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Chapter 11

Accounting for leases

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Deegan, Financial Accounting, 8e 11-1
Objectives of this lecture
• Understand what a ‘lease’ represents
• Understand the core principle and the scope of the accounting
standard pertaining to leases
• Understand when to recognise a lease
• Understand that a customer (lessee) leasing assets shall
recognise assets and liabilities arising from a lease
• Understand how, from the lessee’s perspective, to measure
lease assets and lease liabilities, be able to measure lease-
related expenses, and be able to prepare the related
accounting journal entries
• Understand what interest rate shall be used to calculate the
present value of lease-related assets and liabilities
• Understand how, from the lessor’s (supplier’s) perspective, to
measure a lease receivable, be able to measure lease-related
revenues, and be able to prepare the related accounting journal
entries
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Deegan, Financial Accounting, 8e 11-2
Lease: definition
A contract, or part of a contract, that conveys the right to use an
asset (the underlying asset) for a period of time in exchange for
consideration

For accounting purposes there are some issues to consider:


1. Does it matter who is the asset’s owner?
2. Who has the control over the asset?

Do you remember from assets definition?

A firm may recognise assets it does not own as


long as it is able to control the use

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Deegan, Financial Accounting, 8e 11-3
Lease: definition (cont.)
A lease exists when the customer controls the use of the
underlying asset throughout the period of use, meaning that the
customer:

• obtains substantially all of the economic benefits from the use


of the identified asset throughout the period of use; and
• directs the use of the asset throughout the period of use, which
means the customer has the ability to change how, and for what
purpose, the asset is used during the contractual term.

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Deegan, Financial Accounting, 8e 11-4
Lease contracts: key terms
With the lease contract a supplier (lessor) conveys the right to use
an asset to a customer (lessee) in exchange for consideration
(lease payments) throughout a period of time (lease term).

Lessor: the individual/firm providing the asset and receiving a


payment at established dates

Lessee: the individual/firm acquiring the right to use the asset and
having an obligation to pay the lessor at established dates

Our main focus in this lecture

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Deegan, Financial Accounting, 8e 11-5
Lease contracts: key terms (cont.)
Lease payments: fixed payments (excluding service
cost component, if any) + (if
included in the lease contract)
residual value guarantee and/or
price of a purchase option

Lease term: the period for which a lessee has the


right to use the underlying asset, from
the commencement date of the contract.
Based on expectations about whether
lessee likely to exercise an option to
extend the lease term

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Deegan, Financial Accounting, 8e 11-6
The accounting issue
• Can the right-of-use the asset acquired under the lease contract be
considered an asset?
Future So should
Description of right Control Past event economic asset be
benefit recognised?
Delivery
Legally enforceable
Right to use machinery following
right established by Yes Yes!
during the lease term signing of the
the lease contract
lease contract

• Can the obligation to make lease payments in the future be


considered a liability?
Outflow of So should
Description of economic liability be
obligation Present obligation Past event benefits recognised?

Obligation to pay Legally enforceable Delivery following Yes (cash Yes!


rentals obligation signing of the payments)
established by the lease contract
lease contract

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Deegan, Financial Accounting, 8e 11-7
The accounting issue (cont.)
As a consequence:

‘An entity shall recognise assets and liabilities arising from


a lease’ (AASB 16)

ALL LEASES are represented in the statement of


financial position

With two exceptions:


1. Leases with a duration of 12 months or less
2. Leases of low value assets (tablets, phones, laptops
etc…)

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Deegan, Financial Accounting, 8e 11-8
New vs old lease accounting standard
 AASB 16 Leases is the new accounting standard for leases
which has replaced AASB 117 Leases (the old one).

