Finance/Capital lease

[Craig101]

Having a lot of trouble regarding a question on finance leases in an assignment. The questions asks to:

Calculate the total finance charge, annual allocation of finance charge, annual obligation under finance lease (the annual finance lease liability) and net book value of the asset for each of the four years of the lease term.

From these details

• pay five annual rental payments of £40,000 in advance with the first payment due on 31st December 2010
• The equipment is new and is expected to have a useful life of 6 years after which time it is deemed to have a negligible residual value
• The cash price of the equipment would have been £152,000
• Finance charges are allocated using the interest rate implicit in the lease which is 10%.

I have gone over the numbers using the method provided in lectures and I can't get them to add up for the final payment of £40,000.

Thanks in advance.

 

[Triest123]

Firstly, you should compute the Present Value of the "minimum lease payment"
for the equipment with the implicit interest rate 10% given by the question.

Present Value of the minimum lease payment
= 40000 + 40000 (1+10%)^-1 + 40000 (1+10%)^-2 + 40000 (1+10%)^-3
+ 40000 (1+10%)^-4
=$166,795

As the present value of the minimum lease payment is higher than the cash price
($152,000), so it is a finance lease. This present value is the lease liability and
is also treated as the costs of the equipment.

The total finance charge for the lease
= (40,000 x 5) - 166,795 = $33,205

For the year 2011
The finance charge : (166,795 - 40,000) x 10% = $12,679
The principal repayment : (40,000 - 12,679) = $27,321
The finance lease liability at 31 Dec 2011: (126,795 - 27,321) =$99,474
Annual Depreciation = 166,795 / 4 years = $41,699
(Note : Depreciation is based on the lease period or the useful life, whichever is shorter.
So, in this case, the lease period is selected)
The net book value : (166,795- 41,699) = 125,096

For the remaining years, I think you can do it by yourself....

 

[Craig101]

Massive help thanks, I was using the same formula but ended up at 166,760 somehow.

 

[Triest123]

Massive help thanks, I was using the same formula but ended up at 166,760 somehow.

=> I'm using a scientific calculator and get the figure is 166,794.62

 

[Craig101]

=> I'm using a scientific calculator and get the figure is 166,794.62

This was prior to your help, I'm on the same lines as you are now.

 

[mike99]

Surely the leased asset is recognised at the lower of the present value of the minimum lease payments (MLP) and its cash cost? Is depreciation then not calculated on this amount?

 

[Triest123]

Surely the leased asset is recognised at the lower of the present value of the minimum lease payments (MLP) and its cash cost? Is depreciation then not calculated on this amount?

=> The leased asset is based on its amortised costs rather than its fair value (its cash costs).

You are talking about the fixed asset NOT the leased asset.

 

[mike99]

Wait, I've misunderstood somewhere.

The implicit interest rate (10%) discounts (or should discount) the payments to its fair value. So the cash cost of the asset is not the fair value of the asset?

 

[Triest123]

Wait, I've misunderstood somewhere.

The implicit interest rate (10%) discounts (or should discount) the payments to its fair value. So the cash cost of the asset is not the fair value of the asset?

=> the implicit interest rate is the company's average costs of capital (i.e. estimated rate),
it is not the actual borrowing costs for the lease.

 

[mike99]

Ahhh ... US GAAP. Sorry, I'm coming from IFRS. Lol