Question 5 OR (a)
Finance lease in the lessee's books
10 marks
- Time to write
- About 20 minutes
- Topic
- Leases and AS 19
- Notes
- Crux notes
Question
Question 5 OR (a) · 10 marksTarun Ltd. took a machine on lease from Mahesh Ltd. the fair value being 18,00,000 on April 1,2023. The machine's economic life as well as its lease term is 3 years. At the end of every year Tarun Ltd pays 7,20,000. Tarun Ltd has guaranteed a residual value of 56,256 on the expiry of the lease to the Mahesh Ltd. However, Mahesh Ltd estimates that the machinery's residual value will be only 36,000. The implicit rate of return is 15% p.a.; at 15%, the present value factors are 0.869, 0.756 and 0.657 for the end of the first, second and third year respectively. Tarun Ltd charges depreciation @ 33% p.a. on the straight line basis. Calculate the value of machinery that the lessee is to consider for recording it, and the finance charges in each year. Pass journal entries in the lessee's books for the accounting year ending 31st March, 2024.
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
- Calculate…Pass…Two asks in one question: answer both.
- Pass journal entriesEach entry: the date, the debit and credit lines, and a one-line narration.
- estimatesFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
- The machine is recorded at the lower of its fair value and the present value of the minimum lease payments, which include the residual value the lessee has guaranteed.
- The present-value factors are used as printed.
- Depreciation at 33% on the straight-line basis is applied to the recorded value as the paper states, although the machine's life is three years.
Write it in this order
- Read the data; tick every adjustment as you plan it 1 min
- 1 Value recorded = lower of FV and PV of MLP 3 marks 5 min
- 2 Finance-charge / liability amortisation schedule 4 marks 7 min
- 3 First-year journal entries in the lessee's books 3 marks 5 min
- Check: every adjustment used, both sides agree, dates in 2 min
Final answer
Check your own figures against these.
- Machine recorded at
- ₹16,80,000
- Finance charges
- ₹2,52,000 / ₹1,81,800 / ₹1,02,456
- total ₹5,36,256
- First-year charge to Profit & Loss = finance charge
- ₹2,52,000 + depreciation ₹5,54,400 = ₹8,06,400
Try it first. About 20 minutes for 10 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: value recorded by the lessee
The lease term equals the economic life and the machine passes substantially all the risks and rewards to Tarun Ltd., so it is a finance lease whose classification rests on the substance of the transaction. In the lessee's books a finance lease is both an asset and a liability, and both are recorded in the balance sheet; the leased asset is depreciated like any other long-term asset, and the liability is amortised with each payment separated into interest (finance charge) and principal repayment. The lessee records the asset and the matching liability at the lower of fair value and the present value of the minimum lease payments (rentals plus the residual value it has guaranteed):
| Present value of minimum lease payments | ₹ |
|---|---|
| PV of the rentals: 7,20,000 × (0.869 + 0.756 + 0.657) = 7,20,000 × 2.282 | 16,43,040 |
| PV of the guaranteed residual value: 56,256 × 0.657 (to the nearest rupee) | 36,960 |
| PV of minimum lease payments | 16,80,000 |
Since ₹16,80,000 is lower than the fair value ₹18,00,000, the machine is recorded at ₹16,80,000. Depreciation (SLM @33%) = ₹5,54,400 per year.
Step 2: finance charges (liability amortisation)
The finance charge is the implicit rate (15%) on the outstanding liability; the final year's charge is the balancing figure that clears the liability against the guaranteed residual value paid.
| Year | Opening liability (₹) | Finance charge @15% (₹) | Payment (₹) | Closing liability (₹) |
|---|---|---|---|---|
| 1 | 16,80,000 | 2,52,000 | 7,20,000 | 12,12,000 |
| 2 | 12,12,000 | 1,81,800 | 7,20,000 | 6,73,800 |
| 3 | 6,73,800 | 1,02,456 | 7,76,256 | 0 |
| 5,36,256 |
(The year-3 payment ₹7,76,256 = rental ₹7,20,000 + guaranteed residual value ₹56,256; the ₹1,02,456 charge is the balancing figure that reduces the liability to nil, absorbing the rounding of the three-decimal factors.)
Step 3: journal entries in the books of Tarun Ltd. (year ended 31 March 2024)
| Date | Particulars | Dr (₹) | Cr (₹) |
|---|---|---|---|
| 1 Apr 2023 | Machinery A/c … Dr To Mahesh Ltd. (lessor) A/c | 16,80,000 | 16,80,000 |
| 31 Mar 2024 | Finance Charges A/c … Dr To Mahesh Ltd. (lessor) A/c | 2,52,000 | 2,52,000 |
| 31 Mar 2024 | Mahesh Ltd. (lessor) A/c … Dr To Bank A/c | 7,20,000 | 7,20,000 |
| 31 Mar 2024 | Depreciation A/c … Dr To Machinery A/c | 5,54,400 | 5,54,400 |
| 31 Mar 2024 | Profit & Loss A/c … Dr To Finance Charges A/c To Depreciation A/c | 8,06,400 | 2,52,000 5,54,400 |
Result: machine recorded at ₹16,80,000; finance charges ₹2,52,000 / ₹1,81,800 / ₹1,02,456 (total ₹5,36,256); first-year charge to Profit & Loss = finance charge ₹2,52,000 + depreciation ₹5,54,400 = ₹8,06,400.
Where the 10 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Value recorded = lower of FV and PV of MLP (₹16,80,000) | 3 |
| 2 | Finance-charge / liability amortisation schedule | 4 |
| 3 | First-year journal entries in the lessee's books | 3 |
| Total | 10 |
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