Problem -
On 30 June 20X0 B Ltd entered into a contract with S Ltd to lease a generator that had a fair value (and cost to S Ltd) of $50,000. The generator will be used by B Ltd as an alternative source of power so that it can continue to operate its business during electricity black-outs.
The terms of the lease include:
- Lease rental payments of $10 000 are made annually in advance.
- The term of the lease is 5 years.
- The interest rate implied in the lease is 10%.
- The present value of the lease payments is $41,700.
- The penalty for cancellation is immediate payment of 90% of the remaining lease rentals.
- The residual value of the generator at the end of the lease is not guaranteed.
- The B has an option to extend the lease for 2 years for $7000 per annum. The present value of the lease payments if the option is exercised is $50 000 (i.e., present value of lease payments over 7 years).
Other information about the generator:
- The residual value of the generator is $13,370 (PV = $8,300) after 5 years.
- The estimated useful life is 7 years with nil residual value.
Require:
Answer the following questions in relation to the case data:
1. Describe, in words, how B Ltd would account for the lease on 30 June 20X0 only in accordance with the approach preliminarily adopted in the Discussion Paper. Justify your accounting treatment by applying the principles and proposals specified in the Discussion Paper to the terms of the lease and other information provided in the case, if applicable. Assume that Lessee Ltd intends to exercise the option to extend the lease.
2. Provide a journal entry to illustrate your answer to part i).
3. Evaluate the consistency of the treatment of the option to extend the lease with the definition and recognition criteria of a liability specified in the Conceptual Framework.