sm20

Kieso, Weygandt, Warfield, Young, Wiecek Intermediate Accounting, Ninth Canadian Edition

CHAPTER 20

LEASES

ASSIGNMENT CLASSIFICATION TABLE

TopicsBrief

Exercises Exercises ProblemsWriting

Assignments

*1. Rationale for leasing. 1, 2, 20 2, 3, 5

*2. Lessees: classificationof leases; accounting by lessees.

1, 2, 3, 4, 5, 6, 112, 12

2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 17, 21

3,5, 6, 7, 8, 10, 11, 12, 14, 15, 16, 17, 18, 20

1, 2,

*3. Disclosure of leases. 10 3, 4, 6, 7, 8, 9, 11, 12, 13, 15, 16, 17, 18, 20

*4. Lessors: classificationof leases; accounting by lessors.

7, 8, 9, 10, 13, 14, 15

1, 9, 10, 11, 13, 14, 15, 16, 17, 18, 19, 20

4, 5, 6, 9, 10, 11, 13, 15, 16,18, 21

4, 6

5. Contract-based approach

16 21 19, 20 1,6

*6. Sale and leaseback. 17 22, 23 22, 23 5

*7. Real estate leases. 18, 19 24, 25 23*This material is dealt with in an Appendix to the chapter.

NOTE: If your students are solving the end-of-chapter material using a financial calculator or an Excel spreadsheet as opposed to the PV tables, please note that there will be a difference in amounts. Excel and financial calculators yield a more precise result as opposed to PV tables. The amounts used for the preparation of journal entries in solutions have been prepared from the results of calculations arrived at using the PV tables.

Solutions Manual 20-1 Chapter 20

Copyright © 2010 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited


ASSIGNMENT CHARACTERISTICS TABLE

Item DescriptionLevel ofDifficulty

Time(minutes)

E20-1 Type of lease; amortization schedule. Simple 15-20E20-2 Lessee entries; capital lease with

unguaranteed residual value.Moderate 15-20

E20-3 Lessee Entries; operating lease; comparison Moderate 20-25E20-4 Lessee calculations and entries; capital lease

disclosure.E20-5 Lessee calculations and entries; capital lease

with guaranteed residual value.Moderate 20-25

E20-6 Lessee entries; capital lease with executory costs and unguaranteed residual values.

Moderate 20-30

E20-7 Lessee entries; capital lease with executory costs and unguaranteed residual, lease and fiscal year differ.

Moderate 25-35

E20-8Amortization schedule and journal entries for lessee.

Moderate 20-30

E20-9Accounting for an operating lease. Simple 10-20

E20-10Accounting for an operating lease and disclosure: lessee and lessor

Simple 15-20

E20-11Operating lease for lessee and lessor. Simple 15-20

E20-12 Operating lease versus capital lease. Moderate 25-35

E20-13Capital lease payment; Lessee-lessor entries; capital/sales-type lease.

Moderate 20-25

E20-14Lessor entries; direct financing lease with option to purchase; lessee capitalizable amount.

Moderate 25-35

E20-15 Lessor entries; disclosure, direct financing with unguaranteed residual

Moderate 25-35

E20-16 Lessor entries; sales-type lease. Moderate 15-20E20-17 Type of lease; Lessee entries with bargain

purchase option.Moderate 20-30

E20-18 Lessor entries with bargain purchase option. Moderate 20-30E20-19 Calculation of rental; journal entries for lessor. Moderate 15-25

IFRS compared to contract based approach Moderate 20-30 E20-20 Lessor entries, determine type of lease, capital

lease payments.Moderate 20-25

E20-21 IFRS compared to contract based approach Moderate 30-35*E20-21 Sale and leaseback; lessee and lessor entries. Moderate 20-30*E20-22 Lessee-lessor, sale-leaseback. Moderate 20-30*E20-23 Land lease; lessee and lessor. Moderate 15-20*E20-24 Real estate lease. Moderate 20-25







ASSIGNMENT CHARACTERISTICS TABLE (Continued)

Item DescriptionLevel ofDifficulty

Time(minutes)

P20-1 Operating and capital lease alternatives, statement disclosure—lessee and rationale.

Complex 45-50

P20-2 Leasing alternative comparison—lessee, comparison including cash flows.

Moderate 45-50

P20-3 Lessee entries and balance sheet, income and cash flow presentation; capital lease.

Moderate 45-50

P20-4 Lessor entries and balance sheet, income and cash flow presentation; direct financing lease.

Moderate 40-45

P20-5 Capital lease to lessee and operating lease to lessor; entries and financial statements.

Complex 40-45

P20-6 Operating lease; lessee-lessor entries. Simple 20-30P20-7 Capital lease, lessee with bargain purchase

option.Moderate 30-35

P20-8 Balance sheet and income statement disclosure—lessee.

Moderate 30-40

P20-9 Balance sheet and income statement disclosure—lessor.

Moderate 30-40

P20-10 Basic lessee accounting with difficult PV calculation.

Moderate 40-50

P20-11 Lessee-lessor entries; balance sheet and cash flow presentation; sales-type lease.

Moderate 35-45

P20-12 Lessee entries and balance sheet and cash flow presentation; capital and operating lease.

Moderate 25-35

P20-13 Lessor calculations and entries; sales-type lease with unguaranteed residual value.

Complex 35-45

P20-14 Lessee calculations and entries; capital lease with guaranteed and unguaranteed residual value and bargain option.

Complex 40-50

P20-15 Lessor calculations and entries; sales-type lease with guaranteed and unguaranteed residual value, with disclosure, depreciation calculations for lessee.

Complex 40-45

P20-16 Lessee-lessor accounting for residual value. Complex 30-40P20-17 Contrasting capital and operating lease choice Moderate 30-35P20-18 Lease accounting and reporting – operating

lease to lessee and capital lease to lessor.Complex 40-45

P20-19 Contract-based approach, including revision of estimates for guaranteed residual value.

Moderate 30-35

P20-20 Lease vs. purchase including financing, options to purchase, contract-based approach and summaries—lessee

Complex 50-80

P20-21 Lessor of P20-20 Moderate 20-25*P20-22 Sale and leaseback arrangement Complex 40-45*P20-23 Sale and leaseback of real estate Complex 40-45




SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 20-1

The lease does not meet the transfer of ownership test, (the bargain purchase test), or the economic life test [(5 years ÷ 8 years) < 75%] used for PE GAAP. However, it does pass the recovery of investment test. The present value of the minimum lease payments ($32,000 X 4.31213 = $137,988) (or using the alternatives below) is greater than 90% of the FMV of the asset (90% X $140,000 = $126,000). Therefore, Piper should classify the lease as a capital lease.

Excel formula =PV(rate,nper,pmt,fv,type)

Using a financial calculator:PV $ ? Yields $137,988I 8%N 5 PMT $ (32,000)FV $ 0 Type 1

BRIEF EXERCISE 20-2

Leased Equipment............................................ 112,400Lease Obligation............................ .........112,400

Lease Obligation............................................... 25,173Cash............................................... ......... 25,173




BRIEF EXERCISE 20-3

Using Excel or a financial calculator solve the payment amount:Excel formula =PMT(rate,nper,pv,fv,type)

Using a financial calculatorPV $ 112,400 RATE 6%NPR 5PMT ? Yields $25,173FV $ 0 Type 1

Using Table A-5 Present Value of an annuity due, 5 periods at 6% of 4.46511, payment = $112,400 / 4.46511= $25,172.95.

BRIEF EXERCISE 20-4

Interest Expense................................................. 8,296Interest Payable [($150,000 – $25,561) X 10% X 8/12].... 8,296

Depreciation Expense........................................ 12,500Accumulated Depreciation ($150,000 X 1/8 X 8/12)......................... 12,500

BRIEF EXERCISE 20-5

Interest Payable.................................................. 8,296Interest Expense................................................. 4,148Lease Obligation............................................... 13,117

Cash............................................................. 25,561 ($150,000 – $25,561) X 10% X 4/12 = $4,148




BRIEF EXERCISE 20-6

Leased Machinery............................................... 147,047Lease Obligation......................................... 147,047

Using tables: PV of rentals $28,000 X 4.88965 $136,910[PV of guar. RV $17,000 X .59627 10,137

$147,047Excel formula =PV(rate,nper,pmt,fv,type)

Using a financial calculator:

PV $ ? Yields $147,047I 9%N 6 PMT $ 28,000 FV $ 17,000 Type 1

Lease Obligation................................................. 28,000Cash............................................................. 28,000




BRIEF EXERCISE 20-7

Leased Machinery............................................... 136,910Lease Obligation......................................... 136,910

Using tables: PV of rentals $28,000 X 4.88965 $136,910



PV $ ? Yields $136,910I 9%N 6 PMT $( 28,000) FV 0 Type 1

Lease Obligation................................................. 28,000Cash............................................................ 28,000




BRIEF EXERCISE 20-8

Lease Payments Receivable.............................. 185,000Sales............................................................. 147,047Unearned Interest Income—Leases.......... 37,953

[($28,000 X 4.88965) + ($17,000 X .59627) = $147,047]($28,000 X 6) + $17,000 = $185,000

Payments are assumed to be at the beginning of each yearExcel formula =PV(rate,nper,pmt,fv,type)

Using a financial calculator:PV $ ? Yields $(147,047)I 9%N 6 PMT $ 28,000 FV $ 17,000 Type 1

Cost of Goods Sold............................................ 121,000Inventory...................................................... 121,000

Cash..................................................................... 28,000Lease Payments Receivable...................... 28,000




BRIEF EXERCISE 20-9

August 15, 2011Rent Expense ($31,500 ÷ 12 X 3.5)..................... 9,188Prepaid Rent ($31,500 ÷ 12 X 8.5)...................... 22,312

Cash............................................................. 31,500

An alternate to the above:August 15, 2011

Prepaid Rent ....................................................... 31,500Cash............................................................. 31,500

November 30, 2011Rent Expense ($31,500 ÷ 12 X 3.5).................... 9,188

Prepaid Rent ............................................... 9,188......................................................................

BRIEF EXERCISE 20-10

August 15, 2011Cash..................................................................... 31,500

Unearned Rental Income............................ 31,500

June 30, 2012Unearned Rental Income ................................... 27,563

Rental Income ($31,500 ÷ 12 X 10.5).......... 27,563


Lease Payments Receivable.............................. 202,920Equipment Purchased for Lease............... 175,000Unearned Interest Income—Leases.......... 27,920

Lease payments receivable $202,920[ (5 X $40,584)PV of rentals (4.31213 X $40,584) 175,000Unearned interest $ 27,920

Cash..................................................................... 40,584




Lease Payments Receivable...................... 40,584





Unearned Interest Income—Leases.................. 10,753Interest Income—Leases............................ 10,753 [($175,000 – $40,584) X 8%]


Lease Payments Receivable.............................. 202,920Sales............................................................. 175,000Unearned Interest Income—Leases ......... 27,920

Cost of Goods Sold............................................ 137,500Inventory Finished Goods.......................... 137,500


Unearned Interest Income—Leases.................. 10,753Interest Income—Leases............................ 10,753 [($175,000 – $40,584) X 8%]





Lease Payments Receivable.............................. 519,650Sales............................................................. 410,000Unearned Interest Income—Leases.......... 109,650

[(95,930 X 4.03735) + (40,000 X .56743)] = 410,000(95,930 X 5) + 40,000 = 519,650

Payments are assumed to be at the beginning of each year

Excel formula =PV(rate,nper,pmt,fv,type)Using a financial calculator:PV $ ? Yields $(410,000)I 12%N 5 PMT $ 95,930 FV $ 40,000 Type 1

Cost of Goods Sold............................................ 265,000Inventory...................................................... 265,000






Lease Payments Receivable.............................. 519,650Cost of Goods Sold ($265,000 – $22,697*)........ 242,303

Sales ($410,000 – $22,697).......................... 387,303Unearned Interest Income—Leases.......... 109,650Inventory...................................................... 265,000

* ($40,000 X .56743) = $22,697 ($95,930 X 4.03735) = $387,303 ($95,930 X 5) + $40,000 = $519,650



For the contract-based approach, the probability-weighted expected value of the residual guarantee must be used in the present value calculation of the obligation.

Probability-weighted expected value

$16,000 X 50% = $8,000$12,000 X 30% = 3,600$10,000 X 20% = 2,000 $13,600




*BRIEF EXERCISE 20-17

Cash..................................................................... 65,000Accumulated Depreciation - Truck.................... 26,000

Truck............................................................. 79,000Deferred Profit on Sale-Leaseback............ 12,000

Truck under Capital Lease................................. 65,000Lease Obligation......................................... 65,000 ($17,147 X 3.79079)



Depreciation Expense........................................ 13,000Accumulated Depreciation ($65,000 X 1/5) 13,000

Deferred Profit on Sale-Leaseback.................... 2,400Depreciation Expense ($12,000 X 1/5)....... 2,400

Interest Expense ($65,000 X 10%)..................... 6,500Lease Obligation................................................. 10,647

Cash............................................................. 17,147





January 1, 2011:Leased Land......................................................100,000.00Leased Building................................................150,000.00

Lease Obligation............................ .........250,000.00

Lease Obligation............................................... 23,576.90Cash............................................... ......... 23,576.90


Using a financial calculator:PV $ ? Yields $ 250,000 I 8%N 20 PMT $ 23,576.90 FV $ 0 Type 1

December 31, 2011:Interest Expense................................................. 18,113.85

Interest Payable [($250,000.00 – $23,576.90) X 8%]....... 18,113.85

Depreciation Expense - Building....................... 7,500.00Accumulated Depreciation - Building ($150,000 / 20)....................................... 7,500.00





January 1, 2011Leased Building................................................150,000.00

Lease Obligation............................ .........150,000.00

Lease Obligation............................................... 14,146.14Land Rental Expense....................................... 9,430.76

Cash............................................... ......... 23,576.90[($23,576.90 X $150,000 / $250,000) = $14,146.14]

December 31, 2011:Interest Expense................................................. 10,868.31

Interest Payable [($150,000.00 – $14,146.14) X 8%]....... 10,868.31

Depreciation Expense - Building....................... 7,500.00Accumulated Depreciation - Building ($150,000 / 20)....................................... 7,500.00




SOLUTIONS TO EXERCISES

EXERCISE 20-1 (15-20 minutes)

(a) When using private enterprise GAAP, because the lease term is longer than 75% of the economic life of the asset and the present value of the minimum lease payments is more than 90% of the fair value of the asset, it is a capital lease to the lessee. Assuming collectibility of the rents is reasonably assured, no important uncertainties surround the amount of un-reimbursable costs yet to be incurred by the lessor, and equal cost and fair value to Victoria Leasing, the lease is a direct financing lease to the lessor.

Black Corporation, the lessee should adopt the capital lease method and record the leased asset and lease obligation at the present value of the minimum lease payments using the lessee’s incremental borrowing rate or the interest rate implicit in the lease, if it is lower than the incremental rate and is known to the lessee. The lessee’s depreciation depends on whether ownership transfers to the lessee or if there is a bargain purchase option. If one of these conditions is fulfilled, depreciation would be over the economic life of the asset. Otherwise, the asset would be amortized over the lease term. Because both the economic life of the asset and the lease term are three years, the leased asset should be amortized over this period.

The Victoria Leasing Corporation— If a lease, in substance, transfers the risks and benefits of ownership of the leased asset to the lessee (decided in the same way as for Black Corporation, the lessee) and revenue recognition criteria related to collectability and ability to estimate any remaining un-reimbursable costs are met, the lessor accounts for the lease as either a direct financing or a sales-type lease. Victoria is not a manufacturer or dealer trying to make a sale and so the lease will be a direct financing lease to Victoria.




EXERCISE 20-1 (Continued)

In this case, the credit risks associated with the lease are normal and there are no unreimbursable costs that cannot be estimated by the lessor. Victoria will replace the asset cost of $95,000 with Lease Payments Receivable of $112,590 and Unearned Interest Income of $17,590. (See schedule below.) Interest would be recognized annually at a constant rate applied to the unrecovered net investment.

Cost (fair market value of leased asset).................... $95,000

Amount to be recovered by lessor through lease payments.................................................................. $95,000

Three annual lease payments: $95,000 ÷ 2.53130*. . $37,530

Lease Payments Receivable = $37,530 X 3 ...................... $112,590

*Present value of an ordinary annuity of 1 for 3 periods at 9%.

Excel formula =PMT(rate,nper,pv,fv,type)

Using a financial calculator:PV $ (95,000)I 9%N 3 PMT $ ? Yields $37,530FV $ 0 Type 0





(b)Schedule of Interest and Amortization

RentReceipt/Payment

InterestIncome/Expense

Reductionof Principal

Investment/

Obligation

1/1/1112/31/1112/31/1212/31/13

—$37,530 37,530 37,530

—**$8,550**** 5,942**** 3,098**

—$28,980 31,588 34,432

$95,000 66,020 34,432 0

**$95,000 X .09 = $8,550**rounding difference

(c) For Black Corporation—(the lessee):Rather than using quantitative factors such as the 75 percent and the 90 percent hurdles often referred to as the bright lines used in PE GAAP, the IFRS criteria use qualitative factors to establish whether or not the risks and rewards of ownership are transferred to the lessee, and supports classification as a finance lease:1. There is reasonable assurance that the lessee will

obtain ownership of the leased property by the end of the lease term. If there is a bargain purchase option in the lease, it is assumed that the lessee will exercise it and obtain ownership of the asset.

2. The lease term is long enough that the lessee will receive substantially all of the economic benefits that are expected to be derived from using the leased property over its life.

3. The lease allows the lessor to recover substantially all of its investment in the leased property and to earn a return on the investment. Evidence of this is provided if the present value of the minimum lease payments is close to the fair value of the leased asset.

4. The leased assets are so specialized that, without major modification and/or significant cost to the lessor, they are of use only to the lessee.





None of the numerical thresholds need be applied, as was the case in PE GAAP, and so the treatment of the lease by the lessee would be the same, although it would be referred to as a finance lease, rather than a capital lease.

For Victoria Leasing Corporation—(the lessor):Under IFRS, the lease would receive the same treatment as under PE GAAP except the criteria need not specifically include the two revenue recognition-based tests concerning collectability and estimating unreimbursable costs. These are general recognition tests that would have to be met regardless. The lease would be a financing lease since Victoria is not a manufacturer or dealer.





(a) This is a capital lease to Wong since the lease term (5 years) is greater than 75% of the economic life (6 years) of the leased asset. The lease term is 83⅓% (5 ÷ 6) of the asset’s economic life.

(b) Calculation of present value of minimum lease payments:$13,668 X 4.16986* = $56,994

*Present value of an annuity due of 1 for 5 periods at 10%.



(c)

9/1/11 Leased Machine................................. 56,994Lease Obligation......................... 56,994

Lease Obligation................................ 13,668Cash ........................................... 13,668





12/31/11 Depreciation Expense....................... 3,800Accumulated Depreciation— Leased Machine...................... 3,800 [($56,994/ 5) X 4/ 12 = $3,800]

Interest Expense................................ 1,444Interest Payable.......................... 1,444

[($56,994 – $13,668) X .10 X 4/ 12 = $1,444]

9/1/12 Lease Obligation................................ 9,335Interest Payable................................. 1,444Interest Expense................................ 2,889

Cash ........................................... 13,668 [($56,994 – $13,668) X .10 X 8/ 12 = $2,889]

(d) Under IFRS, any one or a combination of the following situations normally indicates that the risks and rewards of ownership are transferred to the lessee, and supports classification as a finance lease:

There is reasonable assurance that the lessee will obtain ownership of the leased property by the end of the lease term. If there is a bargain purchase option in the lease, it is assumed that the lessee will exercise it and obtain ownership of the asset.

The lease term is long enough that the lessee will receive substantially all of the economic benefits that are expected to be derived from using the leased property over its life.

The lease allows the lessor to recover substantially all of its investment in the leased property and to earn a return on the investment. Evidence of this is provided if the present value of the minimum lease payments is close to the fair value of the leased asset.

The leased assets are so specialized that, without major modification, and/or significant cost to the lessor, they are of use only to the lessee.





Other indicators include situations where the lessee absorbs the lessor’s losses if the lessee cancels the lease, or the lessee assumes the risk associated with the amount of the residual value of the asset at the end of the lease, or where there is a bargain renewal option—when the lessee can renew the lease for an additional term at significantly less than the market rent.

The standard also states that these indicators are not always conclusive. The decision has to be made on the substance of each specific transaction. If the lessee determines that the risks and benefits of ownership have not been transferred to it, the lease is classified as an operating lease.





(a) This is an operating lease to Wong since the lease term (5 years) is less than 75% of the economic life (7 years) of the leased asset. The lease term is 71.4% (5 ÷ 7) of the asset’s economic life. There is no bargain purchase option and the present value of minimum lease payments of $56,994 represent 72% of the fair value at September 1 of $79,000 falling short of the criteria of 90% to treat the lease as a capital lease.

(b) September 1, 2011Prepaid Rent................................................ 13,668

Cash.................................................... 13,668

December 31, 2011Rent Expense.............................................. 4,556

Prepaid Rent..................................... 4,556($13,668 X 4 / 12 = $4,556)

September 1, 2012Prepaid Rent................................................ 13,668

Cash.................................................... 13,668

December 31, 2012Rent Expense.............................................. 13,668

Prepaid Rent....................................... 13,668

Alternately, the September 1, 2012 payment can be recorded to rent expense, in which case no adjusting journal entry is needed at December 31, 2012.





(c) and (d)E20-3 E20-2

Operating CapitalLease Lease

Statement of Financial Position:Current assets:Prepaid rent $9,112 Property Plant & Equipment:Machine under capital lease $ 56,994 Less: Accumulated depreciation (3,800)

53,194 Current LiabilitiesInterest payable 1,444 Current portion of lease obligation 9,335

Long term liabilitiesObligation under capital lease 43,326 Less: Current portion (9,335)

33,991 Income Statement:Depreciation expense $ 3,800 Interest expense 1,444 Rent expense $ 4,556





(e) The amounts appearing on the financial statement in part (c) and (d) above lead to the conclusion that net income would be lower and therefore earnings per share would be lower if the lease were treated as a capital lease, although this difference would decrease over time as the total cash paid out over the life of the asset is the same under either alternative. As well, using statement of financial position information, we can see that liquidity ratios would be adversely affected since the equivalent of one lease payment appears as a current liability when the lease is treated as a capital lease. Debt to total asset ratios will be affected by the presence of the long-term debt obligation and the additional property, plant and equipment.





(a)Capitalized amount of the lease:


Using a financial calculator:PV $ ? Yields $164,995I 10.5%N 8 PMT $ (28,500.00)FV $ 0 Type 1

(b) This is a capital lease to Xu since the lease term (8 years) is greater than 75% of the economic life (8 years) of the leased asset. The lease term is 100% (8 ÷ 8) of the asset’s economic life. This also meets the requirements of IFRS, under which it is referred to as a financing lease.

The present value of the minimum lease payments is greater than 90% of the fair value of the leased asset; that is, the present value of $164,995 is 99% of the fair value of the leased asset: ($164,995 / $166,000 = 99.4%). This criteria for treating the lease as a capital lease has also been met. Note that meeting just one of the criteria is sufficient for classification as a capital lease.

There is no bargain purchase option in this case.





(c) Xu Ltd.Lease Amortization Schedule

(Lessee)

Date

Annual

LeasePayments

Interest (10.5%)

on UnpaidObligation

Reduction

of LeaseObligation

Balance

of LeaseObligation

$164,995.00 Jan. 1, 2012 $28,500.00 $28,500.00 136,495.00 Jan. 1, 2013 28,500.00 $14,331.98 14,168.03 122,326.97 Jan. 1, 2014 28,500.00 12,844.33 15,655.67 106,671.30 Jan. 1, 2015 28,500.00 11,200.49 17,299.51 89,371.79 Jan. 1, 2016 28,500.00 9,384.04 19,115.96 70,255.83 Jan. 1, 2017 28,500.00 7,376.86 21,123.14 49,132.70 Jan. 1, 2018 28,500.00 5,158.93 23,341.07 25,791.63 Jan. 1, 2019 28,500.00 2,708.37 25,791.63 (0.00)

$228,000.00 $63,005.00 $164,995.00

(d)1/1/12 Leased Equipment...................... 164,995

Lease Obligation.................. 164,995

1/1/12 Lease Obligation......................... 28,500Cash...................................... 28,500

12/31/12 Depreciation Expense................. 20,624Accumulated Depreciation— Leased Equipment........... 20,624 ($164,995 ÷ 8)





(d) (Continued)12/31/12 Interest Expense.......................... 14,332

Interest Payable................... 14,332

1/1/13 Interest Payable........................... 14,332Lease Obligation ....................... 14,168

Cash...................................... 28,500

12/31/13 Depreciation Expense................. 20,624Accumulated Depreciation— Leased Equipment.......... 20,624

12/31/13 Interest Expense.......................... 12,844Interest Payable................... 12,844

(e)Xu Ltd.

Balance sheet (partial)December 31,

2013 2012 Non-current assetsProperty plant and equipment

Leased equipment $164,995 $164,995Less accumulated depreciation 41,248 _20,624

123,747 144,371

Current liabilitiesInterest payable 12,844 14,332Lease obligation 15,656 14,168

Non-current liabilitiesLease obligation (Note X) 122,327 136,495Current portion (15,656) (14,168)





(f) Note X: The following is a schedule of future minimum lease payments under the capital lease expiring December 31, 2019 together with the balance of the obligation under capital lease.

Year ending December 312013 $28,5002014 28,5002015 28,5002016 28,5002017 28,5002018 28,500

Total minimum lease payments 171,000Less amount representing interest at 10.5% 48,673Balance of the obligation $122,327

(g) When negotiating a lease arrangement, the lessor sets the lease payments receivable to obtain the appropriate return for the asset leased. The amounts arrived at are negotiable. In this case, the lessor likely tried to obtain an amount near to or exceeding the resale price of the equipment and arrived at annual payments in round amounts ($28,500). The present value of the minimum lease payment approximated the resale price without being exactly equal (99.4% in this case). This is a natural outcome from the negotiations process between the parties involved.





(a) To New Bay, the lessee, this lease is a capital lease because the terms satisfy the following criteria:

1. The lease term is greater than 75% of the economic life of the leased asset; that is, the lease term is 76.4% (55/72) of the economic life.

2. The present value of the minimum lease payments is greater than or equal to 90% of the fair value of the leased asset; that is, the present value of $19,356 is 90% of the fair value of the leased asset: ($19,356 / $21,500 = 90%)

(b) The minimum lease payments, in the case of a residual value guaranteed by the lessee include the guaranteed residual value. The present value therefore is:

PV of monthly payment of $425 for 55 months...... $17,910PV of residual value of $2,500................................. 1,446Present value of minimum lease payments........... $19,356


Using a financial calculator:PV $ ? Yields $19,358.88I 1%N 55 PMT $ (425)FV $ (2,500)Type 0

(c) Leased Property.......................................... 19,356Lease Obligation.................................. 19,356





(d) Depreciation Expense................................. 306.47Accumulated Depreciation—Leased Property............................................ 306.47 [($19,356 – $2,500) ÷ 55 months = $306.47]

(e) Lease Obligation......................................... 231.44Interest Expense (1% X $19,356)................ 193.56

Cash...................................................... 425.00

(f) Rather than using quantitative factors such as the 75 percent and the 90 percent hurdles often referred to as the bright lines used in PE GAAP, the IFRS criteria use qualitative factors to establish whether or not the risks and rewards of ownership are transferred to the lessee, and supports classification as a finance lease:1. There is reasonable assurance that the lessee will




4. The leased assets are so specialized that, without major modification, they are of use only to the lessee.






(a)Capitalized amount of the lease:

Yearly payment $73,580.00Executory costs 2,470.29Minimum annual lease payment $71,109.71

Present value of minimum lease payments$71,109.71 X 6.32825 = $450,000.00


Using a financial calculator:PV $ ? Yields $450,000I 12%N 10 PMT $ (71,109.71)FV $ 0 Type 1





FINE CORP.Lease Amortization Schedule

(Lessee)

Date

Annual Pmt. Excl.Exec. Costs

Interest (12%)

on UnpaidObligation

Reduction

of LeaseObligation

Balance

of LeaseObligation

$450,000.00 Jan. 1, 2011 $71,109.71 $71,109.71 378,890.29 Jan. 1, 2012 71,109.71 $45,466.83 25,642.88 353,247.41 Jan. 1, 2013 71,109.71 42,389.69 28,720.02 324,527.39 Jan. 1, 2014 71,109.71 38,943.29 32,166.42 292,360.97 Jan. 1, 2015 71,109.71 35,083.32 36,026.39 256,334.58 Jan. 1, 2016 71,109.71 30,760.15 40,349.56 215,985.02 Jan. 1, 2017 71,109.71 25,918.20 45,191.51 170,793.51 Jan. 1, 2018 71,109.71 20,495.22 50,614.49 120,179.02 Jan. 1, 2019 71,109.71 14,421.48 56,688.23 63,490.79 Jan. 1, 2020 71,109.71 7,618.92 63,490.79 0

711,097.10 261,097.10 450,000.00

(b)1/1/11 Leases Equipment....................... 450,000.00

Lease Obligation.................. 450,000.00

1/1/11 Insurance Expense...................... 2,470.29Lease Obligation......................... 71,109.71

Cash...................................... 73,580.00

12/31/11 Depreciation Expense................. 45,000.00Accumulated Depreciation— Leased Equipment........... 45,000.00 ($450,000 ÷ 10)





12/31/11 Interest Expense (See Schedule 1)...................... 45,466.83

Interest Payable................... 45,466.83

1/1/12 Insurance Expense...................... 2,470.29Interest Payable........................... 45,466.83Lease Obligation........................ 25,642.88

Cash...................................... 73,580.00

12/31/12 Depreciation Expense................. 45,000.00Accumulated Depreciation— Leased Equipment.......... 45,000.00

12/31/12 Interest Expense.......................... 42,389.69Interest Payable................... 42,389.69

(c) Note X: The following is a schedule of future minimum lease payments under the capital lease expiring December 31, 2020 together with the balance of the obligation under capital lease.

