On 1 July 2022 the lessee ABC Ltdenters into a five-year lease of a machine with an option to extend the lease for another five years at usual market rates, which are expected to rise relative to current lease payments. ABCs initial direct costs associated with the lease are $10,000 (these costs represent the costs that are directly attributable to negotiating and arranging the lease and would not have been incurred without entering the lease). According to the contract, contracted payments will be $115,000 in the first five years, with the first payment being made at the commencement of the lease, and $135,000 per year if the option for the further five years is taken. Lease payments are made on 30 June each year (meaning there are four more lease payments following the initial payment). Included within all these payments is a $15,000 per year service arrangement, which requires the supplier to maintain the machine in good working order. There is no guaranteed residual payment.

At the commencement of the lease, ABC Ltd makes a judgement that it does not intend to exercise the option to lease the asset beyond the first five years.

The rate of interest charged by the lessor is not readily determinable, but ABC Ltd incremental borrowing rate is 10% for similar transactions.

The machine is expected to have an economic useful life of 10 years and the financial year end is 30 June.[QN1]

Ignore Tax Effects.

Required:

a) Very briefly, explain why service contracts cannot be capitalised? (1 mark)

b) Provide the analysis (calculations) for the lease liability. (5 marks)

c) Provide the lease Payment schedule calculations for the years 2022 and 2023. (4 marks)

d) Provide all the necessary initial accounting journal entries to recognise the lease liability and right-of-use asset and for the year 2023. (4 marks)