1.

If a lease agreement states that ‘the lessee guarantees a residual value, at the end of
the lease term, of $20 000’, what does this mean?

The residual value guarantee is that part of the residual value of the leased asset guaranteed
by the lessee, a party related to the lessee or a third party unrelated to the lessor (AASB
16/IFRS 16, Appendix A). The lessor will estimate the residual value of the leased asset at
the end of the lease term based on market conditions at the inception of the lease and the
lessee may guarantee that, when the asset is returned to the lessor, it will realise at least a part
of that amount. If the lessee guarantees a residual value, at the end of the lease term, of $20
000, the lessee has to make sure that the value of the leased asset at the end of the lease is at
least $20 000 – if the value is less, the lessee may need to make up the difference in cash for
example.

The guarantee may range from 1% to 100% of the residual value estimated by the lessor and
is a matter for negotiation between lessor and lessee. Where a lessee guarantees some or all
of the residual value of the asset, the lessor has transferred risks associated with movements
in the residual value to the lessee.

2. What is meant by ‘the interest rate implicit in a lease’ and ‘the lessee’s incremental
borrowing rate’?

The interest rate implicit in a lease is defined in AASB 16/IFRS 16, Appendix A 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.

This interest rate is used to discount the lease payments to their present value for recognition
purposes. This discount rate is implicit in the lease because it is the terms of the lease
(number, timing and quantum of repayments, residual value guarantee or purchase option)
that determine its value.

The lessee’s incremental borrowing rate is defined in AASB 16/IFRS 16, Appendix A as
the rate of interest that a lessee would have to pay to borrow over a similar term, and with a
similar security, the funds necessary to obtain an asset of a similar value to the right-of-use
asset in a similar economic environment.

Exercise 10.3

Accounting by lessee

On 1 July 2022, Monkey Ltd leased a plastic-moulding machine from Wise Ltd. The
machine cost Wise Ltd $65 000 to manufacture and had a fair value of $77 055 on 1 July
2022. The lease agreement contained the following provisions.

Lease term 4 years

 Annual rental payment, in advance on 1 July each year $20 750
Residual value at end of the lease term $7 500
Residual guaranteed by lessee nil
Interest rate implicit in lease 8%
The lease is cancellable only with the permission of the lessor.

The expected useful life of the machine is 5 years. Monkey Ltd intends to return the
machine to the Wise Ltd at the end of the lease term. Included in the annual rental
payment is an amount of $750 to cover the costs of maintenance and insurance paid for
by the lessor.

Required
1. Prepare the lease payments schedule for the Monkey Ltd (show all workings).
2. Prepare the journal entries in the books of Monkey Ltd for the year ended 30 June
2023.
(LO3)

1. PV of LP = $20 000 + $20 000 x 2.5771 [T2 8% 3yrs]

= $20 000 + $51 542
= $71 542

MONKEY LTD
Lease payments schedule
Date Lease Interest expense Reduction in Balance of
payments (8%) liability liability
$ $ $ $ $
1 July 2022 71 542
1 July 2022 20 000 — 20 000 51 542
1 July 2023 20 000 4 123 15 877 35 665
1 July 2024 20 000 2 853 17 147 18 519
1 July 2025 20 000 1 481 18 519 —
80 000 8 458 71 542
2. The journal entry to recognise right-of-use asset and lease liability at the commencement
of the lease, plus the upfront payment in cash (at 1 July 2022) is as follows:

Right-of use asset Dr 71 542

Lease liability Cr 51 542
Cash Cr 20 000

The lease liability recognised at the commencement of the lease is the present value of the 3
yearly payments of $20 000 each, discounted by the implicit rate in the lease of 8% (the first
payment is made on the commencement date, so it is not included in the liability).

The journal entry to recognise the upfront payment of executory costs of $750 in cash (at 1
July 2022) is as follows:

Prepaid executory costs Dr 750

Cash Cr 750
The journal entry to recognise the prepayment expired for executory costs of $750 (at 30 June
2023, and every year after than until the end of lease term) is as follows:

Executory costs expense Dr 750

Prepaid executory costs Cr 750

The journal entry to recognise interest expense (at 30 June 2023, and every year after than
until the end of lease term – the amounts are taken from the lease payments schedule above)
is as follows:

Interest expense Dr 4 123

Interest payable Cr 4 123

The journal entry to recognise depreciation expense on the right-of-use asset (at 30 June
2023, and every year after than until the end of lease term) is as follows:

Depreciation expense Dr 17 886

Accumulated depreciation Cr 17 886

The annual depreciation expense is calculated on a straight-line basis over the duration of the
lease term of 4 years (as the asset is going to be returned to the lessor at the end of the lease).
The depreciable amount is equal to the cost of the right-of-use asset as there is no residual
value guarantee.