Year ending December 312013 $73,5802014 73,5802015 73,5802016 73,5802017 73,5802018 and beyond 220,740

Total minimum lease payments 588,640Less amount representing executory costs 19,763

568,877Less amount representing interest at 12% 215,630Balance of the obligation $353,247

Additional disclosures would also be required about material lease arrangements including contingent rents,





sub-lease payments and lease-imposed restrictions. These do not apply in this case.





1/1/11 Leased Equipment...................... 450,000.00Lease Obligation.................. 450,000.00

1/1/11 Insurance Expense *................... 1,029.29Prepaid Insurance **................... 1,441.00Lease Obligation......................... 71,109.71

Cash...................................... 73,580.00* ($2,470.29 X 5/12)** ($2,470.29 X 7/12)

05/31/11 Depreciation Expense................. 18,750.00Accumulated Depreciation— Capital Leases.................. 18,750.00

($450,000 ÷ 10 X 5/12)

05/31/11 Interest Expense *....................... 18,944.51Interest Payable................... 18,944.51

* ($45,466.83 x 5/12)

12/31/11 Insurance Expense...................... 1,441.00Prepaid Insurance................ 1,441.00

Note: This entry could also be done at May 31, 2012 as a year-end adjusting entry.

1/1/12 Insurance Expense...................... 1,029.29Prepaid Insurance....................... 1,441.00Interest Expense *....................... 26,522.32Interest Payable........................... 18,944.51Lease Obligation......................... 25,642.88

Cash.................................. 73,580.00* ($45,466.83 – $18,944.51)





05/31/12 Depreciation Expense................. 45,000.00Accumulated Depreciation— Leased Equipment...........

45,000.00

05/31/12 Interest Expense.......................... 17,662.37Interest Payable................... 17,662.37

($42,389.69 X 5/12)





Note: This lease is a capital lease to the lessee because the lease term (five years) exceeds 75% of the economic life of the asset (six years). Also, the present value of the minimum lease payments exceeds 90% of the fair value of the asset.

$18,142.95 Annual rental paymentX 4.16986 PV of an annuity due of 1 for n = 5, i = 10%$75,653.56 PV of minimum lease payments


Using a financial calculator:PV $ ? Yields $75,654I 10%N 5 PMT $ (18,142.95)FV $ 0 Type 1

(a)LeBlanc Limited (Lessee)

Lease Amortization Schedule

Date

AnnualLease

Payment

Interest (10%)1

on UnpaidObligation

Reduction

of LeaseObligation

Balanceof Lease

Obligation

1/1/111/1/111/1/121/1/131/1/141/1/15

$18,142.95 18,142.95 18,142.95 18,142.95 18,142.95$90,714.75

*$ 5,751.06** 4,511.87** 3,148.76** 1,649.50**$15,061.19*

$18,142.95 12,391.89 13,631.08 14,994.19 16,493.45$75,653.56

$75,653.56 57,510.61 45,118.72 31,487.64 16,493.45 0.00

*Rounding error is 15 cents.

1 The implicit rate is known and is lower than the lessee’s incremental borrowing rate of 11%





(b)1/1/11 Leased Equipment.......................... 75,653.56

Lease Obligation.................. 75,653.56

1/1/11 Lease Obligation............................. 18,142.95Cash...................................... 18,142.95

During 2011Insurance Expense.......................... 900.00

Cash...................................... 900.00

Property Tax Expense..................... 1,600.00Cash...................................... 1,600.00

12/31/11 Interest Expense.............................. 5,751.06Interest Payable................... 5,751.06

Depreciation Expense..................... 15,130.71Accumulated Depreciation —Leased Equipment........ 15,130.71 ($75,653.56 ÷ 5 = $15,130.71)

1/1/12 Interest Payable* ............................ 5,751.06Interest Expense.................. 5,751.06

Interest Expense.............................. 5,751.06Lease Obligation............................. 12,391.89

Cash...................................... 18,142.95

* Note to instructor:The use of reversing entries is optional





During 2012Insurance Expense.......................... 900.00

Cash...................................... 900.00

Property Tax Expense..................... 1,600.00Cash...................................... 1,600.00

12/31/12 Interest Expense.............................. 4,511.87Interest Payable.................. 4,511.87

Depreciation Expense.................... 15,130.71Accumulated Depreciation

—Leased Equipment. . 15,130.71

Note to instructor:

The lessor sets the annual rental payment as follows:Fair market value of leased asset to lessor $80,000.00Less: Present value of unguaranteed

residual value $7,000 X .62092 (present value of 1 at 10% for 5 periods) 4,346.44

Amount to be recovered through lease payments $75,653.56Five periodic lease payments

$75,653.56 ÷ 4.16986* $18,142.95

*Present value of annuity due of 1 for 5 periods at 10%.


Using a financial calculator:PV $ (80,000)I 10%N 5 PMT $ ? Yields $18,142.92FV $ 7,000 Type 1





(c) Note X: The following is a schedule of future minimum lease payments under the capital lease expiring December 31, 2015 together with the balance of the obligation under capital lease.

Year ending December 312013 $18,1432014 18,1432015 18,143

Total minimum lease payments 54,429Less amount representing interest at 10% 9,310Balance of the obligation $45,119

(d) Rather than using quantitative factors such as the 75 percent and the 90 percent hurdles often referred to as the bright lines used in PE GAAP, the IFRS criteria use qualitative factors to establish whether or not the risks and rewards of ownership are transferred to the lessee, and supports classification as a finance lease:1. There is reasonable assurance that the lessee will










As for the note disclosure provided in part (c) above, additional disclosures would also be required about material lease arrangements including contingent rents, sub-lease payments and lease-imposed restrictions. These do not apply in this case.





(a) Entries for Morrison Corp. are as follows:

1/7/11 Building (Leased)........................... 5,500,000 Cash....................................... 5,500,000

Property Tax Expense................... 57,000Insurance Expense........................ 11,000

Cash....................................... 68,000

12/31/11 Rent Receivable............................. 162,500Rental Income....................... 162,500($325,000 X 6 / 12 = $162,500)

Depreciation Expense.................... 68,750Accumulated Depreciation —Building.......................... 68,750 [($5,500,000 ÷ 40) X 6 / 12 = $68,750]

(b) Entries for Wisen Inc. are as follows:

12/31/11 Rent Expense................................. 162,500Rent Payable......................... 162,500

(c) The real estate broker’s fee should be amortized equally over the 10-year period. As a result, real estate fee expense of $1,500 ($30,000 ÷ 10 X 6 ÷ 12) should be reported as an expense in 2011 and $3,000 per year for each of the next nine years until the last year of the lease when the expense will be $1,500.

(d) None of the accounting treatment above would change if Morrison were to use private enterprise GAAP.





(a) Annual rental income ($480,000 X 8/12) $320,000Less maintenance and other executory costs (61,000)Depreciation ($1,750,000 ÷ 8 X 8/12) (145,833 )Income before income tax $113,167

Note that any interest expense incurred by Pomeroy would also be fully deductible for income tax purposes.

(b) Rent expense $320,000

Note: Both the rent security deposit and the last month’s rent prepayment should be reported as a non-current asset on St. Isidor’s books and as a non-current liability on Pomeroy’s books.

(c) Under private enterprise GAAP:

The disclosure requirements for operating leases from the point of view of the lessee are few and include:

1. The future minimum lease payments, in total and for each of the next three years.

2. A description of the nature of other commitments such as this lease.

For the lessor, the disclosure recommended includes:

1. A description of the cost of property held for leasing purposes and the amount of the accumulated depreciation.

2. The amount of rental income from operating leases.

3. Any impairment information.

(d) Under IFRS




For the lessee, additional disclosures are required about material lease arrangements including contingent rents, sub-lease payments and lease-imposed restrictions.





For IFRS for operating leases, the lessor reports information about the future minimum lease payments due within one year, years two to five and after five years, as well as about the entity’s leasing arrangements.

As well, the property interest under an operating lease may be recognized as an investment property and accounted for under the fair value model.





(a)Densmore Corporation

Rent ExpenseFor the Year Ended December 31, 2011

Monthly rental $26,500Lease period in 2011 (March–December) X 10 months

$265,000(b)

Sigouin Inc.Income or Loss from Lease before TaxesFor the Year Ended December 31, 2011

Rental income ($26,500 X 10 months) $265,000Less expense

Depreciation $133,333**Commission 7,500** 140,833

Income from lease before taxes $124,167

**$1,600,000 cost ÷ 10 years = $160,000/year$160,000 X 10/12 = $133,333

**(Note to instructor: Under principles of accrual accounting, the commission should be amortized over the life of the lease: $36,000 ÷ 4 years = $9,000 X 10/12 = $7,500.)

(c) The amounts reported in (a) and (b) above would not change if IFRS had been used by either company.





Memorandum Prepared by: (Your Initials)Date:

DENG, INC.December 31, 2011

Reclassification of Leased AutoAs a Capital Lease

While performing a routine inspection of the client’s garage, I found a 2010 Shirk automobile, which was not listed among the company’s assets in the equipment subsidiary ledger. I asked the plant manager about the vehicle, and she indicated that because the Shirk was only being leased, it was not listed along with other company assets. Having accounted for this agreement as an operating lease, Deng, Inc. had charged $2,160 to 2011 rent expense.

Examining the lease agreement entered into with Quick Deal New and Used Cars on January 1, 2011, I determined that the Shirk should be capitalized because its lease term (50 months) is greater than 75% of its estimated useful life (60 months).

I advised the client to capitalize this lease at the present value of its minimum lease payments: $8,623 (the present value of the monthly payments), plus $1,277 (the present value of the guaranteed residual). The following journal entry was suggested:

Leased Asset.................................................. 9,900Lease Obligation..................................... 9,900

To account for the first year’s payments as well as to reverse the original entries, I advised the client to make the following entry:





Lease Obligation............................................ 1,535Interest Expense............................................. 1,105*

Rent Expense.......................................... 2,640


Month

Monthly

LeasePayment

Interest(1%)

Expense

Reductionof Lease

Obligation

Balanceof Lease

Investment $9,900.00

1 $220.00 $99.00 $121.00 9,779.00 2 220.00 97.79 122.21 9,656.79 3 220.00 96.57 123.43 9,533.36 4 220.00 95.33 124.67 9,408.69 5 220.00 94.09 125.91 9,282.78 6 220.00 92.83 127.17 9,155.61 7 220.00 91.56 128.44 9,027.16 8 220.00 90.27 129.73 8,897.43 9 220.00 88.97 131.03 8,766.41

10 220.00 87.66 132.34 8,634.07 11 220.00 86.34 133.66 8,500.41 12 220.00 85.00 135.00 8,365.42

$2,640.00 $1,105.42 * $1,534.58

Finally, this Shirk must be amortized over its lease term. Using straight-line, I calculated monthly depreciation of $156 (the capitalized amount, $9,900, minus the estimated residual, $2,100, divided by the 50-month lease term). The client was advised to make the following entry to record 2011 depreciation:

Depreciation Expense............................ 1,872Accumulated Depreciation............. 1,872....................................................................................................................




..........................................................





(a) This is a capital lease to Flynn since the lease term is 75% (6 ÷ 7) of the asset’s economic life. In addition, the present value of the minimum lease payments is more than 90% of the fair value of the asset.

This is a sales-type lease to Lavery since the lease is a capital lease to Flynn, the lessee, and because the collectability of the lease payments is reasonably predictable, there are no important uncertainties surrounding the unreimbursable costs yet to be incurred by the lessor and the fair value of the equipment ($144,000) exceeds the lessor’s cost ($111,000).

(b) Calculation of annual rental payment:

$144,000 – $6,000 X 0.59627*= $28,718

4.8897**

**Present value of $1 at 9% for 6 periods.**Present value of an annuity due at 9% for 6 periods.


Using a financial calculator:PV $ (144,000)I 9%N 6 PMT $ ? Yields $28,718FV $ 6,000 Type 1





(c)1/1/08 Leased Equipment............................... 137,582

Lease Obligation......................... 137,582 ($28,718 X 4.79079)***

Lease Obligation.................................. 28,718Cash............................................. 28,718

***Present value of an annuity due at 10% for 6 periods.



12/31/11 Depreciation Expense......................... 22,930Accumulated Depreciation...... 22,930

($137,582 ÷ 6 years)

Interest Expense................................. 10,886Interest Payable........................ 10,886[($137,582 – $28,718) X .10]





(d)1/1/08 Lease Payments Receivable.......... 178,308*

Cost of Goods Sold......................... 107,422Sales....................................... 140,422Inventory................................ 111,000Unearned Interest Income—

Leases........................ 34,308**

*($28,718 X 6) + $6,000**$178,308 – $144,000

Since the residual value is not guaranteed, the present value of the residual value of $6,000 is excluded from both sales and cost of goods sold.

Sales $144,000Less present value of residual value 3,578*

$140,422

Cost of Goods Sold $111,000Less present value of residual value 3,578*

$107,422 *($6,000 X .59627**)**Present value of $1 at 9% for 6 periods.

Cash ............................................... 28,718Lease Payments

Receivable................. 28,718

12/31/11 Unearned Interest Income— Leases................................. 10,375Interest Income—Leases...... 10,375 [($144,000 – $28,718) X .09]





(c) For Lavery Corporation—(the lessee):Rather than using quantitative factors such as the 75 percent and the 90 percent hurdles often referred to as the bright lines used in PE GAAP, the IFRS criteria use qualitative factors to establish whether or not the risks and rewards of ownership are transferred to the lessee, and supports classification as a finance lease:1. There is reasonable assurance that the lessee will





None of the numerical thresholds need be applied, as was the case in PE GAAP, and so the treatment of the lease by the lessee would be the same, although it would be referred to as a finance lease, rather than a direct financing lease.

For Flynn Corporation—(the lessor):Under IFRS, the lease would receive the same treatment as under PE GAAP except the criteria need not include the two revenue recognition-based tests concerning collectability and estimating unreimbursable costs. Instead of being referred to as a sales-type lease, the lease would be referred to as a finance lease—manufacturer or dealer.





(a) Calculation of annual paymentsCost (fair market value) of leased asset to lessor $135,000.00Less: Present value of residual value

$13,000 X .82645(Present value of 1 at 10% for 2 periods) (10,743.85 )

Amount to be recovered through lease payments $124,256.15

Two periodic lease payments $124,256.15 ÷ 1.73554* $71,595.09

*Present value of an ordinary annuity of 1 for 2 periods at 10%


Using a financial calculator:PV $ (135,000)I 10%N 2 PMT $ ? Yields $71,595.24FV $ 13,000 Type 0

Calculation of lease payments receivableAnnual payments ($71,595.09 X 2) $143,190.18Residual value 13,000.00Lease payments receivable $156,190.18

Calculation of unearned interest incomeGross investment by lessee $156,190.18Asset cost (fair value) 135,000.00Unearned interest income $ 21,190.18





(b) Castle Leasing Corporation should classify the lease as a finance lease because it is not a manufacturer or dealer. The capitalization of the lease will also be done by Wai Corporation, the lessee which will treat the lease as a finance lease.

The IFRS criteria use qualitative factors to establish whether or not the risks and rewards of ownership are transferred to the lessee, and supports classification as a finance lease:1. There is reasonable assurance that the lessee will





(c) For PE GAAP, rather than using quantitative factors described under part (c) above for IFRS, quantitative criteria such as:

1. the term of the lease exceeding 75% of the remaining economic life of the asset,

2. the present value of the minimum lease payments exceeding 90% of the fair value of the asset, or

3. the presence of a bargain purchase optionwill be applied as the basis for the classification of the lease as a direct financing lease for Wai Corporation.





For Castle Leasing, the lessor, the lease would receive the same treatment as under IFRS, as long as the two revenue recognition-based tests concerning collectability and estimating unreimbursable are passed.

(d)CASTLE LEASING CORPORATION (Lessor)


Date

Annual Pmt.Excl. Exec.

Costs

Intereston Net

Investment

NetInvestmentRecovery

NetInvestment

1/1/1112/31/1112/31/11

$71,595.09 71,595.09

*$13,500.00** 7,690.18**$21,190.18*

$58,095.09 63,904.91

$135,000.00 76,904.91 13,000.00

*Difference of $.31 due to rounding.

(e)

1/1/11 Lease Payments Receivable....... 156,190.18Equipment Purchased for Lease............................ 135,000.00Unearned Interest Income—Leases................ 21,190.18

12/31/11 Cash ($71,595.09 + $5,000).......... 76,595.09Executory Costs Payable/Expense............... 5,000.00Lease Payments Receivable.......................... 71,595.09

Unearned Interest Income— Leases....................................... 13,500.00

Interest Income— Leases................................ 13,500.00





12/31/12 Cash.............................................. 76,595.09Executory Costs Payable/Expense............... 5,000.00Lease Payments Receivable.......................... 71,595.09

Unearned Interest Income— Leases....................................... 7,690.18

Interest Income— Leases................................ 7,690.18

(f) 12/31/11 Cash...................................... 13,000.00Lease Payments Receivable................. 13,000.00

(g) Upon signing the lease, Wai Corporation should capitalize the present value of the minimum lease payments in the amount of $71,595.09 excluding the present value of the option to purchase the equipment for $13,000. This will yield an amount of $124,256.15 as calculated in part (a). The lessee excludes this last payment, as it is not a guaranteed payment by the lessee, Wai to the lessor, Castle Leasing. Correspondingly the lease obligation should be recorded at $124,256.15.

Using a financial calculator:PV $ ? Yields $ 124,255.94 I 10%N 2 PMT $ 71,595.09FV $ 0 Type 0





(a) Part 1. Annuity Due:

Fair market value of leased asset to lessor $415,000.00Less: Present value of unguaranteed



Five periodic lease payments $397,985.50 ÷ 4.31213* $92,294.41








(a) Part 2. Ordinary Annuity:

Fair market value of leased asset to lessor $415,000.00Less: Present value of unguaranteed



Five periodic lease payments $397,985.50 ÷ 3.99271* $99,678.04









(b) 1Vick Leasing Inc., (Lessor)


Date

AnnualLease

PaymentPlus URV

Interest(8%) on NetInvestment


Balanceof Net

InvestmentJan. 1, 2011 $415,000.00 Jan. 1, 2011 $92,294.00 $92,294.00 322,706.00 Jan. 1, 2012 92,294.00 $25,816.48 66,477.52 256,228.48 Jan. 1, 2013 92,294.00 20,498.28 71,795.72 184,432.76 Jan. 1, 2014 92,294.00 14,754.62 77,539.38 106,893.38 Jan. 1, 2015 92,294.00 8,551.47 83,742.53 23,150.85 Jan. 1, 2016 25,000.00 1,849.15 23,150.85 0

$486,470.00 $71,470.00 $415,000.00

(b) 2Vick Leasing Inc., (Lessor)


Date

AnnualLease

PaymentPlus URV



Balanceof Net

InvestmentJan. 1, 2011 $415,000.00 Dec. 31, 2011 $99,678.00 $33,200.00 $66,478.00 348,522.00 Dec. 31, 2012 99,678.00 27,881.76 71,796.24 276,725.76 Dec. 31, 2013 99,678.00 22,138.06 77,539.94 199,185.82 Dec. 31, 2014 99,678.00 15,934.87 83,743.13 115,442.69 Dec. 31, 2015 99,678.00 9,235.31 90,442.69 25,000.00 Dec. 31, 2015 25,000.00 - 25,000.00 0.00

$523,390.00 $108,390.00 $415,000.00





(c)1/1/11 Equipment Purchased for Lease. .415.000.00

Cash....................................... 415,000.00

Lease Payments Receivable...................................486,470.00

Unearned Interest Income—Leases................ 71,470.00Equipment Purchased for Lease 415,000.00

1/1/11 Cash................................................96,294.00 Maintenance Expense.......... 4,000.00Lease Payments Receivable.......................... 92,294.00

during Maintenance Expense.................... 6,000.00 2011 Cash....................................... 6,000.00

12/31/11 Unearned Interest Income— Leases...................................... 25,816.48

Interest Income— Leases............................. 25,816.48

1/1/12 Cash................................................96,294.00 Maintenance Expense.......... 4,000.00Lease Payments Receivable.......................... 92,294.00

during Maintenance Expense.................... 6,000.00 2012 Cash....................................... 6,000.00

12/31/12 Unearned Interest Income— Leases...................................... 20,498.28






(d) Note X: (on Vick Leasing Inc.’s financial statements:)The company's net investment in a financing lease includes the following:Total minimum lease payments receivable $301,882Unearned income 45,654

$256,228

Future minimum lease payments receivable under the financing lease are as follows:

Year ending December 312013 $92,2942014 92,2942015 92,294

Total minimum lease payments receivable 276,882Unguaranteed residual value 25,000

$301,882

Vick Leasing would also need to disclose any contingent rental income in the year, the allowance for doubtful receivables and general information about their leasing arrangement with Rock Corporation.





(a) (1) Calculation of gross investment:$24,736 X 6 = $148,416

(2) Calculation of unearned interest income:Gross investment $148,416Less: Fair market value of machine 123,500

*Unearned interest income $ 24,916

*$24,736 X 4.99271 (PV factor of annuity due at 8% for 6 periods)Excel formula =PV(rate,nper,pmt,fv,type)

Using a financial calculator:PV $ ? Yields $123,499.68I 8%N 6 PMT $ 24,736 FV $ 0 Type 1

(3) Net investment in lease:Lease payments receivable $148,416Less: Unearned interest income – leases 24,916

$123,500





(b)

1/1/11 Lease Payments Receivable...............148,416Cost of Goods Sold............................. 99,000

Sales............................................ 123,500Inventory...................................... 99,000Unearned Interest Income— Leases...................................... 24,916

1/1/11 Cash ..................................................... 24,736Lease Payments Receivable..... 24,736

12/31/11 Unearned Interest Income— Leases...................................... 7,901Interest Income.......................... 7,901 [($123,500 – $24,736) X .08]





(a) The lease agreement has a bargain purchase option and thus meets the criteria to be classified as a capital lease from the viewpoint of the lessee. The present value of the minimum lease payments exceeds 90% of the fair value of the assets.

(b) The lease agreement has a bargain purchase option. The collectability of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. The initial amount of net investment (which in this case equals the present value of the minimum lease payments, $88,000) exceeds the lessor’s cost ($60,000), the lease is a sales-type lease to the lessor.

(c) Net investment calculation:$20,066.26 Annual rental paymentX 4.23972 PV of annuity due of 1 for n = 5, i = 9%$85,075.32 PV of periodic rental payments

$ 4,500.00Bargain purchase optionX .64993 PV of 1 for n= 5, i = 9%$ 2,924.69PV of bargain purchase option

$85,075.32 PV of periodic rental payments+ 2,924.69 PV of bargain purchase option$88,000.01 Net investment at inception of lease


Using a financial calculator:PV $ ? Yields $ 88,000I 9%N 5 PMT $ (20,066.26)FV $ (4,500)Type 1





Russell Corporation (Lessee)Lease Amortization Schedule

Date

AnnualLease

PaymentPlus BPO

Interest (9%)on UnpaidObligation

Reductionof Lease

Obligation

BalanceLease

Obligation

7/1/117/1/117/1/127/1/137/1/147/1/156/30/16

$ 20,066.26 20,066.26 20,066.26 20,066.26 20,066.26 4,500.00$104,831.30

*$ 6,114.04** 4,858.34** 3,489.62** 1,997.73** 371.58**$16,831.30*

$20,066.26 13,952.22 15,207.92 16,576.64 18,068.53 4,128.42$88,000.00

$88,000.00 67,933.74 53,981.52 38,773.59 22,196.96 4,128.42 0.00

*Rounding error is $.02 cents.

(d)7/1/11 Leased Equipment ......................... 88,000.00

Lease Obligation.................... 88,000.00

Lease Obligation............................. 20,066.26Cash....................................... 20,066.26

12/31/11 Interest Expense.............................. 3,057.02Interest Payable.................... 3,057.02

($6,114.04 X 6/12 = ($3,057.02)

Depreciation Expense..................... 4,400.00Accumulated Depreciation —Leased Equipment......... 4,400.00 ($88,000.00 ÷ 10 = ($8,800.00; $8,800.00 X 6/12 = $4,400)





7/1/12 Interest Payable.............................. 3,057.02Interest Expense*.......................... 3,057.02Lease Obligation............................ 13,952.22

Cash...................................... 20,066.26* ($6,114.04 – $3,057.02)

12/31/12 Interest Expense............................ 2,429.17Interest Payable................... 2,429.17 ($4,858.34 X 6/12 = ($2,429.17)

12/31/12 Depreciation Expense.................... 8,800.00Accumulated Depreciation

—Leased Equipment... 8,800.00($88,000.00 ÷ 10 years = ($8,800.00)

(Note to instructor: Because a bargain purchase option was involved, the leased asset is amortized over its economic life rather than over the lease term.)

(e) For Russell Corporation—(the lessee):Rather than using quantitative factors such as the 75 percent and the 90 percent hurdles often referred to as the bright lines used in PE GAAP, the IFRS criteria use qualitative factors to establish whether or not the risks and rewards of ownership are transferred to the lessee, and supports classification as a finance lease:1. There is reasonable assurance that the lessee will









None of the numerical thresholds need be applied, as was the case in PE GAAP, and so the treatment of the lease by the lessee would be the same, although it would be referred to as a finance lease, rather than a direct financing lease.

For Hebert Corporation—(the lessor):Under IFRS, the lease would receive the same treatment as under PE GAAP except the criteria need not include the two revenue recognition-based tests concerning collectability and estimating unreimbursable costs. Instead of being referred to as a sales-type lease, the lease would be referred to as a finance lease—manufacturer or dealer.





Note as determined in Exercise 20-17, part (b):The lease agreement has a bargain purchase option. The collectability of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. The lease also qualifies as a capital lease from the viewpoint of the lessee.

Due to the fact that the initial amount of net investment (which in this case equals the present value of the minimum lease payments, $88,000) exceeds the lessor’s cost ($60,000), the lease is a sales-type lease.

(a) Gross investment = Minimum lease payments + any unguaranteed residual value.

The minimum lease payments associated with this lease are the periodic annual rents plus the bargain purchase option. There is no residual value relevant to the lessor’s accounting in this lease.