 AASB 117 was criticised because:


1. Many leases were not represented on the entity’s balance
sheet
2. The accounting model failed to meet the needs of users of
financial statements
3. The requirements for recognition of leases were too
complicated

 AASB 16 is an improvement because:


1. ALL LEASES are represented in the statement of financial
position of the lessee (only with two exceptions)
2. Reduced complexity of application

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Deegan, Financial Accounting, 8e 11-9
Some implications of the new accounting standard

• For some organisations (e.g. particularly large retailers who lease


many retail outlets) many more leased assets and lease liabilities
will need to be recognised
• This will increase their reported debt and assets and this will
increase their reported leverage
• The increased leverage could have implications for various
accounting-based debt covenants
• The new leasing standard also means that the expenses tend to
be ‘front loaded’—that is, they are higher in the earlier years
(because the interest expense is higher in earlier years.This will
have implications for reported profits and also for contractual
arrangements that use reported profits

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Deegan, Financial Accounting, 8e 11-10
How to account for leases
under AASB 16
• The core principle of the new accounting standard is that an
entity shall recognise assets and liabilities arising from a
lease ‘to ensure that lessees and lessors provide relevant
information in a manner that faithfully represents those
transactions’
• AASB 16 requires assets and liabilities to be recognised by
the lessee for all leases of more than 12 months, with
– the asset being of the nature of a ‘right-of-use asset’ that
provides a right to use the lease’s asset for the term of
the lease, and
– the liability would be for lease payments that are
economically unavoidable over the lease term

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Deegan, Financial Accounting, 8e 11-11
How to account for leases under
AASB 16 (cont.)
When to recognise a lease?

At the commencement date, a lessee shall recognise a right-


of-use asset and a lease liability.

Commencement date is defined as:


The date on which a lessor makes an underlying
asset available for use by a lessee.

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Deegan, Financial Accounting, 8e 11-12
Accounting for leases by the lessee
Commencement End of the
date lease term

Fixed payments Last fixed payment


+
Guaranteed residual
If any +
Price of bargain
purchase option
The lessee acquires the right to use the asset and
commits to lease payments.
How is this accounted for? Let’s consider the following
example/illustration.
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Deegan, Financial Accounting, 8e 11-13
Accounting for leases by the lessee
Illustration 1
On 1 July 2018, Mini Ltd enters into a four-year lease of a machine.
Mini will pay fixed annual payments of $100 000 for four years with the first
payment on 30 June 2019.
To enter the lease Mini incurs direct costs of $10 000 at the commencement
of the lease term.
There is a bargain purchase price option (that Mini is willing to exercise) for
$25 000 at the end of the lease term.
The machine is expected to have a useful life of 10 years and no residual
value.

Additional information:
• Lessee’s incremental borrowing rate: 6%.
• Present value of an annuity in arrears of $1 for 4 periods at 6% = 3.4651
• Present value of $1 in 4 periods at 6% = 0.7921

Determine the initial measure of the lease liability and right-of-use asset
and prepare the related accounting journal entry.

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Deegan, Financial Accounting, 8e 11-14
Accounting for leases by the lessee
Lease liability

It is measured as the present value of the lease payments* that are to


be made over the lease term by the lessee.

= $100 000
= $25 000

To determine their present value, the lease payments shall


be discounted using the interest rate implicit in the lease or
the lessee’s incremental borrowing rate (6 per cent).

* = fixed payments + (if included in the lease contract) expected payment under a
residual value guaranteed and/or price of bargain purchase option

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Deegan, Financial Accounting, 8e 11-15
Accounting for leases by the lessee
Lease liability

• Fixed payments are to be multiplied for present value of an


annuity in arrears of $1 for 4 periods at 6 per cent
• Purchase options is to be multiplied by the present value of $1 in
4 periods at 6 per cent

$100 000 x 3.4651 = $346 510 +


$25 000 x 0.7921 = $19 802 =
Lease liability $366 312

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Deegan, Financial Accounting, 8e 11-16
Accounting for leases by the lessee
right-of-use asset

The lessee shall measure the right-of-use asset at COST.

