ASSIGNMENT No. 02

Advance Accounting (444) BA/ B.Com

Spring, 2019

A capital lease is a lease in which the lessor only finances the leased asset, and all other rights of
ownership transfer to the lessee. This results in the recordation of the asset as the lessee's
property in its general ledger, as a fixed asset. The lessee can only record the interest portion of a
capital lease payment as expense, as opposed to the amount of the entire lease payment in the
case of the more common operating lease.
Note: The capital lease concept was replaced in Accounting Standards Update 2016-02 (released
in 2016 and in effect as of 2019) with the concept of a finance lease. Consequently, the following
discussion is for historical purposes only.
The criteria for a capital lease can be any one of the following four alternatives:
 Ownership. The ownership of the asset is shifted from the lessor to the lessee by the end of
the lease period; or
 Bargain purchase option. The lessee can buy the asset from the lessor at the end of the
lease term for a below-market price; or
 Lease term. The period of the lease encompasses at least 75% of the useful life of the
asset (and the lease is noncancellable during that time); or
 Present value. The present value of the minimum lease payments required under the lease
is at least 90% of the fair value of the asset at the inception of the lease.
If a lease agreement contains any one of the preceding four criteria, the lessee records it as a
capital lease. Otherwise, the lease is recorded as an operating lease. The recordation of these two
types of leases is as follows:
 Capital lease. The present value of all lease payments is considered to be the cost of the
asset, which is recorded as a fixed asset, with an offsetting credit to a capital lease liability
account. As each monthly lease payment is made to the lessor, the lessee records a combined
reduction in the capital lease liability account and a charge to interest expense. The lessee also
records a periodic depreciation charge to gradually reduce the carrying amount of the fixed asset
in its accounting records.
 Operating lease. Record each lease payment as an expense. There is no other entry.
Given the precise definition of a capital lease, the parties to a lease are usually well aware of the
status of their lease arrangement before a lease is signed, and typically write the lease agreement
so that the arrangement will be clearly defined as either a capital lease or operating lease.

PRESENT VALUE
The aggregate of present value of each periodic rental (or lease payment) over the lease term should
be more than 90% of the market value of the underlying asset at the beginning of the lease. For
example, if the lease rentals of the leased assets whose value is $100,000 are $12,000 every year for
say 10 years, the present value of these lease rentals @ 5% would be $92,660.82. We can see that
the present value is 92.66% which is more than 90% of the current market value of $100,000. This
lease criterion is therefore satisfied for the above lease arrangements.
Therefore, all these listed capital lease criteria are conditions for capital leases and if a lease
agreement has any one of these criteria, then the lessee should record the agreement as a capital
lease. Otherwise, it is known as an operating lease agreement.

EXAMPLE OF CAPITAL LEASE CRITERIA
Suppose you saw a nice machinery that you would love to own for your business, it has everything you
need as an ideal machinery, but the problem is that you don’t have the money to outrightly buy or pay
for it. Having a knowledge of capital lease, you contact the owner of the machinery owner to know if
he would be willing to finance the purchase of the machinery as long as you agree to make the lease
payments. And since you are not willing to return the car after the lease agreement, you can enter
what is called a capital lease agreement (which satisfies the criteria explained above) and you take
charge of all maintenance, repairs while still paying for your monthly payment depending on the lease agreement.

CAPITAL LEASE CRITERIA FASB
Capital lease criteria according to Financial Accounting Standards Board (FASB) amendment of 2016
asked every corporation operating in the US to capitalize all lease above one year with. This
amendment should become effective and fully implemented by December 15, 2018. This capital lease
amendment has a serious effect on most corporations in the US. This issue is as a result of GAAP view
of the capital lease as a purchase of assets if some criteria are met instead of a rental agreement that
it is.