Calculation: 5 X $20,066.26 =$100,331.30 + 4,500.00

Gross investment at inception $104,831.30

(b) The net investment equals the present value of the components of the gross investment calculation.Net investment calculation:

$20,066.26 Annual rental paymentX 4.23972 PV of annuity due of 1 for n = 5, i = 9%$85,075.32 PV of periodic rental payments

$ 4,500.00Bargain purchase optionX .64993 PV of 1 for n = 5, i = 9%$ 2,924.69PV of bargain purchase option

$85,075.32 PV of periodic rental payments+ 2,924.69 PV of bargain purchase option$88,000.01 Net investment at inception






Using a financial calculator:PV $ ? Yields $88,000I 9%N 5 PMT $ 20,066.26FV $ 4,500Type 1

(c)Herbert Leasing Corporation (Lessor)


Date

AnnualLease

PaymentPlus BPO

Interest (9%)on Net

Investment

Net InvestmentRecovery

BalanceNet

Investment

7/1/117/1/117/1/127/1/137/1/147/1/156/30/16

$ 20,066.26 20,066.26 20,066.26 20,066.26 20,066.26 4,500.00$104,831.30

*$ 6,114.04** 4,858.34** 3,489.62** 1,997.73** 371.58**$16,831.30*

$20,066.26 13,952.22 15,207.92 16,576.64 18,068.53 4,128.42$88,000.00

$88,000.00 67,933.74 53,981.52 38,773.59 22,196.96 4,128.42 0.00

*Rounding error is $.02 cents.(d)

7/1/11 Lease Payments Receivable................................... 104,831.30Cost of Goods Sold........................ 60,000.00

Sales....................................... 88,000.00Unearned Interest Income—Leases................ 16,831.30Inventory................................ 60,000.00





7/1/11 Cash................................................ 20,066.26Lease Payments Receivable.......................... 20,066.26

12/31/11 Unearned Interest Income— Leases......................................... 3,057.02

Interest Income— Leases................................ 3,057.02 ($6,114.04 X 6/12 = $3,057.02)



Interest Income—Leases...... 3,057.02 ($6,114.04 – $3,057.02)


Interest Income—Leases...... 2,429.17 ($4,858.34 X 6/12 = ($2,429.17)


Unearned Interest Income— Leases......................................... 2,429.17

Interest Income—Leases...... 2,429.17 ($4,858.34 – $2,429.17)


Interest Income—Leases...... 1,744.81 ($3,489.62 X 6/12 = $1,744.81)





(a)Fair market value of leased asset to lessor $305,000.00Less: Present value of unguaranteed



Six periodic lease payments $279,245.49 ÷ 4.79079* $58,288.00**

*Present value of annuity due of 1 for 6 periods at 10%.**Rounded to the nearest dollar.







(b) Zoppas Leasing Corporation (Lessor)Lease Amortization Schedule

Date

AnnualLease

PaymentPlus URV



Balanceof Net

Investment

1/1/111/1/111/1/121/1/131/1/141/1/151/1/1612/31/16

$ 58,288 58,288 58,288 58,288 58,288 58,288 45,626$395,354

$24,671 21,310 17,612 13,544 9,070 4,147*$90,354

$ 58,288 33,617 36,978 40,676 44,744 49,218 41,479$305,000

$305,000 246,712 213,095 176,117 135,441 90,697 41,479 0

* rounding of $1

(c)1/1/11 Lease Payments Receivable......... 395,354

Equipment Purchased for Lease 305,000Unearned Interest Income— Leases................................. 90,354

1/1/11 Cash................................................ 58,288Lease Payments Receivable. 58,288

30/10/11 Unearned Interest Income— Leases......................................... 20,559

Interest Income—Leases....... 20,559($24,671 ÷ 12 X 10)

1/1/12 Cash................................................ 58,288Lease Payments Receivable. 58,288





30/10/11 Unearned Interest Income— Leases......................................... 21,870

Interest Income—Leases....... 21,870($24,671 ÷ 12 X 2) + ($21,310 ÷ 12 X 10)





(a)The lessor sets the annual rental payment as follows:

Fair market value of leased asset to lessor $28,500.00*Less: Present value of bargain purchase

option $5,000 X .62026(present value of 1 at 1% for 48 periods) 3,101.30

Amount to be recovered through lease payments $25,398.70Forty-eight periodic lease payments

$25,398.70 ÷ 38.3538** $662.22

* Fair value of $29,500.00 less down payment of $1,000.00

**Present value of annuity due of 1 for 48 periods at 1%.


Using a financial calculator:PV $ (28,500)I 1%N 48 PMT $ ? Yields $662.22FV $ 5,000 Type 1

(b)The lease agreement has a bargain purchase option. The lease, therefore, qualifies as a capital lease from the viewpoint of the lessee. The collectability of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. Due to the fact that the initial amount of net investment (which in this case equals the present value of the minimum lease payments, ($28,500 + the down payment of $1,000) exceeds the lessor’s cost ($21,200), the lease is a sales-type lease to the lessor.





(c)Turpin Corp. (Lessor)


Month

AnnualLease

PaymentPlus RV



Balanceof Net

Investment $28,500.00

1 $662.22 $662.22 27,837.78 2 662.22 $278.38 383.84 27,453.94 3 662.22 274.54 387.68 27,066.26 4 662.22 270.66 391.56 26,674.70 5 662.22 266.75 395.47 26,279.23 6 662.22 262.79 399.43 25,879.80 7 662.22 258.80 403.42 25,476.38 8 662.22 254.76 407.46 25,068.92 9 662.22 250.69 411.53 24,657.39

10 662.22 246.57 415.65 24,241.74 11 662.22 242.42 419.80 23,821.94 12 662.22 238.22 424.00 23,397.94 13 662.22 233.98 428.24 22,969.70 14 662.22 229.70 432.52 22,537.18 15 662.22 225.37 436.85 22,100.33 16 662.22 221.00 441.22 21,659.11 17 662.22 216.59 445.63 21,213.48 18 662.22 212.13 450.09 20,763.40 19 662.22 207.63 454.59 20,308.81 20 662.22 203.09 459.13 19,849.68 21 662.22 198.50 463.72 19,385.96 22 662.22 193.86 468.36 18,917.60 23 662.22 189.18 473.04 18,444.55





Month

AnnualLease

PaymentPlus RV



Balanceof Net

Investment24 662.22 184.45 477.77 17,966.78 25 662.22 179.67 482.55 17,484.23 26 662.22 174.84 487.38 16,996.85 27 662.22 169.97 492.25 16,504.60 28 662.22 165.05 497.17 16,007.42 29 662.22 160.07 502.15 15,505.28 30 662.22 155.05 507.17 14,998.11 31 662.22 149.98 512.24 14,485.87 32 662.22 144.86 517.36 13,968.51 33 662.22 139.69 522.53 13,445.97 34 662.22 134.46 527.76 12,918.21 35 662.22 129.18 533.04 12,385.18 36 662.22 123.85 538.37 11,846.81 37 662.22 118.47 543.75 11,303.06 38 662.22 113.03 549.19 10,753.87 39 662.22 107.54 554.68 10,199.19 40 662.22 101.99 560.23 9,638.96 41 662.22 96.39 565.83 9,073.13 42 662.22 90.73 571.49 8,501.64 43 662.22 85.02 577.20 7,924.43 44 662.22 79.24 582.98 7,341.46 45 662.22 73.41 588.81 6,752.65 46 662.22 67.53 594.69 6,157.96 47 662.22 61.58 600.64 5,557.32 48 662.22 55.57 606.65 4,950.67

5,000.00 49.33 * 4,950.67 - $8,286.56 $28,500.00

* rounding by $.18





(d) A journal entry would be required on December 31, 2011 by Turpin Corp. to accrue the interest in the amount of $254.76 related to payment no. 8, which is due January 1, 2012.

Unearned Interest Income—Leases ........ 254.76Interest Income—Leases .................... 254.76

...................................................

(e) The income to be reported on the income statement of Turpin Corp. for the fiscal year ending December 31, 2011 concerning this lease will be as follows:

Sales $29,500Cost of goods sold 21,200Gross profit 8,300Interest income - lease 1,867

(Interest income represents the sum of the interest for the first 7 payments from the table above and an accrual of interest for the 8th payment)

(f) At December 31, 2011, the balance sheet would have reported as a current asset, the amount of the principal reduction that will be obtained in the next twelve months. Based on the table above the sum of the principal reduction for monthly payment 8 through 19 total $5,168. The remaining amount of the balance of the investment at December 31, 2011 ($25,476 less the current portion of $5,168) of $20,308 will be reported as a long-term lease payment receivable.





Part 1 – Using IFRS

(a)

In spite of Cuomo’s intention to exercise the one year renewal option on the lease of the excavation equipment, the risks and rewards of ownership have not been transferred at the time of signing the lease and so the lease is treated as an operating lease. The maximum term of the lease is four years and the asset is expected to have an economic life of ten years.

Under IFRS, meeting any one or a combination of the following criteria normally indicates that the risks and rewards of ownership are transferred to the lessee, and supports classification as a finance lease:

There is reasonable assurance that the lessee will obtain ownership of the leased property by the end of the lease term. If there is a bargain purchase option in the lease, it is assumed that the lessee will exercise it and obtain ownership of the asset.



The leased assets are so specialized that, without major modification, they are of use only to the lessee.

(b)April 1, 2011

Rent Expense ($135,000 ÷ 12 X 9).................. 101,250Prepaid Rent ($135,000 ÷ 12 X 3).................... 33,750

Cash.......................................................... 135,000





An alternate to the above:April 1, 2011

Prepaid Rent ................................................... 135,000Cash.......................................................... 135,000

December 31, 2011Rent Expense ($135,000 ÷ 12 X 9)..................... 101,250

Prepaid Rent ............................................... 101,250......................................................................

Part 2 – Contract-based Approach

When using this approach, the longest possible lease term that is “more likely than not” to occur, is used in the calculations of the discounted contractual lease obligation.

Because the payments under the renewal are 125% of the original lease payment ($135,000 X 125% = $168,750), two calculations need to be made.

The first will be for the first term of the lease involving an annuity due of $135,000 for three years at 8%, the implicit rate in the lease, known to Cuomo.

$135,000 Annual rental payment X 2.78326 PV of annuity due of 1 for n = 3, i = 8%$375,740.10 PV of periodic rental payments

$ 168,750 PV of renewal option rental in 3 years X .79383 PV of 1 for n = 3, i = 8%$133,958.81 PV of renewal option rental

$375,740.10 PV of periodic rental payments+133,958.81 PV of renewal option rental$509,698.91 PV of contractual lease obligation






Using a financial calculator:PV $ ? Yields $509,699.93I 8%N 3 PMT $( 135,000)FV $( 168,750)Type 1

(b) Cuomo Mining CorporationLease Amortization Schedule

Date

Annual

LeasePayments

Interest (8%)

on UnpaidObligation

Reduction

of LeaseObligation

Balance

of LeaseObligation $509,700

Apr. 1 2011 $135,000 $135,000 374,700 Apr. 1 2012 135,000 $29,976 105,024 269,676 Apr. 1 2013 135,000 21,574 113,426 156,250 Apr. 1 2014 168,750 12,500 156,250 0

$573,750 $64,050

(c)April 1, 2011

Contractual Lease Rights.................... 509,700Contractual Lease Obligations. . 509,700

Contractual Lease Obligations........... 135,000Cash............................................. 135,000





December 31, 2011Interest Expense.................................. 22,482

Interest Payable.......................... 22,482($29,976 X 9 ÷ 12 = $22,482)

Amortization Expense......................... 95,569Contractual Lease Rights.......... 95,569($509,700 ÷ 4 years X 9 ÷ 12 = $95,569)

April 1, 2012Interest Expense.................................. 7,494*Interest Payable................................... 22,482Contractual Lease Obligations........... 105,024

Cash............................................. 135,000*($29,976 X 3 ÷ 12 = $7,494)


Interest Payable.......................... 16,181($21,574 X 9 ÷ 12 = $16,181)

Amortization Expense......................... 127,425Contractual Lease Rights.......... 127,425($509,700 ÷ 4 years = $127,425)





Part 3Cuomo Mining Corporation

December 31, 2012

Balance Sheet – PartialContract OperatingBased Lease

Current assetsPrepaid rent $33,750

Intangible assetsContractual lease rights $509,700 Amortization of rights to date (222,994) (1)Net 286,706

Liabilities:Current liabilities:Interest payable 16,181 Obligation under leased rights 113,426

Non-current liabilities:Obligation under leased rights 156,250

Total liabilities $285,857

Income statementAmortization expense $127,425 Interest expense 23,675 Rent expense 135,000

$151,100 $ 135,000

Contract OperatingTotal expense - 4 years Based Lease

Amortization expense $509,700 Interest expense 64,050 (2)Rent expense (3) $438,750

$ 573,750 $ 438,750





(1) Sum of amortization 2010................... $95,569And 2012............................................... 127,425Total ...................................................... $222,994

(2) Refer to total interest expense on amortization table.

(3) Rent expense – refer to total payments made on amortization table in part 2 (b),





Hein Corporation (Lessee)*1/1/11 Cash............................................ 720,000.00

Equipment (net)................... 640,000.00Deferred Profit on Sale- Leaseback......................... 80,000.00

Equipment Under Capital Leases..................................... 720,000.00

Obligations Under Capital Leases............................... 720,000.00 ($117,176.68 X 6.14457**)

**Present value of annuity of 1 for 10 periods at 10%


PV $ ? Yields $720,000I 10%N 10 PMT $ (117,176.68)FV $ 0 Type 0

Throughout 2011Executory Costs........................ 11,000.00

Accounts Payable or Cash.. 11,000.00

12/31/11 Deferred Profit on Sale- Leaseback............................... 8,000.00

Depreciation Expense***..... 8,000.00 ($80,000 ÷ 10)

**Lease should be treated as a capital lease because present value of minimum lease payments equals the fair value of the computer. The lease term is greater than 75% of the economic life of the asset, and title transfers at the end of the lease.

***The credit could also be to a gain account.




*EXERCISE 20-22 (Continued)

12/31/11 Depreciation Expense............... 72,000.00Accumulated Depreciation.. 72,000.00 ($720,000 ÷ 10)

Interest Expense........................ 72,000.00Obligations Under Capital Leases*................................... 45,176.68

Cash...................................... 117,176.68

Note to instructor:1. The present value of an ordinary annuity at 10% for 10

periods should be used to capitalize the asset. In this case, Hein would use the implicit rate of the lessor because it is lower than its own incremental borrowing rate and known to Hein.

2. The deferred profit on the sale-leaseback should be amortized on the same basis that the asset is being amortized.

Partial Lease Amortization Schedule

Date

AnnualLease

PaymentInterest(10%) Amortization Balance

1/1/1112/31/11 $117,176.68 $72,000.00 $45,176.68*

$720,000.00 674,823.32

Liquidity Finance Corp. (Lessor)*1/1/11 Equipment................................... 720.000.00

Cash.................................... 720,000.00

Lease Payments Receivable...............................1,171,766.80 ($117,176.68 X 10)

Unearned Interest Income—Leases............. 451,766.80Equipment.......................... 720,000.00





12/31/11 Cash............................................. 117,176.68Lease Payments Receivable...................... 117,176.68

Unearned Interest Income— Leases...................................... 72,000.00


* Lease should be treated as a direct financing lease because the present value of the minimum lease payments equals the fair value of the equipment, and (1) collectability of the payments is reasonably assured, (2) no important uncertainties surround the costs yet to be incurred by the lessor, and (3) the cost to the lessor equals the fair market value of the asset at the inception of the lease.

(b) The primary reason for Hein to enter into a sale and leaseback arrangement for its equipment is to borrow cash. This transaction is similar to the purchase of new equipment using capital leases, except that in this case, Hein is using an asset it is already using and is familiar with. Hein wishes to obtain some leverage by borrowing funds for an amount that exceeds the carrying value of the asset at the time of the sale.

Since the carrying value of the equipment on the books of Hein at the time of the sale represents the amortized cost of the asset in use, this value is not intended to correspond to its fair market value. Hein can continue with its intention to use the asset to the completion of its planned useful life. The sale and leaseback arrangement will not disturb this plan. Hein is taking advantage of the increase in value to obtain additional financing at preferential rates. Creditors will not view this action as a desperate measure since the gain on the sale is being deferred and amortized.




*EXERCISE 20-23 (20-30 minutes)

(a) Sale-leaseback arrangements are treated as though two transactions were a single financing transaction if the lease qualifies as a capital lease. Any gain or loss on the sale is considered unearned and is deferred and amortized over the lease term (if possession reverts to the lessor) or the economic life (if ownership transfers to the lessee). In this case, the lease qualifies as a capital lease because the lease term (10 years) is 83% of the remaining economic life of the leased property (12 years). Therefore, at 12/31/11, all of the gain of $120,000 ($520,000 – $400,000) would be deferred and amortized over 10 years. Since the sale took place on 12/31/11, there is no depreciation for 2011.

(b) A sale-leaseback is usually treated as a single financing transaction in which any profit on the sale is deferred and amortized by the seller. However, the lease does not meet any of the criteria of a capital lease for the property sold. In this case, the sale and the leaseback are accounted for as separate transactions. Therefore, the full gain ($480,000 – $420,000, or $60,000) is recognized.

(c) The profit on the sale of $121,000 should be deferred and amortized over the lease term. The lease qualifies as a capital lease. Since the leased asset is being amortized using the straight-line depreciation method, the deferred gain should also be reported in the same manner. Therefore, in the first year, $12,100 ($121,000 ÷ 10) of the gain would be recognized.

(d) In this case, Barnes Corp. would report a loss of $87,300 ($300,000 – $212,700) for the difference between the book value and lower fair value. The CICA Handbook requires that when the fair value of the asset is less than the book value (carrying amount), a loss must be recognized immediately. In addition, rent expense of $72,000 ($6,000 per month X 12 months) should be reported.




*EXERCISE 20-24 (15-20 minutes)

(a)September 15, 2011Prepaid Land Rental........................................... 30,000

Cash................................................... ...... 30,000

December 31, 2011Land Rent Expense............................................. 8,750

Prepaid Land Rental........................ ...... 8,750($30,000 X 3.5 / 12) = $8,750

(b) The rental of land can only be accounted for as a capital lease by the lessee if the rental of the property contains a bargain purchase option or if the lease transfers ownership of the property to the lessee. Since this is not the case, here the lease of the land had to be treated as an operating lease. In the case of equipment the possibility of accounting for the lease as a capital lease is more likely depending on the terms of the lease in relation to the capitalization criteria.

(c)September 15, 2011Cash..................................................................... 30,000

Unearned Land Rental Income........ 30,000

December 31, 2011Unearned Land Rental Income.......................... 8,750

Land Rental Income........................ 8,750($30,000 X 3.5 / 12) = $8,750




*EXERCISE 20-25(20-25 minutes)

(a)March 30, 2011Land under Capital Leases *................................ 43,358Leased Building..................................................... 86,717

Lease Obligation**.............................. ....130,075* (1/3 X $130,075** = $43,358)

Lease Obligation............................................... ... 10,000Cash.................................................... 10,000


**Using a financial calculator:PV $ ? Yields $ (130,075)I 7%N 15 PMT $ (10,000)FV $ (90,000)Type 1

(b)December 31, 2011:Interest Expense................................................. 6,304

Interest Payable........................................... 6,304[($130,075 – $10,000) X 7% X 9/12 = $6,304]

Depreciation Expense - Building....................... 3,252Accumulated Depreciation – Building 3,252

($86,717 / 20 year X 9/12 = $3,252)

March 31, 2012Interest Expense *............................................. 2,101Interest Payable................................................. 6,304Lease Obligation............................................. 1,595

Cash.................................................. 10,000* [($130,075 – $10,000) X 7% X 3/12]





December 31, 2012:Interest Expense................................................. 6,220

Interest Payable........................................... 6,220[($130,075 – $10,000 - $1,595) X 7% X 9/12 = $6,220]

Depreciation Expense - Building....................... 4,336Accumulated Depreciation – Building 4,336

($86,717 / 20 year = $4,336)




TIME AND PURPOSE OF PROBLEMS

Problem 20-1 (Time 45-50 minutes)Purpose—to provide an opportunity for the student to contrast two alternative means by which a business can acquire software for its business by using leasing. Along with preparing all the necessary calculations, and journal entries, the student must also contrast the financial statement effect of the two different leasing alternatives. Finally the qualitative considerations and the short and long-term implications of each option must be outlined by the student.

Problem 20-2 (Time 45-50 minutes)Purpose—to provide an opportunity for the student to contrast two alternative means by which a business can acquire equipment and software for its business by using leasing. Along with preparing all the necessary calculations, the student must also contrast the financial statement effect of the two different leasing alternatives for the first year and for the overall term of lease plus a renewal period under one option. Finally the qualitative considerations and the short and long-term implications of each option must be outlined by the student, emphasizing the effects on cash flow.

Problem 20-3 (Time 45-50 minutes)

Purpose—to provide the student with a lease situation involving monthly payments made for a truck. The lease has a residual value guaranteed by the lessee. Along with preparing all the necessary calculations, and journal entries, the student must also prepare the statement of financial position, the income and cash flow statements on a comparative basis as well as any required note disclosures. The must also prepare the journal entry at the completion of the term of the lease involving the disposal of the truck and the lessee’s involvement concerning the guaranteed residual value.


Purpose—to provide the student with a lease situation described in Problem 20-2 but from the perspective of the lessor. The requirement for comparative financial statement disclosure is included in the problem.


Purpose—to provide an opportunity for the student to contrast the entries and corresponding financial statements of the lessor and lessee when the conditions call for the accounting of the lease as a capital lease to the lessee but as an operating lease to the lessor. The odd result is that the asset is reported on both balance sheets.




TIME AND PURPOSE OF PROBLEMS (CONTINUED)


Purpose—to develop an understanding of the accounting treatment for operating leases. The student is required to identify the type of lease involved, explain the respective reasons for their classification, and discuss the accounting treatment that should be applied for both the lessee and lessor. The student is also asked to record executory costs paid by the lessor and prepare the journal entries to reflect the first year of this lease contract for both the lessee and lessor and to discuss the disclosures required of the lessee and lessor. Included in this problem is a requirement to compare the factors and criteria for classification differences between IFRS and private enterprise GAAP.


Purpose—to provide the student with a lease situation containing a bargain purchase option and both an implicit rate and a stated interest rate between which the student must choose. The student must first discuss the conditions of the case that support the argument to capitalize the lease and list specific evidence to demonstrate that the transfer of risks and rewards of ownership has taken place. The student must then calculate the appropriate amount at which to capitalize the lease and, in a last requirement, given different interest rates, prepare the balance sheet and income statement presentation of this lease by the lessee.


Purpose—to provide an understanding of how lease information is reported on the statement of financial position and income statement for two different years in regard to the lessee. In addition, the year-end month is changed in order to help provide an understanding of the complications involved with partial periods. Included in this problem is a requirement to compare the factors and criteria for classification differences between IFRS and private enterprise GAAP.


Purpose—to provide an understanding of how lease information is reported on the statement of financial position and income statement for two different years in regard to the lessor. In addition, the year-end month is changed in order to help provide an understanding of the complications involved with partial periods. Included in this problem is a requirement to compare the factors and criteria for classification differences between IFRS and private enterprise GAAP.






Purpose—to develop an understanding of the accounting for capital leases where the lease payments for the first half of the lease term differ from those for the latter half. The student is required to calculate for the lessee the discounted present value of the leased property and the related obligation at the lease’s inception date. The student is also asked to prepare journal entries for the lessee.


Purpose—to develop an understanding of the accounting procedures involved in a sales-type leasing arrangement. The student is required to discuss the nature of this lease transaction from the viewpoint of both the lessee and lessor. The student is also requested to prepare the journal entries to record the lease for both the lessee and lessor plus illustrate the items and amounts that would be reported on the balance sheet and statement of cash flows at the end of the first year for the lessee and the lessor.


Purpose—to develop an understanding of the accounting for a capital lease by the lessee in an annuity due arrangement. The student is required to prepare the lease amortization schedule for the entire term of the lease and all the necessary journal entries for the lease through the first two lease payments. The student is also asked to indicate the amounts that would be reported on the lessee’s balance sheet and statement of cash flows. Finally the student must contrast the financial statement reporting with that obtained for a new set of conditions leading to the treatment of the lease as an operating lease.


Purpose—to develop an understanding of the accounting treatment accorded a sales-type lease involving an unguaranteed and guaranteed residual value. The student is required to discuss the nature of the lease with regard to the lessor and to calculate the amount of the gross investment, the unearned interest income, the sales price, and the cost of sales. The student is also required to construct a 10-year lease amortization schedule for the leasing arrangement, and to prepare the lessor’s journal entries for the first year of the lease contract. Finally disclosure of the net investment must be prepared.






Purpose—to develop an understanding of a capital lease with an unguaranteed and guaranteed residual value, with and without a bargain purchase option. The student explains why it is a capital lease and calculates the amount of the initial obligation. The student prepares a 10-year amortization schedule and all of the lessee’s journal entries for the first year under each of the different assumptions. Included in this problem is a requirement to compare the factors and criteria for classification differences between IFRS and private enterprise GAAP.


Purpose—to develop an understanding of a sales-type lease with a guaranteed and unguaranteed residual value. The student discusses the classification of the lease and calculates the gross investment, unearned interest income, sales price, and cost of sales. The student prepares a 10-year amortization schedule and all of the lessor’s journal entries for the first year. The problem then goes on to require the student to calculate the amount of depreciation to be recorded by the lessee under conditions where the residual value is and is not guaranteed by the lessee. The financial statement disclosure requirements to the lessor must also be outlined based on these two conditions. Included in this problem is a requirement to compare the factors and criteria for classification differences between IFRS and private enterprise GAAP.


Purpose—to develop an understanding of how residual values and direct costs in processing the lease affect the accounting for the lessee and the lessor. The student must understand both the accounting for a guaranteed and unguaranteed residual value and determine how large the residual value must be to have operating lease treatment. Included in this problem is a requirement to compare the factors and criteria for classification differences between IFRS and private enterprise GAAP.


Purpose—to provide the student with the opportunity to contrast the financial implications of two alternative leases offered to a business with liquidity problems. The student must perform the necessary analysis to conclude as to how the leases would be accounted for and provide a basis for the recommendation in a formal report. The student will need to eliminate some unnecessary minor factors (such as small differences in lease term dates) in order to quickly zero in on the essential issues surrounding the choices offered.






Purpose—to provide the student with the opportunity to contrast the financial implications and reporting when a lease is treated as an operating lease by the lessee and a capital lease by the lessor, on account of the involvement of a third party when a guaranteed residual value exists. The student must prepare the entries and the financial statement disclosure of both parties in the lease agreement. This problem highlights the unsolved issue of the equipment not being reported on either balance sheet.


Purpose—to provide the student with the opportunity to prepare the accounting for lease using the contract-based approach. Included in the instructions is a revision of estimate concerning the guaranteed residual value of the leased asset. Journal entries, adjusting journal entries and a revised amortization schedule must also be prepared by the student.


Purpose—to provide the student with the opportunity to contrast three different options to obtain a luxury vehicle, including: finance a purchase, lease and renew a lease and lease and exercise the option to purchase. A fourth option must be prepared suing the contract-based approach. Several calculations, amortization tables and journal entries are also required in this problem. Finally, a summary for the first year’s balance sheet and income statement for all options as well as a summary of all expenses for the 5 years use of the vehicle must be summarized. Additional considerations in making choices must also be provided by the student.


Purpose—to provide the student with the lessor’s accounting of one of the options discussed in P20-20.

Problem 20-22* (Time 40-45 minutes)

Purpose—to develop an understanding of how to handle a sales and leaseback transaction, including the preparation of the lessee’s journal entries. A second set of assumptions is used to arrive at a different conclusion, which is to account for the lease as an operating lease.





Problem 20-23* (Time 40-45 minutes)

Purpose—to provide an opportunity for the student to account for a sale and leaseback transaction where land and buildings are involved. The student must apply the capitalization criteria to the building but leave the land as an operating lease. The lease payments must therefore be disaggregated. This problem also involves the financial statement disclosure required at the end of the first year of the lease.




SOLUTIONS TO PROBLEMS

PROBLEM 20-1

(a) Option No. 1 - Precision Inc.

Calculation of present value of minimum lease payments: The $5,000 option to buy the software at the end of the lease of five years is not considered a bargain purchase option in view of the $200 price offered by Graphic Design Inc. in Option No. 2.

The lease payments are in the amount of $3,500 as the $1,000 annual licensing fee is an executory cost.

$3,500 X 3.79079* = $13,268*Present value of an ordinary annuity of 1 for 5 periods at 10%.



Total lease payments: At inception of lease – January 1, 2011 $12,000Present value of minimum lease payments 13,268Total $25,268

This is an operating lease to Interior Design Inc. since the lease term (5 years) is less than 75% of the economic life (8 years) of the leased asset. The lease term is 62.5% (5 ÷ 8) of the asset’s economic life. There is no bargain purchase option and the present value of minimum lease payments of $25,268 represent 84% of the fair value at January 1, 2011 of $30,000 falling short of the criteria of 90% to treat the lease as a capital lease under PE GAAP.




PROBLEM 20-1 (Continued)

(a) Option No. 2 – Graphic Design Inc.

