Lessee Ltd., a British company that applies IFRSs, and Lessor Inc. engaged in a lease agreement on January 1, 2007. The three year lease agreement stated that the lease payments of $100,000 would be due to Lessor Ltd. each year. In addition to the lease payments, Lessee Ltd. was also responsible for other expenses that amount to $2,000 per year, such as insurance and taxes. The equipment would be reverted back to Lessor Ltd. at the end of the lease agreement because the lease did not include purchase or renewal options. The equipment had a fair value of $265,000, a remaining useful life of four years, and a salvage value of $2,000. At the end of the lease term, Lessee Ltd. has guaranteed $20,000 as the residual value. The lessee’s incremental borrowing rate was 11 percent and lessor’s implicit rate was 10 percent.
Two accountants of Lessee Ltd. analyzed the assets of the lease and prepared computations. For the present value of lease obligation, if using the implicit rate in the lease (10%), the residual value would be $15,026 and the present value of annual payment would be $248,690. If using the incremental borrowing rate (11%), the residual value would be $14,624 and the present value of the annual payment would be $244,370. The junior and senior accountant used two different methods when they computed the lease payments. The junior accountant identified the agreement as an operating lease and simply added the lease payment and insurance expense together. The senior accountant used a three step method to calculate the expense. He classified the agreement as a finance lease and used the incremental borrowing rate to determine the present value of lease payments. He then allocated the interest and reduced the lease liability. The issue of this case is to determine which accountant’s analysis is correct and how the answer would differ under U.S. GAAP.
Requirement 1: Was the junior accountant’s analysis correct? Why or why not?...