Orange Ltd. enters into a 12-year lease of a whole a building, with an option to extend for five yea

Orange Ltd. enters into a 12-year lease of a whole a building, with an option to extend for five
years. Orange will make periodic payments of $77,000 per year during the initial term and
$87,000 per year during the optional period, all payable at the start of each year. Lima, the
landlord, will charge Orange another $5,000 per year for executory costs, relating to insurance
and maintenance of the building. These are included in the periodic payments mentioned
above. To obtain the lease, Orange paid initial direct costs of $30,000 of which $12,000 relates
to a payment to a former tenant occupying one of the floors of the building and $18,000 as a
commission for the real estate agent that arranged the lease. As an incentive to Orange for
entering into the lease, Lima Ltd (the lessor) made the following payments to Orange: $18,000
for the real estate and $8,000 for leasehold improvements. Orange is required to restore the
building at the end of the lease. This involves removing all branding, floor coverings, internal
walls put up by Orange, etc. Orange spoke to some builders and real estate agents and the
consensus view is that Orange will have to pay $600,000 in 12 years’ time. Your old manager
referred you to section 45 of AASB 137 and requested you to use the company’s incremental
borrowing rate. This manager also mumbled something about ensuring you ‘unwind the
discount’ relating to this provision over the life of the lease. You smiled politely and wondered
what the manager was talking about. This manager noticed your strange look and suggested
you have a look at example 1 in Interpretation 1 (see Pronouncements) on the AASB website.
The manager said to ignore material relating to changes in decommissioning liabilities in that
Interpretation, just get a sense of what unwinding the discount means and how it is treated
for accounting purposes.
Group Assignment Page 3 of 3
Lima Ltd. (the lessor) has incurred in the following costs: $35,000 for terminating the lease
contract with the previous lessee; $5,000 legal fees; $18,000 restoration and $23,000
renovation.
At the commencement date, Orange concludes that it is not reasonably certain to exercise the
option to extend the lease and, therefore, determines that the lease term is 12 years.
The interest rate implicit in the lease is not readily determinable. Orange’s incremental
borrowing rate is 5.8 per cent per annum, which reflects the rate at which Orange could borrow
an amount similar to the value of the right-of-use asset, in the same currency, for a 12-year
term, and with similar collateral.
Required:
a. Calculate the initial amount the lease liability will be measured at. (2 marks)
b. Calculate the initial amount the right-of-use asset will be measured at. (5 marks)
c. Justify your answer in (b) using the Australian Accounting Standards. (3 marks)
d. Prepare a table which shows the amortization of the lease liability over its life. (3 marks)
e. Prepare journal entries for the commencement date and for the next 3 lease payments
(15 marks)
f. Prepare a table which shows changes in the ‘make good’ provision over the life of the
asset. Based on this table, prepare relevant journal entries for the first 4 years. (7
marks)
g. Assume at the end of the lease Orange handed back the leased asset and incurred
exactly $600,000 restoring the property to the condition demanded by Lima the
landlord. Prepare the relevant journal entries. (2 marks)
h. This time assume that Orange only had to pay $585,000 to restore the property to the
condition demanded by the landlord. Prepare the relevant journal entries. (3 marks

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