Calculation of present value of minimum lease payments:

The minimum lease payments in the case include the bargain purchase option of $200. The present value therefore is:

PV of monthly payment *............................................ $27,104PV of bargain purchase option of $200 **................. 124Present value of minimum lease payments.............. $27,228

* Present value of an annuity due of 1 for 5 periods at 10%.$6,500 X 4.16986 = $27,104

** Present value of a single payment of 1 for 5 periods at 10% $200 X .62092 = $124


Using a financial calculator:PV $ ? Yields $27,228I 10%N 5 PMT $ (6,500)FV $ (200) Type 1

To Interior Design Inc., this lease is a capital lease because the terms satisfy the following criteria:

1. Although as in Option No. 1, the lease term is not greater than 75% of the economic life of the leased asset; that is, the lease term is 62.5% (5/8) of the economic life, there is a bargain purchase option.

2. The present value of the minimum lease payments is greater than 90% of the fair value of the leased asset; that is, the present value of $27,228 is 91% of the fair value of the leased asset of $30,000: ($27,228 / $30,000 = 90.76%)





(b)January 1, 2012

Prepaid Software Rental Expense............. 12,000Cash.................................................... 12,000

The first payment will be amortized straight-line over the term of the lease.

December 31, 2012Software Rental Expense........................... 3,500Software License Expense......................... 1,000

Cash.................................................... 4,500

December 31, 2012Software Rental Expense........................... 2,400

Prepaid Software Rental Expense...... 2,400($12,000 / 5 = $2,400)

(c)Interior Design Inc.

Lease Amortization Schedule with Graphic Design Inc.

Date

AnnualLease

Payment

Interest (10%)

on UnpaidObligation

Reduction

of LeaseObligation

Balanceof Lease

Obligation

1/1/121/1/121/1/131/1/141/1/151/1/161/1/16

$6,500 6,5006,5006,5006,500

200 $32,700

*$2,073* 1,630* 1,143

605607 18 *$5,471

$6,5004,427

4,870 5,357 5,893

182 $27,229

$27,22820,728

16,301 11,431

6,074181

0





(d)January 1, 2012

Leased Software........................................... 27,228Lease Obligation.................................. 27,228

January 1, 2012

Lease Obligation.......................................... 6,500Cash...................................................... 6,500

December 31, 2012Interest Expense..................................... 2,073

Interest Payable.................... 2,073

December 31, 2012

Depreciation Expense.................................. 3,404Accumulated Depreciation—Leased Software............................................ 3,404 ($27,228 ÷ 8 years = $3,404)Use 8 years, as option to purchase will be exercised as it is a bargain price.

January 1, 2013Interest Payable...................................... 2,073Lease Obligation..................................... 4,427

Cash...................................... 6,500





(e) Option No. 1 Option No. 2

Operating Capital Income statement effects: Lease Lease Rent expense $3,500 Software licensing expense 1,000

Interest expense $2,073 Depreciation expense _____ 3,404 Total expenses $4,500 $5,477

Asset and liability balances Dec. 31, 2012Current assets:Prepaid software rental $9,600

Non-current assets:Software under capital lease $27,228 Less: accumulated depreciation (3,404)

$23,824

Current liabilities:Interest payable 2,073 Current portion of lease obligation 4,427

Non-current liabilities:Lease obligation 20,728 Less current portion (4,427)

16,301 Total liabilities: $22,801

Total cash outflows during 2012 ($16,500) ($6,500)





(f) Among Interior’s paramount concerns will be ensuring that it continues to meet its debt to equity covenant. Since all financing is done with the bank, Interior Design Inc. may be perceived to be of high risk by the bank. Entering into the Precision Inc. lease (Option No. 1) would provide off balance sheet financing keeping the lease obligation off the balance sheet. Equity would be reduced by the lease payments expensed each period.

In contrast the Graphic Design Inc. (Option No. 2) lease would increase Interior’s liabilities by the present value of the minimum lease payments. Interest expense each period and depreciation of the leased asset will decrease net income and therefore equity each period.

To maintain their debt to equity covenant, Interior would probably choose to enter into the Precision lease (operating lease Option No. 1) to minimize debt on their balance sheet.

(g) In the long term, Option No. 2 presents the better option. The software will be owned and used by Interior over the eight-year useful life of the asset, instead of the five-year term of lease under the operating lease, Option No. 1. The other immediate disadvantage to the operating lease option No. 1 is the large immediate (January 1, 2011) cash outflow required by the prepayment clause under the operating lease of $12,000. This payment could create an important liquidity problem over the term of the lease, especially in the first year.

The conclusion to be drawn from this study is that choices are often made by businesses for reasons outside what makes economic sense overall. The FASB and IASB movement towards removing the distinction between operating and capital leases will eliminate this problem as choices between leases will not be made based on the objective to reduce or eliminate the presence of liabilities on the balance sheet.





Note to instructor:

The two alternatives are not, strictly speaking, comparable in a capital budgeting sense as the difference in the purchase option leaves option 1 with a 5 year life and option 2 with an 8 year life. The present value of the purchase option in Option 1 (although a non-GAAP treatment) is needed to make the two options comparable (PV is $3,100). Option 2 is therefore superior in a present value sense. It is important to add in any discussion that comparing the accounting treatment without the full picture of the cash flows in arriving at management’s decision is inadequate.




PROBLEM 20-2

Memorandum Prepared by: (Your Initials)TO: President of SWTDate:

I have summarized the information regarding the two leases for the customer service telecommunications and computer equipment that you left with me.

Both leases are considered capital leases under generally acceptable accounting principles, and I have indicated why this is in the following chart, followed by my detailed calculations. Capital lease arrangements are considered to be purchases from an accounting standpoint, and accordingly, the costs that will affect the income statement each year include: interest expense, depreciation expense and any annual operating costs.

The following table shows that Lease Two has less of an impact on income than Lease One in the 2011 year, and on average over the number of years we will be using the leased equipment. As both leases provide the SWT with similar equipment that meets our requirement, it is my recommendation that we sign Lease Two. From a cash flow standpoint, the lease payments of Lease One are made in advance every year, while Lease Two payments are made at the end of the year which gives us more liquidity. Please keep in mind that with Lease One, the equipment will not belong to us at the end of the lease term of five years, it will revert to the lessor, and we are required to guarantee the value at that time of $85,000. If we are interested in keeping the equipment, we can decide at the end of the lease term if we wish to purchase the equipment for $85,000; if we do not acquire it, we may be required to make up any deficiency in its market value and this introduces considerable uncertainty. With Lease Two, we will acquire the equipment over the seven year term of the lease and cash flows are clearly defined. Accordingly, I am recommending Lease Two.





Lease One Lease TwoInterest rate used in calculations

10% - implicit rate unknown

8% - lower of implicit rate and incremental borrowing rate

Number of years of use by SWT

5 years 7 years

Present value of minimum lease payments

$487,697 (1) $444,404 (2)

Type of Lease Capital (3) Capital (4)

Total cash outflow from minimum lease payments

$606,500 (5) $557,000 (6)

Average per year (÷12) $121,300 $79,571

Income statement effect first yearInterest expense $38,339 (7) $35,552 (8)Depreciation expense $80,539 (9) $63,486 (10)Operating expenses $23,500 $26,500Total expenses $142,378 $125,538

Total income statement effect over life of lease and renewal Interest expense $118,805 (11) $112,596 (12)Depreciation expense $402,694 (13) $444,404 (14)Operating expenses $117,500 (15) $185,500 (16)Total expenses $638,999 $742,500Average per year (÷12) $127,800 $106,071

Refer to Appendix A for details of calculations referenced to the above.





Appendix A:

(1) $104,300Annual rental paymentX 4.16986 PV of an annuity due 5 years at 10% (Table A-

5)$ 434,916.40 PV of minimum lease payments

$85,000 Guaranteed residual value (or purchase price)

X .62092 PV of 1 in 5 years at 10% (Table A-2)$52,778.20 Present value of guaranteed residual value

$487,694.60 Total present value of minimum lease payments


Using a financial calculator:PV $ ? Yields $487,695.28I 10%N 5 PMT $ (104,300)FV $ (85,000)Type 1

(2) $111,000 Annual rental payments ($137,500 – $26,500)X 3.99271 PV of ordinary annuity 5 years at 8% (Table A-

4)$ 443,190.81 PV of minimum lease payments

$1,000 Annual rental renewal period ($27,500 –$26,500)

X 1.78326 PV of ordinary annuity 2 years at 8% (Table A-4)

1,783.26X .68058 PV of 1 in 5 years at 8% (Table A-2)

$1,213.65 PV of lease renewal payments$444,404.46 Total present value of minimum lease

payments






Using a financial calculator:PV $ ? Yields $443,190.81I 8%N 5 PMT $ 111,000*FV $ 0Type 0

*($137,500 – $26,500)

Using a financial calculator:PV $ ? Yields $1,783.26I 8%N 2 PMT $ 1,000*FV $ 0Type 0

* ($27,500 − $26,500)

Using a financial calculator:PV $ ? Yields $1,213.66I 8%N 5 PMT $ 0FV $ 1,783.26Type 0

(3) The lease term is greater than 75% of the economic life of the leased asset; that is, the lease term is 83% (5/6) of the economic life. The present value of the minimum lease payments equal the fair value of the equipment—see calculation





(4) The present value of the minimum lease payments is equal to the fair value of the equipment.

(5)$104,300 x 5 + $85,000 = $606,500

(6)[($137,500 – $26,500)*5] + [($27,500 – $26,500) x 2)] = $557,000

(7)($487,694 – 104,300) x 10% = $38,339

(8)$444,404 x 8% = $35,552

(9)($487,694 – $85,000) ÷ 5 years = $80,539

(10) $444,404 ÷ 7 = $63,486

(11) Cash outflows from lease (item 5) less PV min. lease payments (item 1)($606,500 – $487,695 = $118,805)

(12) Cash outflows from lease (item 6) less PV min. lease payments (item 2)($557,000 – $444,404 = $112,596)

(13) $487,694 – $85,000 = $402,694 or item 9 X 5

(14) Capitalized amount of the lease or Item 10 X 7 = $444,404

(15) $23,500 X 5 = $117,500

(16) $26,500 X 7 = 185,500




PROBLEM 20-3

(a) This is a finance lease to Hunter Ltd. The IFRS criteria use qualitative factors to establish whether or not the risks and rewards of ownership are transferred to the lessee, and supports classification as a finance lease:1. There is reasonable assurance that the lessee will




4. The leased assets are so specialized that, without major modification and/or significant cost to the lessor, they are of use only to the lessee.

Other indicators include situations where the lessee absorbs the lessor’s losses if the lessee cancels the lease, or the lessee assumes the risk associated with the amount of the residual value of the asset at the end of the lease, or where there is a bargain renewal option—when the lessee can renew the lease for an additional term at significantly less than the market rent.

The standard also states that these indicators are not always conclusive. The decision has to be made on the substance of each specific transaction. If the lessee determines that the risks and benefits of ownership have not been transferred to it, the lease is classified as an operating lease.





For Situ Ltd. the lessor, under IFRS, the lease would receive the same treatment as under PE GAAP except the criteria need not include the two revenue recognition-based tests concerning collectability and estimating unreimbursable costs. Situ is not a manufacturer or dealer and so this is finance lease.

(b) Calculation of annual rental payment:(Hint when using a financial calculator: ensure that the compounding is done monthly, P/Y = 1)


Using a financial calculator:PV $ 20,691I 1%N 36 PMT $ ? Yields ($600)FV $ (3,500) Type 1

The lease payments include the executory costs of $20 per month and are therefore in the amount of $620.





(c)


Date

MonthlyLease

PaymentPlus GRV


Reductionof Lease

Obligation

BalanceLease

Obligation $20,691

Jan. 1 2011 $ 600 $600 20,091 Feb. 1 2011 600 $ 201 399 19,692 Mar. 1 2011 600 197 403 19,289 Apr. 1 2011 600 193 407 18,882 May 1 2011 600 189 411 18,471 June 1 2011 600 185 415 18,055 July 1 2011 600 181 419 17,636 Aug. 1 2011 600 176 424 17,212 Sep. 1 2011 600 172 428 16,784 Oct. 1 2011 600 168 432 16,352 Nov. 1 2011 600 164 436 15,916 Dec. 1 2011 600 159 441 15,475 Jan. 1 2012 600 155 445 15,030 Feb. 1 2012 600 150 450 14,580 Mar. 1 2012 600 146 454 14,126 Apr. 1 2012 600 141 459 13,667 May 1 2012 600 137 463 13,204 Jun. 1 2012 600 132 468 12,736 July 1 2012 600 127 473 12,263 Aug. 1 2012 600 123 477 11,786 Sep. 1 2012 600 118 482 11,303 Oct. 1 2012 600 113 487 10,816 Nov. 1 2012 600 108 492 10,325 Dec. 1 2012 600 103 497 9,828






Date

MonthlyLease

PaymentPlus GRV


Reductionof Lease

Obligation

BalanceLease

Obligation

Jan. 1 2013 $600 $98 $502 $9,326 Feb. 1 2013 600 93 507 8,819 Mar. 1 2013 600 88 512 8,308 Apr. 1 2013 600 83 517 7,791 May 1 2013 600 78 522 7,269 Jun. 1 2013 600 73 527 6,741 July 1 2013 600 67 533 6,209 Aug. 1 2013 600 62 538 5,671 Sep. 1 2013 600 57 543 5,127 Oct. 1 2013 600 51 549 4,579 Nov. 1 2013 600 46 554 4,025 Dec. 1 2013 600 40 560 3,465 Dec. 31 2013 3,500 36* 3,464 0

$25,100 $4,409 $ 20,691 * Rounding $1

(d)January 1, 2011

Leased Equipment........................................... 20,691Lease Obligation...................................... 20,691 (To record the lease of equipment using capital lease method)

Lease Obligation.............................................. 600Insurance Expense.......................................... 20

Cash.......................................................... 620 (To record the first rental payment)





(d) (Continued)

December 31, 2011Interest Expense.............................................. 155

Interest Payable....................................... 155 (To record accrual of Dec/2011 interest on

lease obligation)

Depreciation Expense..................................... 5,730Accumulated Depreciation—Leased Assets................................................... 5,730 (To record depreciation expense for first year [$20,691 - $3,500] ÷ 3)

January 1, 2012Lease Obligation.............................................. 445Interest Payable............................................... 155Insurance Expense.......................................... 20

Cash.......................................................... 620

(e)Hunter Ltd.

Statement of Financial PositionDecember 31,

2012 2011 Non-current assetsProperty plant and equipment

Leased Equipment $20,691 $20,691Less accumulated depreciation 11,460 5,730

9,231 14,961Current liabilities

Interest payable 98 155Lease obligation* 9,828 5,704

Non-current liabilitiesLease obligation (Note X) 15,475Current portion (5,704)





(e) (Continued)

(Note X)The following is a schedule of future minimum payments under finance lease expiring December 31, 2013, together with the present balance of the obligation under the lease.

2012 2011 Amounts due in 2012 $7,440Amounts due in 2013 $10,940 10,940

10,940 18,380Amount representing executory costs (240) (480)Amount representing interest (774) (2,270)Balance of obligation $9,926 $15,630

From lease amortization schedule:Balance at December 31 $9,828 $15,475Add accrued interest 98 155Balance $9,926 $15,630

Hunter Ltd. Income Statement

For the Year Ended December 31,

2012 2011Administrative expense

Depreciation expense $5,730 $5,730Insurance expense 240 240

Other expensesInterest expense* 1,497 2,139

* from lease amortization schedule part (c)





(f)December 21, 2013

Interest Expense.............................................. 36 Lease Obligation.............................................. 3,465*Accumulated Depreciation—Leased

Assets................................................... 17,190Loss on Capital Leases................................... 300

Leased Equipment................................... 20,691Cash.......................................................... 300

* rounding $1

(g)Hunter Ltd.

Statement of Cash FlowsFor the Year Ended December 31,

2012 2011Indirect Format:Cash flows from operating activities

Depreciation expense $5,730 $5,730Increase (decrease) in interest payable (57)* 155

Financing Activities:Lease payment ** (5,646) (5,216)

* ($155 – $98)** from lease amortization schedule part (c)

In the notes to the financial statements:Non-cash Investing and Financing Activities:Purchase of truck with lease $20,691

D irect Format: Cash flows from operating activities

Cash paid for interest ($1,554) ($1,984)Cash paid for insurance (240) (240)




PROBLEM 20-4

(a)January 1, 2011

Lease Payments Receivable......................... 25,100Equipment............................................... 20,691Unearned Interest Income—Leases...... 4,409

Cash............................................................... 620Insurance Expense................................. 20Lease Payments Receivable.................. 600

December 31, 2011Unearned Interest Income—Leases.............. 1,984

Interest Income—Leases....................... 1,984

Interest Receivable.......................................... 155Interest Income—Leases......................... 155

(b)Situ Ltd.

Income StatementFor the Year Ended December 31,

2012 2011Revenue

Interest Income—Leases* $1,497 $2,139

Other expenses(Recovery) of insurance expense (240) (240)

* from lease amortization schedule part (c) of P20-2





(b) (Continued)

Situ Ltd.Balance sheetDecember 31,

2012 2011 Current assets

Interest receivable $98 $155Net investment in leases 9,828 5,647

Non-current assetsNet investment in leases 9,828

Balance. $9,926 $15,630

Net investment in lease : 2012 2011 Beginning balance........................................... 15,475 20,691Less recovery in year (see table P20-3)........ (5,647) (5,216)Ending balance................................................ $9,828 15,475Recoverable within 12 months....................... (5,647)Non-current portion of net investment.......... $9,828

Reconciliation of balance:From lease amortization schedule P20-3:

Balance at December 31 $9,828 $15,475Add accrued interest 98 155Balance $9,926 $15,630





(c)Situ Ltd.

Statement of Cash FlowsFor the Year Ended December 31,

2012 2011Indirect Format:Cash flows from operating activities

(Increase) decrease in interest receivable $57 ($155)

Investing Activities:Collected on finance lease* 5,646 5,216Increase in finance lease (net) (20,691)

D irect Format: Cash flows from operating activitiesCash collected for interest** $1,554 $1,984Cash collected for insurance expense 240 240

* Amounts are the same as Cash paid on finance lease – financing activity of Hunter Ltd. P20-3 part (g)

** Amounts are the same as Cash paid for interest – operating activity of Hunter Ltd. P20-3 part (g)




PROBLEM 20-5

(a) This is a capital lease to Labonté since the lease term is greater than 75% of the economic life of the leased asset. The lease term is 78% (7 ÷ 9) of the asset’s economic life.

For LePage, the collectibility of the lease payments is not reasonably predictable, and there are important uncertainties surrounding the costs yet to be incurred. Accordingly, the earnings process is not considered complete and, in spite of the fact that the fair value ($560,000) of the equipment exceeds the lessor’s cost ($420,000), the lease cannot be recorded as a sales-type lease by LePage and must be recorded as an operating lease.

(b) Calculation of annual rental payment:

To calculate the amount of the payments using Tables:

= $110,759

**Present value of $1 at 15% for 7 periods.**Present value of an annuity due at 15% for 7 periods.


Using a financial calculator:PV $ (560,000.00)I 15%N 7 PMT $ ? Yields $110,759FV $ 80,000 Type 1





(c)7/15/11 Leased Machinery.......................... 560,000

Lease Obligation..................... 560,000

Lease Obligation.......................... 110,759Cash......................................... 110,759

12/31/11 Depreciation Expense.................... 31,429Accumulated Depreciation..... 31,429

($560,000 - $80,000) ÷ 7 X 5.5/12

Interest Expense............................ 30,885Interest Payable....................... 30,885

($560,000 – $110,759) X .15 X 5.5/12

7/15/12 Lease Obligation............................ 43,373Interest Expense*........................... 36,501Interest Payable.............................. 30,885

Cash......................................... 110,759 *($560,000 – $110,759) X .15 X 6.5/12


($560,000 - $80,000) ÷ 7

Interest Expense............................ 27,903Interest Payable....................... 27,903

[($560,000 – $110,759 – $43,373) X .15 X 5.5/12]





(e)7/15/11 Machinery Leased to Others......... 420,000

Inventory.................................. 420,000

Cash............................................... 110,759Unearned Rental Income........ 110,759

Legal Fees Expense*.................... 4,000Cash......................................... 4,000

12/31/11 Unearned Rental Income............... 50,765Rental Income.......................... 50,765

($110,759 X 5.5/12)

Depreciation Expense.................... 22,262Accumulated Depreciation..... 22,262

($420,000 - $80,000) ÷ 7 X 5.5/12


($110,759 X 6.5/12)

Cash............................................... 110,759Unearned Rental Income........ 110,759


($420,000 - $80,000) ÷ 7


($110,759 X 6.5/12)

* If the amounts are significant, these costs might be capitalized and amortized to expense to achieve better matching with revenues.





(d) (f)Labonté LePageCapital Operating Lease Lease

Balance sheet:Property Plant & Equipment:Machinery under capital lease $560,000 Machinery leased to others $ 420,000 Less: Accumulated depreciation (31,429) (22,262)

528,571 397,738 Current Liabilities:Interest payable 30,885 Current portion of lease obligation 43,373 Unearned rental income 59,994

Long term liabilities:Lease obligation 449,241 Less: Current portion (43,373)

405,868

Statement of income:Rental income $ 50,765 Depreciation expense $ 31,429 22,262 Interest expense 30,885 Legal fees expense 4,000





(g) Although it might seem odd that the same asset is reported on two different balance sheets, the collection risks under which the lessor, LePage, is operating do not justify the recognition of income under a sales type lease. There are too many uncertainties surrounding the related costs and collections under the terms of its lease with Labonté. Should Labonté default on the lease, LePage might have to rent the used machinery to another lessee. It is not unreasonable, also, to consider that the “guarantee” of the residual value by the lease, Labonté, should not be considered in the calculations (e.g. for depreciation) as that company’s financial situation may make them unable to “make good” on the guarantee.




PROBLEM 20-6

(a)Under IFRS, meeting any one or a combination of the following criteria normally indicates that the risks and rewards of ownership are transferred to the lessee, and supports classification as a finance lease:

1. There is reasonable assurance that the lessee will obtain ownership of the leased property by the end of the lease term. If there is a bargain purchase option in the lease, it is assumed that the lessee will exercise it and obtain ownership of the asset.



4. The leased assets are so specialized that, without major modification and/or significant cost to the lessor they are of use only to the lessee.

None of these conditions have been met and so the lease is an operating lease to both Synergetics and Gumowski.

(b)Under private enterprise GAAP, the lease is an operating lease to the lessee and lessor because:

1. it does not transfer ownership, or it does not contain a bargain purchase option,

2. it does not cover at least 75% of the estimated economic life of the crane, and

3. the present value of the lease payments is not at least 90% of the fair value of the leased crane.





$21,500 Annual Lease Payments X PV of annuity due at 7% for 6 years $21,500 X 5.10020 = $109,654, which is less than $144,000.00 (90% X $160,000.00)

At least one of the three criteria would have had to be satisfied for the lease to be classified as other than an operating lease. The property is recorded as a rental property to the lessor and will be treated as a payment of rent by the lessee under the operating lease.

(c) Lessee’s EntriesFebruary 1, 2011Prepaid Rent Expense............................... 21,500

Cash..................................................... 21,500

December 31, 2011Rent Expense............................................. 19,708

Prepaid Rent Expense........................ 19,708($21,500 X 11/12)

Lessor’s EntriesFebruary 1, 2011Cash................................................................ 21,500

Unearned Rental Income....................... 21,500

February 1, 2011Prepaid Insurance Expense ($450 X 1/12)... 38 Insurance Expense ($450 X 11/12)............... 412Tax Expense (leased property)..................... 200Prepaid Maintenance Expense ($1,200 X 1/12) 100Maintenance Expense ($1,200 X 11/12).... 1,100

Cash or Accounts Payable.................... 1,850





December 31, 2011Unearned Rental Income........................... 19,708

Rental income..................................... 19,708($21,500 X 11/12)

Depreciation Expense........................ 10,694 Accumulated Depreciation—Crane 10,694 [($160,000 – $20,000) ÷ 12 X 11/12]

(d) Gumowski Construction as lessee must disclose in the income statement the $19,708 of rent expense and in the notes the future minimum rental payments required as of January 1 (in total, $86,000) and for each of the succeeding four years: 2012—$21,500; 2013—$21,500; 2014—$21,500; 2015—$21,500. Additional disclosures are required about material lease arrangements including contingent rents, sub-lease payments and lease-imposed restrictions. No information regarding this lease would appear on the lessee’s balance sheet.

Synergetics Inc. as lessor must disclose in the balance sheet or in the notes the cost of the leased crane ($160,000) and the accumulated depreciation of $10,694 separately from assets not leased. Additionally, Synergetics may disclose in the notes the minimum future rental revenues as a total of $86,000, and for each of the succeeding four years: 2012—$21,500; 2013—$21,500; 2014—$21,500; 2015—$21,500.




PROBLEM 20-7

(a) Benefits of ownership are the ability to use the asset to generate profits over its useful life, to benefit from any appreciation in the asset’s value, and to realize its residual value at the end of its economic life. The risks, on the other hand, are the exposure to uncertain costs and returns, and to risk of loss from use or idle capacity and from technological obsolescence.

The IFRS criteria use qualitative factors to establish whether or not the risks and rewards of ownership are transferred to the lessee, and supports classification as a finance lease:1. There is reasonable assurance that the lessee will




4. The leased assets are so specialized that, without major modification at significant cost to the lessor, they are of use only to the lessee.

No numerical thresholds are applied, as is the case with PE GAAP, and so the treatment of the lease by the lessee would be the same, although it would be referred to as a finance lease, rather than a capital lease.





(b) The conditions of the lease lead us to conclude that the risks and benefits of ownership have passed from the lessor to the lessee. Evidence of this includes the bargain purchase option of $44,440 compared to the residual value, which is estimated at $100,000 and will never fall below $75,000. This fact taken with the fact that the lease term is 10 of the 15 years of the useful life of the airplane, it would be foolish for Ramey not to exercise the option to purchase the plane. Airplanes, when properly maintained, retain their value. Since Ramey is already paying for the maintenance, it will benefit from this investment in the increased resale value of the airplane once the bargain purchase option is exercised. Ramey will consequently benefit from any appreciation in value of this asset, beyond the term of the lease.

(c) The appropriate amount for the leased aircraft on Ramey

Corporation’s balance sheet after the lease is signed is $1,000,000, the fair market value of the plane. In this case, fair market value is less than the present value of the net rental payments plus purchase option ($1,019,061). When this occurs, the asset is recorded at the fair market value.

(d) The leased aircraft will be reflected on Ramey Corporation’s balance sheet as follows:

Noncurrent assetsLeased property $1,000,000

Less accumulated depreciation 59,300$ 940,700

Current liabilitiesLease obligation (Note A):

Interest payable $ 74,623Principal – current portion 60,180

Non-current liabilitiesLease obligation (Note A) $ 802,040





The following items relating to the leased aircraft will be reflected on Ramey Corporation’s income statement:

Depreciation expense (Note A) $59,300Interest expense 74,623*Maintenance expense 6,900Insurance and tax expense 4,000

*[($1,000,000 - $137,780) X (9% X 351/365)]

Note AThe company leases a Viking turboprop aircraft under a

capital lease. The lease runs until January 14, 2021. The annual lease payment is paid in advance on January 14 and amounts to $141,780, of which $4,000 is executory costs. The aircraft is being amortized on the straight-line basis over the economic life of the asset, estimated as 15 years. The depreciation on the aircraft included in the current year’s depreciation expense and the accumulated depreciation on the aircraft amount to $59,300.

