Accounting for lease by lessee Dogberry Security Services wins a five-year contract in late x1 to provide routine police services to Messina’s municipal government. Rather than buy all the equipment it needs, it decides to lease some of it. Polease, a vehicle dealer, offers to lease to Dogberry an armoured van for the transport of prisoners. The van has a fair value of 39,925 and is expected to yield economic benefits evenly over its five-year life. Under the terms of the proposed lease, Dogberry will pay Polease 10,000 at the end of each of the five years which indicates an implicit interest rate in the lease of 8%

(39,925/10,000 = 3.9925 = PVA (8%, 5 payments)). At the end of the lease term, Dogberry will return the vehicle to Polease. There is no transfer-of-title clause or bargain purchase option in the lease contract.

Dogberry’s management are concerned about the financial implications of Polease’s offer. They ask you to determine the financial statement impact of the lease under two assumptions – that it’s classified as (i) an operating lease and (ii) a finance lease. Dogberry plans to sign the lease contract on 1/1/x2. The company has a 31 December financial year-end.

Required

(a) What is the effect of the lease on Dogberry’s accounts at the start of x2 when the contract is signed if the lease is:

(i) an operating lease?

(ii) a finance lease?

(b) How should Dogberry account for the lease in its x2 and x3 accounts (income statement and endyear balance sheet) if the lease is:

(i) an operating lease?

(ii) a finance lease?

(c) Is the lease an operating lease or a finance lease under IAS? Give reasons for your answer.

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