The cost comprises:


(a) the initial lease liability
(b) any lease payments made at or before the commencement date
(c) any initial direct costs incurred by the lessee, and
(d) an estimate of costs to be incurred by the lessee in dismantling and
removing the underlying asset

right-of-use asset =

Lease liability $366 312 +


Direct costs $10 000 = $376 312

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Deegan, Financial Accounting, 8e 11-17
Accounting for leases by the lessee

• On initial recognition, the accounting journal entry would


be:

1 July 2018
Dr Lease machine 376 312
Cr Lease liability 366 312
Cr Cash/payables etc 10 000

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Deegan, Financial Accounting, 8e 11-18
Accounting for leases by the lessee
Subsequent measurement —Lease liability
The liability will be reduced each period with each lease
payment constituting part interest expense, and part
repayment of the lease liability using the effective interest
method
Lease payment (cash outflow) = $100 000

Interest expense = Principal repayment =


6% of $366 312 = $21 979 $100 000 – $21 979 =
$78 021

Interest expense and repayment are recalculated every period on the outstanding lease
liability

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Deegan, Financial Accounting, 8e 11-19
Subsequent measurement (cont.)
• Each period we would also need to amortise the leased asset
(or else it will stay in the accounts indefinitely)
• The general principle is that the leased asset shall be amortised
over the life of the lease if the lessee is not going to retain the
asset at the end of the lease term
• If the lessee is expected to retain the leased asset at the end of
the lease term (perhaps by way of making an additional
payment) then the leased asset shall be amortised over its
expected useful life
– In this example, the leased asset will be acquired at the end
of the lease term so the useful life of the asset will be used
for amortisation purposes

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Deegan, Financial Accounting, 8e 11-20
Accounting for leases by the lessee
Subsequent measurement —Lease liability
Date Lease Interest Principal Present value of
payment expense reduction lease liability

1 July 2018 0 0 0 366 312

30 June
100 000 21 979 78 021 288 291
2019
30 June
2020 100 000 17 297 82 703 205 588

30 June
2021 100 000 12 335 87 665 117 923

30 June
2022 125 000 7 076 117 923 0

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Deegan, Financial Accounting, 8e 11-21
Accounting for the lease by the lessee
The subsequent accounting journal entries would be:

30 June 2019
Dr Interest expense 21 979
Dr Lease liability 78 021
Cr Cash 100 000

Dr Lease amortisation 37 631


expense
Cr Accum lease amort 37 631
expense—machine

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Deegan, Financial Accounting, 8e 11-22
Accounting for leases by the lessee
The exceptions: leases of 12 months or less

 lessees do not have to recognise lease-related assets and liabilities


 the lessee shall simply recognise the lease payments as an expense

Illustration 2
On 1 July 2019, Maggie Ltd enters a lease agreement with Riva
Ltd for the lease of an item of machinery for eight months. The
lease cost is $20 000 per month. Maggie Ltd has decided that
for such leases, the exemption available within the accounting
standard will be used.

Provide the required accounting journal entry


Dr Lease expenses 20 000
Cr Cash at bank 20 000
(no lease liability or lease asset is recognised and therefore also no
depreciation expense)
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Deegan, Financial Accounting, 8e 11-23
Some further issues to
consider
Service cost component
– Contracts for the use of an asset often also include
associated services (a service agreement).
– For example, a customer might sign a contract to lease a
car and the contract could include a requirement that the
lessee pay a specific ongoing amount to have the car
maintained and serviced by a particular service provider.
– The service cost component is not treated as part of the
‘lease’ and therefore is not capitalised as part of the lease
liability or lease asset.

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Deegan, Financial Accounting, 8e 11-24
Some further issues to consider (cont.)

Initial measurement of lease liability (par. 27):


At the commencement date, the lease payments included in the measurement of
the lease liability comprise the following payments for the right to use the underlying
asset during the lease term that are not paid at the commencement date:
(a) fixed payments (including in-substance fixed payments as described in
paragraph B42), less any lease incentives receivable;
(b) variable lease payments that depend on an index or a rate, initially measured
using the index or rate as at the commencement date (as described in paragraph
28);
(c) amounts expected to be payable by the lessee under residual value
guarantees;
(d) the exercise price of a purchase option if the lessee is reasonably certain to
exercise that option (assessed considering the factors described in paragraphs
B37–B40); and
(e) payments of penalties for terminating the lease, if the lease term reflects the
lessee exercising an option to terminate the lease.