CalculationsDepreciation expense:

Capitalized amount $1,000,000Residual value 75,000

$ 925,000Economic life 15 yearsAnnual depreciation

$61,667

Depreciation for the first year prorated to 351 days $59,300

Liability amounts:Lease liability 1/14/11 $1,000,000Payment 1/14/11 ($141,780 - $4,000) 137,780Lease liability 12/31/11 862,220Reduction of principal 60,180Non-current liability 12/31/11 $ 802,040




PROBLEM 20-8

(a) 1. Interest expense (See amort. schedule) $10,216Lease executory expense $2,500Depreciation expense ($150,690 ÷ 6) $25,115

2. Property, plant, and equipment:Leased computer $150,690Accumulated depreciation ($25,115)

Current liabilities:Lease obligation $20,284Interest payable $10,216

Long-term liabilities:Lease obligation $99,906

3. Interest expense (See amort. schedule) $8,492Lease executory expense $2,500Depreciation expense ($150,690 ÷ 6) $25,115

4. Property, plant, and equipment:Leased computer $150,690Accumulated depreciation ($50,230)







(b) 1. Interest expense ($10,216 X 3/12 ) $2,554Lease executory expense ($2,500 X 3/12) $625Depreciation expense $6,279

($150,690 ÷ 6 = $25,115 X 3/12)

2. Current assets:Prepaid lease executory costs $1,875

($2,500 X 9/12 = $1,875)

Property, plant, and equipment:Leased computer $150,690Accumulated depreciation ($6,279)



3. Interest expense $9,785[($10,216 – $2,554) + ($8,492 X 3/12) =

$7,662 + [$2,123 = $9,785]Lease executory expense $2,500Depreciation expense ($150,690 ÷ 6) $25,115





4. Current assets:Prepaid lease executory costs $1,875

($2,500 X 9/12 = $1,875)

Property, plant, and equipment:Leased computer $150,690Accumulated depreciation ($31,394)

($6,279 + $25,115 = $31,394)

Current liabilities:Lease obligation $22,008Interest payable ($8,492 X 3/12) $2,123


(c) For McKee Electronics Ltd.—(the lessee):Rather than using quantitative factors such as the 75 percent and the 90 percent hurdles often referred to as the bright lines used in PE GAAP, IFRS criteria use qualitative factors to establish whether or not the risks and rewards of ownership are transferred to the lessee, and supports classification as a finance lease:1. There is reasonable assurance that the lessee will








4. The leased assets are so specialized that, without major modification and cost to the lessor, they are of use only to the lessee.




PROBLEM 20-9

(a) 1. Interest income $10,216

2. Current assets:Lease payments receivable $30,500Unearned interest income (0)Net investment in lease $30,500

Noncurrent assets:Lease payments receivable $122,000

($183,000 – $30,500 – $30,500)Unearned interest income (22,094)($32,310 – $10,216)

Net investment in lease $99,906

3. Interest income $8,492

4. Current assets:Lease payments receivable $30,500Unearned interest income (0)Net investment in lease $30,500


($183,000 – $30,500 – $30,500– $30,500)Unearned interest income (13,602)

($32,310 – $10,216 – $8,492)Net investment in lease $77,898

(b) 1. Interest income ($10,216 X 3/12 = $2,554) $2,554

2. Current assets:Lease payments receivable $30,500Unearned interest income (7,662)

($10,216 – $2,554)Net investment in lease $22,838






($183,000 – $30,500 – $30,500)Unearned interest income (22,094)


3. Interest income $9,785[($10,216 – $2,554) + ($8,492 X 3/12) =$7,662 +$2,123]

4. Current assets:Lease payments receivable $30,500Unearned interest income (6,369)



($183,000 – $30,500 – $30,500 – 30,500)Unearned interest income (13,602)

($32,310 – $10,216 – $8,492)Net investment in lease $77,898

(c) Using IFRS, Woodhouse considers the same factors as McKee, the lessee, in determining whether the risks and benefits of ownership of the leased property are transferred. These factors include:

1. There is reasonable assurance that the lessee will obtain ownership of the leased property by the end of the lease term. If there is a bargain purchase option in the lease, it is assumed that the lessee will exercise it and obtain ownership of the asset.







4. The leased assets are so specialized that, without major modification, and significant cost to the lessor, they are of use only to the lessee.

In this case, the lessee would record the lease as a financing lease, as Woodhouse is not a manufacturer or dealer. Consequently, the lease is a financing lease to Woodhouse.




PROBLEM 20-10

(a) YIN TRUCKING CORPORATIONSchedule to Calculate the Discounted Present Value of

Terminal Facilities and the Related ObligationJanuary 1, 2009

Present value of first 10 payments:Present value of an annuity due for 10 years at 6% ($900,000 X 7.80169) $7,021,521

Present value of last 10 payments:Present value of an annuity due for 10 years at 6% ($320,000 X 7.80169) 2,496,541

Discounted to January 1, 2009 ($2,496,541 X .558395) 1,394,056

Present value of bargain purchase option of ($1,000,000 X .31180) 311,800 Present value of terminal facilities and related obligation $8,727,377

(Note to instructor: For the last ten periods, the present value of an annuity due for 20 periods less the present value of an annuity due for 10 periods can be used as follows: ([12.15812 – 7.80169] X $320,000 = $1,394,056).






Present value of the first ten years of annuity of $900,000 is $7,021,523

Using a financial calculator:PV $ ? Yields $7,021,523.05I 6%N 10 PMT $ (900,000)FV $ 0 Type 1

Present value (at end of first ten years of the next ten year annuity of $320,000 is $2,496,541

Using a financial calculator:PV $ ? Yields $2,496,541I 6%N 10 PMT $ (320,000)FV $ 0 Type 1

Calculate the present value of single amount of $2,496,541 for ten years at 6% and obtain $1,394,056

Using a financial calculator:PV $ ? Yields $1,394,056I 6%N 10 PMT $ 0 FV $ (2,496,541)Type 1





(b) YIN TRUCKING CORPORATIONJournal Entries

2011(1) 1/1/11

Interest Payable............................................. 442,080Lease Obligation........................................... 457,920Property Taxes Expense............................... 125,000Property Insurance Expense...................... 23,000

Cash........................................................ 1,048,000

Partial Amortization Schedule(Annuity Due Basis)

DateLease

PaymentExecutory

CostsInterestat 6%

PrincipalReduction

PrincipalBalance

1/1/091/1/091/1/101/1/111/1/12

—$1,048,000 1,048,000 1,048,000 1,048,000

—$148,000 148,000 148,000 148,000

—$ 0 468,000 442,080

414,605

—$900,000 432,000 457,920 485,395

$8,700,000 7,800,000 7,368,000 6,910,080 6,424,685

(2) 12/31/11Depreciation Expense—Leased Assets...... 217,500

Accumulated Depreciation—Leased Assets................................................. 217,500 (To record annual depreciation expense on leased assets) ($8,700,000 ÷ 40)

(3) 12/31/11Interest Expense............................................. 414,605

Interest Payable...................................... 414,605 (To record interest accrual at 6% on outstanding debt of $6,910,080)





(c) Yin’s balance sheet at December 31, 2011 would show the following:

Property plant and equipmentLeased Terminal $8,700,000Accumulated depreciation 652,500*

8,047,500Current liabilities:Interest payable $442,080Current portion of lease obligation 457,920

Long-term liabilities:Lease obligation 6,910,080

* $217,500 X 3 years




PROBLEM 20-11

(a) The lease should be treated as a capital lease by Lee Industries, requiring the lessee to capitalize the leased asset. The lease qualifies for capital lease accounting by the lessee because: (1) title to the engines transfers to the lessee, (2) the lease term is equal to the estimated life of the asset, and (3) the present value of the minimum lease payments exceeds 90% of the fair value of the leased engines. The transaction represents a purchase financed by instalment payments over a 10-year period.

For Lor Inc. the transaction is a sales-type lease because a manufacturer’s profit accrues to Lor Inc. This lease arrangement also represents the manufacturer’s financing of the transaction over a period of 10 years.

Lease Payment ReceivablePayment per period $ 620,956Periods X 10Lease payments receivable $6,209,560

Present Value of Lease Payments$620,956 X 7.24689* $4,500,000

*Present value of an annuity due at 8% for 10 years.







Unearned Interest IncomeLease payments receivable $6,209,560Less: Present value of lease payments 4,500,000Unearned interest income $1,709,560

Dealer ProfitSales (present value of lease payments) $4,500,000Less cost 3,900,000Profit on sale $ 600,000

(b) Leased Engines.........................................4,500,000Lease Obligation............................... 4,500,000

Lease Obligation..................................... 620,956Cash................................................. 620,956

(c) Lease Payments Receivable.................. 6,209,560Cost of Goods Sold................................ 3,900,000

Sales................................................. 4,500,000Inventory.......................................... 3,900,000Unearned Interest Income—Leases 1,709,560

Cash......................................................... 620,956Lease Payments Receivable.......... 620,956





(d) Lee IndustriesLor Inc.


Date

AnnualLease

Payment/Receipt

InterestIncome/Expense

at 8%

Reductionin PresentValue ofLease

PresentValue ofLease

1/1/111/1/111/1/121/1/13

620,956620,956620,956

310,324285,473

620,956310,632335,483

4,500,0003,879,0443,568,4123,232,929

Lessee (December 31, 2011)Interest Expense..................................... 310,324

Interest Payable.............................. 310,324

Lessor (December 31, 2011)Unearned Interest Income—Leases...... 310,324

Interest Income—Leases................ 310,324

(e) LEE INDUSTRIESBalance sheet

December 31, 2011

Property, plant, and equipment:Property under capital leases $4,500,000Less accumulated depreciation 450,000*

$4,050,000

Current liabilities:Interest payable $ 310,324Obligations under capital leases 310,632***

Long-term liabilities:Obligations under capital leases 3,568,412**

***$4,500,000 ÷ 10 = $450,000*** taken from amortization schedule above





LOR INC.Balance sheet

December 31, 2011

Assets:Current assets:

Net investment in sales-type leases $ 310,632*

Noncurrent assets:Net investment in sales-type leases $3,568,412

*

* from amortization schedule

(f) The transaction securing the equipment using the capital lease would not be reported on the statement of cash flows for the year ending December 31, 2011 of Lee, the lessee. This is a non-cash financing and investing transaction to Lee. These transactions would be described in the notes to the respective financial statements. The only cash transaction between the parties during 2011 is the January 1, 2011 lease payment in the amount of $620,956. This transaction is an operating activity inflow to Lor and is a financing outflow to Lee. For Lee, the annual depreciation for 2011 would be an adjustment to determine cash flow from operations under the indirect approach. For Lor, the operating cash flows would be included in the adjustments to net income under the indirect approach and would be shown as part of cash collected from customers under the direct approach.





(g) Note X: (on Lee’s financial statements:)The following is a schedule of future minimum lease payments under the capital lease expiring December 31, 2020 together with the balance of the obligation under capital lease.

Year ending December 312012 $620,9562013 620,9562014 620,9562015 620,9562016 620,9562017 and beyond 2,483,824

Total minimum lease payments 5,588,604Less amount representing interest at 8% 1,709,560Balance of the obligation $3,879,044

(h) Note Y: (on Lor’s financial statements:)The company's future minimum lease payments receivable under the sales-type lease and the net investment in lease are as follows:

Year ending December 312012 $620,9562013 620,9562014 620,9562015 620,9562016 620,9562017 and beyond 2,483,824

Total minimum lease payments receivable $5,588,604Unearned income 1,709,560Net investment in lease $3,879,044




PROBLEM 20-12

(a) January 31, 2011

Leased Equipment...................................... 173,448Lease Obligation.................................. 173,448(To record leased asset and related obligation)

PV of monthly payment of $41,000 X 4.16987*...............$170,964PV of residual value of $4,000 X .62092**..................... 2,484 Present value of minimum lease payments...................$ 173,448 * (PV factor for annuity due for 5 years at 10%)** (PV factor for $1 for 5 years at 10%)


Using a financial calculator:PV $ ? Yields $ 173,448.17I 10%N 5 PMT $ (41,000)FV $ (4,000)Type 1

January 31, 2011Lease Obligation......................................... 41,000

Cash...................................................... 41,000 (To record the first rental payment)

(b) December 31, 2011Depreciation Expense................................. 22,713

Accumulated Depreciation—Leased Equipment........................................ 22,713 (To record depreciation of the leased asset based upon a cost to Dubois of $173,448 and a life of 7 years X 11/ 12)





December 31, 2011Interest Expense................................................. 12,141

Interest Payable........................................... 12,141(To record accrual of interest on lease obligation $13,245 X 11 / 12)

January 31, 2012Interest Payable.................................................. 12,141Interest Expense................................................. 1,104Lease Obligation................................................. 27,755

Cash............................................................. 41,000(To record annual payment on lease obligation)

During yearProperty Tax Expense....................................... XXXInsurance Expense............................................ XXXMaintenance Expense...................................... XXX

Cash............................................................. XXX(To record payment for executory costs)

Dubois Steel Corporation (Lessee)Lease Amortization Schedule

(Annuity Due Basis)

Date

AnnualLease

Payment


Reductionof Lease

Obligation

Balanceof Lease

Obligation

1/31/111/31/111/31/121/31/131/31/141/31/15

—$41,000 41,000 41,000 41,000 41,000

—$ 0 13,245

10,469 7,416 4,058

—$41,000 27,755 30,531 33,584 36,942

$173,448 132,448

104,693 74,162 40,578 3,636

1/31/16 4,000 364* 3,636* rounded





(c) December 31, 2012Depreciation Expense..................................... 24,778

Accumulated Depreciation—Leased Equipment............................................. 24,778 (To record annual depreciation

on assets leased $173,448 ÷ 7)

December 31, 2012Interest Expense.............................................. 9,597

Interest Payable....................................... 9,597(To record accrual of interest on lease obligation $10,469 X 11 ÷ 12)

January 31, 2013Interest Payable.................................................. 9,597Interest Expense................................................. 872Lease Obligation................................................. 30,531

Cash............................................................. 41,000(To record annual payment on lease obligation)

(d) Dubois Steel CorporationBalance Sheet

December 31, 2012

Property, plant, and equipment:Leased equipment $173,448Less: Accumulated

depreciation 47,491 $125,957

Current liabilities:Interest payable $9,597Lease obligation 30,531

Long-term:Lease obligation 74,162





(e) The transaction securing the equipment using the finance lease would not be reported on the statement of cash flows for the year ending December 31, 2011. This is non-cash investing transaction, which should be described in the notes to the financial statements. The first lease payment would appear as a cash outflow for the debt repayment in the financing activities section of the statement.

When using the direct method, for the operating activities of the cash flow statement, no amounts need to appear. On the other hand using the indirect method, adjustments to net income would include the adding back of depreciation expense in the amount of $22,713 and the increase in the interest payable in the amount of $9,597.

(f) Based on these new facts, the lease would be reported as an operating lease by Dubois as the risks and rewards of ownership are not transferred to the lessee.

Consequently, no balances would appear on the balance sheet of Dubois at December 31, 2012. No amount would appear on the statement of cash flows as the amount of rent expense would correspond to the lease payment made of $41,000.




PROBLEM 20-13

(a) The lease is a sales-type lease because: (1) the lease term exceeds 75% of the asset’s estimated economic life, (2) collectability of payments is reasonably assured and there are no further costs to be incurred, and (3) CHL Corporation realized an element of profit aside from the financing charge.

1. Gross investment is $265,000 (10 annual lease payments of $25,000 each, plus the unguaranteed residual value of $15,000).

2. Unearned interest income, $76,880, is the gross investment of $265,000 less $188,120, the fair market value of the asset and the initial present value of the investment, calculated as follows:

Annual lease payment $ 25,000 Present value of an annuity due of $1 for 10 periods discounted at 8% 7.24689

Present value of the 10 rental payments 181,172Add present value of estimated residual value of $15,000 in 10 years at 8% ($15,000 X .46319) 6,948Initial present value $188,120


Using a financial calculator:PV $ ? Yields $188,120I 8%N 10 PMT $ (25,000)FV $ (15,000)Type 1





3. Sales price is $181,172 (the present value of the 10 annual lease payments); i.e. the initial PV of $188,120 minus the PV of the unguaranteed residual value of $6,948.

4. Cost of sales is $98,052 (the $105,000 cost of the asset less the present value of the unguaranteed residual value of $6,948).

(b) CHL CORPORATION (Lessor)Lease Amortization Schedule

Annuity Due Basis, Unguaranteed Residual Value

Beginningof Year

Annual LeasePayment Plus

Residual Value



NetInvestment

Initial PV12345678910

End of 10

(a)—

$ 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 15,000$265,000

(b)——

*$ 13,050** 12,094** 11,061** 9,946** 8,742** 7,441*

* 6,036** 4,519** 2,881** 1,110**$76,880*

(c)—

$ 25,000 11,952 12,906 13,939 15,054 16,258 17,559 18,964 20,481 22,119 13,890$188,120

(d)$188,120 163,120 151,170 138,264 124,325 109,271

93,013 75,454 56,490 36,009 13,890 0

*Rounding error is $1.

(a) Annual lease payment required by lease contract.(b) Preceding balance of (d) X 8%, except beginning of first

year of lease term.(c) (a) minus (b).(d) Preceding balance minus (c).





(c) Beginning of Lease Year 1Lease Payments Receivable............................. 265,000Cost of Sales...................................................... 98,052

Sales............................................................ 181,172Inventory..................................................... 105,000Unearned Interest Income—Leases......... 76,880 (To record the sale and the cost of sales in the lease transaction)

Selling Expense................................................. 7,000Cash............................................................ 7,000 (To record payment of the initial direct costs relating to the lease)

Cash.................................................................... 25,000Lease Payments Receivable...... ............... 25,000 (To record receipt of the first lease payment)

End of the Year – 5 months after signing leaseUnearned Interest Income—Leases................. 5,438

Interest Income—Leases........... ......5,438 (To record interest earned during the first year of the lease $13,050 X 5/12)





(d) The balance of the net investment should be the net investment of $163,120 plus the interest earned to the end of the year of $5,438, for a total of $168,558. This should be reported as follows:Current portion $17,388*Non-current portion 151,170**Total ($188,120 – $25,000 + $5,438) $168,558

* Lease payment receivable $25,000Less unearned payment ($13,050 – $5,438) 7,612Current Portion $17,388

** Non-current:Total lease payments receivable $215,000Less unearned ($76,880 – $13,050) 63,830

$151,170

(e) Assuming the $15,000 residual value was guaranteed by the lessee, this would change the initial entry for the sale to be as follows:

Lease Payments Receivable............................. 265,000Cost of Sales...................................................... 105,000

Sales............................................................ 188,120Inventory..................................................... 105,000Unearned Interest Income—Leases......... 76,880

The sales and cost of goods sold would not need to be reduced by the present value of the estimated residual value calculated in part (a) of $6,948.




PROBLEM 20-14

(a) For the lessee under PE GAAP, rather than using quantitative factors described under part (b) below for IFRS, quantitative criteria such as:

1. the term of the lease exceeding 75% of the remaining economic life of the asset,

2. the present value of the minimum lease payments exceeding 90% of the fair value of the asset, or

3. the presence of a bargain purchase option will be applied as the basis for the classification of the lease.

(b) It will be classified as a direct financing lease for Provincial Airlines Corp. because:

(1) the lease term is 75% or more of the asset’s economic life and (2) the present value of the minimum lease payments exceeds 90% of the fair value of the leased asset.

(c) The IFRS criteria use qualitative factors to establish whether or not the risks and rewards of ownership are transferred to the lessee, and supports classification as a finance lease:1. There is reasonable assurance that the lessee will





The lease would be classified as a finance lease.





(d) Initial Obligation Under Capital Leases:Minimum lease payments ($25,000) X PV of an annuity due for 10 periods at 8% (7.24689) $181,172



(e) Provincial Airlines Corp. (Lessee)Lease Amortization Schedule(Annuity due basis and URV)

Beginningof Year

AnnualLease

Payment


Reductionof Lease

ObligationLease

Obligation

Initial PV123456789

10

(a)—

$25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000

$250,000

(b)——

*$12,494** 11,493** 10,413** 9,246** 7,985*

* 6,624** 5,154** 3,566** 1,853**$68,828*

(c)—

$ 25,000 12,506 13,507 14,589 15,754 17,015 18,376 19,846 21,434 23,147$181,172

(d)$181,172 156,172 143,666 130,159 115,572

99,818 82,803 64,427 44,581 23,147 0






(a) Annual lease payment required by lease contract.(b) Preceding balance of (d) X 8%, except beginning of first

year of lease term.(c) (a) minus (b).(d) Preceding balance minus (c).

(f) Lessee’s journal entries:

Beginning of the YearLeased Equipment........................................... 181,172

Lease Obligation...................................... 181,172 (To record the lease of equipment using capital lease method)

Lease Obligation.............................................. 25,000Cash.......................................................... 25,000 (To record the first rental payment)

End of the YearInterest Expense.............................................. 12,494

Interest Payable....................................... 12,494 (To record accrual of annual interest on

lease obligation)

Depreciation Expense..................................... 18,117Accumulated Depreciation—Leased Equipment............................................. 18,117 (To record depreciation expense for first year [$181,172 ÷ 10])





(g) Refer to the calculations and table of P20-13 for the amounts using the guaranteed residual value in the calculations of payments made by the lessee Provincial Airlines Corp.






lease obligation)

Depreciation Expense..................................... 17,312Accumulated Depreciation—Leased Equipment............................................. 17,312 (To record depreciation expense for first year [$188,120 - $15,000 ÷ 10])





(h) The residual value of $45,000 will not be included in calculation of the present value of the minimum lease payments. Rather, the bargain purchase option of $15,000 will be the future outflow in the calculations below. The bargain purchase option will permit depreciation of the equipment over its economic life of 12 years.

Excel formula =PV(rate,nper,pmt,fv,type)Using a financial calculator:PV $ ? Yields $188,120I 8%N 10 PMT $ (25,000)FV $ (15,000) Type 1






lease obligation)[($188,120 - $25,000) X 8%]

Depreciation Expense..................................... 15,677Accumulated Depreciation—Leased Equipment............................................. 15,677 (To record depreciation expense for first year [$188,120 ÷ 12])




PROBLEM 20-15

(a) Jennings, the lessor, considers the same factors as SNC Medical, the lessee, in determining whether the risks and benefits of ownership of the leased property are transferred. These factors include:1. There is reasonable assurance that the lessee will

obtain ownership of the leased property, including through a bargain purchase option.

2. The lessee will benefit from most of the asset use due to the length of the lease term which is substantially all of the leased property's economic life.

3. The lessor recovers substantially all of its investment and earns a return on that investment

Jennings is a manufacturer and consequently the signing of the lease involves the sale of inventory and the financing of their customer’s purchase. The lease is therefore a manufacturer or dealer lease to Jennings.

Present value of minimum lease payments:

1. Present value of annual payments of $50,000 made at the beginning of each period for 10 years, $50,000 X 6.75902

(PV of an annuity due at 10%) $337,951

2. Present value of guaranteed residual value, $15,000 X .38554 (PV of $1, 10 years at 10%) 5,783

Present value of minimum lease payments $343,734






Using a financial calculator:PV $ ? Yields $343,734I 10%N 10 PMT $ (50,000)FV $ (15,000)Type 1

1. Gross investment:Lease payments of $50,000 made at the beginning of each year for 10 years $500,000Guaranteed residual value due at the end of 10 years 15,000

Gross investment $515,000

2. Unearned interest income:Gross investment $515,000Less: Fair market value of the X-ray

machine 343,734Unearned interest income $171,266

3. Sales price is the same as the present value of minimum lease payments $343,734

4. Cost of sales is the cost of manufacturing the X-ray machine $210,000





(b) JENNINGS INC. (Lessor)Lease Amortization Schedule

(Annuity due basis, guaranteed residual value)

Beginningof Year

Annual LeasePayment Plus

Residual Value



NetInvestment

Initial PV12345678910

End of 10

$ 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 15,000$515,000

—*$ 29,373** 27,311** 25,042** 22,546** 19,801** 16,781** 13,459** 9,805** 5,785** 1,363**$171,266*

$ 50,000 20,627 22,689 24,958 27,454 30,199 33,219 36,541 40,195 44,215 13,637$343,734

$343,734 293,734 273,107 250,418 225,460 198,006 167,807 134,588 98,047 57,852 13,637 0


(c) Lessor’s journal entries:

Beginning of the YearLease Payments Receivable............................. 515,000Cost of Sales...................................................... 210,000

Sales............................................................ 343,734X-ray Machine Inventory............................ 210,000Unearned Interest Income—Leases......... 171,266 (To record the sale and the cost of sales in the lease transaction)

Selling Expense.................................................. 14,000Cash/Payable............................................... 14,000 (To record the incurrence of initial direct costs relating to the lease)





Cash..................................................................... 50,000Lease Payments Receivable...................... 50,000 (To record receipt of the first lease payment)

End of the YearUnearned Interest Income—Leases.................. 29,373

Interest Income—Leases............................ 29,373 (To record interest earned during the first year of the lease)

(d) At December 31, the end of the first year of the lease, Jennings Inc. will report on the income statement the sales amount of $343,734 and cost of sales of $210,000, indicating gross profit from the sale of the X-ray equipment in the amount of $133,734. They will also report the interest income on the lease of $29,373 and selling expenses of $14,000.The balance sheet would report the current portion of the lease payments receivable of $50,000 and the non-current portion of $415,000, reduced by the current portion of the unearned interest income on the lease in the amount of $27,311 and the non-current portion for $114,582.For the statement of cash flows, using the indirect format for the cash flow from operations, there will be an adjustment of an addition to income for the reduction of inventory of $210,000 and an addition for the net increase in unearned income of $141,893 ($171,266 – $29,373). For investing activities the statement will show a net increase in lease payments receivable of $465,000 ($515,000 – $50,000).For the note disclosure, the list of required and desirable disclosures include: the total future minimum lease payments receivable, unguaranteed residual values, unearned finance income, executory costs included in minimum lease payments, contingent rentals taken into





income, lease terms, and the amounts of minimum lease payments receivable for each of the next five years.

(e) Since the implicit rate in the lease of 10% is known to the lessee, SNC Medical Centre, the interest rate used by SNC will be the same as that of the lessor, Jennings Inc. Consequently, the machinery will be capitalized at the amount of $343,734, the present value of the minimum lease payments as calculated in (a) above. The depreciation of the machinery will be based on the term of the lease as SNC has guaranteed the residual value. The depreciation expense will therefore be $32,873 (($343,734 - $15,000) / 10 years).

(f) Had the residual value of the X-ray machine not been guaranteed, the amount of the sale and the cost of goods sold recorded would have been reduced by the present value of the residual value in the amount of $5,783 ($15,000 X .38554 for PV of $1, for 10 years at 10%).


Using a financial calculator:PV $ ? Yields $5,783I 10%N 10 PMT $ 0 FV $ 15,000 Type 1





From the perspective of the lessor, the entries concerning the recording of the lease payments receivable do not change, except as noted above since the lessor assumes that they will recover the residual value whether that amount is guaranteed by the lessee or not. Consequently the amount of interest accrued at the end of the year will be the same amount as given in (c). The financial statements of the lessor remain unaffected with the exception of the reduction of $5,783 for the sales and cost of goods sold amounts on the income statement.

From the perspective of the lessee, the amount used to capitalize the machinery will exclude the residual value, since the lessee does not guarantee that amount. Using the same variables as in (a) above but excluding the residual value yields an amount of $337,951. The depreciation expense will therefore be $33,795 ($337,951 / 10 years).

(g) Had Jennings been using private enterprise GAAP, quantitative factors would apply. The lease is a sales-type lease because: (1) the lease term is for 83% (10 ÷ 12) of the economic life of the leased asset, (2) the present value of the minimum lease payments exceeds 90% of the fair market value of the leased property, (3) the collectability of the lease payments is reasonably predictable and no uncertainties exist as to unreimbursable costs yet to be incurred by the lessor, and (4) the lease provides the lessor with manufacturer’s profit in addition to interest income.




PROBLEM 20-16

(a) Green Finance Corporation, the lessor, considers the same factors as Lanier Dairy Ltd., the lessee, in determining whether the risks and benefits of ownership of the leased property are transferred. These factors include: There is reasonable assurance that the lessee will




The leased assets are so specialized that, without major modification and significant cost to the lessor they are of use only to the lessee.

In this case, Lanier Dairy Ltd., the lessee, would record the lease as a financing lease. Green Finance Corporation is not a manufacturer or dealer and consequently the lease is a finance lease to Green Finance Corporation.

(b) May 30, 2011Lessee:Leased Equipment......................................... 211,902

Lease Obligation..................................... 211,902 $30,000 X 6.58238* = $197,471.40) ($23,000 X .62741** = 14,430.43)

= $211,901.83* PV factor of annuity due at 6% for 8 years




** PV factor of $1 at 6% for 8 years






Using a financial calculator:PV $ ? Yields $211,901.93I 6%N 8 PMT $ (30,000)FV $ (23,000)Type 1

Lease Obligation............................................ 30,000Cash......................................................... 30,000

May 30, 2011 Lessor:Lease Payments Receivable......................... 263,000

Equipment............................................... 211,902Unearned Interest Income—Leases...... 51,098 ($263,000 = 8 X $30,000; add $23,000 for residual value)

Cash................................................................. 30,000Lease Payments Receivable.................. 30,000

December 31, 2011Lessee:Interest Expense............................................. 6,367

Interest Payable...................................... 6,367 [($211,902 – $30,000) X .06 X 7/12]

Depreciation Expense.................................... 13,774Accumulated Depreciation.................... 13,774 [($211,902 – $23,000) ÷ 8 X 7/12]





December 31, 2011Lessor:Unearned Interest Income—Leases.............. 6,367


(c) May 30, 2012Lessee:Lease Obligation............................................ 19,086Interest Expense............................................. 4,547*Interest Payable.............................................. 6,367

Cash......................................................... 30,000

*[($211,902 – $30,000) X .06 X 5/12]

Depreciation Expense.................................... 9,839Accumulated Depreciation.................... 9,839 [($211,902 – $23,000) ÷ 8 X 5/12]

Lessor:Unearned Interest Income—Leases.............. 4,547


Cash................................................................. 25,250Lease Payments Receivable................. 25,250

(d) (1) and (2) are both $197,471, as the lessee has no obligation to pay the residual value.

