Question

On January 2, 2020, Petronila Company leased several machines from
Petrakos Corporation under a three-year lease agreement. The lease
calls for semiannual payments of $15,000 each, payable on June 30
and December 31 of each year. The machines were acquired by
Petrakos at a cost of $130,000 and are expected to have a useful life of
6 years with no expected residual value.
Required:

1. How Petronila classify this lease? and how Petrakos’s classified it?

2. Prepare the appropriate journal entries only for the lessor from the
inception of the lease through the end of 2020.

II. Micro Company leased equipment from Macro Leasing on January 2,
2020. Macro purchased the equipment at a cost of $300,000 equal to fair
value of asset. The lease term is for 3 years and the useful life of
equipment is 4 years with no residual value. Annual lease payments at
January 2, each year. The interest rate is 8% on lease contract and its
equal to lessee incremental borrowing.

Required:
1. Classify the lease for the lessee view point. Calculate the annual lease
payment and prepare a lease amortization schedule.

2. Prepare appropriate journal entries for Micro Company (Lessee) for 2020
and 2021. Assume a December 31 year-end.

Answer 1

As per the Chegg policy only the first question has been answered

1. How Petronila classify this lease? and how Petrakos’s classified it?

Answer: Since the question has not specified under which accounting standard is the answer required, I have provided the answer both under IFRS 16 and IAS 17.

As per IFRS 16 there is no concept of lease classification from a lessee point of view i.e. Petronila. It will just recognise a right to use in its financial statement.

However under IAS 17, the lease is classified under two category - finance lease and operating lease. The standard has provided few indicators suggesting a lease to be finance and operating lease. These are indicators and not an exhaustive list which indicate the lease classification: extract from IAS 17 is as below

" Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form. Situations that would normally lead to a lease being classified as a finance lease include the following:

• the lease transfers ownership of the asset to the lessee by the end of the lease term
• the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that the option will be exercised
• the lease term is for the major part of the economic life of the asset, even if title is not transferred
• at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset
• the lease assets are of a specialised nature such that only the lessee can use them without major modifications being made

Other situations that might also lead to classification as a finance lease are: [IAS 17.11]

• if the lessee is entitled to cancel the lease, the lessor's losses associated with the cancellation are borne by the lessee
• gains or losses from fluctuations in the fair value of the residual fall to the lessee (for example, by means of a rebate of lease payments)
• the lessee has the ability to continue to lease for a secondary period at a rent that is substantially lower than market rent"

Reading the indicators of finance lease and the facts of the question-

a) The ownership of the leased asset does not transfer to the leasee at the end of the lease term

b) The lessee i.e. Petronila does not have the option to purchase the leased asset at the end of the lease term

c) The lease term is for 3 years and expected useful life is 6 years. Hence, the lease term is not for the entire economic life of the asset

d) Assuming fair value as the purchase cost i.e. $130,000. Petronila the lessee is paying $15,000 semi annual for 3 years, the miniumum lease payment = $90,000 only. The present value of $90,000 will be less than $90,000. Hence, at the inception of present value of miniumum lease payment is not substantially the fair value of lease asset.

e) The question does not specify that the asset is a specialised asset hence this clause is not relevant

Hence, it would be classified as an operating lease by lessee i.e. Petronila as per IAS 17.

The lease indicator discussed above are same for lessor under IAS 17 and IFRS 16. Hence, even the lessor i.e.Petrakos would recognise the lease as an operating lease.

2. Prepare the appropriate journal entries only for the lessor from the inception of the lease through the end of 2020.

At the inception of the lease no entry required as it is an operating lease

Date	Particulars	Debit	Credit
30 June 2020	Bank	$15,000
	To Lease income		$15,000
	(Being semi annual lease income for the period ending 30 June 2020 recognised)
31 December 2020	Bank	$15,000
	To Lease income		$15,000
	(Being semi annual lease income for the period ending 31 December 2020 recognised)

It has been assumed that lessor would pass accrual entry as well semi-annually which coincides with payment entry.

The lessor will also recognise depreciation expense for the lease asset. Since depreciation rate is not specified the entry has not been made.