 000
(First lease receipt in arrears)

Maintenance expense Dr 15 000

Cash/Payable Cr 15 000
(Maintenance costs incurred)

30 June 2017

Cash Dr 165 000

Lease receivable Cr 128 694
Interest revenue Cr 21 306
Reimbursement revenue Cr 15 000
(Second lease receipt in arrears)

Maintenance expense Dr 15 000

Cash/Payable Cr 15 000
(Maintenance costs incurred)

30 June 2018

Cash Dr 165 000

Lease receivable Cr 136 411
Interest revenue Cr 13 589
Reimbursement revenue Cr 15 000
(Third lease receipt in arrears)

Maintenance expense Dr 15 000

Cash/Payable Cr 15 000
(Maintenance costs incurred)

Processing plant Dr 90 000

Lease receivable Cr 90 000
(Return of processing plant)
PART D – LEASE CANCELLABLE WITHOUT PENALTY
As the lease is now cancellable without penalty the lease can no longer be classified as a
finance lease and thus should be treated as an operating lease. The consequences are:

From Squeal Ltd’s perspective

1. the leased asset is not capitalised – no asset/liability is raised on 1 July 2015

2. the profit on the sale of the processing plant can be recognised immediately in the
statement of profit or loss and other comprehensive income
3. the lease payment is treated as an expense item when paid.
4. no depreciation expense is recorded

Journal Entries

1 July 2015

Cash Dr 467 100

Gain on sale Cr 67 100
Processing plant Cr 400 000
(Sale of plant under sale
and leaseback agreement)

30 June 2016

Rental expense Dr 150 000

Executory costs expense Dr 15 000
Cash Cr 165 000
(First lease payment in arrears)

30 June 2017

Rental expense Dr 150 000

Executory costs expense Dr 15 000
Cash Cr 165 000
(Second lease payment in arrears)

30 June 2018

Rental expense Dr 150 000

Executory costs expense Dr 15 000
Cash Cr 165 000
(Third lease payment in arrears)

PART E – LESSOR A MANUFACTURER/DEALER

If Tyres Ltd had manufactured the plant at cost of $400 000 then this would not be a sale and
leaseback transaction. Accordingly, the following changes to the answer would occur:

 Tyres Ltd (lessor) would record the initial direct costs as an expense
 The lease receivable recorded by Tyres Ltd would revert back to the fair value of $467
100 and the interest rate implicit in the lease would change to approx. 7%*.

* $150 000 x 2.6243 + $90 000 x 0.8163

= $393 645 + $73 467
= $467 112

 The initial entry to record the lease in Tyres Ltd’s books would change to:

Lease receivable Dr 467 100

Sales revenue Cr *442 623
Cost of sales Dr **375 523
Processing plant Cr 400 000
(Initial recognition of lease and recording sale of plant)

* Using 7%, PV of MLP = $150 000 x 2.6243 + $60 000 x 0.8163

**[$400 000 (cost of plant) less $24 489 (PV of unguaranteed residual value)
= $30 000 x 0.8163]

Lease establishment expense Dr 9 414

Cash Cr 9 414
(Payment of establishment costs)

Thus, a profit on ‘sale’ of $67 100 (net of initial direct costs) would be recorded.

 Squeal Ltd (lessee) would have no ‘sale’ of plant entries and would simply record the
leased asset/lease liability. As a result there would be no amortisation of the gain over
the lease term.