Using a financial calculator:PV $ ? Yields $197,471.44I 6%N 8 PMT $ (30,000)FV $ 0 Type 1





(e) In the case of (1) the amount of the net investment at the inception of the lease would be $211,902 + $1,200 or $213,102. For (2) and (3) both would be $211,902, as the estimated residual value exists whether or not it is guaranteed.

(f) Since 90% of $197,471 is $177,724, the difference of $19,747 is the present value of the residual amount. The future value of $19,747 for n = 8, i = .06 is $31,474 ($19,747 X 1.59385). Therefore, the residual value would have had to be greater than $31,474.

(g) Had Green been using private enterprise GAAP:

The lease agreement satisfies both the 75% and 90% quantitative requirements, collectability is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. For Lanier Dairy Ltd., the lessee, it is a capital lease, and for Green Finance Corporation, the lessor, it is a direct financing lease (since cost equals fair value).




PROBLEM 20-17

Memorandum Prepared by: (Your Initials)Date:

Fram Fibreglass Corp. (FFC)Assessing Leasing Proposals

Industrial Development Bank (IDB) vs.Municipal Finance Corp. (MFC)

The purpose of this memorandum is to outline the analysis and recommendations concerning leasing alternatives obtained from IDB and MFC.

The objective is to lease equipment with a current selling price of $50,000 for a term of 5 years. Both proposals require that the equipment be returned to the lessor at the end of the term. Both lease terms start and end at approximately the same dates. The terms of the leases differ in other respects, which will result in alternate accounting treatments on the books of FFC.

MFC – proposal:To FFC, this lease is a capital lease because the terms satisfy the following criteria:

1. The present value of the minimum lease payments is slightly greater than 90% of the fair value of the leased asset; that is, the present value of $45,030 (see below) is 90.1% of the fair value of the leased asset ($45,030 / $50,000).

2. The lease fails in the second criteria concerning the presence of a bargain purchase option.

3. The lease also fails the third capitalization criteria in that the lease term is not greater than 75% of the economic life of the leased asset; that is, the lease term is 71% (5/7) of the economic life of the equipment.

Note that in this case, since there is no interest rate mentioned in the lease proposal, FFC must impute the company’s incremental borrowing rate of 15%.





Using a financial calculator:PV $ ? Yields $ 45,030I 15%N 5 PMT $ (11,681)FV $ 0 Type 1

IDB - proposal:IDB is providing an operating lease to FFC since the lease term (5 years) is less than 75% of the economic life (7 years) of the leased asset. The lease term is 71.4% (5 ÷ 7) of the asset’s economic life. There is no bargain purchase option and the present value of minimum lease payments of $44,330 (see below) represents 88.7% of the fair value at April 23, 2011 of $50,000 falling short of the criteria of 90% to treat the lease as a capital lease.

Using a financial calculator:PV $ ? Yields $ 44,330I 12%N 5 PMT $ (10,980)*FV $ 0 Type 1

* Rental payment of $12,000 less $1,020 in executory costs.





Let us contrast the charges to the income statement for a typical lease year as well as look at the cash outflows and balance sheet balances at the end of the first lease year. The table below assumes a 12 month period from the inception of the lease to eliminate any differences caused by different start dates.

MFC IDBCapital Operating Lease Lease

Balance sheet:Property Plant & Equipment:Leased machinery $ 45,030 Less: Accumulated depreciation (9,006) (1)

36,024 Current LiabilitiesInterest payable 5,002 (2)Current portion of lease obligation 6,679 (3)

Long term liabilitiesLease obligation 33,349 (4)Less: Current portion (6,679) (3)

26,670

Statement of income:Rent expense $ 10,980 Depreciation expense $ 9,006 Interest expense 5,002 Executory costs 300 1,020

$ 14,308 $ 12,000

Statement of cash flows:Cash paid for lease $ (11,981) $ (12,000)

(1) $45,030 / 5 (2), (3), and (4) – See Amortization schedulePROBLEM 20-17 (Continued)




MFC LeaseLease Amortization Schedule

Yr.

Annual Pmt.

Excl.Exec. Costs

Interest (15%)

on UnpaidObligation

Reduction

of LeaseObligation

Balance

of LeaseObligation

45,030.00 1 11,681.00 11,681.00 33,349.00 (4)

2 11,681.00 5,002.35 (2) 6,678.65 (3) 26,670.35 3 11,681.00 4,000.55 7,680.45 18,989.90 4 11,681.00 2,848.49 8,832.51 10,157.39 5 11,681.00 1,523.61 10,157.39 (0.00)

Based on the analysis above, my recommendation is for FFC to choose the operating lease with IDB because:

1. Although the cash outflows are practically identical, the charges to the income statement are 19% lower with the operating lease.

2. Given the current financial situation of FFC concerning liquidity, the capital lease would adversely affect the current ratio.

3. Additional debt on the balance sheet will not be viewed well by FFC’s creditors if the capital lease alternative offered by MFC were selected. Choosing this alternative would be violating the stipulation of Royal Montreal Bank that FFC not increase the debt-to-equity ratio above the current levels.

Note to Instructor: Some students will treat this as a capital budgeting problem and compare the present value of the cash flows of the two alternatives. It may be useful when assigning the problem to remind the students to write the report based on financial reporting considerations.




PROBLEM 20-18

(a) For the purpose of calculating the lease payment that will yield a 12% return to Galt, the residual value guaranteed by a third party will be included in the calculations below:


(b)Galt Manufacturing Ltd. (Lessor)


Date

AnnualLease

PaymentPlus RV



Balanceof Net

Investment

5/2/115/2/115/2/125/2/135/2/145/2/155/2/165/2/175/2/18

$ 72,341 72,341 72,341 72,341 72,341 72,341 72,341 100,000 $606,387

$41,119 37,372 33,176 28,476

23,21317,317 10,714

$191,387

$ 72,341 31,222 34,969 39,165 43,865 49,128

55,024 89,286

$415,000

$415,000 342,659 311,437 276,468 237,303

193,438 144,310

89,286 0




PROBLEM 20-18 (Continued)(c)

5/2/11 Lease Payments Receivable*..............606,387Cost of Goods Sold.............................327,500

Sales............................................ 415,000Inventory...................................... 327,500Unearned Interest Income— Leases...................................... 191,387* ($72,341 X 7) +$100,000


12/31/11 Unearned Interest Income— Leases...................................... 27,413Interest Income.......................... 27,413 [($415,000 – $72,341) X .12 X 8/12]

5/2/12 Unearned Interest Income— Leases...................................... 13,706Interest Income.......................... 13,706 [($415,000 – $72,341) X .12 X 4/12]


12/31/12 Unearned Interest Income— Leases...................................... 24,915Interest Income.......................... 24,915 [($415,000 – $72,341 - $31,222) X .12 X 8/12]

5/2/13 Unearned Interest Income— Leases...................................... 12,457Interest Income.......................... 12,457 [($415,000 – $72,341 - $31,222) X .12 X 4/12]






(d)As at and for the period ending December 31, 2011Balance sheet:Current assetsNet investment in leases $ 72,341

Noncurrent assets (investments) 297,731 *

* ($342,659 + $27,413 - $72,341 current)

Statement of income:Sales $ 415,000 Cost of goods sold 327,500 Gross profit 87,500 Interest income 27,413

Statement of cash flows:Operating Activities:Cash received for lease $ 72,341





(e) Mulholland Corp. would account for the lease as an operating lease since:

Using a financial calculator:PV $ ? Yields $369,764I 12%N 7 PMT $ 72,341 FV $ 0 Type 1

The lease term (7 years) is less than 75% of the economic life (10 years) of the leased asset. The lease term is 70% (7 ÷ 10) of the asset’s economic life. There is no bargain purchase option and the present value of minimum lease payments of $72,341 represents 89% ($369,764 / $415,000) of the fair value at May 2, 2011 of $415,000 falling short of the criteria of 90% to treat the lease as a capital lease.

Fiscal year ending December 31, 2011:During 2011:

Executory Expenses ..................... 14,000Cash........................................... 14,000

5/2/11 Prepaid Rent .................................. 72,341Cash........................................... 72,341

12/31/11 Rent Expense ................................ 48,227Prepaid Rent................................. 48,227

($72,341 X 8/12)


Executory Expenses...................... 14,400




Cash........................................... 14,400






($72,341 X 4/12)



($72,341 X 8/12)


Executory Expenses ..................... 14,950Cash........................................... 14,950

5/2/13 Rent Expense................................. 24,114Prepaid Rent................................. 24,114

($72,341 X 4/12)


(f)As at and for the period ending December 31, 2011

Balance sheet:Current assets:Prepaid rent $ 24,114

Statement of Income:Rent expense $ 48,227 Executory costs 14,000

Statement of cash flows:




Operating Activities:Cash paid for lease $ (72,341)





(g) In this set of circumstances, the equipment is on neither the lessor’s (Galt’s) nor the lessee’s (Mulholland’s) balance sheets. The equipment should likely be on the balance sheet of the lessor as they have avoided recording the lease as an operating lease by involving a third party in the guaranteed residual value. In this case, the present value of minimum lease payments represents 89% of the fair value of the asset. This is very close to the 90% capitalization criteria guideline. The 90% criteria is not an absolute rule and therefore accountants should look beyond the numbers to the substance of the transaction to determine the accounting treatment of the lease; in this case capitalization of the lease may be a more meaningful presentation.




PROBLEM 20-19

(a)1. Contractual obligations and rights under lease, July 1, 2011.

Using tables:PV of lease payments $545,000 X 5.62288* $3,064,470

* Annuity due Table A-5 at 8%


Using a financial calculator:PV $ ? Yields $3,064,469.42I 8%N 7 PMT $ 545,000FV $ 0Type 1

2. Wagner Inc.Lease Amortization Schedule

Date

Annual

LeasePayments

Interest (8%)

on UnpaidObligation

Reduction

of LeaseObligation

Balance

of LeaseObligation $3,064,470

July 1 2011 $ 545,000 $545,000 2,519,470 July 1 2012 545,000 $201,558 343,442 2,176,028 July 1 2013 545,000 174,082 370,918 1,805,110 July 1 2014 545,000 144,409 400,591 1,404,519 July 1 2015 545,000 112,361 432,639 971,880 July 1 2016 545,000 77,750 467,250 504,630 July 1 2017 545,000 40,369 * 504,631 (0)* one dollar rounding





3.July 1, 2011

Contractual Lease Rights.................... 3,064,470Contractual Lease Obligations. . 3,064,470

Contractual Lease Obligations........... 545,000Cash............................................. 545,000


Interest Payable.......................... 100,779($201,558 X 6 / 12 = $100,779)

Amortization Expense........................ 218,891Contractual Lease Rights.......... 218,891($3,064,470 ÷ 7 years X 6/ 12 = $218,891)

July 1, 2012Interest Expense.................................. 100,779Interest Payable................................... 100,779Contractual Lease Obligations........... 343,442

Cash............................................. 545,000

(b)1. Probability-weighted expected value of residual

$400,000 X 60% = $240,000$300,000 X 40% = 120,000Probability-weighted value 360,000Guaranteed value 450,000Liability July 1, 2018 $90,000





To calculate the present value of this additional cash outflow:Excel formula =PV(rate,nper,pmt,fv,type)

Using a financial calculator:PV $ ? Yields $56,715I 8%N 5 PMT $ 0FV $ 90,000Type 1

2.July 1, 2012

Contractual Lease Rights........................... 56,715Contractual Lease Obligations. . 56,715

The carrying amount of the lease obligation after the above entry is $2,232,743 (balance from the original amortization schedule $2,176,028 after the July 1, 2012 payment + $56,715)

3. Wagner Inc.Lease Amortization Schedule—Revised July 1, 2012

Date

Annual

LeasePayments

Interest (8%)

on UnpaidObligation

Reduction

of LeaseObligation

Balance

of LeaseObligation $ 2,232,743

July 1 2013 $ 545,000 $ 178,619 $366,381 1,866,362 July 1 2014 545,000 149,309 395,691 1,470,671 July 1 2015 545,000 117,654 427,346 1,043,325 July 1 2016 545,000 83,466 461,534 581,791 July 1 2017 545,000 46,543 498,457 83,334 July 1 2018 90,000 6,666 * 83,334 (0) * one dollar rounding





4. December 31, 2012

Interest Expense.................................. 89,310Interest Payable.......................... 89,310($178,619 X 6 ÷ 12 = $89,310)

Amortization Expense........................ 483,716Contractual Lease Rights.......... 483,716($2,902,294* ÷ 6 years = $483,716)

* Original entry for the rights $3,064,470Amortization recorded in 2011 (218,891)Adjustment for residual value 56,715 Amortizable balance $2,902,294




PROBLEM 20-20

(a) Option 1:

1.Excel formula =PMT(rate,nper,pv,fv,type)

PV $79,000I 1.75%*N 20PMT ? Yields $4,715.61FV $ 0Type 1

* 7 % ÷ 4

2.Sanderson Inc.

Instalment Note Payable Amortization ScheduleNote Effective Principal Carrying

Payment Interest Reduction Amount1/1/2011 $79,000.00 1/4/2011 $4,715.61 $ 1,382.50 $3,333.11 75,666.89 1/7/2011 4,715.61 1,324.17 3,391.44 72,275.46

1/10/2011 4,715.61 1,264.82 3,450.79 68,824.67 1/1/2012 4,715.61 1,204.43 3,511.17 65,313.50 1/4/2012 4,715.61 1,142.99 3,572.62 61,740.88 1/7/2012 4,715.61 1,080.47 3,635.14 58,105.73

1/10/2012 4,715.61 1,016.85 3,698.76 54,406.98 1/1/2013 4,715.61 952.12 3,763.48 50,643.49 1/4/2013 4,715.61 886.26 3,829.35 46,814.15 1/7/2013 4,715.61 819.25 3,896.36 42,917.79

1/10/2013 4,715.61 751.06 3,964.55 38,953.24 1/1/2014 4,715.61 681.68 4,033.92 34,919.32 1/4/2014 4,715.61 611.09 4,104.52 30,814.80





Sanderson Inc.Instalment Note Payable Amortization Schedule

Note Effective Principal CarryingPayment Interest Reduction Amount

1/7/2014 4,715.61 539.26 4,176.35 26,638.45 1/10/2014 4,715.61 466.17 4,249.43 22,389.02 1/1/2015 4,715.61 391.81 4,323.80 18,065.22 1/4/2015 4,715.61 316.14 4,399.47 13,665.75 1/7/2015 4,715.61 239.15 4,476.46 9,189.30

1/10/2015 4,715.61 160.81 4,554.79 4,634.50 1/1/2016 4,715.61 81.10 4,634.50 0.00

$15,312.13

3.January 1, 2011

Vehicles.......................................................79,000.00Note Payable....................................... 79,000.00

April 1, 2011Interest Expense........................................ 1,382.50Note Payable............................................... 3,333.11

Cash..................................................... 4,715.61

December 31, 2011Interest Expense........................................ 1,204.43

Interest Payable.................................. 1,204.43

December 31, 2011Depreciation Expense................................13,800.00

Accumulated Depreciation – Vehicles 13,800.00[($79,000 – $10,000) ÷ 5]





(b) Option 2:

1. BMW Canada calculates the lease payments using a two step approach.

The first step involves the calculation of the lease payments for the original lease period of 36 months beginning January 1, 2011. For this lease, the recoverable amount of 50% of the fair value of the car on January 1, 2011 is used for the future value, at the end of the three year period.


Using a financial calculator:PV $(79,000) I 0.5%*N 36 PMT ? Yields $ 1,392.21FV $39,500**Type 1

* 6% ÷ 12** ($79,000 X 50% = $39,500)

The second step is the calculation of the lease payments for the lease renewal period of 24 months beginning January 1, 2014.

Although the fair value of the car at January 1, 2015 of $10,000 is not guaranteed, it is used in the calculation of the lease amortization schedule by the lessor, BMW Canada.

As well, although there is a small probability that Sanderson will incur additional kilometre charges for exceeding the limits set in the lease, these penalties are not included in the calculation.






PV $(39,500)I .05833%*N 24PMT ? Yields $1,371.00FV $10,000Type 1

* 7% ÷ 12

2. The lease is an operating lease to Sanderson because:

a) it does not transfer ownership, nor does it contain a bargain purchase option,

b) it does not cover at least 75% of the estimated economic life of the car, (3 ÷ 8 = 37.5%) and

c) the present value of the lease payments of $45,992* is not at least 90% of the fair value of the car.



PV $ ? * Yields $45,992I .5%N 36 PMT $ 1,392.21 FV 0 Type 1

At least one of the three criteria would have had to be satisfied for the lease to be classified as other than an operating lease.





3. The private enterprise standards assume that the risks and benefits of ownership are normally transferred to the lessee, and the lessee should classify and account for the arrangement as a capital lease if any one or more of the following criteria is met:a) There is reasonable assurance that the lessee will

obtain ownership of the leased property, including through a bargain purchase option.

b) The lessee will benefit from most of the asset benefits due to the length of the lease term. In addition, a numerical threshold is included: this is usually assumed to occur if the lease term is 75% or more of the leased property's economic life.

c) The lessor recovers substantially all of its investment and earns a return on that investment. In addition, a numerical threshold is included: this is usually assumed if the present value of the minimum lease payments is equal to 90% or more of the fair value of the leased asset.

Including the renewal period, Sanderson is using the car for 5 of its 8 years of economic life. This translates to 62.5% and so the 75% threshold is not reached.

There is no option to purchase that is a bargain during the initial or renewal terms of the lease with BMW Canada.

The present value of the minimum lease payments paid by Sanderson Inc. is $71,730.00 calculated as follows, in a three step approach:

The first step is for the renewal period of 2 years:






Using a financial calculator:PV $ ? Yields $30,800.05I .05833%*N 24 PMT 1,371.00FV $ 0 Type 1 *7 % ÷ 12

The second step is to calculate the present value of the amount arrived in the first step back to January 1, 2011 for a period of 3 years.


Using a financial calculator:PV $ ? Yields $25,737.91I 0.5%*N 36 PMT 0FV $ 30,800.05Type 1 * 6% ÷ 12

The third step is for the calculation of the present value of the initial lease payments by Sanderson Inc.






Using a financial calculator:PV $ ? Yields $45,992.17I 0.5%*N 36 PMT $1,392.21FV $ 0Type 1 * 6% ÷ 12

Add the present value of the lease renewal $25,737.91to the present value of the initial lease 45,992.17Present value of the minimum lease payments $71,730.08

rounded

Present value of the minimum lease payments divided by the fair value of the asset $71,730 ÷ $79,000 = 90.8% and so the lease is a capital lease to Sanderson Inc.

4. Sanderson Inc. Lessee

Lease Amortization ScheduleAnnual Interest Reduction BalanceLease on Unpaid of Lease of Lease

Date Payment Obligation Obligation Obligation 71,730.00

Jan. 1 2011 1,392.21 1,392.21 70,337.79 Feb. 1 2011 1,392.21 351.69 1,040.52 69,297.27 Mar 1 2011 1,392.21 346.49 1,045.72 68,251.55 Apr. 1 2011 1,392.21 341.26 1,050.95 67,200.59 May 1 2011 1,392.21 336.00 1,056.21 66,144.39 June 1 2011 1,392.21 330.72 1,061.49 65,082.90 July 1 2011 1,392.21 325.41 1,066.80 64,016.10





Annual Interest Reduction BalanceLease on Unpaid of Lease of Lease

Date Payment Obligation Obligation ObligationAug. 1 2011 1,392.21 320.08 1,072.13 62,943.97 Sep. 1 2012 1,392.21 314.72 1,077.49 61,866.48 Oct 1 2012 1,392.21 309.33 1,082.88 60,783.61 Nov. 1 2012 1,392.21 303.92 1,088.29 59,695.31 Dec. 1 2012 1,392.21 298.48 1,093.73 58,601.58 Jan. 1 2012 1,392.21 293.01 1,099.20 57,502.38 Feb. 1 2012 1,392.21 287.51 1,104.70 56,397.68 Mar 1 2012 1,392.21 281.99 1,110.22 55,287.46 Apr. 1 2012 1,392.21 276.44 1,115.77 54,171.69 May 1 2012 1,392.21 270.86 1,121.35 53,050.33 June 1 2012 1,392.21 265.25 1,126.96 51,923.38 July 1 2012 1,392.21 259.62 1,132.59 50,790.78 Aug. 1 2012 1,392.21 253.95 1,138.26 49,652.53 Sep. 1 2013 1,392.21 248.26 1,143.95 48,508.58 Oct 1 2013 1,392.21 242.54 1,149.67 47,358.91 Nov. 1 2013 1,392.21 236.79 1,155.42 46,203.50 Dec. 1 2013 1,392.21 231.02 1,161.19 45,042.30 Jan. 1 2013 1,392.21 225.21 1,167.00 43,875.31 Feb. 1 2013 1,392.21 219.38 1,172.83 42,702.47 Mar 1 2013 1,392.21 213.51 1,178.70 41,523.77 Apr. 1 2013 1,392.21 207.62 1,184.59 40,339.18 May 1 2013 1,392.21 201.70 1,190.51 39,148.67 June 1 2013 1,392.21 195.74 1,196.47 37,952.20 July 1 2013 1,392.21 189.76 1,202.45 36,749.75 Aug. 1 2013 1,392.21 183.75 1,208.46 35,541.29 Sep. 1 2013 1,392.21 177.71 1,214.50 34,326.79 Oct 1 2013 1,392.21 171.63 1,220.58 33,106.21 Nov. 1 2013 1,392.21 165.53 1,226.68 31,879.53 Dec. 1 2013 1,392.21 159.40 1,232.81 30,646.72 Jan. 1 2014 153.41 (153.41) 30,800.13






Date Payment Obligation Obligation ObligationJan. 1 2014 1,371.00 1,371.00 29,429.13 Feb. 1 2014 1,371.00 171.67 1,199.33 28,229.80 Mar 1 2014 1,371.00 164.67 1,206.33 27,023.48 Apr. 1 2014 1,371.00 157.64 1,213.36 25,810.12 May 1 2014 1,371.00 150.56 1,220.44 24,589.67 June 1 2014 1,371.00 143.44 1,227.56 23,362.11 July 1 2014 1,371.00 136.28 1,234.72 22,127.39 Aug. 1 2014 1,371.00 129.08 1,241.92 20,885.47 Sep. 1 2014 1,371.00 121.83 1,249.17 19,636.30 Oct 1 2014 1,371.00 114.55 1,256.45 18,379.85 Nov. 1 2014 1,371.00 107.22 1,263.78 17,116.06 Dec. 1 2014 1,371.00 99.84 1,271.16 15,844.91 Jan. 1 2015 1,371.00 92.43 1,278.57 14,566.33 Feb. 1 2015 1,371.00 84.97 1,286.03 13,280.31 Mar 1 2015 1,371.00 77.47 1,293.53 11,986.77 Apr. 1 2015 1,371.00 69.92 1,301.08 10,685.70 May 1 2015 1,371.00 62.33 1,308.67 9,377.03 June 1 2015 1,371.00 54.70 1,316.30 8,060.73 July 1 2015 1,371.00 47.02 1,323.98 6,736.75 Aug. 1 2015 1,371.00 39.30 1,331.70 5,405.05 Sep. 1 2015 1,371.00 31.53 1,339.47 4,065.58 Oct 1 2015 1,371.00 23.72 1,347.28 2,718.29 Nov. 1 2015 1,371.00 15.86 1,355.14 1,363.15 Dec. 1 2015 1,371.00 7.85 1,363.15 0.00

83,023.56 11,293.56





5.

January 1, 2011Leased Vehicle........................................... 71,730.00

Lease Obligation................................. 71,730.00

Lease Obligation........................................ 1,392.21Cash..................................................... 1,392.21

February 1, 2011Lease Obligation........................................ 1,040.52Interest Expense........................................ 351.69

Cash..................................................... 1,392.21December 31, 2011

Interest Expense........................................ 293.01Interest Payable.................................. 293.01

Depreciation Expense................................12,346.00Accumulated Depreciation —LeasedVehicle................................................. 12,346.00[($71,730 – $10,000) ÷ 5]

(c) Option 3:

1. Under this option, Sanderson Inc. must treat the lease as an operating lease as none of the criteria for treatment as a capital lease are met.

2.January 1, 2011

Rent Expense............................................. 1,392.21Cash..................................................... 1,392.21

December 31, 2011Rent Expense............................................. 1,392.21

Rent Payable....................................... 1,392.21





3.Excel formula =PMT(rate,nper,pv,fv,type)

PV $39,500I 2%*N 24PMT ? Yields $5,392.14FV $0Type 1

* 8% ÷ 4

4.Sanderson Inc.

Instalment Note Payable Amortization Schedule

Effective Principal CarryingPayment Interest Reduction Amount

1/1/2014 $39,500.001/4/2014 $5,392.14 $790.00 $4,602.14 34,897.861/7/2014 5,392.14 697.96 4,694.18 30,203.68

1/10/2014 5,392.14 604.07 4,788.06 25,415.621/1/2015 5,392.14 508.31 4,883.82 20,531.801/4/2015 5,392.14 410.64 4,981.50 15,550.291/7/2015 5,392.14 311.01 5,081.13 10,469.16

1/10/2015 5,392.14 209.38 5,182.75 5,286.411/1/2016 5,392.14 105.73 5,286.41 0.00

$3,637.105.

January 1, 2014Cash............................................................39,500.00

Note Payable....................................... 39,500.00

Vehicle.........................................................39,500.00Cash..................................................... 39,500.00





April 1, 2014Interest Expense........................................ 790.00Note Payable............................................... 4,602.14

Cash..................................................... 5,392.14

December 31, 2014Interest Expense........................................ 508.31

Interest Payable.................................. 508.31

Depreciation Expense................................14,750.00Accumulated Depreciation – Vehicle 14,750.00[($39,500 – $10,000) ÷ 2]

(d) For the contract-based approach, the probability-weighted expected value of the excess mileage penalty must be used in the present value calculation of the lease rights and obligations.

$0 X 75%10,000 kilometres X 25 cents X 10%= $1,00020,000 kilometres X 25 cents X 15%= 3,000Probability-weighted amount $4,000


Using a financial calculator:PV $ ? Yields $3,342.58I 0.5%*N 36 PMT $ 4,000FV $ 0Type 0 * 6% ÷ 12





Consequently the capitalized amount of the right and the lease obligation increases by $3,342.58. The same lease amortization schedule for Option 2, item 4, except that the carrying amount at the inception will be $71,730.00 + $3,342.58 = $75,072.58 and a payment of $4,000 is made January 1, 2014.

Sanderson Inc. LesseeLease Amortization Schedule —Contract Based Approach


Date Payment Obligation Obligation Obligation $75,072.58

Jan. 1 2011 $1,392.21 $1,392.21 73,680.37 Feb. 1 2011 1,392.21 $368.40 1,023.81 72,656.56 Mar 1 2011 1,392.21 363.28 1,028.93 71,627.63 Apr. 1 2011 1,392.21 358.14 1,034.07 70,593.56 May 1 2011 1,392.21 352.97 1,039.24 69,554.32 June 1 2011 1,392.21 347.77 1,044.44 68,509.88 July 1 2011 1,392.21 342.55 1,049.66 67,460.22 Aug. 1 2011 1,392.21 337.30 1,054.91 66,405.31 Sep. 1 2012 1,392.21 332.03 1,060.18 65,345.13 Oct 1 2012 1,392.21 326.73 1,065.48 64,279.64 Nov. 1 2012 1,392.21 321.40 1,070.81 63,208.83 Dec. 1 2012 1,392.21 316.04 1,076.17 62,132.67 Jan. 1 2012 1,392.21 310.66 1,081.55 61,051.12

January 1, 2011Contractual Lease Rights........................ 75,072.58

Contractual Lease Obligations.......... 75,072.58

Contractual Lease Obligations................. 1,392.21Cash..................................................... 1,392.21





February 1, 2011Contractual Lease Obligations................. 1,023.81Interest Expense........................................ 368.40

Cash..................................................... 1,392.21

December 31, 2011Interest Expense........................................ 310.66

Interest Payable.................................. 310.66

Amortization Expense.............................13,015.00Contractual Lease Rights.................. 13,015.00

[($75,072.58 – $10,000) ÷ 5]

(e) If Sanderson is able to reasonably estimate in advance of the actual payment date of July 1, 2014, an accrual should be made for that estimate which can then be allocated over the period of benefit. The accrual should be charged to an expense. The total of the amount paid would be $4,000 as calculated in (d) above.