Exercise 10.17

Finance lease – manufacturer lessor

Stella Ltd manufactures specialised equipment for both sale and lease. On 1 July 2022,
Stella Ltd leased one of these equipment to Freddy Ltd, incurring $1200 in costs to
prepare and execute the lease document. Freddy Ltd incurred $650 in costs to negotiate
the agreement. The equipment being leased cost Stella Ltd $55 072 to manufacture. The
equipment is expected to have an economic life of 6 years, after which time it will have a
residual value of $950. The lease agreement details are as follows.

Length of lease 5 years

Commencement date 1 July 2022
Annual lease payment, payable 30 June each year commencing 30 June 2023 $16 000
Residual value at the end of the lease term, fully guaranteed by Freddy Ltd $8 000
Interest rate implicit in the lease 8%

All insurance and maintenance costs are paid by Stella Ltd and amount to $3 000 per
year and will be reimbursed by Freddy Ltd by being included in the annual lease
payment of $16 000. The equipment will be depreciated on a straight-line basis. It is
expected that Freddy Ltd will purchase the equipment from Stella Ltd at the end of the
lease.
Required
1. Calculate the fair value of the leased equipment at 1 July 2022.
2. Prepare the journal entries to account for the lease in the books of Freddy Ltd for
the year ended 30 June 2023.
3. Prepare a schedule of lease receipts for Stella Ltd.
4. Prepare the journal entries to account for the lease in the books of Stella Ltd for the
year ended 30 June 2023.
(LO3, LO4 and LO7)

2. PV of LP = ($16 000 - $3 000) x 3.9927 [T2 8% 5yrs] + $8 000 x 0.6806 [T1 8% 5yrs]
= $51 905 + $5 445
= $57 350

FV = PV of LP
= $57 350.

3.

FREDDY LTD
Lease payments schedule
Date Lease Interest expense Reduction in Balance of
payments (8%) liability liability
$ $ $ $ $
1 July 2022 57 350
30 June 2023 13 000 4 588 8 412 48 938
30 June 2024 13 000 3 915 9 085 39 853
30 June 2025 13 000 3 188 9 812 30 041
30 June 2026 13 000 2 403 10 597 19 444
30 June 2027 21 000 1 556 19 444 —
73 000 15 650 57 350

1 July 2022
Right-of-use equipment Dr 58 000
Lease liability Cr 57 350
Cash Cr 650
(Recognition of right-of-use asset and lease liability at the inception of the lease)

30 June 2023
Lease liability Dr 8 412
Interest expense Dr 4 588
Executory expense Dr 3 000
Cash Cr 16 000
(First lease payment)

Depreciation expense Dr 9 508

Accumulated depreciation Cr 9 508
(Depreciation of the leased asset for the year = $5 971 = ($58 000 - $950) / 6 years)
4.
STELLA LTD
Lease receipts schedule
Date Lease Interest revenue Reduction in Balance of
receipts (8%) receivable receivable
$ $ $ $ $
1 July 2022 57 350
30 June 2023 13 000 4 588 8 412 48 938
30 June 2024 13 000 3 915 9 085 39 853
30 June 2025 13 000 3 188 9 812 30 041
30 June 2026 13 000 2 403 10 597 19 444
30 June 2027 21 000 1 556 19 444 —
73 000 15 650 57 350

5. Journal entries for Stella Ltd (lessor).

1 July 2022
Lease receivable Dr 57 350
Cost of sales Dr 55 072
Inventories Cr 55 072
Sales revenue Cr 57 350
(Recognition of lease receivable)

Lease costs Cr 1 200

Cash Cr 1 200
(Payment of initial direct costs)

30 June 2023
Cash Dr 16 000
Lease receivable Cr 8 412
Interest revenue Cr 4 588
Reimbursement revenue Cr 3 000
(First lease receipt)

Insurance and maintenance expense Dr 3 000

Cash Cr 3 000
(Payment of executory costs)