Accounting Theory III Assignment

On 30 June 20X0 Lessee Ltd entered into a contract with Owner Ltd to lease a generator that had a fair value (and cost to Owner Ltd) of $50,000. The generator will be used by Lessee 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 the following characteristics:

• The term of the lease is 5 years.
•  Lease rental payments of $10 000 are made annually in advance.
•  The interest rate implied in the lease is 10%.
•  The present value (PV) of the lease payments is $41,700.
•  The residual value of the generator at the end of the lease is not guaranteed.
•  The penalty for cancellation is immediate payment of 90% of the remaining lease rentals.

 The lessee 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 estimated useful life is 7 years with nil residual value.
• The residual value of the generator is $13,370 (PV = $8,300) after 5 years.

i) Describe, in words, how Lessee 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 extension of the lease is highly uncertain.
ii) Provide a journal entry to illustrate your answer to part i).