QUESTION FOUR [23]

Cereal Limited entered into a contract with Rent a Space Limited for the lease of retail space for a new speciality cereal store. The retail space is specified, and the lessor cannot require Cereal Limited to move to a different retail space. Cereal Limited also makes all decisions relating to the retail space.

The commencement date of the lease was 1 January 2019 and the lease term is 5 years.

The lease payments are R525 000 per year payable in advance.

Commission and legal fees of R18 500 were incurred by Cereal Limited and paid for in cash at the inception of the lease.

The contract contains an option for Cereal Limited to extend the contract for a further 5 years with lease payments of R550 000 per year payable in advance. These rentals are at market rates.

The speciality cereal shop is of new format that is not yet tested in the local market nor by Cereal Limited. The shop fittings and furnishing provided by the lessor are expected to have reached the end of their useful lives at the end of the 5th year.

At the inception of the lease, management of Cereal Limited were unable to determine the interest rate implicit in the lease. The incremental borrowing rate at the inception of the lease is 4%.

After 3 years, at 31 December 2021, it is apparent that the new format has not been successful and management has taken the decision to change the format of the shop. This will result in significant costs that Cereal Limited will need to incur to change the fittings and furnishing to a more traditional format and to one that in being used more successfully in the food and beverage sector. The incremental borrowing rate at 31 December 2021 is 3%.

Required:

1. Determine with reasons, the lease term that Cereal Limited should use when measuring the lease liability at inception of the lease and whether this will change with the new circumstances as at 31 December 2021. (10)

2. Calculate the value of the lease liability on inception of the lease i.e. 1 st January 2019 (3)

3. Calculate the value of the right of use asset as at the 31st December 2021 (5)

4. Prepare the journal entries in the accounting records of Cereal Limited for the year ended 31 December 2019. (5)