X Ltd is asset rich but cash poor. In an attempt to alleviate its liquidity problems, it

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Question:

X Ltd is asset rich but cash poor. In an attempt to alleviate its liquidity problems, it entered into an agreement on 1 June 2014 to sell its processing plant to Y Ltd for 467,100. At the date of sale, the plant had a carrying amount of 400,000 and a future useful life of 5 years. Y Ltd immediately leased the processing plant back to X Ltd. The terms of the lease agreement were:

Lease term - 3 years

Economic life of plant - 5 years

Annual rental payment, in arrears (commencing 30/5/15) - 165,000

Residual value of plant at end of lease term - 90,000

Residual value guaranteed by Ultramarine Ltd - 60,000

Interest rate implicit in the lease - 6%

The lease is cancellable, but only with the permission of the lessor.

At the end of the lease term, the plant is to be returned to Y Ltd. In setting up the lease agreement Y Ltd incurred 9,414 in legal fees and stamp duty costs. The annual rental payment includes 15,000 to reimburse the lessor for maintenance costs incurred on behalf of the lessee.

Required

Classify the lease for both lessor and lessee and justify your answer accordingly. Prepare a lease payments schedule in the records of X Ltd and a lease receipts schedule and the journal entries in the records of Y Ltd for the year ending 30 May 2015. Show all workings. Finally, explain how and why your answers would change if the lease agreement could be cancelled at any time without penalty. Discuss this with regard to both companies involved in this transaction.