Question 5 OR (b)
Finance lease: classification and unearned finance income
8 marks
- Time to write
- About 16 minutes
- Topic
- Leases and AS 19
- Notes
- Crux notes
Question
Question 5 OR (b) · 8 marksAnanya Ltd. Availed a lease from Keshav Ltd. The lease terms and conditions are as under:
The lease period is 3years, in the beginning of the year 2016, for equipment costing ₹15,00,000 with an expected useful life of 5 years.
Its fair market value is also ₹15,00,000.
On the termination of the lease, the property reverts back to the lessor.
The unguaranteed residual value is estimated at ₹1,50,000 at the end of the year 2018.
3 equal annual payments are made at the end of every year.
Take IRR as 10%
The present value of ₹1 due at the end of the 3rd year at a 10% rate of interest is ₹0.7513.
The present value of an annuity of ?1 due at the end of the 3rd 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.
Differentiate between an Operating and a Financial lease. (4×2)
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…Differentiate…3 questions in all: answer every one.
- Differentiate betweenSet the differences out in a table, basis by basis, not as two separate essays.
- IRRCash flows year by year in one table, then discount, then a one-line decision.
What the paper leaves open
- "?1" in the annuity line is a misprinted rupee sign and is read as ₹1.
- The present-value factors are used as printed.
- Part (i)'s "unearned finance income" is the lessor's gross investment (the three payments plus the unguaranteed residual value) less its present value, the fair value.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Finance-lease determination and unearned finance income 4 marks 7 min
- 2 Differentiating operating and finance leases 4 marks 7 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
Final answer
Check your own figures against these.
- finance lease
- Net investment
- ₹15,00,000
- Gross investment
- ₹18,23,604
- Unearned finance income
- ₹3,23,604
Try it first. About 16 minutes for 8 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.
(i) Finance-lease determination and unearned finance income
Annual payment (derived from fair value). At the implicit rate (10%), the present value of the minimum lease payments (MLP) plus the present value of the unguaranteed residual value (URV) equals the fair value:
- PV of URV = 1,50,000 × 0.7513 = ₹1,12,695.
- PV of MLP = Fair value − PV of URV = 15,00,000 − 1,12,695 = ₹13,87,305.
- Annual payment = PV of MLP ÷ annuity factor = 13,87,305 ÷ 2.4868 = ₹5,57,868 (to the nearest rupee).
Classification. The PV of the minimum lease payments, ₹13,87,305, is 92.5% of the fair value, so it covers substantially all (at least 90%) of the asset's cost. On the substance of the transaction this is a finance lease. (The lease term is 3 of 5 years, 60% of the economic life; the classification rests on the present-value test.) The reversion of the equipment to the lessor at the end does not by itself make it an operating lease, because the risks and rewards in substance pass to the lessee for the lease term.
Unearned finance income = gross investment − net investment.
| Particulars | ₹ |
|---|---|
| Net investment in the lease: PV of MLP 13,87,305 + PV of URV 1,12,695 | 15,00,000 |
| Gross investment: total minimum lease payments (3 × 5,57,868) 16,73,604 + URV 1,50,000 | 18,23,604 |
Reconciliation:
| Particulars | ₹ |
|---|---|
| Net investment in the lease | 15,00,000 |
| Add: Unearned finance income | 3,23,604 |
| Gross investment in the lease | 18,23,604 |
Unearned finance income = 18,23,604 − 15,00,000 = ₹3,23,604.
(ii) Operating lease vs finance lease
| Basis | Finance lease | Operating lease |
|---|---|---|
| Transfer of risks & rewards | Substantially transferred to the lessee | Retained by the lessor |
| PV of minimum lease payments | Substantially all (about 90% or more) of the asset's fair value | Well below the fair value |
| Lease term vs useful life | Major part of the economic life | Small part of the economic life |
| Who records the asset | Lessee capitalises it; lessor shows a lease receivable | Lessor keeps and depreciates it |
| Cancellability / nature | Usually non-cancellable, long-term financing arrangement | Normally cancellable, short-term hire |
| Lessee's charge | Depreciation + finance charge | Lease rent as an expense |
The distinction turns on the substance of the transaction rather than its legal form; a finance lease is non-cancellable and long-term.
Result: finance lease · net investment ₹15,00,000 · gross investment ₹18,23,604 · unearned finance income ₹3,23,604.
Where the 8 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Finance-lease determination and unearned finance income (₹3,23,604) | 4 |
| 2 | Differentiating operating and finance leases | 4 |
| Total | 8 |
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