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Deegan, Financial Accounting, 8e 11-25
Some further issues to consider (cont.)

Interest rate to be applied


For a lessee, the interest rate implicit in the lease is to be used to
discount the lease payments if this is practicable to determine; if
not, the lessee’s incremental borrowing rate is to be used. The rate
implicit in the lease is the rate of interest being charged by the
lessor and is defined in the accounting standard as:
The rate of interest that causes the present value of (a) the
lease payments and (b) the unguaranteed residual value to
equal the sum of (i) the fair value of the underlying asset and
(ii) any initial direct costs of the lessor.

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Deegan, Financial Accounting, 8e 11-26
Determining the interest rate implicit in the
lease
Illustration 3
McTavish Ltd decides to lease some machinery from Cornish Ltd
on the following terms:
• Date of entering lease 1 July 2019
• Duration of lease 10 years
• Life of leased asset 11 years
• Unguaranteed residual value $2000
• Lease payments $4000 at lease inception, $3500 on 30 June
each year (i.e. 10 yearly payments in arrears of $3500 each)
• Fair value of leased asset at date of lease inception $26 277
REQUIRED
Determine the interest rate implicit in the lease.

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Deegan, Financial Accounting, 8e 11-27
Determining the interest rate implicit in the
lease
Illustration 3: Solution
The present value of the up-front payment of $4000 is not
discounted. Therefore, using a rate of 10 per cent for discounting
purposes, the present value of the lease payments and the
unguaranteed residual is:
Present value of payment on 1 July 2019 $ 4 000
Present value of 10 yearly payments $21 506
Present value of unguaranteed residual $ 771
$26 277
The discounted value of $26 277 is the same as the fair value of
the asset at lease inception. Thus, 10 per cent is the implicit rate in
this example.
Note that some degree of trial and error might be involved in
determining the discount rate.

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Deegan, Financial Accounting, 8e 11-28
Lease accounting for lessees
Illustration 4
Trigger Ltd enters into a five-year lease agreement with Brothers
Ltd on 1 July 2019 for an item of machinery.
There is a bargain purchase option that Trigger Ltd will be willing
to exercise at the end of the fifth year for $80 000. The machinery
is expected to have a useful life of six years.
There are to be five annual payments of $100 000, the first being
made on 30 June 2020. Included within these payments is $10 000
representing payment to the lessor for insurance and maintenance
of the equipment.
Additional information:
• Implicit interest rate: 12 per cent
• Present value of an annuity in arrears of $1 for five years at
12 per cent = 3.6048
• Present value of $1 in five years at 12 per cent = 0.5674

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Deegan, Financial Accounting, 8e 11-29
Illustration 4 (cont.)

REQUIRED
(a) Determine the initial measurement of the lease liability
(b) Determine the initial measurement of right-of-use asset
cost.
(c) Provide the accounting journal entries for the year ended
30 June 2020

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Deegan, Financial Accounting, 8e 11-30
Illustration 4: Solution
(a) Determine the initial measurement of the lease liability
• Present value of five lease payments of $90 000
discounted at 12 per cent
= $90 000 x 3.6048 = $324 432 +
+
• Present value of the bargain purchase option
= $80 000 x 0.5674 = $45 392 =

lease liability = $369 824


(b) Determine the initial measurement of right-of-use asset cost.
Right-of-use asset cost = lease liability, as there are no
other costs to add
Right-of-use asset cost = $369 824

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Deegan, Financial Accounting, 8e 11-31
Illustration 4: Solution (cont.)
Calculate the interest expense and the principal
repayment on 30 June 2020

Date Lease payment Interest Principal Outstand


expense repayment ing
balance
01/07/2019 369 824

30/06/2020 90 000 44 379 45 621 324 203

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Deegan, Financial Accounting, 8e 11-32
(c) Accounting journal entries
1 July 2019
Dr Leased machine 369 824
Cr Lease liability 369 824

30 June 2020
Dr Service costs 10 000
Dr Interest expense 44 379
Dr Lease liability 45 621
Cr Cash at bank 100 000

Dr Lease amort exp 61 637


Cr Accum lease amort 61 637

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Deegan, Financial Accounting, 8e 11-33
Lease accounting for lessees
Illustration 5

As at 1 July 2018, Winki Company enter into a 10-year lease


contract for a building. Lease payments are $400 000 per year,
starting on 30 June 2019 and there is no purchase option or
residual value guaranteed. Winki pays $5000 to enter the lease
contract (direct costs). The implicit interest rate is 15 per cent
(use the textbook Appendixes to calculate the present values).