Kieso, Weygandt, Warfield, Young, Wiecek Intermediate Accounting, Ninth Canadian

Edition

PROBLEM 20-20 (Continued)(f) Contract

Option 1 Option 2 Option 3 BasedStatement of financial positionAssets:Property plant and equipmentVehicles $79,000 Leased vehicle $71,730 Accumulated depreciation (13,800) (12,346)Net 65,200 59,384

Intangible assetsContractual lease rights $75,073 Amortization of rights to date (13,015) Net 62,058

Liabilities:Current liabilities:Interest payable 1,204 293 311 Rent payable 1,392 Instalment note payable - current 14,418 Lease obligation - current 13,559 Obligation under leased rights - current 13,341



Kieso, Weygandt, Warfield, Young, Wiecek Intermediate Accounting, Ninth Canadian

Edition


Non-current liabilities:Instalment note payable 54,407 Lease obligation 45,042 Obligation under leased rights 48,791 Total liabilities 70,029 58,894 1,392 62,443

Income statement - 2011Depreciation expense $13,800 $12,346 Amortization expense $13,015 Rent expense $16,707 Interest expense 5,176 3,871 4,077

$18.976 $16,666 $16,707 $17,092

(g)

Contract Total expense - 5 years Option 1 Option 2 Option 3 BasedDepreciation expense $69,000 (1) $61,730 (3) $29,500 (5)Amortization expense $65,073 (8)

Auto expense (excess km.) 4,000Rent expense 50,120 (6)

Interest expense 15,312 (2) 11,29

4 (4) 3,637 (7) 11,95

1 (9) $84,312 $77,024 $83,257 $77,024





(1) Annual depreciation X 5 or Cost $79,000 less residual value $10,000

(2) Refer to Instalment note table Option 1 part 2(3) Annual depreciation X 5 or capitalized amount $71,730

less residual value $10,000(4) Refer to lease amortization schedule Option 2 part 4(5) Annual depreciation $14,750 X 2 or Cost $39,500 less

residual value $10,000(6) Monthly rental of $1,392.21 X 36 months(7) Refer to Instalment note table Option 3 part 4(8) Annual depreciation X 5 or capitalized amount $75,073

less residual value $10,000(9) Same as item 4 of $11,293.56 plus the interest on the

penalty of $657.42 (difference between present value of $3,342.58 and future value of $4,000.00) = $11,950.98

(h) Not coincidently, the total expenses under Option 2 are equal to those for the accounting using the contract-based approach in part (c). The main difference in the choices can be found in the choice between purchase Option 1 or lease Option 2. Option 3 is somewhat of a hybrid between the Option 1 and 2 but what it has most in common with Option 1 is that the vehicle is purchased. Although the purchase option results in the highest total expense for five year, (Option 1 and 3) it also provides the highest potential for a gain from the sale of the vehicle at the end of the useful life, as the residual value employed in the calculations at lease inception might be a conservative estimate.

The second major consideration is the difference in the way in which income taxes will be applied to the different alternatives, particularly since the asset is a luxury vehicle and there are limits on deductibility under the Income Tax Act. Finally, cash flow consideration should be taken into account as well as financial ratios that are of particular interest to the creditors and investors of Sanderson Inc.




PROBLEM 20-21

(a) The lease is an operating lease to BMW Canada. The lease

1. does not transfer ownership, nor contain a bargain purchase option,

2. does not cover at least 75% of the estimated economic life of the car, (3 ÷ 8 = 37.5%) and

3. the present value of the lease payments of $45,992* is not at least 90% of the fair value of the car.



PV $ ? * Yields $45,992I .5%N 36 PMT $ 1,392.21 FV 0 Type 1

At least one of the three criteria would have had to be satisfied for the lease to be classified as other than an operating lease. The property is recorded as a rental property to BMW and will be treated as a payment of rent by the lessee under the operating lease.

(b)January 1, 2011

Cash..................................................... 1,392.21Unearned Rental Income............ 1,392.21





(c) 1.

BMW Canada – LessorLease Amortization ScheduleAnnualLease Interest Net Balance

Payment on Net Investment of NetDate Plus URV Investment Recovery Investment

79,000.00 Jan. 1 2011 1,392.21 1,392.21 77,607.79 Feb. 1 2011 1,392.21 388.04 1,004.17 76,603.62 Mar 1 2011 1,392.21 383.02 1,009.19 75,594.43 Apr. 1 2011 1,392.21 377.97 1,014.24 74,580.19 May 1 2011 1,392.21 372.90 1,019.31 73,560.88 June 1 2011 1,392.21 367.80 1,024.41 72,536.47 July 1 2011 1,392.21 362.68 1,029.53 71,506.95 Aug. 1 2011 1,392.21 357.53 1,034.68 70,472.27 Sep. 1 2012 1,392.21 352.36 1,039.85 69,432.42 Oct 1 2012 1,392.21 347.16 1,045.05 68,387.38 Nov. 1 2012 1,392.21 341.94 1,050.27 67,337.10 Dec. 1 2012 1,392.21 336.69 1,055.52 66,281.58 Jan. 1 2012 1,392.21 331.41 1,060.80 65,220.78 Feb. 1 2012 1,392.21 326.10 1,066.11 64,154.67 Mar 1 2012 1,392.21 320.77 1,071.44 63,083.23 Apr. 1 2012 1,392.21 315.42 1,076.79 62,006.44 May 1 2012 1,392.21 310.03 1,082.18 60,924.26 June 1 2012 1,392.21 304.62 1,087.59 59,836.67 July 1 2012 1,392.21 299.18 1,093.03 58,743.65 Aug. 1 2012 1,392.21 293.72 1,098.49 57,645.15 Sep. 1 2013 1,392.21 288.23 1,103.98 56,541.17 Oct 1 2013 1,392.21 282.71 1,109.50 55,431.67 Nov. 1 2013 1,392.21 277.16 1,115.05 54,316.61 Dec. 1 2013 1,392.21 271.58 1,120.63 53,195.99





AnnualLease Interest Net Balance


Jan. 1 2013 1,392.21 265.98 1,126.23 52,069.76 Feb. 1 2013 1,392.21 260.35 1,131.86 50,937.90 Mar 1 2013 1,392.21 254.69 1,137.52 49,800.38 Apr. 1 2013 1,392.21 249.00 1,143.21 48,657.17 May 1 2013 1,392.21 243.29 1,148.92 47,508.24 June 1 2013 1,392.21 237.54 1,154.67 46,353.57 July 1 2013 1,392.21 231.77 1,160.44 45,193.13 Aug. 1 2013 1,392.21 225.97 1,166.24 44,026.89 Sep. 1 2013 1,392.21 220.13 1,172.08 42,854.81 Oct 1 2013 1,392.21 214.27 1,177.94 41,676.88 Nov. 1 2013 1,392.21 208.38 1,183.83 40,493.05 Dec. 1 2013 1,392.21 202.47 1,189.74 39,303.31 Jan. 1 2014 196.70 196.70 39,500.00 Jan. 1 2014 1,371.00 1,371.00 38,129.00 Feb. 1 2014 1,371.00 222.42 1,148.58 36,980.42 Mar 1 2014 1,371.00 215.72 1,155.28 35,825.14 Apr. 1 2014 1,371.00 208.98 1,162.02 34,663.12 May 1 2014 1,371.00 202.20 1,168.80 33,494.32 June 1 2014 1,371.00 195.38 1,175.62 32,318.71 July 1 2014 1,371.00 188.53 1,182.47 31,136.23 Aug. 1 2014 1,371.00 181.63 1,189.37 29,946.86 Sep. 1 2014 1,371.00 174.69 1,196.31 28,750.55 Oct 1 2014 1,371.00 167.71 1,203.29 27,547.26 Nov. 1 2014 1,371.00 160.69 1,210.31 26,336.95 Dec. 1 2014 1,371.00 153.63 1,217.37 25,119.59 Jan. 1 2015 1,371.00 146.53 1,224.47 23,895.12 Feb. 1 2015 1,371.00 139.39 1,231.61 22,663.50 Mar 1 2015 1,371.00 132.20 1,238.80 21,424.71 Apr. 1 2015 1,371.00 124.98 1,246.02 20,178.69





AnnualLease Interest Net Balance


May 1 2015 1,371.00 117.71 1,253.29 18,925.39 June 1 2015 1,371.00 110.40 1,260.60 17,664.79 July 1 2015 1,371.00 103.04 1,267.96 16,396.84 Aug. 1 2015 1,371.00 95.65 1,275.35 15,121.49 Sep. 1 2015 1,371.00 88.21 1,282.79 13,838.69 Oct 1 2015 1,371.00 80.73 1,290.27 12,548.42 Nov. 1 2015 1,371.00 73.20 1,297.80 11,250.62 Dec. 1 2015 1,371.00 65.71 1,305.29 9,945.33 Jan. 1 2015 10,000.00 54.67 9,945.33 0.00

$13,968.89

2. The lease is a sales-type lease to BMW Canada. The present value of the unguaranteed residual value is calculated as follows using two steps:The first step is for the renewal period of 2 years:


Using a financial calculator:PV $ ? Yields $8,734.29I 7%N 2 PMT 0FV $ 10,000 Type 1

The second step is to calculate the present value of the amount arrived in the first step back to January 1, 2011 for a period of 3 years.






Using a financial calculator:PV $ ? Yields $7,333.56I 6%N 3 PMT 0FV $ 8,734.29 Type 1

Consequently the sales price is $79,000.00 less the present value of the unguaranteed residual value of $7,333.56 or $71,666.44

The cost of sales is $70,000.00 less the present value of the unguaranteed residual value of $7,333.56 or $71,666.44.

The amount of the lease payments receivable is the sum of the lease payments under the initial lease and the renewal lease calculated as follows:

36 payments @ 1,392.21 = $50,119.5624 payments @ 1,371.00 = 32,904.00Unguaranteed residual value 10,000.00Total receivable $93,023.56

3.

January 1, 2011Lease Payments Receivable....................93,023.56Cost of Sales.............................................62,666.44

Sales................................................... 71,666.44Inventory............................................ 70,000.00Unearned Interest Income—Leases 14,023.56

Cash........................................................... 1,392.21Lease Payments Receivable 1,392.21





February 1, 2011Cash........................................................... 1,392.21

Lease Payments Receivable 1,392.21

December 31, 2011Unearned Interest Income—Leases........ 4,319.51

Interest Income—Leases............. 4,319.51




PROBLEM 20-22*

(a)29/6/11 Cash............................................ 8,000,000

Building ............................... 9,500,000Accumulated Depreciation....... 3,321,429*

Deferred Profit on Sale- Leaseback......................... 1,821,429

*($9,500,000 - $2,000,000) / 35 X 15.5 years)

29/6/11 Building Under Capital Leases..................................... 8,000,000

Obligations Under Capital Leases............................... 8,000,000 ($838,380 X 9.36492*) + ($1,000,000 X .14864**)

* Present value of annuity due for 20 periods at 10%** Present value of single payment for 20 periods at 10%


PV $ ? Yields $8,000,005I 10%N 20 PMT $ (838,380)FV $ (1,000,000) Type 1

29/6/11 Lease Obligation............................... 838,380Cash...................................... 838,380




PROBLEM 20-22* (Continued)

Partial Lease Amortization Schedule

Date

AnnualLease

PaymentInterest(10%) Amortization Balance

29/06/1129/06/11 $838,380 $838,380

$8,000,000 7,161,620

29/06/12 838,380 $716,162 122,218 7,039,402

12/31/11 Deferred Profit on Sale- Leaseback.................................. 45,536

Depreciation Expense**......... 45,536 ($1,821,429 ÷ 20 X 6/12)

**The credit could also be to a gain account.The deferred profit on the sale-leaseback should be amortized on the same basis that the asset is being amortized.Maintenance, insurance and property taxes would also have been paid during the year.

12/31/11 Depreciation Expense................... 150,000Accumulated Depreciation.... 150,000 (($8,000,000 - $2,000,000) ÷ 20 X 6/12)

12/31/11 Interest Expense........................... 358,081Interest Payable...................... 358,081

($7,161,620 X 10% X 6/12)

29/6/12 Lease Obligation............................. 122,218Interest Payable.............................. 358,081Interest Expense............................. 358,081

Cash........................................ 838,380

12/31/12 Deferred Profit on Sale- Leaseback.................................. 91,071

Depreciation Expense............ 91,071




($1,821,429 ÷ 20)PROBLEM 20-22* (Continued)

12/31/12 Depreciation Expense................... 300,000Accumulated Depreciation.... 300,000(($8,000,000 - $2,000,000) ÷ 20)

12/31/12 Interest Expense........................... 351,970Interest Payable...................... 351,970

($7,039,402 X 10% X 6/12)

(b) The lease must now be recorded as an operating lease as it is no longer a capital lease because: (1) the lease term is for 60% (12 ÷ 20) of the economic life of the leased asset and (2) the present value of the minimum lease payments is 79% ($6,283,709 / $8,000,000) of the fair market value of the leased asset and (3) there is no longer a bargain purchase option. Maintenance, insurance and property tax expenses would also be incurred.

The present value of the minimum lease payments:Using a financial calculator:PV $ ? Yields $ 6,283,709 I 10%N 12 PMT $ (838,380)FV $ 0 Type 1

29/6/11 Cash................................................ 8,000,000 Building .................................... 9,500,000

Accumulated Depreciation............ 3,321,429*Deferred Profit on Sale

of Building............................. 1,821,429*($9,500,000 - $2,000,000) / 35 X 15.5 years)

29/6/11 Rent Expense.................................. 838,380




Cash........................................... 838,380


31/12/11 Prepaid Rent .................................. 419,190Rent Expense............................ 419,190

31/12/11 Deferred Profit on Saleof Building .................................. 75,893

Rent Expense............................ 75,893*($1,821,429 / 12 X 6/12)

29/6/12 *Rent Expense................................. 419,190Prepaid Rent............................. 419,190

29/6/12 Rent Expense.................................. 838,380Cash........................................... 838,380

31/12/12 *Prepaid Rent................................... 419,190Rent Expense............................ 419,190

31/12/12 Deferred Profit on Saleof Building .................................. 151,786

Rent Expense............................ 151,786($1,821,429 / 12)

*Note to instructor: these two entries cancel each other out and could be omitted.

(a) The net assets amount (or equity) on the balance sheet of North Central will be very similar after the completion of the sale and leaseback as it was before. Any excess of the capitalized amount of the building over the carrying value at the time of the sale (i.e. the gain) will be deferred and amortized over the term of the lease, or the life of the asset. Eventually this gain will be realized to equity. Over the term of the lease, the additional costs related to the borrowing will affect equity but this is no different, for example, than if




a loan had been obtained in exchange for a mortgage obligation.




PROBLEM 20-23*

(a)To the lessee, this lease of the building is accounted for as a capital lease and the lease of the land is treated an operating lease, since there is no bargain purchase option for the property and because the terms of the lease satisfy at least one of the quantitative criteria for capitalization.

The present value of the minimum lease payments is greater than 90% of the fair value of the leased property; that is, the present value of $1,705,457 (see below) is 97.5% of the fair value of the leased property ($1,705,457 / $1,750,000).


The land and building must be considered separately for the purpose of classifying the lease. The minimum lease payments must be allocated between the land and the building in proportion to their fair values.

The portion of the gain related to the lease of the land, which is an operating lease, is amortized over the term of the lease. The portion of the gain related to the building must be deferred and amortized in proportion to the depreciation of the leased asset.





October 1, 2011Cash.................................................................... 1,750,000

Land and Building (net)............................. 250,000Deferred Gain on Sale of Land (40%) 600,000Deferred Gain on Sale of Building (60%) 900,000

Leased Building................................................. 1,023,274Lease Obligation............................. ........1,023,274

($1,705,457 X 60% = $1,023,274)

Lease Obligation................................................... 105,000Land Rental Expense........................................... . 70,000

Cash................................................... ..... 175,000[($175,000 X 40 % = $70,000]

September 30, 2012:Interest Expense................................................. 64,279

Interest Payable [($1,023,274 – $105,000) X 7%]............ 64,279

Depreciation Expense – Building Under Lease 102,327Accumulated Depreciation - Building ($1,023,274 X 10%).............................. 102,327

Deferred Gain on Sale of Land ........................... 40,000Gain on Sale of Land....................... 40,000

($600,000 / 15)

Deferred Gain on Sale of Building ..................... 90,000Gain on Sale of Building................. 90,000

($900,000 X 10%)

October 1, 2012:Interest Payable.................................................... 64,279Lease Obligation.................................................. 40,721Land Rental Expense........................................... 70,000

Cash................................................... ..... 175,000





(b) Financial Statement disclosure at September 30, 2012:Balance sheet:Property Plant & Equipment:Leased building $ 1,023,274 Less: Accumulated depreciation (102,327)

920,947 Current LiabilitiesInterest payable 64,279 Current portion of lease obligation 40,721 Deferred gain in sale of land and building 121,000

Long term liabilitiesDeferred gain in sale of land and building 1,249,000Lease obligation 918,274 Less: Current portion (40,721)

877,553

Land Building TotalDeferred gain on sale of land

and building $ 600,000 $ 900,000

Depreciation - Fiscal year 2012 (40,0

00) (90,0

00)

Balance September 30, 2012 560,

000 810,0

00

Current Portion 40,

000 81,

000 $ 121,000

Non- Current Portion 520,

000 729,0

00 $1,249,

000





Statement of Income:Gain on sale of property $130,000Land rent expense 70,000 Depreciation expense 102,327 Interest expense 64,279

Statement of cash flows: - indirect formatOperating Activities:Gain on disposal of property $ (1,500,000)Increase in interest payable 64,279 *

Financing activities:Payment of long term lease obligation (105,000)* would likely be combined with other amounts of interest

The sale and leaseback transaction is a non-cash financing and investing activity, which would be reported in the notes to the financial statements and not on the face of the statement of cash flows.

The disclosure requirements for the operating lease for the land includes the future minimum lease payments, in total and for each of the next five years.




TIME AND PURPOSE OF WRITING ASSIGNMENTS

WA 20-1 (Time 15–25 minutes)

Purpose—to provide the student with an ethics case involving the capitalization criteria applied to technology that is fast becoming obsolete for the capitalization and contract-based approaches. The student must assess the validity of the arguments given for not capitalizing equipment and make recommendations.


Purpose—to provide the student with an understanding of the different impacts of the current ASPE and IFRS lease treatments on financial statements and the proposed contract-based approach. The student must describe the changes in basic financial ratios under these different standards. The student is also required to use the conceptual framework to explain the contract- based approach for leases, which appears to gain more support from the joint FASB-IASB study group.


Purpose—to provide the student with an understanding of issues that the IASB/FASB Joint International Working Group has discussed regarding lease accounting. This assignment focuses on the prior academic research on lease accounting and its potential implications for the lease accounting project.


Purpose—to provide the student with an understanding of the two approaches being considered for lessor accounting – derecognition approach and the performance obligation approach. It also requires students to demonstrate their understanding of the initial recording of a lease under the two alternatives.


Purpose—to provide the student with an understanding of the theoretical reasons for requiring certain leases to be capitalized by the lessee. It also requires students to demonstrate their understanding of the classification of three leases. The student determines how the lessee should classify each lease, what amount should be recorded as a liability at the inception of each lease, and how the lessee should record each minimum lease payment for each lease.




TIME AND PURPOSE OF WRITING ASSIGNMENTS(Continued)

WA 20-6 (Time 30 – 35 minutes)

Purpose—to provide the student with an opportunity to compare and contrast the accounting for leases under ASPE, IFRS and the contract based approach and to understand the underlying concepts for these different treatments.

SOLUTIONS TO WRITING ASSIGNMENTS

WA 20-1

(a) The ethical issues relate to fairness and integrity of financial reporting versus profits and possibly misleading financial statements. On one hand, if




Koba can substantiate her position, it is possible that the agreement should be considered an operating lease arguing that this is not a bargain purchase option, in reality, since the value of the photocopiers will likely be below this price. On the other hand, if Koba cannot or will not provide substantiation, she would appear to be trying to manipulate the financial statements for some reason such as a debt covenant or minimum levels of certain ratios.

(b) If Koba has no particular expertise in copier technology, she has no rational case for her suggestion. If she has expertise, then her suggestion may be rational and would not be merely a means to manipulate the statement of financial position to avoid recording a liability. Another explanation may be based on Koba’s past experience, where photocopy manufacturers or lessors have approached Koba before the expiration of past leases to upgrade existing equipment with more modern and cost effective models in order to keep good customer relations. Under those circumstances, Koba would expect that this trend would continue in the future, justifying her position that this is not a bargain purchase option that will be exercised, and to treat the lease as an operating lease.

(c) Beckert must decide whether the situation presents a legitimate difference of opinion where professional judgment could take the answer either way, or as an attempt by Koba to mislead reporting on the financial statements. Beckert must decide whether he wishes to argue with Koba or simply accept Koba’s position. Beckert should assess the consequences of both alternatives.

(d) Under the contract-based approach, the contractual lease obligation will be reported on the statement of financial position regardless of whether a bargain purchase option is seen to exist or not. The only difference will be how the asset will be recognized. If the bargain purchase option does not exist, based on Koba’s arguments, then the contractual lease rights are recognized as an intangible asset. This intangible asset would be amortized on some systematic pattern of usage over the lease term. If the bargain purchase option is likely to be exercised, then the lease agreement

WA 20-1 (Continued)

is, in substance, an acquisition, and the copiers would be recorded as equipment. In this case, the equipment would be depreciated over their useful lives.




WA 20-2

(a) The retail outlet leases: Based on the lease terms and conditions for the retail outlets noted in the question, these leases represent operating leases. Leases that are operating leases are recognized and reported in the same manner under both ASPE and IFRS: the monthly lease payments and contingent rental payments are all expensed as incurred.

Building Lease: The information notes that the building lease has been assessed against the capitalization criteria under private enterprise accounting standards, and found to qualify as an operating lease.

However, there are a few differences in these criteria under IFRS that might change the final conclusion as noted below:

1. Transfer of benefits and risks: In assessing the transfer of risks and rewards, IFRS also requires an assessment of the degree to which an asset is specialized and of use only to the lessee without major expense to the lessor. If it is found on review, that the new facility is so specialized that the lessor would have difficulty leasing to another tenant without a lot of extra costs, then the lease contract transfers substantially all of the benefits and risks of property ownership, and should be capitalized. Considering that the building was designed specifically for Sporon’s needs, substantial amounts of benefits may be transferred to Sporon. Thus, careful review of the lease contract is required to identify any substantial transfer of risks, including the requirement to pay property tax increases.

2. Depending on which interest rate was used to test the minimum lease payment criterion, Sporon may need to account for the lease as a finance lease under IFRS. While CICA Handbook Part II, Section 3065 specifies the use of the lower of the interest rate implicit in the lease and the lessee's incremental borrowing rate, IAS 17 specifies use of the interest rate implicit in the lease when it is practicably determinable; otherwise, the lessee's incremental borrowing rate is used.

(b) To Louise Bren,Subject: Accounting Treatment for Leases under the approach of the FASB-IASB joint project.

The IASB and FASB, through a Joint International Working Group, are currently looking at a variety of topics related to financial reporting. As for leases, the contract based approach is being considered as they intend to choose a model that will rely on asset and liability definitions in the conceptual framework. This approach is based on the idea that all arrangements that provide one party the right to use an item of another party should be accounted for similarly. The contract based approach is expected to be more useful to users as some entities are not recognizing a substantial amount of lease obligations that meet the definition of liabilities




WA 20-2 (Continued)

under the conceptual framework. Under the contract based approach, the capital (or finance) and operating lease distinction would disappear and most leases would qualify for recognition as assets and liabilities by the lessee.

Retail outlet leases: If this approach is adopted, these leases will be shown on the statement of financial position. An intangible asset for the contractual lease rights will be recognized, and amortized over a systematic period, likely a straight-line basis over the lease term. A liability for the contractual lease obligation will be recognized and amortized using the appropriate discount rate over the lease term. As payments are made, the obligation will be reduced and interest expense will be recognized. There are three issues with respect to these leases that would have to be assessed: 1. What is the lease term? The lease term should be the “longest lease term that is more likely than not” to occur. This would be 10 years for the current retail leases – the initial term and the renewal period.2. What are the payments to be included in the contractual obligations? In this case, the monthly payments and the contingent payments would be included in determining the value of the obligation. The value for the contingent rental payments would be determined using probability weighted expected values over the term of the lease. The value of these contingent payments would have to be reassessed at each reporting period, with any changes related to the current and past period contingencies being reported immediately into income and any impact on future periods would change the amount of the obligation.3. What discount rate should be used in determining the amount of the obligation and asset? Sporon’s incremental borrowing rate would be used to discount the payments to determine the contractual obligation.

Building lease: For the building lease, the first assessment that needs to be made is whether substantially all of the risks and rewards have been transferred since the building is unique to Sporon’s purposes and the lease, by design, perhaps earns the lessor a fixed return. If this is the case, then the lease would be seen to be a purchase in substance, and the value of the contractual obligation and the building as an asset would be recognised. The building would be depreciated over its useful life, and the obligation would be reduced as payments are made, and interest is expensed. If it is found that the lease does not substantially transfer the risks and rewards, then an intangible asset is recognized instead and amortized over some systematic basis – likely straight-line over the 20 year term of the lease. The amount of the obligation would be the same in either case. For this assessment, the lease term would be 20 years, and the discount rate would be Sporon’s incremental borrowing rate.




WA 20-2 (Continued)

The impact on the cash flow statement would remove the lease payments from operating cash flows, and instead, the portion of the payment that represents interest would be shown as either operating or financing (depending on the company’s policy) and the reduction in the obligation would be recorded as a financing activity. This would cause the operating cash flow to be higher under the contract based approach.

(c) Appendix: The impact of the revised standard on basic ratios.

Profitability Profit margin The ratio will be lower in the earlier years and

higher in the later years under the contract-based lease treatment because 1) operating leases recognize lease expenses evenly during the lease term; and 2) interest expense and amortization expenses, which are recorded under a capital lease, are higher in the earlier years.

Return on assets

Lower: Assets, the denominator, would increase by the value of the intangible assets. The net income will be lower in the earlier years due to the higher interest and amortization expenses. As a result, the return on assets will be lower. Over time, this will increase as the asset is reduced and net income is higher with the lower amounts charged for interest and amortization expenses.

Return on equity

Lower: The return would decrease in the earlier years and so would retained earnings in equity for the same reasons noted above

RiskDebt-to-equity Higher: Debt would increase by the contractual

lease obligation amount while equity (retained earnings) would decrease (in the earlier years).

Times interest earned

EBIT would increase because although there is an amortization expense this may be lower than the rent expense disappears. However, the denominator, interest expense, would increase as well.

Solvency Operating cash flows to total debt

As cash outflows for the principal balance of the lease obligation would be reported under ”financing activities”, the cash flow from operating activities would be higher. At the same time, the amount of total debt, which is the denominator of this ratio, would increase by the lease obligation and later get smaller as the obligation gets repaid.




WA 20-3

(a) The issues that have been addressed by academic research on lease accounting are as follows:

To what extent would recognition of off-balance sheet leases affect financial statements, and which industries would be most affected?

What is the relationship between leases and other forms of financing, including debt and equity? How do leases, in conjunction with debt, affect equity risk?

How is lease accounting information perceived or used by investors, creditors, and other financial statement users?

What was the impact of Statement of Financial Accounting Standards 13 on market assessments of risk and profitability and on the use of leases relative to other types of financing?

(b) The findings of the research on each issue are presented below.

The impact of capitalizing leases

i. Balance sheet measures such as gearing or leverage ratios would be significantly increased by capitalization of operating leases.

ii. Performance measures such as profit margin, return on assets, and asset turnover would also be affected by capitalization of operating leases, although not as dramatically as balance sheet measures.

iii. The impact on balance sheet and performance measures would be most pronounced for service industry firms such as airlines, hotels, retailers, media agencies, and vehicle distributors.

iv. Capitalization of operating leases would likely alter the relative standing of firms within and across industries for gearing and other debt-related ratios. In contrast, capitalization of operating leases is not as likely to alter the relative standing of firms for performance measures, within or across industries.

