Question 5 (a)
Lease classification and first-year entries (lessor and lessee)
10 marks
- Time to write
- About 20 minutes
- Topic
- Leases and AS 19
- Notes
- Crux notes
Question
Question 5 (a) · 10 marksRuby Craft Co. acquired machinery on lease from Meher and Co. on April 1, 2020 on these terms:
| Lease term: | 5 years |
| Fair Value of machinery: | ₹40,00,000 |
| Useful Life: | 15 years |
The annual lease rental is payable at ₹3,50,000, ₹2,40,000, ₹1,20,000, ₹60,000 and ₹40,000. Implicit rate of return is 15%
Present value factors of 0.8696, 0.7561, 0.6575, 0.5718 and 0.4972 apply to the first, second, third, fourth and fifth years respectively, at 15% IRR.
Depreciation: 10% p.a. on the straight line basis.
Is the lease an operating lease or a finance lease? Give reasons.
How would the lease be accounted for in the books of the lessor and the lessee? Pass the journal entries for the first year in the books of both lessor and lessee, assuming the accounts are closed on 31st March each year.
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
- Is…?Give…How…?4 questions in all: answer every one.
- assuming the accounts are closed on…The paper fixes this: use it as given, and say so in your answer.
- Pass the journal entriesEach entry: the date, the debit and credit lines, and a one-line narration.
- IRRCash flows year by year in one table, then discount, then a one-line decision.
What the paper leaves open
- It says only that the rentals are "payable at" the listed amounts, not when in the year; the present-value factors start at 0.8696, one year's discount at 15%, so we read the rentals as paid at the end of each year.
- It fixes depreciation at 10% p.a. on the straight-line basis while giving a 15-year useful life (10% implies 10 years); we apply the 10% rate as printed.
Write it in this order
- Read the data; tick every adjustment as you plan it 1 min
- 1 PV of minimum lease payments and the 90% test 2 marks 4 min
- 2 Lease term against useful life; no transfer of ownership; conclusion: operating lease 2 marks 4 min
- 3 Accounting in each set of books who keeps the asset; how the rentals are charged 2 marks 4 min
- 4 Lessee's first-year entries 2 marks 3 min
- 5 Lessor's first-year entries 2 marks 3 min
- Check: every adjustment used, both sides agree, dates in 1 min
Try it first. About 20 minutes for 10 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
(i) Classification: an operating lease
Whether a lease is a finance or an operating lease depends on the substance of the transaction, not its form; a basic feature of a finance lease is that the minimum lease payments are at least 90% of the cost of the asset.
| Year | Rental (₹) | PV factor @ 15% | Present value (₹) |
|---|---|---|---|
| 1 | 3,50,000 | 0.8696 | 3,04,360 |
| 2 | 2,40,000 | 0.7561 | 1,81,464 |
| 3 | 1,20,000 | 0.6575 | 78,900 |
| 4 | 60,000 | 0.5718 | 34,308 |
| 5 | 40,000 | 0.4972 | 19,888 |
| Total | 8,10,000 | 6,18,920 |
- The present value of the minimum lease payments, ₹6,18,920, is only about 15.5% of the ₹40,00,000 fair value, far short of substantially all of it.
- The lease runs 5 years of a 15-year useful life, a third of it, not the major part.
- Ownership does not pass and there is no bargain purchase option; the risks and rewards stay with the lessor.
None of the finance-lease indicators is met, so this is an operating lease.
(ii) Accounting, and the first-year entries
Under an operating lease the lessor keeps the machine in its books and depreciates it; the lessee records no asset and charges the rentals to profit and loss. Because the rentals fall year by year, the charge is spread evenly over the lease term (the AS-19 operating-lease rule, unless another systematic basis better reflects the benefit): total rentals ₹8,10,000 ÷ 5 = ₹1,62,000 a year. The year-1 payment of ₹3,50,000 exceeds that by ₹1,88,000, carried forward as prepaid by the lessee and as received in advance by the lessor.
Books of Ruby Craft Co. (lessee), year ended 31 March 2021
| Particulars | Dr (₹) | Cr (₹) |
|---|---|---|
| Lease Rent A/c... Dr | 1,62,000 | |
| Prepaid Lease Rent A/c... Dr | 1,88,000 | |
| To Bank A/c | 3,50,000 | |
| (first rental paid on 31 March 2021; charge spread evenly, excess carried forward) | ||
| Profit & Loss A/c... Dr | 1,62,000 | |
| To Lease Rent A/c | 1,62,000 |
Books of Meher and Co. (lessor), year ended 31 March 2021
| Particulars | Dr (₹) | Cr (₹) |
|---|---|---|
| Bank A/c... Dr | 3,50,000 | |
| To Lease Rent Income A/c | 1,62,000 | |
| To Lease Rent Received in Advance A/c | 1,88,000 | |
| Depreciation A/c... Dr (10% SLM on ₹40,00,000) | 4,00,000 | |
| To Machinery A/c | 4,00,000 | |
| Lease Rent Income A/c... Dr | 1,62,000 | |
| To Profit & Loss A/c | 1,62,000 | |
| Profit & Loss A/c... Dr | 4,00,000 | |
| To Depreciation A/c | 4,00,000 |
Treatment choices, stated. (1) The falling rentals are spread evenly because the operating-lease rule straight-lines the charge unless another basis is more representative; charging each rental as paid would put ₹3,50,000 in year 1. (2) Depreciation uses the printed 10% (paper note). No local examiner key settles either point.
Where the 10 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | PV of minimum lease payments (₹6,18,920) and the 90% test | 2 |
| 2 | Lease term against useful life; no transfer of ownership; conclusion: operating lease | 2 |
| 3 | Accounting in each set of books (who keeps the asset; how the rentals are charged) | 2 |
| 4 | Lessee's first-year entries (₹1,62,000 charge; ₹1,88,000 prepaid) | 2 |
| 5 | Lessor's first-year entries (rental income; advance; depreciation ₹4,00,000) | 2 |
| Total | 10 |
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