Introduction:
TechCo, a company that manufactures electronic gadgets, recently acquired a piece of equipment on a lease purchase basis. The lease agreement requires monthly installment payments over a 36-month period. The purchase was subject to VAT, and the installment payments include both interest and principal repayment.
Case Facts:
TechCo purchased a new piece of equipment for $50,000. The equipment purchase was subject to a 10% VAT, amounting to $5,000. Therefore, the total cost including VAT was $55,000.
Upfront payment: $5,000 at lease commencement
Total remaining balance: $50,000 (to be paid in 36 monthly installments)
Interest rate: 12% per annum
Monthly interest rate: 1% (12% ÷ 12 months)
The monthly installment amount is determined by the lease agreement and includes both principal repayment and interest. Each installment will reduce the principal amount, and the interest portion will decrease over time.
IFRS Journal Entries
1. At Lease Commencement (Initial Payment):
Debit: Equipment for $50,000 (equipment purchase cost).
Debit: VAT Receivable for $5,000 (VAT on the equipment).
Credit: Cash/Bank for $5,000 (upfront payment).
Credit: Lease Liability for $50,000 (remaining liability).
Explanation: The initial payment reduces the cash balance, and the remaining lease liability is recorded as a lease liability.
2. Monthly Installment Payment:
Assume the first installment is due at the end of the first month. The monthly payment will cover both the interest and principal.
Monthly installment payment (including VAT): $1,664.92 (for illustrative purposes)
For the first month:
Interest component: (1% of $50,000) = $500
Principal component: $1,164.92
Journal Entries for Each Monthly Payment:
Debit: Interest Expense for $500 (interest portion of the installment).
Debit: Lease Liability for $1,164.92 (principal repayment portion).
Credit: Cash/Bank for $1,664.92 (total installment payment).
Explanation: The interest portion is recorded as an expense, while the principal portion reduces the lease liability. The installment payment covers the total installment.
Allocation of Each Installment Payment
For each subsequent installment, the interest component will decrease as the outstanding lease liability decreases, while the principal repayment portion of the installment payment will increase.
Second Month Payment (Example):
Outstanding principal after first payment: $48,835.08 ($50,000 - $1,164.92)
Interest component for second month: $488.35 (1% of $48,835.08)
Principal component: $1,176.57 ($1,664.92 - $488.35)
Journal Entries for the Second Monthly Payment:
Debit: Interest Expense for $488.35 (interest portion of the installment).
Debit: Lease Liability for $1,176.57 (principal repayment portion).
Credit: Cash/Bank for $1,664.92 (total installment payment).
Final Explanation:
Equipment (Debit): Represents the value of the asset acquired.
VAT Receivable (Debit): Represents the VAT amount TechCo can reclaim from the government.
Lease Liability (Credit/Debit): Represents the ongoing obligation to make future lease payments.
Interest Expense (Debit): Recognizes the interest component of each monthly installment payment.
Cash/Bank (Credit): Reflects the cash outflow for each payment.
This case study shows how TechCo recorded the installment payments for the leased liability, including the allocation of interest and principal, and ensures that all aspects of the transaction are accurately reflected in TechCo’s financial records.
Disclaimer: This case study is designed to enhance digital financial literacy and business management skills among students, to help them apply these concepts in real-world scenarios to boost their earnings, employability and entrepreneurial potential. The case was edited by Razi Amin, a Harvard MBA with 30+ years of leadership and advisory experiences at major international banks in New York, London, Hong Kong and Washington, DC. Razi is also a member of Harvard Alumni for Global Women's Empowerment. While AI technology was used for prompt-engineering to generate case content, every case has been rigorously reviewed and edited to ensure accuracy, clarity, and educational effectiveness. Reproduction of this case material is prohibited without permission from ASPEN Capital Solutions LLC.
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