REQUIRED
(a) Determine the initial measurement of the lease liability
(b) Determine the initial measurement of right-of-use asset cost
(c) Provide the accounting journal entries for the year ended
30 June 2019

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Deegan, Financial Accounting, 8e 11-34
Illustration 5: Solution

(a) Determine the initial measurement of the lease liability


• Present value of 10 lease payments of $400 000
discounted at 15 per cent
= $400 000 x 5.0188 = $2 007 520
lease liability = $2 007 520

(b) Determine the initial measurement of right-of-use asset


cost.
right-of-use asset cost = lease liability + any payment
before the commencement + any direct cost

right-of-use asset cost = $2 007 520 + $5 000 = $2 012 520

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Deegan, Financial Accounting, 8e 11-35
Illustration 5: Solution (cont.)
Calculate the interest expense and the principal repayment
on 30 June 2019

Date Lease payment Interest Principal Outstanding


expense repayment balance

01/07/2018 2 007 520

30/06/2019 400 000 301 128 98 872 1 908 648

Income statement; Balance sheet;


Debit/expenses Debit (reduction in
liability)

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Deegan, Financial Accounting, 8e 11-36
(c) Accounting journal entries
1 July 2018
Dr Leased machine 2 012 520
Cr Lease liability 2 007 520
Cr Cash/payables etc 5 000

30 June 2019
Dr Interest expense 301 128
Dr Lease liability 98 872
Cr Cash at bank 400 000

Dr Lease amort exp 201 252


Cr Accum lease amort 201 252

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Deegan, Financial Accounting, 8e 11-37
Lease accounting by lessors
Illustration 6
Considering the information from Illustration 3 and the
solution for the Lessee, let’s see what happens in the
Lessor’s accounting.

Lessor: the individual/firm providing the asset and


receiving a payment at established dates

Initial measurement

What constitutes a It’s a receivable for the


liability for the lessor, which replaces
lessee the underlying asset
which has been leased
to the lessee
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Deegan, Financial Accounting, 8e 11-38
Lease accounting by lessor

Subsequent measurement
What constitutes interest It’s interest revenue
expense for the Lessee for the Lessor

Date Lease payment Interest Principal Outstanding


received revenue repayment balance lease
receivable
01/07/2018 2 007 520

30/06/2019 400 000 301 128 98 872 1 908 648

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Deegan, Financial Accounting, 8e 11-39
Subsequent measurement (cont.)

1 July 2018
Dr Lease receivable 2 007 520
Cr Machinery 2007 520

30 June 2019
Dr Cash at bank 400 000
Cr Interest revenue 301 128
Cr Lease receivable 98 872

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Deegan, Financial Accounting, 8e 11-40
For the time being, the IASB has retained the ‘old’
leasing system for accounting for leases by lessors
• From the perspective of the lessor, leases shall still be
classified as either finance leases or operating leases
• A finance lease is a lease that transfers—from the lessor to the
lessee—substantially all of the risks and rewards incidental to
ownership of an underlying asset
• An operating lease is a lease that does not transfer
substantially all of the risks and rewards to ownership of an
underlying asset
• Short-term leases would typically be considered as operating
leases
• For a finance lease—a lease receivable would be recognised
• For an operating lease—no lease receivable would be
recognised
• For the purposes of the examples that follow we will assume
they are finance leases
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Deegan, Financial Accounting, 8e 11-41
Classification of leases by
lessors

