QUESTION $1(60$ marks$)$

Hydrocraft Ltd is a manufacturing company in the deep$-$sea exploration sector and the entity has a $31$ December financial year end. The entity is the only entity in the country that specializes in the manufacture of deep$-$sea vessels $($submersibles$)$ for their customers, namely private tourist entities. The deep$-$sea vessels are manufactured using specialized machines and it usually takes approximately $24$ months to manufacture each deep$-$sea vessel.

Hydrocraft Ltd embarked on the manufacture of a deep$-$sea vessel for a client who ordered a vessel for their company, which takes tourists to visit the Titanic wreckage at the bottom of the Atlantic Ocean. As soon as the order was received on $1$ January $2023,$ Hydrocraft Ltd started manufacturing the vessel.

In order to manufacture the inventory item $($deep$-$sea vessel$),$ a new specialized machine, Machine C$,$ was required, which Hydrocraft Ltd decided to lease from a third party. Details of the lease agreement are as follows:

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Five annual fixed lease installments are due at the end of December each year.

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The lease installments will increase by $10\%$ each year as per the table below:

Due date

Lease installment

R

$31$ December $2023$

$80000$

$31$ December $2024$

$88000$

$31$ December $2025$

$96800$

$31$ December $2026$

$106480$

$31$ December $2027$

$117128$

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The implicit rate applicable to the lease is $7\%$ per annum.

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Machine C has an unguaranteed residual value at the end of the lease term of R$15842.$ The lessee is not expected to make a payment for this at the end of the lease.Machine C had a fair value of R$396000$ at the start of the lease term on $1$ January $2023.$

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The machine was modified by the third party prior to the start of the lease to be specifically suited for the manufacturing of deep$-$sea vessels created by Hydrocraft Ltd$.$

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At the end of the lease, ownership of the machine reverts to the lessor however Hydrocraft Ltd has a right to continue with the lease for another three years for R$25000$ per annum. The market$-$related rent for a similar specialized machine would cost approximately R$112000$ per annum, at that time.

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The machine has an expected economic and useful life of $5$ years.

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The first installment was paid on $31$ December $2023$ as per the agreement.

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Costs incurred in negotiating and securing the lease agreement amounted to R$3450$ which were paid in cash on $1$ January $2023$ once the lease contract was entered into and finalized.

Hydrocraft Ltd continuously used Machine C throughout the financial year to manufacture the deep$-$sea vessel and therefore the machine was never left idle.

The accountant of Hydrocraft Ltd accounted for the lease and lease related costs in the current financial year as follows along with an explanation as to how it was calculated:

Date

Journal Details

Dr

Cr

Explanation

R

R

$1$ Jan $2023$

Indirect lease costs $($P$/$L$)$

$3450$

Expensing of the initial indirect cost of the lease.

Bank $($SFP$)$

$3450$

$($Accounting for the indirect costs to secure the lease$)$

$31$ Dec

$2023$

Lease expense $($P$/$L$)$

$100850$

Expense calculated by straight$-$lining the total of the lease payments and the unguaranteed residual

Bank $($SFP$)$

$80000$

Lease liability $($SFP$)$

$20850($Accounting for the lease expense regarding Machine C for the year$)$

value over the lease term i$.$e$.($R$80000+$ R$88000+$ R$96800+$ R$106480+$ R$117128+$ R$15842)/5=$ R$100850$

Additional information:

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Hydrocraft Ltd$$s policy is to depreciate all machinery using a straight$-$line basis over its useful life and depreciate their right$-$of$-$use assets in accordance with the depreciation requirements of IAS $16,$ using the cost model.

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SARS grants the same wear and tear allowance for Machine C i$.$e$.5$ years.

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The lease payments are deductible for tax purposes when paid.

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The company tax rate is $27\%$ for all financial years.

REQUIRED:

$1\mathrm{.}1$ Briefly discuss how you would classify the lease $($i$.$e$.,$ operating or finance lease$)$ in the accounting records of the lessor at the start of the lease. As part of your justification $($amongst as many other factors as you can mention as per IFRS $16),$ calculate and comment on the present value of minimum lease payments.

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Structure you answer neatly using relevant headings where possible.

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Use only the information given in the question.

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Round off calculations to the nearest Rand.

$(15$ marks$)$

$1\mathrm{.}2$ Briefly discuss whether or not the accountant$$s treatment of the lease is correct, in the accounting records of Hydrocraft, in terms of IFRS $16.$ Also briefly discuss how it should be measured $($initially and subsequently$)$ if you do not agree with the accountant$$s treatment. No calculations are required as part of your answer.

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Structure your discussion neatly using relevant headings where possible.

$(15$ marks$)1\mathrm{.}3$ Assume that the lease is a finance lease. Prepare the general journal entries of Hydrocraft Ltd for the year ended $31$ December $2023,$ in accordance with the International Financial Reporting Standards $($IFRS$),$ using only the information given in the question. Make reference to your calculations in