Flow Ltd prepares financial statements to 31 March each year. On 1 April 1998, Flow Ltd sold a freehold property to another company, River plc. Flow Ltd had purchased the property for £500 000 on 1 April 1988 and had charged total depreciation of £60 000 on the property for the period 1 April 1988 to 31 March 1998.

River plc paid £850 000 for the property on 1 April 1998, at which date its true market value was £550 000.

From 1 April 1998 the property was leased back by Flow Ltd on a ten-year operating lease for annual rentals (payable in arrears) of £100 000. A normal annual rental for such a property would have been £50000.

River plc is a financial institution which, on 1 April 1998, charged interest of 10.56% per annum on ten-year fixed rate loans.

Requirements

(a) Explain what is meant by the terms ‘finance lease’ and ‘operating lease’ and how operating leases should be accounted for in the financial statements of lessee companies.

(7 marks)

(b) Show the journal entries which Flow Ltd will make to record:

● its sale of the property to River plc on 1 April 1998,

● the payment of the first rental to River plc on 31 March 1999.

Justify your answer with reference to appropriate Accounting Standards. (13 marks)

CIMA, Financial Reporting, May 1999 (20 marks)