CAPITAL LEASE REQUIREMENT DISCLOSURES
For a lease agreement to take place, the lessor and lessee are required under the GAAP disclosure
form to disclose the following information.
1. The general leasing arrangements should be properly described
2. There should be a gross amount disclosure of assets and it should be recorded under capital
leases.
3. The disclosure should also show a major asset class and accumulated depreciationamount.
4. There should be a separate identification of the asset obligations. This information is found on
the balance sheet of the organization and appropriate classification of the current and noncurrent
assets.
5. There should be a minimum of all future lease payments for the next five years in total.
6. The whole net investment components as of the date of which each balance sheet was
presented should show:
7. The minimum payment to be received in the future. A number of separate deductions should be
made such as representing executor costs, profits that are in the minimum lease payments
8. It also shows the minimum lease payments receivable for uncollectible accumulated allowances.
9. The benefits (unguaranteed) accruing to the lessor should be disclosed
10. Unearned income included offsetting the direct cost that is initially charged against the income
for the different period with respect to the presented income statement.

(b) On January 01, 2012 Mr. Aqeel took possession of a Machine from Mr. Nouman and enters into lease agreement for 10 years. Annual rentals are payable at the beginning ofeach year amounting Rs. 12,000. Useful life of the machine is 15 years and interest rate implicit in the lease was agreed 13%. Fair value of the machine was Rs. 140,000. Required: You are required to identify the type of lease and Pass the necessary journal entries in the books of lesser and lessee both to record the rental payment. 

Q. 2 What do you understand by the terms Amalgamation, Absorption and Reconstruction? How will you distinguish among them? 

Amalgamation is when two or more companies merge. It is the conversion of two companies and two
balance sheets into one company and one (combined) balance sheet. In amalgamation, the identity of
both the companies exist and survive. It is the pooling of assets and liabilities and interest of two
companies. It usually consists of two companies of same size and stature.
Example: Maruti motors(India) and Suzuki(Japan) were amalgamated to form Maruti Suzuki.
Absorption refers to takeover. In absorption, one company is taken over by another and hence it loses
its own core identity. The identity of absorbing company only sustains. Here, it's not pooling of
interest. It is the dominance of absorbing company. Here, it is the taking of a small company by a
comparatively bigger business company.
Example: Takeover of Myntra by Flipkart.

Reconstruction

It includes internal reconstruction and external reconstruction.
Internal reconstruction is carried when when the company faces consistent financial pressure and is
incurring loss since long. Here, there might be some alterations in share capital and waiver of some
debts. The company is neither liquidated nor any new company is formed. “ And reduced” words are to be added in balance sheet . This procedure includes involvement of court and is bit tedious and
lengthy.
External reconstruction refers to forming of a new company to takeover the assets and liabilities of old company. Here, the new company if formed with the deliberate purpose of taking over the old
company. And hence here old company is liquidated and new company is formed. It doesn't require
court’s permission and takes less time as compared to internal reconstruction.

Legal process of amalgamation

An amalgamation is, in fact, a specific subset within a broader group of “business combinations”. There
are three main types of business combinations, which are outlined below in more detail. It’s important
to understand the subtle differences when talking about mergers, acquisitions, and amalgamations.
1. Acquisition (two survivors): The purchasing company acquires more than 50% of the shares
of the acquired company and both companies survive.
2. Merger (one survivor): The purchasing company buys the selling company’s assets. The sale
of the acquired company’s assets leads to the survival of only the purchasing company.
3. Amalgamation (no survivors): This third option creates a new company in which none of the
pre-existing companies survive.
As you can see with the above examples, the difference comes down to the surviving companies. In
an amalgamation, a new company is created and none of the old companies survive.

Why perform an amalgamation?

Amalgamations are often done when competing companies engaged in similar business would achieve
some synergy or cost savings by combining their operations, which can be quantified in a financial
model. By contrast, it can also occur when companies want to enter new markets or get into new
business and mergers and acquisitions as a way to achieve that. Here is a list of reasons why
companies perform consolidations:
 Access to new markets
 Access to new technologies
 Access to new clients / geographies
 Cheaper financing for a bigger company
 Cost savings (synergies) achieved through bargaining power with suppliers and clients
 Eliminating competition

Who is involved in amalgamations?