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Deegan, Financial Accounting, 8e 11-42
Lessor accounting for direct financing
leases
Direct financing lease
• A lease where the lessor provides the financial
resources to acquire the asset
• Lessor typically acquires the asset, giving the lessor
legal title, then enters a lease agreement to lease the
asset to the lessee, who subsequently controls the
asset
• No sale is recorded
• Lessor derives income through periodic interest
revenue
• Where risks and rewards of ownership are held by
lessee, the lessor substitutes lease receivable for the
underlying asset

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Deegan, Financial Accounting, 8e 11-43
Accounting for leases by the lessor
Illustration 7

To show how the entries for a lessor compare with the entries
made by the lessee, we will use the same data as that used in
Illustration 4 except this time we will be doing the exercise from the
perspective of Brothers Ltd.

REQUIRED
Prepare the journal entries for the years ending 30 June 2020 and
30 June 2021.

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Deegan, Financial Accounting, 8e 11-44
Illustration 7: Solution

Date Lease receipt Interest revenue Principal Outstanding


(exclusive of reduction balance
service costs)
01/07/2019 369 824

30/06/2020 90 000 44 379 45 621 324 203

30/06/2021 90 000 38 904 51 096 273 107

30/06/2022 90 000 32 773 57 227 215 880

30/06/2023 90 000 25 906 64 094 151 786

30/06/2024 170 000 18 214 151 786 0


530 000 160 176 369 824

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Deegan, Financial Accounting, 8e 11-45
Illustration 7: Solution (cont.)

1 July 2019
Dr Machinery 369 824
Cr Cash 369 824
(to recognise the initial acquisition of the machinery by the lessor)

Dr Lease receivable 369 824


Cr Machinery 369 824
(to substitute the lease receivable for the asset; it would be
inappropriate to continue to show the machinery in the balance
sheet since the lessor no longer ‘controls’ it)

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Deegan, Financial Accounting, 8e 11-46
Illustration 7: Solution (cont.)
30 June 2020
Dr Cash 100 000
Cr Service costs recoupment
(part of profit or loss) 10 000
Cr Interest revenue 44 379
Cr Lease receivable 45 621

30 June 2021
Dr Cash 100 000
Cr Service costs recoupment
(part of profit or loss) 10 000
Cr Interest revenue 38 904
Cr Lease receivable 51 096

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Deegan, Financial Accounting, 8e 11-47
Accounting for lessors who are
manufacturers or dealers of the leased asset
• Where fair value of the property at the inception of the lease
differs from its cost to the lessor (dealer or manufacturer)
• Represents a finance lease

Two parts of the transaction


1. A sale with a resulting gain (fair value vs cost to
dealer/manufacturer)
2. A lease transaction that will provide interest revenue
over the period of the lease

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Deegan, Financial Accounting, 8e 11-48
General format of journal entries for manufacturer’s
or dealer’s-type leases
At the commencement of the lease:
Dr Lease receivable x
Dr Cost of goods sold x
Cr Inventory x
Cr Sales x

When lease payment subsequently received:


Dr Cash x
Cr Interest revenue x
Cr Lease receivable x

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Deegan, Financial Accounting, 8e 11-49
Lessor accounting for an operating lease
Illustration 8
On 1 July 2019, Tamarama Ltd—the lessor—leases a building to
Bronte Ltd (the lessee) for a period of three years. The lease
requires an up-front payment (prepayment) of $100 000 and then
payments (prepayments for the following 12 months) on 30 June
2020 and 30 June 2021 of $100 000 each.
The building is expected to have an economic life of 60 years.
REQUIRED
Provide the required journal entries for Tamarama Ltd for the year
ending 30 June 2020.

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Deegan, Financial Accounting, 8e 11-50
Illustration 8: Solution
1 July 2019
Dr Cash 100 000
Cr Rent received in advance 100 000
(the initial payment would be treated as a liability labelled ‘Rent received
in advance’)

30 June 2020
Dr Rent received in advance 100 000
Cr Rental income 100 000
(as the rent has now been earned, we recognise revenue)

Dr Cash 100 000


Cr Rent received in advance 100 000
(the payment made on 30 June 2020 represents rent received in advance
for the next 12 months)

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Deegan, Financial Accounting, 8e 11-51