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On 1 January 20X4 Badger entered into a lease agreement to lease an item of machinery for 4 years with rentals of $210,000 payable annually in arrears. The asset has a useful life of 5 years and at the end of the lease term legal ownership will pass to Badger. The present
value of the lease payments at the inception of the lease was $635,000 and the interest
rate implicit in the lease is 12.2%. For the year ended 31 December 20X4 Badger accounted for this lease by recording the payment of $210,000 as an operating expense. This treatment was discovered during 20X5, after the financial statements for 20X4 had been finalised.
In the statement of changes in equity for 20X5 what adjustment will be necessary to
retained earnings brought forward?The answer is $5530 credit.
1. The working is as follows. Could you explain it?
Reverse incorrect treatment of rental:
Dr Liability $210,000, Cr Retained Earnings $210,000
Charge asset depreciation ($635,000/5):
Dr Retained earnings $127,000, Cr Property, plant and equipment $127,000
Charge finance cost ($635,000 × 12.2%):
Dr Retained Earnings $77,470, Cr Liability $77,470
This gives a net adjustment of $5,530 to be credited to opening retained earnings.Actually, I’ve not understood the neither the working nor how to obtain the anwer
Hi,
They’ve recorded the lease as a short lease in 20X4 when it shouldn’t have been. As this was the prior year then any adjustments need to be put through the opening retained earnings in the SOCIE.
Firstly, in the solution above they have reversed out the $210,000 that was incorrectly expensed through profit or loss when it was treated as a short life asset. This results in a credit to retained earnings of $210,000
Secondly the lease now needs to be recognised correctly, so this means recognising the asset and depreciating it, as well as recording the lease liability and associated finance costs that should have been recognised last year and weren’t.
The depreciation expense will give a debit to retained earnings as too will the finance cost, so debits of $127,000 and $77,470.
If you then net-off the three entries above then it gives a net credit of $5,530.
Thanks
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