Question 5 OR (a)
Finance lease: classification and unearned finance income
12 marks
- Time to write
- About 24 minutes
- Topic
- Leases and AS 19
- Notes
- Crux notes
Question
Question 5 OR (a) · 12 marksOrion Ltd. Availed a lease form Vega Ltd. The lease terms and conditions are as under:
The lease period is 3 years in the beginning of the year 2023, for equipment costing ₹ 12,00,000 with an expected useful life of 5 years.
its fair maker value is also ₹ 12,00,000.
on termination of the lease, the Property reverts back to the lessor.
the unguaranteed residual value is estimated to be ₹ 1,20,000 at the end of the year 2025.
three equal annual payments are made at the end of every year.
Take the implicit rate of return to be 10%.
The present value of ? 1, due at the end of the third year, at a 10% rate of interest is ₹ 0.7513.
The present value of an annuity of ₹ 1 at the end of the third year at a 10% IRR is ₹ 2.4868
State whether or not the lease constitute a finance lease, and also calculate the unearned finance income.
Reworded from the university paper: names and figures differ, the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- State…Calculate…Two asks in one question: answer both.
- IRRCash flows year by year in one table, then discount, then a one-line decision.
What the paper leaves open
- "Availed a lease form" is read as availed a lease from, and "fair maker value" as fair market value.
- "? 1" in the first present-value line is a misprinted rupee sign and is read as ₹ 1.
- The present-value factors are used as printed.
- "Unearned finance income" is the lessor's gross investment (the three payments plus the unguaranteed residual value) less its present value, which equals the fair value.
Write it in this order
- Read the data; note exactly what is asked 2 min
- 1 PV of URV, PV of MLP and the derived annual payment 3 marks 5 min
- 2 Classification as a finance lease, with reasons 3 marks 5 min
- 3 Net and gross investment 4 marks 7 min
- 4 Allocation of the finance income over the term 2 marks 3 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Final answer
Check your own figures against these.
- Finance lease (PV of MLP
- 92.5% of fair value)
- Annual payment
- ₹4,46,294
- Net investment
- ₹12,00,000
- Gross investment
- ₹14,58,882
- Unearned finance income
- ₹2,58,882
Try it first. About 24 minutes for 12 marks. Write it out, then open the solution and check your figures against the final answer.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Step 1: derive the annual lease payment
At the implicit rate, the present value of the minimum lease payments (MLP) plus the present value of the unguaranteed residual value (URV) equals the fair value. So:
| Particulars | ₹ |
|---|---|
| Fair value of the equipment | 12,00,000 |
| Less: PV of URV = 1,20,000 × 0.7513 | 90,156 |
| PV of the minimum lease payments | 11,09,844 |
| Annual lease payment = 11,09,844 ÷ 2.4868 (to the nearest rupee) | 4,46,294 |
Step 2: is it a finance lease?
Whether a lease is a finance lease depends on the substance of the transaction rather than its form, and a feature of a finance lease is that the minimum amount payable is at least 90% of the cost of the leased asset.
| Test | Here | Points to |
|---|---|---|
| PV of MLP against fair value | 11,09,844 ÷ 12,00,000 = 92.5%, substantially all of the fair value | Finance |
| Lease term against useful life | 3 of 5 years = 60% of the life | Not decisive on its own |
| Ownership at the end | Reverts to the lessor | Does not by itself make it operating |
| Who bears the risks and rewards | The lessee pays, in present-value terms, for 92.5% of the asset | Finance |
Conclusion: the lease is a finance lease. The equipment returning to the lessor does not change this, because in substance the lessee pays for nearly the whole of the asset's value; the lessor's interest at the end is only the small unguaranteed residual.
Step 3: unearned finance income (in the books of the lessor)
A lessor records a finance lease as a receivable equal to its net investment in the lease. Unearned finance income is the excess of the gross investment over that net investment.
| Particulars | ₹ |
|---|---|
| PV of minimum lease payments | 11,09,844 |
| PV of unguaranteed residual value | 90,156 |
| Net investment in the lease (= fair value) | 12,00,000 |
| Particulars | ₹ |
|---|---|
| Total minimum lease payments (3 × 4,46,294) | 13,38,882 |
| Unguaranteed residual value | 1,20,000 |
| Gross investment in the lease | 14,58,882 |
| Reconciliation | ₹ |
|---|---|
| Net investment in the lease | 12,00,000 |
| Add: Unearned finance income | 2,58,882 |
| Gross investment in the lease | 14,58,882 |
Unearned finance income = 14,58,882 − 12,00,000 = ₹2,58,882.
Step 4: how the unearned finance income is earned
The lessor spreads finance income over the lease term so as to give a constant periodic return on its net investment outstanding, and each lease payment reduces both the principal and the unearned finance income:
| Year | Net investment at start | Finance income @ 10% | Lease payment | Net investment at end |
|---|---|---|---|---|
| 2023 | 12,00,000 | 1,20,000 | 4,46,294 | 8,73,706 |
| 2024 | 8,73,706 | 87,371 | 4,46,294 | 5,14,783 |
| 2025 | 5,14,783 | 51,511 | 4,46,294 | 1,20,000 |
| Total | 2,58,882 | 13,38,882 |
The net investment falls to exactly the ₹1,20,000 residual value at the end of 2025. The 2025 income is ₹33 above 10% of its opening balance; that is the rounding of the printed four-decimal factors (the printed annuity factor is the sum of the three rounded yearly factors), absorbed in the final year.
Result: finance lease (PV of MLP 92.5% of fair value) · annual payment ₹4,46,294 · net investment ₹12,00,000 · gross investment ₹14,58,882 · unearned finance income ₹2,58,882.
Where the 12 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | PV of URV, PV of MLP and the derived annual payment | 3 |
| 2 | Classification as a finance lease, with reasons | 3 |
| 3 | Net and gross investment; unearned finance income ₹2,58,882 | 4 |
| 4 | Allocation of the finance income over the term | 2 |
| Total | 12 |
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