Patrick Killeavy
6/4/2015
ACCT 7116
Lessee Ltd.
INTRODUCTION:
Lessee Ltd. is a British company that applies IFRS for financial reporting purposes. On January 1, 2013, Lessee Ltd. leased equipment from Lessor Inc. The lease term covers a period of three years and reverts back to the lessor at the end of three years. The lease costs consist of $100,000 annual rental payments as well as $2000 of annual expenses that relate to insurance, maintenance, and taxes. The equipment has a 4 year useful life, $265,000 fair value, $20,000 guaranteed residual value, and $2000 salvage value. According to IFRS IAS 17, a lease can either be classified as a finance lease or as an operating lease. Lessee Ltd. has several concerns about the classification of the lease and whether to use the 10% implicit rate in the lease or the 11% incremental borrowing rate. As a result, both a junior and senior accountant of Lessee Ltd. provided an analysis discussing whether the lease was an operating or capital lease and each prepared the applicable journal entries.
Was the junior accountant's analysis correct?: According to the junior accountant, the lease should be classified as an operating lease because the equipment reverts back to the lessor. The accountant believed that the proper annual journal entry consists of debiting legal expense of $100,000, insurance expense of $2000, and crediting cash of $102,000.
According to IFRS IAS 17.10 "Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form. Situations that would normally lead to a lease being classified as a finance lease include the following: the lease transfers ownership of the asset to the lessee by the end of the lease term the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than fair value