An amalgamation typically requires investment bankers, lawyers, accountants, and the executives at
each of the combining companies. The bankers will typically perform extensive financial
modeling and valuation to evaluate the potential transaction and advise the individual corporations. In
parallel to this process, the lawyers will work with the bankers and their corporate clients to determine which of the above legal structures is optimal: acquisition, merger, or amalgamation.
The amalgamation of two companies in corporate circles means that the two entities are combined into a single company. In accounting, it means the combination of two or more financial statements. For instance, a group of companies can consolidate the financial statements of each individual company and report their financials as one single entity.

Amalgamation versus Absorption

Amalgamation refers to the joining of multiple companies and should be differentiated from absorption, which is the process by which a more- powerful company takes control of a weaker one. The transferor company is the company that is amalgamated, while the transfer company is the company into which the transferor company is amalgamated into.

Q. 3 Explain the relationship between solvency, liquidity and profitability. 

Liquidity ratios and solvency ratios are tools investors use to make investment decisions. Liquidity
ratios measure a company's ability to convert its assets to cash. On the other hand, solvency ratios
measure a company's ability to meet its financial obligations.
Solvency ratios include financial obligations in both the long and short term, whereas liquidity ratios
focus more on a company's short-term debt obligations and current assets.
Solvency Ratios
The solvency ratio is a comprehensive measure of solvency, as it measures a firm's actual cash flow
rather than net income—by adding back depreciation and other non-cash expenses to assess the
company’s capacity to stay afloat. It measures this cash flow capacity in relation to all liabilities, rather than only short-term debt. This way, the solvency ratio assesses a company's long-term health by evaluating its repayment ability for its long-term debt and the interest on that debt.
The solvency ratio is used often by prospective business lenders to discover whether a company’s cash flow is sufficient to meet its short-and long-term liabilities. The lower a company's solvency ratio, the greater the probability that it will default on its debt obligations.
In contrast to liquidity ratios, solvency ratios measure a company's ability to meet its total financial
obligations. The solvency ratio is calculated by dividing a company's net income and depreciation by its short-term and long-term liabilities. This indicates whether a company's net income is able to cover it total liabilities. Generally, a company with a higher solvency ratio is considered to be a more favorable investment.

Liquidity Ratios

Liquidity ratios gauge a company's ability to pay off its short-term debt obligations and convert its
assets to cash. It is important that a company has the ability to convert its short-term assets into cash
so it can meet its short-term debt obligations. A healthy liquidity ratio is also essential when the
company wants to purchase additional assets. For example, internal analysis regarding liquidity ratios
involves using multiple accounting periods that are reported using the same accounting methods.
Comparing previous time periods to current operations allows analysts to track changes in the
business. In general, a higher liquidity ratio shows a company is more liquid and has better coverage
of outstanding debts. One common liquidity ratio is the current ratio. The current ratio measures a
company's ability to meet its short-term debt obligations. It is calculated by dividing its current assets
by its current liabilities. Generally, a higher current ratio indicates that the company is capable of
paying off all of its short-term debt obligations. Another common liquidity ratio is known as the quick ratio. It measures a company's ability to meet its short-term obligations with its most liquid assets and therefore excludes inventories from its current assets. It is also known as the "acid-test ratio"
Liquidity ratio analysis may not be as effective when looking across industries as various businesses
require different financing structures. Liquidity ratio analysis is less effective for comparing businesses
of different sizes in different geographical locations.

The following data is available from the financial statements of XYZ Ltd, you are required to calculate:

(i) Current Ratio
(ii) Inventory Turnover Ratio
(iii) Debtors Turnover Ratio
(iv) Creditors Turnover Ratio (12)
Opening Stock Rs. 47,000 Sundry debtors Rs. 42,000
Closing stock 53,000 Cash 10,000
Sales less returns 2,52,000 Bank 8,000
Provision for bad debts 2,000 Bills Receivable 15,000
Sundry Creditors 32,000 Provision for Taxation 15,000
Loose tools 4,000 Bills Payable29,000
Purchases 1,80,000 Marketable securities 8,000

Ans.