You are the new chief finance officer (CFO) at a medium-size manufacturing business, Sapphire Ltd. You have

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Question:

You are the new chief finance officer (CFO) at a medium-size manufacturing business, Sapphire Ltd. You have recently graduated from UWA and passed your chartered accountant exams and training.

When you got the job, the chief executive officer warned you that the previous CFO, who was in the job for less than a year, appears to have left the accounts in a mess.

You have been reviewing the accounting records and came upon a lease contract for a machine which Sapphire Ltd leased from X Ltd. The details are as follows

The lease was signed on 1 July 2021 and X Ltd is a financier lessor. The lease term is 4 years and the economic useful life of the machine is 5 years. The machine will be returned to the lessor at the end of

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The annual rental payment, in arrears (commencing 30/6/22) is $100 000; this includes $10 000 which is a repayment to X Ltd for maintenance costs.

The residual value of the machine at end of lease term is $40 000 and the residual value guaranteed by Sapphire Ltd is $5 000. The interest rate implicit in the lease is 4%. Sapphire limited incurred initial

costs of $7 000 to get the machine set up for use.

The previous CFO at Sapphire Ltd had recorded the following for the lease:

1 July 2021: Dr Lease expense $7 000, Cr Bank (initial costs) $7 000

30 June 2022: Dr Lease expense $100 000, Cr Bank $100 000 (annual rental payment)

You realize that these entries are incorrect, so you have reversed them out of the accounts by exact opposite journal entries

The CEO has told you that the company has debt covenants that restrict the debt to equity ratio (debt (at year-end)/equity (at year-end)).

You may ignore tax. The present value interest factor of an annuity of 4 payments at 4% is 3.6299. The present value interest factor of a lump sum at 4% over 4 periods is 0.8548. Sapphire Ltd uses straight

line depreciation.

Required:

1. Provide all the correct journal entries for Sapphire Ltd (lessee) for the year ended 30 June 2022 relating to the lease contract. Note, that no narrations are required. Please use the present value interest

lacrs n e .u marks

Assume the debt to equity ratio is $1 000 000 / $3 000 000 on 30 June 2022, before taking the lease into account. Compute the effect of the lease on the debt to equity ratio based a) on the journals of the previous CFO and b) based on your correct lease journals. Explain why top management may be unhappy about the way you are accounting for the lease contract.