Digi Ltd. a company that manufactures sells and leases cranes has entered into an agreement to lease a crane to Alum Ltd. The crane cost Digi Ltd 570,000 to make and has a fair value of $75.400 on 1 July 2013. Alum is having difficulties meeting its debt covenant obligations and the parties have agreed to refer to the lease as an operating lease in all documentation. The lease agreement details are as follows:
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Lease term
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3 years
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Commencement date
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1 July 2013
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Lease payments:
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At lease inception
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$20,000
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Annual lease payments commencing 30 June 2014
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$20,000
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Fair value of the machinery at 1 July 2013
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$75,400
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Estimated economic life of the machinery
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$years
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Estimated residual value of the machinery at the end of its economic life
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$1,000
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Residual value at the end of the lease term
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$10,000
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Residual value guaranteed by Alum Ltd
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$6.000
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Included in the annual lease payments is an amount of $2,000 payable to Digi Ltd for insurance and maintenance of the machinery The lease is cancellable, but a penalty of 50% of the total lease payments is payable on cancellation and Alum Ltd would need to enter into a new lease with Digi Ltd. Maintenance of the machindry. The lease is cancellable, but a penalty of 50% of the total lease payments is payable on cancellation and Alum Ltd would need to enter into a new lease with Digi Ltd. Alum Ltd does not intend to take ownership of the machinery at the end of the lease term. Digi Ltd had legal fees of $1,110 associated with preparing the lease agreement.
Required:
A. State how both companies should classify the lease. Give reasons for your answer.
B. Determine the interest rate implicit in the lease. Show workings
C. For Alum Ltd, prepare a schedule of lease payments and show the journal entries for the years ended 30 June 2014 and 30 June 2015. (Note: Year ended means all entries from 1 July to 30 June).
D. For Digi Ltd. prepare a schedule of lease receipts and show the journal entries for the year ended 30 June 2014. (Note: Year ended means all entries from 1 July to 30 June).
E. Assume none of the residual value is guaranteed by Alum Ltd and there were no legal fees associated with preparing the lease agreement. Classify the lease for both companies and justify your answer. Show journal entries for both companies for the year ended 30 June 2014.