ABC Limited manufactures and sells high-end fashion products. Its financial year-end is on 31 December. On 1 January 2019, ABC Limited entered into an agreement with XYZ Limited (‘XYZ’), an Italian manufacturer, to lease a production machine, namely ‘The Queen’, for a term of four years commencing 1 January 2019 and ending 31 December 2022 for exclusive use. The expected useful life of The Queen is five years. ABC Limited is the first to introduce the machine to the Hong Kong market. According to the contract with XYZ, ABC Limited must follow all the safety instructions in operating the machine and the machine can only be used in Hong Kong. Furthermore, XYZ is permitted to substitute The Queen at any time during the contract period if the substitute machine can meet the specifications and is of better performance than The Queen, as stipulated in the contract. Besides, XYZ must substitute the production machine if the machine is not working. XYZ would be responsible for all the costs involved in the substitution (e.g. delivery and installation of the new machine).
The annual lease payment is $800,000 payable at the end of each year. ABC Limited’s incremental borrowing rate on the commencement date is 5% per annum. Initial delivery cost and installation of The Queen amounting to HK$1,170,000 would be borne by ABC Limited.
a Explain whether the contract is, or contains, a lease with reference to the Hong Kong financial reporting and accounting standards. (35 marks)
b Determine the amount of right-of-use asset and lease liability to be recognized on the inception date. (18 marks)
c Prepare a table showing the movement of lease liability throughout the lease period. (18 marks)
d Prepare journal entries (without narratives) to record the transactions in relation to the lease in 2019. (29 marks)
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