Question 5 OR (d)
Lease with falling rentals: classification, first-year entries, Balance Sheet extracts
10 marks
- Time to write
- About 20 minutes
- Topic
- Leases and AS 19
- Notes
- Crux notes
Question
Question 5 OR (d) · 10 marksP Ltd acquired machinery on Lease from Q Ltd on these terms:
| Lease Term | 5Year |
| Fair Value of Machinery | Rs 50 Lakhs (useful life 16 years) |
| Annual Lease Rental Payable at the end of every year | Rs 7 lakh, Rs.6 Lakh, Rs.5 Lakh, Rs.4 lakh, Rs. 3 Lakh |
| IRR | 16% |
Required:
State whether the lease is an operating lease or a Financial Lease.
For the first year, pass the entries needed in the books of the lessee and the lessor. Also prepare their Balance Sheet (Extract). Depreciation is charged on the straight line basis @10% per annum.
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…Prepare…Two asks in one question: answer both.
- prepare their Balance SheetProper formats (heading, date, both sides): post the plain items, then each adjustment, and balance last.
- pass the entriesEach entry: the date, the debit and credit lines, and a one-line narration.
What the paper leaves open
Points the paper leaves open (figures are our version's).
- No present-value factors are given; they are worked out from the stated IRR (16%).
- For an operating lease the falling rentals are spread evenly over the lease term (the AS-19 operating-lease rule, unless another systematic basis better reflects the benefit); charging each rental as paid would put the first year's full ₹7 lakh to profit and loss.
- Depreciation is at the stated 10% per annum although the useful life is given as 16 years.
- "Their Balance Sheet (Extract)" is left as printed; the answer gives one extract for the lessee and one for the lessor.
Write it in this order
- Read the data; tick every adjustment as you plan it 1 min
- 1 Classification with reasons: PV of payments against fair value, term against life 3 marks 5 min
- 2 Lessee entries on the straight-line basis 2 marks 4 min
- 3 Lessor entries: income, receipt, depreciation, transfers 3 marks 5 min
- 4 Balance Sheet extracts of both 2 marks 4 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
AS-19 treats a lease as an operating lease when the risks and rewards of owning the asset stay, in substance, with the lessor rather than passing to the lessee. Typical signs are a lease period shorter than the asset's economic life, no transfer of ownership, and the asset returning to the lessor at the end.
Present value of the minimum lease payments at the IRR of 16%
| Year | Rental (₹) | PV factor @16% | Present value (₹) |
|---|---|---|---|
| 1 | 7,00,000 | 0.8621 | 6,03,470 |
| 2 | 6,00,000 | 0.7432 | 4,45,920 |
| 3 | 5,00,000 | 0.6407 | 3,20,350 |
| 4 | 4,00,000 | 0.5523 | 2,20,920 |
| 5 | 3,00,000 | 0.4761 | 1,42,830 |
| Total | 25,00,000 | 17,33,490 |
- The present value, ₹17,33,490, is only about 35% of the fair value of ₹50 lakh, far from substantially all of it.
- The lease runs 5 years of a 16-year useful life.
- Nothing transfers ownership or gives the lessee a purchase option, so the machine goes back to Q Ltd.
Conclusion: an operating lease. Q Ltd keeps the risks and rewards of ownership.
(ii) Entries for the first year
Basis. The lessee records the lease rent as an expense on a straight-line basis over the lease term, that is, total rentals divided by the lease period: ₹25,00,000 ÷ 5 = ₹5,00,000 a year. The first payment of ₹7,00,000 therefore leaves ₹2,00,000 paid in advance. Under an operating lease the lessor keeps the machine on its own Balance Sheet as a fixed asset and charges depreciation on it. Its lease income is spread over the term on the same straight-line basis (paper note).
Lessee's first-year payment
| Particulars | ₹ |
|---|---|
| Lease rent charged for the year (straight line) | 5,00,000 |
| Lease rent paid in advance (carried forward) | 2,00,000 |
| Rental paid at the end of year 1 | 7,00,000 |
Journal of P Ltd (lessee), year 1
| # | Particulars | Dr (₹) | Cr (₹) |
|---|---|---|---|
| 1 | Lease Rent A/c Dr. To Q Ltd (lessor) A/c: rent for the year on the straight-line basis | 5,00,000 | 5,00,000 |
| 2 | Q Ltd A/c Dr. To Bank A/c: first rental paid at the year end | 7,00,000 | 7,00,000 |
| 3 | Profit and Loss A/c Dr. To Lease Rent A/c: rent for the year transferred | 5,00,000 | 5,00,000 |
After entry 2, Q Ltd's account in P Ltd's books has a debit balance of ₹2,00,000, rent paid in advance.
Journal of Q Ltd (lessor), year 1
| # | Particulars | Dr (₹) | Cr (₹) |
|---|---|---|---|
| 1 | Operating Lease Receivable (P Ltd) A/c Dr. To Lease Rental Income A/c: income for the year, straight line | 5,00,000 | 5,00,000 |
| 2 | Bank A/c Dr. To Operating Lease Receivable (P Ltd) A/c: first rental received | 7,00,000 | 7,00,000 |
| 3 | Depreciation A/c Dr. To Machinery A/c: 10% of ₹50,00,000 | 5,00,000 | 5,00,000 |
| 4 | Lease Rental Income A/c Dr. To Profit and Loss A/c: income transferred | 5,00,000 | 5,00,000 |
| 5 | Profit and Loss A/c Dr. To Depreciation A/c: depreciation transferred | 5,00,000 | 5,00,000 |
After entry 2, P Ltd's account in Q Ltd's books has a credit balance of ₹2,00,000, rent received in advance.
Machinery Account in Q Ltd's books, year 1
| Dr | ₹ | Cr | ₹ |
|---|---|---|---|
| To Balance b/d (cost, equal to fair value) | 50,00,000 | By Depreciation A/c (10%) | 5,00,000 |
| By Balance c/d | 45,00,000 | ||
| 50,00,000 | 50,00,000 |
| Dr | ₹ |
|---|---|
| To Balance b/d (cost, equal to fair value) | 50,00,000 |
| 50,00,000 | |
| Cr | ₹ |
| By Depreciation A/c (10%) | 5,00,000 |
| By Balance c/d | 45,00,000 |
| 50,00,000 |
Balance Sheet extracts at the end of year 1
P Ltd (lessee): the machine and any lease liability are not shown. Under Current assets, Lease rent paid in advance (Q Ltd) ₹2,00,000. The Profit and Loss charge is lease rent ₹5,00,000.
Q Ltd (lessor): under Fixed assets, Machinery (leased out) ₹50,00,000 less depreciation ₹5,00,000 = ₹45,00,000. Under Current liabilities, Lease rent received in advance (P Ltd) ₹2,00,000. The Profit and Loss Account shows lease income ₹5,00,000 and depreciation ₹5,00,000.
The other reading (paper note). If each rental were taken to profit and loss as it falls due, the first year's charge (lessee) and income (lessor) would be the full ₹7,00,000, with no advance balance on either side.
Where the 10 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Classification with reasons: PV of payments against fair value, term against life | 3 |
| 2 | Lessee entries on the straight-line basis | 2 |
| 3 | Lessor entries: income, receipt, depreciation, transfers | 3 |
| 4 | Balance Sheet extracts of both | 2 |
| Total | 10 |
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