The similarity between operating leases and debt

i. Disclosed capital leases under ASR 147 are positively associated with equity risk, after controlling for debt levels (which also are associated with equity risk).

ii. The present value of operating leases (calculated using a typical present value approach or a factor approach) also is positively associated with equity risk, after controlling for debt levels.

iii. Amounts paid under contingent fee lease arrangements are not associated with equity risk, suggesting that the contingent fee component of lease payments does not behave like debt in its effect on equity risk.




WA 20-3 (Continued)

iv. Leases (operating leases in particular) appear to be partial substitutes for debt financing, with leases partially consuming debt capacity.

How lease accounting information is used

i. Lending officers are willing to lend at lower rates and assign higher credit ratings to firms that use more operating leases than capital leases, suggesting either that lenders perceive capital leases and operating leases to be economically different, or that lenders are misled by the accounting.

ii. At least one credit rating firm consistently adjusts its debt and leverage analyses to recognize the present value of operating leases, suggesting that it considers operating leases to be equivalent to debt.

iii. Stockbroker analysts do not appear to capitalize operating leases when performing stock valuation or forecasting.

iv. Users and preparers often hold quite distinct views on how to account for leases. However, they both seem to agree on some important issues as well.

The impact of SFAS 13

i. The market’s assessment of firms’ equity risk did not change following the adoption of SFAS 13. This result holds for numerous measurements of equity risk across multiple industries.

ii. In a side-by-side comparison of identical firms that differ only in their use of capital or operating leases, CFOs, bank lenders, auditors, bond analysts, and stock analysts tend to prefer the operating-lease firm over the capital-lease firm on metrics such as profitability, ability to repay, and ability to predict cash flows. This result seems at odds with the finding that SFAS 13 had no impact on firms’ equity risk, but this difference may have occurred because participants in these studies were assessing more than just equity risk when expressing a preference for the operating-lease firm over the capital-lease firm.

iii. Firms mitigated the impact of SFAS 13 by renegotiating the terms of lease contracts to avoid capital lease criteria. Firms also shifted their financing away from fixed-price financing toward equity financing. This result was documented in the United States and in Australia in response to the issuance of their respective lease accounting standards.

iv. Stock prices declined for firms that would have experienced tightened debt covenant restrictions as a result of SFAS 13. The magnitude of the stock price decline was positively associated with the change in the tightness in debt covenant restrictions that would have resulted.




WA 20-3 (Continued)

v. No other stock price reactions to events leading up to the issuance of SFAS 13 have been documented, suggesting the possibility that the market’s reaction to any new lease accounting standard also would be minimal.

(c) Identify what the implications are of the research findings for the development of new accounting standards for leases.

Based on these studies and other opinions, the IASB considered various accounting models for lease accounting. It discussed

the right-of-use (contract based) approach. In this approach, the lessee recognizes its right to use the leased item and an obligation to pay for that item. The lessor recognizes, as an asset, its right to receive payments from the lessee and its residual interest in the leased item at the end of the lease.

the whole asset model. In this approach, the lessee records the whole of the physical item on its balance sheet. To correspond to that asset, the lessee recognizes two liabilities: the obligation to make payments to the lessor and an obligation to return the physical item at the end of the lease. The lessor recognizes its right to receive payments from the lessee and its right to have the leased item returned at the end of the lease.

the executory contract model. In this approach, the lessee recognizes no assets or liabilities upon entering into the lease contract. Lease rentals are recognised in profit or loss as they become due. The lessor recognizes the leased item as an asset.

the model used in current standards. The lessee either accounts for the lease as an executory contract or recognizes an asset and liability depending upon the classification of the lease contract. Lessor accounting similarly depends upon the lease classification.

The IASB tentatively concluded that the right-of-use (contract based) approach is the only approach that results in the recognition of the assets and liabilities identified in a simple lease. Under the right-of-use (contract based) approach, the capital and operating lease distinction would disappear and most leases would qualify for recognition as assets and liabilities by the lessee. As a result, the changes in the standards would be very different from current recognition and measurement standards.




WA 20-4

(a) The “performance obligation approach” is the approach discussed in the text book. In this approach, the lessor is granting the right to use the asset to the lessee over the term of the lease. The lessor does not lose control of the asset, which continues to be recognized on the statement of financial position. In this case, the lessor has the right to receive the lease payments, and an unconditional obligation to permit the use of the asset over the term of the lease. As a consequence, at the time the lease is entered into, a lease receivable is recorded as an asset and a performance obligation is recorded as the offsetting liability. The receivable and obligation are calculated to be the present value of the lease payments. As the lessor discharges the performance obligation, leasing income is recognized into income. As payments are received from the lessee, interest income is recognized and the receivable is reduced. Finally, the asset would continue to be depreciated over its useful life, On the statement of financial position, the asset, the lease receivable and the performance obligation are shown as a net liability or asset. On the statement of comprehensive income, the lessor would report leasing income, interest income and depreciation expense.




WA 20-4 (Continued)

(b) The “derecognition approach” assumes that a portion of the leased asset is sold when the rights of use are transferred to the lessee under the lease agreement. This requires that the leased assets be derecognized. The lease contract is a promise to transfer the asset to the lessee and so once delivery is completed, the performance obligation has been met and no longer exists. In derecognizing the leased asset, a receivable for the present value of the lease payments and a residual value are recognized. The residual value is a non-financial asset which represents the rights to economic benefits from the asset arising after the lease term. These economic benefits would arise from subsequent sale of the asset or re-leasing the asset under a new contract. The company will recognize revenue on the sale of the asset, and then interest income on the receivable as the lease payments are received. The impact on the statement of financial position will be a receivable and a residual value as assets. The impact on the statement of comprehensive income will show revenue from the sale of the leased asset, and interest income over the term of the lease.

(c) Using the information given, below is what would be shown on the statement of financial position for assets and liabilities on initial recognition of the lease:

Performance obligation Derecognition

Leased asset $100,000

Lease receivable $92,900 $92,900

Residual value $7,100

Performance obligation ($92,900)

Net assets $100,000 $100,000




WA 20-5

(a) In addition to triggering a gain, most likely Truttman was motivated to sell and leaseback equipment to generate some much needed cash flow. The interest rate offered by the leasing company was most likely favourable from the point of view of Truttman, in comparison to other sources of financing.

(b) 1. A lease is categorized as a finance lease if, at the date of the lease agreement, it meets any one of three criteria under ASPE or four criteria under IFRS. As the lease has no provision for Truttman to reacquire ownership of the equipment, it fails the criteria of transfer of ownership at the end of the lease under both IFRS and ASPE; there is no bargain purchase option. Truttman’s lease payments, with a present value equalling 75% of the equipment’s fair value, fails the criterion for a present value equalling or exceeding 90% of the equipment’s fair value for ASPE. However, under IFRS, since there are no “bright lines” one would have to judgementally determine if the present value of the payments allows the lessor to recover substantially all of its investment in the property with an appropriate rate of return. This criteria is likely not to be met under IFRS either. Under ASPE, the final criterion is whether its term allows the lessee to substantially use the building for its economic useful life. In this case, 73% is below the 75% threshold and therefore the criteria would not be met. In this case, under ASPE the lease would be classified as an operating lease. However, under IFRS, since there are again no bright lies, one could conclude that 73% of the economic life is long enough to receive substantially all of the economic benefits. In this case, the lease might be recorded as a finance lease. The final criteria under IFRS would look at whether or not the asset is specialized for the lessee’s use, which in this case, does not seem to be the case.

2. Comparisons of equipment’s fair value to its lease payments’ present value, and of its useful life to the lease term, are used to determine whether the lease is equivalent to an instalment sale and is therefore a finance lease. If the fair value test or the useful life test is met, there is an indication that the lessee is obtaining most of the benefits that the asset has to offer.

(d) Operating lease treatment under ASPE: Truttman should account for the sale portion of the sale-leaseback transaction at October 31, 2011, by increasing cash for the sale price for $13 million, decreasing building (and related accumulated depreciation) by the carrying amount of $10 million, and recognizing a deferred gain on sale of $3 million for the excess of the




WA 20-5 (Continued)

equipment’s carrying amount over its sale price. The deferred gain will be recognized over the term of the lease. If the sale price is greater than the fair value, the total gain deferred would be $4 million. All of the gain over the carrying value is deferred and amortized over the operating lease term. The operating lease payments are then recorded as an expense as made.

Operating lease treatment under IFRS: IFRS recognizes that if an operating lease is taken back, then the asset has been technically sold, and therefore all of the gain of $3 million, representing the difference between fair value ($13 million) and the carrying value ($10 million) is fully recognized into income at the time of the sale on October 31, 2011. If, as proposed in the question, the selling price was actually greater than its fair value, then the portion of the selling price greater than fair value of $1 million would be recognized as a deferred gain and amortized over the term of the lease, and the $3 million gain would be recognized immediately. The operating lease payments are then recorded as an expense as made during November and December, 2011.

(d) Capital lease treatment under ASPE: Truttman should account for the sale portion of the sale-leaseback transaction at October 31, 2011, by increasing cash for the sale price for $13 million, decreasing building (and related accumulated depreciation) by the carrying amount of $10 million, and recognizing a deferred gain on sale of $3 million for the excess of the equipment’s carrying amount over its sale price. The deferred gain will be recognized on the same basis as depreciation of the leased asset. At the same time, a capital leased asset and an offsetting capital lease obligation will be recognized and will equal the present value of the lease payments. At the end of the year, December 31, 2011, Truttman would recognize interest expense on the obligation at the effective interest rate, principal reduction in the obligation, and depreciation expense on the building (depreciated over the term of the lease).

Accrued interest on the obligation for the period from November 1, to December 31, 2011, will appear in the current liabilities section of the statement of financial position along with the principal portion of the first lease payment due October 30, 2012.

The remaining portion of the principal to be repaid beyond 2012 will be reported as a non-current liability. The cash flow statement for the year ended December 31, 2011, will show proceeds from the sale of the equipment as a source of cash in the investing section of the cash flow statement. For the operating activities section, prepared using the indirect format, the gain on the sale of the equipment and the depreciation expense




WA 20-5 (Continued)

will be added back to income as well as the increase in the interest payable for the accrual recorded on the lease at the end of the year.

Finally the capital lease and the related obligation under capital lease from the leaseback transaction are a non-cash financing and investing transaction that will not appear on the face of the cash flow statement but will be reported in the notes to the financial statements.

Capital lease treatment under IFRS: Truttman should account for the sale portion of the sale-leaseback transaction at October 31, 2011, by increasing cash for the sale price for $13 million, decreasing building (and related accumulated depreciation) by the carrying amount of $10 million, and recognizing a deferred gain on sale of $3 million for the excess of the equipment’s carrying amount over its sale price. The deferred gain will be recognized over the term of the lease (which differs from ASPE). At the same time, a capital leased asset and an offsetting capital lease obligation will be recognized and equal to the present value of the lease payments. At the end of the year, December 31, 2011, Truttman would recognize interest expense on the obligation at the effective interest rate, principal reduction in the obligation, and depreciation expense on the building (depreciated over the term of the lease).

Accrued interest on the obligation for the period from November 1, to December 31, 2011, will appear in the current liabilities section of the statement of financial position along with the principal portion of the first lease payment due October 30, 2012.

The remaining portion of the principal to be repaid beyond 2012 will be reported as a non-current liability. The cash flow statement for the year ended December 31, 2011, will show proceeds from the sale of the equipment as a source of cash in the investing section of the cash flow statement. For the operating activities section, prepared using the indirect format, the gain on the sale of the equipment and the depreciation expense will be added back to income as well as the increase in the interest payable for the accrual recorded on the lease at the end of the year.

Finally the capital lease and the related obligation under capital lease from the leaseback transaction are a non-cash financing and investing transaction that will not appear on the face of the cash flow statement but will be reported in the notes to the financial statements.




WA 20-6

There are many differences between IFRS and private enterprise GAAP and the contract based approach with respect to measurement and reporting for leases. Primarily, ASPE has been written to follow historical Canadian practice. ASPE has also been designed with the primary user in mind of being the creditor, rather than outside shareholders and creditors. Given that generally creditors have access to management; the disclosure has also been simplified. The contract based approach has been designed to eliminate the requirement to arbitrarily classify a lease into operating or capital. Under this approach, all leases are treated the same and will impact the statement of financial position and the statement of comprehensive income in the same manner. Any perceived manipulation to keep leases off the balance sheet is eliminated.

In most areas of lease accounting, IFRS and ASPE are converged. There are some subtle differences that are highlighted below:

a) ASPE and IFRS use the classification approach for leases – either operating or capital. ASPE refers to capital leases and operating leases for lessees, and operating, sales-type or direct financing leases for lessors. IFRS uses the term “finance leases” or operating leases for lessees or lessors. In contrast, the contract based approach does not require classification of leases, since they are all treated the same.

b) ASPE has three criteria to assess for determining lease treatment and numerical thresholds are provided to assist with this. IFRS requires that the criteria be applied more judgmentally, with no “bright lines” of numerical thresholds provided. In addition, IFRS has one more criteria to assess which looks at the uniqueness of the asset specifically designed for use by only the lessee. The only aspect that the contract based approach would assess is to determine if the lease is in substance a purchase or sale, and if so, would not be recognized under the lease recognition and measurement standards.

c) For an operating lease, both ASPE and IFRS would recognize the lease payments as they are made, either to income or expense for the lessor and lessee, respectively.

d) For the contract based approach for the lessee, the rights to use the asset are recognized as an intangible asset and contractual lease obligations are recognized as a liability. Both of these amounts are determined using the present value of the lease payments. Amortization of the intangible right and interest expense on the obligation is recognized over the term of the lease. The concept




WA 20-6 (Continued)

behind the contract based approach is that a contractual obligation has been entered into on the signing of the lease, and this obligation should be reported on the statement of financial position. As the right to the asset is used, amortization is reported; and as the obligation is paid, the obligation is reduced. In this way, it does not matter what type of lease is entered into, and judgment is no longer required to determine if the lease should be treated as operating or a finance lease. The contract based approach uses the lessee’s incremental borrowing rate. For the contract based approach for the lessor, the treatment is similar as described above except a lease receivable and offsetting performance obligation is reported.

e) For capital (finance) leases, both IFRS and ASPE recognize the present value of the lease payments as a lease obligation and leased asset for the lessee. As the lease term progresses, the asset is amortized and interest expense is recognized on the lease obligation. Payments reduce the lease obligation. IFRS uses the interest rate implied in the lease when it can be reasonably determined, or the lessee’s incremental borrowing rate. ASPE uses the lower of the implied lease rate or the lessee’s incremental borrowing rate. Under the contract based approach, the treatment is the same as described above since no differentiation is made between operating and finance leases.

f) For the lessor, ASPE has two other recognition criteria which IFRS does not specifically require under the lease standards, but does by default under revenue recognition. Accounting treatment is the same under both standards.

g) There are differences in what would be included in the lease payments. IFRS and ASPE have similar standards, but the contract approach would also require that contingent payments under the lease agreements be estimated.

h) Disclosure is minimized for ASPE. For IFRS, more extensive disclosure is required including reconciliations and additional information about terms of the leases.




CASES

Note: See the Case Primer on the Student website, as well as the Summary of the Case Primer in the front of the text. Note that the first few chapters in volume 1 lay the foundation for financial reporting decision making.

CA 20-1 CROWN INC.

Overview

- CI’s management has a financial reporting bias; that is, they do not want to increase the debt that is presently on the balance sheet.

- IFRS is a constraint since CI is public. Note that the company also wants to know the differences between IFRS and ASPE.

- Since the company appears to have other debt, the creditors will be key users. They will want objective information and will be concerned with the debt-to-equity ratio to assess how leveraged the company is, and thereby assess the company's ability to repay debt.

- As the auditor you will want conservative and transparent financial statements.

Analysis and Recommendations

Issue: Whether the lease is a capital/finance lease or an operating lease

- There is no evidence that legal title passes to CI at the end of the lease.- There is no BPO since the purchase option allows CI to purchase at the

FV.- The term of the lease is only 12 years, which is less than 75% of the

economic life of 20 years.- The PVMLP is as follows:

$150,000 X 7.16073 = $1,074,110 $1,074,110/$1,900,000 = 56.5% which is less than 90%

Therefore, it would appear, on the surface that the lease was an operating lease.

On the other hand, given that the asset is manufactured specifically for CI, there is no other possible use for the machine, and AL likely does not want the machine back, it would appear to be common sense that the lease is indeed a capital lease that represents a purchase in substance by CI. The written agreement should not be reviewed in isolation but rather within the context of the




CA 20-1 (CONTINUED)

reporting environment (management bias) and the additional unwritten agreement to purchase.

The principle hinges on the transfer of the risk and rewards of ownership. In this case, both the auditor and the client know that the substance is such that the lease has been used as alternative financing in order to obtain off-balance-sheet financing; however, the client will argue that it is not a capital/finance lease since it does not meet the criteria if numerical thresholds are used as a benchmark. Note that under ASPE the numerical thresholds are often used but under IFRS the analysis does not hinge upon this. The key is on assessing the substance of the arrangement.

Minor differences from the perspective of the lessee include:- Terminology – IFRS refers to capital leases as finance leases- Discount rates – ASPE requires the use of the lower of the IR and IBR if

IR known whereas IFRS requires the use of IR if known (otherwise IBR).

Recommendation: As an auditor, there is an overriding concern that the financial statements are fairly presented, the implication being that the substance of all transactions is appropriately reflected in the financial statements. In this case, the evidence is too strong that this is a capital/finance lease and, therefore, the auditor should argue to capitalize the lease, especially if the amounts are material.




CA 20-2 KELLY’S SHOES

Overview

- Not clear whether GAAP is a constraint but users will likely want GAAP financial statements since they provide more useful information. Differences between IFRS and ASPE are provided as requested.

- Landlords in particular might want to see the financial statements in order to help negotiate the restructuring.

- In addition, creditors and shareholders would be interested in transparent statements.

- As management – would want to show a realistic picture of the state of affairs. May be biased to make the situation look at bit worse so as to be in a better negotiating situation.

Analysis and Recommendations

Issue: How to account for the three months bonus of free rent/costs of cancellation. Not clear as to whether operating or capital leases (termination of a capital lease would result in removal of assets/liabilities with a gain/loss recognized).

Accrue costs Do not- If likely that the costs would be

incurred and measurable. Per IAS 37 – present obligation as a result of past transaction, probable outflow and measurable (essentially the same as ASPE).

- In this case— the leases are non-cancellable and therefore, it is likely that there would be costs to break the lease.

- The key would be whether these are measurable – would depend on stage that negotiations were in.

- Measurement may be an issue since each landlord might make a different deal.

- Some landlords may even be willing to provide financial support to the company to keep the stores open as long as possible— cannot accrue this benefit until received (contingency accounting).

- An exit plan by itself does not necessarily create an obligation.

- Would wait until contracts are actually terminated.

Recommendation: It would appear that the negotiations were at a very preliminary stage and that the landlords might have been willing to offer some inducements/concessions to the company to stay longer. Therefore, the outcome of the uncertainty was not yet determinable and recognition would not be




CA 20-2 (CONTINUED)

recommended. This would be further supported since, even if it were argued that the costs were likely, it is difficult to measure the cost. At the one end of the spectrum, the landlords could require the full commitment to the end of the lease be honoured. At the other end, the landlord might agree to a lesser amount, i.e., the company would pay rent until a new tenant is found.




IC 20-1 AIR CANADA

Overview:

- The company was under bankruptcy protection at the time.- It is a public company and therefore GAAP is a constraint. As noted in the

case, use IFRS for simplicity sake even though the company would have been following pre-2011 Canadian GAAP.

- GE Capital is a key user and wants payment for leased planes; it has accused the company of hiding behind bankruptcy protection.

- The company is looking for new investors who will rely on the statements —therefore it may try to make the statements present the company in a favourable light.

- Role of auditor— will want to be conservative – may be sued if company subsequently goes under.

Analysis and recommendations:

Issue: Classification of leased planes

Capital Operating- These planes are essential assets of the company, i.e., the company cannot run without them. They should therefore be capitalized and shown as assets and liabilities on the balance sheet.- Would give GE more comfort seeing the liability acknowledged.

- According to GAAP – qualify as operating leases and therefore need not be fully capitalized.- Should the total rent be spread over the lease term (straight line) or should the company recognize the legal rent owed according to the lease agreement?- Makes more sense to look at the total to be paid and spread this amount over the lease = economic substance.- Recognizing the rent according to the contract (legal form) leaves room for manipulation and does not reflect the economic substance.

Recommendation:

Revisit the lease presentation analysis to ensure that the planes should not be treated as capital leases. If operating, ensure appropriate disclosure as to cash flow obligations. If operating, GAAP supports spreading the total lease costs over the term of the lease. Regardless of classification, these are obligations that should be reflected clearly in the financial statements either as obligations (capital lease) or as future cash outflows (operating lease) that become liabilities once the assets has been used.




IC 20-1 (CONTINUED)

Issue: Convertible Subordinated Debentures. These would have been recorded in 1999 and so not really an issue – compound instrument – part debt/part equity

Issue: $209 million damages- Accrue if likely and measurable/probable—depends on status of

complaint. More information is needed.

Issue: Offsetting of financing and amounts receivable from CIBC.- May offset if legal right to offset and management intent to settle net.

Need more information.

Issue: How to account for severance plans- Recognize when entity committed and the amount can be reasonably

determinable.o i.e., when approved, when plan with specifics outlined (no

possibility of withdrawal of plan). - It sounds like the plan was articulated and approved and that the

terminations were carried out swiftly— therefore would recognize costs and liability.




IC 20-2 IMAX

Overview:

- A public company whose shares trade on the TSX and NASDAQ so Canadian and US GAAP are a constraint.

- Note that the OSC allows the company to file under US GAAP.- NB – the case asks that IFRS be used for the analysis for simplicity sake.- Debt covenants require monitoring several things including debt levels and

therefore debt levels will be important and there may be some bias to keeping them low.

- As a potential investor— will want conservative transparent financial statements

Analysis and recommendations:

Issue: How to account for conversion of contracts relating to older technology to new contracts with IMAX digital theatre systems

- Theses contracts for older systems are sometimes converted to new contracts with newer technology

Treat as two contracts – cancel old contract and set up new contract

Treat as one contract – both contracts are part of the same overall deal

- Terminate old contract and write-off/recognize any deferred revenues/costs.

- Set up new contract and recognize revenues as earned.

- Review both contracts together and ensure that revenues are equal to fair value of the new system.

- Continue to defer any revenues received in advance under either contract and recognize only as earned.

- May recognize any excess revenues (over the fair value of the new system) once contracts are signed and deal is finalized. At that point, the transaction will be measurable.

Recommendation: Do not recognize revenues even if cash received in advance. Unearned revenues should be equal to the fair value of the new system and should be recognized as earned. This is the position that the company has taken.

Issue: Concessions/considerations given to a customer including free products and services




IC 20-2 (CONTINUED)

Treat as multiple element arrangements (as unearned revenues)

Treat as costs and recognize liability

- These concessions are essentially part of what is being sold to the customer.

- Therefore, part of the total revenues should be separated and allocated to these services/products and recognized when earned.

- These are costs of selling and should be accrued and recognized as costs/liabilities when revenues are recognized (matching).

- If revenues are deferred, may have to recognize the costs up front unless they meet the definition of an asset. Alternatively, recognize revenues equal to the costs (or with normal profit margins).

Recommendation: Treat as multiple element arrangements and separate units of account as the company has done for the free products and services.

Issue: Fees for film production where financing provided in exchange for rights in the film. The company retains distribution rights. Therefore the company receives cash and distribution rights and provides film production services.

Recognize as revenues Recognize as decrease in cost of producing film

- Recognize as revenues when significant events completed as this is likely a long term contract with many significant events.

- Significant events would occur as film is being produced.

- Films are produced for third parties – service provided.

- Consider also recognizing distribution rights as an asset.

- Represents a source of cost reduction.

- Often the films are jointly owned by more than one party including the company.

- This does not represent an investment in the company, only in the film and therefore would not be presented as equity.

- Nor does it represent debt since it is not repayable.

Recommendation: Okay to treat financing as cost reduction. A third option would be to recognize as debt— that would be the royalties owed to the third parties once the film is sold. Due to the complexity—ensure adequate note disclosure.




IC 20-2 (CONTINUED)

Issue: How to account for costs of digitally remastered films where film rights belong to third party?

Expense Capitalize- Underlying film rights belong to a third party.- Future benefits uncertain as do not know if films will sell.

- Will yield future benefits when sold.

Recommendation: Acceptable to capitalize— would not do the work if did not think that it would generate future benefits.




RESEARCH AND FINANCIAL ANALYSIS

RA20-1 EASTERN PLATINUM.

(a) At the beginning of Note 1, “Summary of Significant Accounting Policies”, it’s stated that “Eastern is a platinum group metal producer involved in the mining, development and exploration of properties in South Africa.

(b) From Note 3(e), we see that Eastern has rental income from residential properties which is recognized on a straight-line basis over the term of the lease. These would be operating leases for which Eastern is the lessor. As described in Note 3 (r)(i), any direct costs incurred in negotiating these leases is added to the value of these properties and depreciated over the term of the lease on a straight-line basis. Note 3(k)(ii) identifies that Eastern has leased assets. These assets represent finance leased assets which are recorded at the lower of fair value and the present value of the lease obligations at the inception of the lease. These leased assets are amortized and tested for impairment. As further explained in Note 3 (r)(ii), Eastern recognizes finance charges on the lease obligations into net earnings. Finally, Eastern is also a lessee under operating leases as described in Note 3(r)(ii). Under these types of leases, the lease payments are expensed on a straight-line basis over the term of the lease. Any incentives received at the beginning of the lease are recognized over the lease term into income.Note 12 provides the details of the lease obligations and payment terms. The finance leases relate to mining vehicles and are for 5 years, with payments half yearly in advance with the vehicles being security for the leases. The interest rate is the South African prime rate plus 1%. These leases are repayable in 3 annual payments with a top up payment due in December 2011. The present value of these leases is US$3.776 million. Note 19 also indicates that finance charges on these leases totalled US$377 thousand during 2009.

Although the company has operating leases, there were no commitments noted for these leases. Only the finance lease commitments are disclosed in the notes.

(c) On the statement of financial position, we can see current portion and non-current portion of the finance leases. These leases are for the mining vehicles that are included in property, plant and equipment. As detailed in Note 3(w)(iii), these mining leased assets are depreciated over 5 years,




RA20-1 (Continued)

which ties into the lease term. Also included in property, plant and equipment are the residential properties that are leased and for which Eastern is the lessor. On the income statement, there is rental income, which has not been separately shown on the face of the statement and may be included in revenue or netted with some other number. We also know that included in finance charges is the interest on the finance leases of US$377 thousand. Finally, included in the depletion and depreciation expense is depreciation on residential properties of US$111 thousand and on the mining leased assets of US$1.112 million (from Note 8).

(d) Lease payments for finance leases are included in two types of activities on the statement of cash flows: operating activities and financing activities. The portion that represents interest expense is reported in “finance costs paid” of US$69 and there is an add back of the finance costs expense (which includes the interest expense on these finance leases of US$1.691 million. Also included in operating activities would be the operating lease costs paid and the rental income received on operating leases related to the residential properties. Under financing activities, the repayment on finance lease obligations representing the reduction of principle of US$1.223 million is shown.

Under Note 8, there are no new additions to plant and equipment leased, so there were no new finance leases entered into during 2008 or 2009.

(e) in thousands of US$Dec. 31, 200 9

Net income $ 1,222Total assets 706,850Return on total assets 0.17%

Total liabilities 77,338Shareholders’ equity 629,512Total debt-to-equity ratio 0.12

(f) Under the contract based approach, the asset that is acquired by a lessee is not the physical property that is leased; rather, it is an intangible asset that represents the right to use the asset that is conveyed under the lease agreement. The liability is the contractual obligation to make lease payments. In the case of the lessor, a lease receivable would be set up with an offsetting performance obligation. In both cases, the asset and the obligation are initially recorded at the present value of the lease payments. For the lessee, the intangible asset is then amortized over the term of the lease on some systematic basis to earnings, and obligation is reduced by payments less the interest charge.




RA20-1 (Continued)

For a lessor, the lease receivable would be reduced by lease payments less related interest earned, and the performance obligation would be reduced to net income over the term of the lease and would represent rental revenue. There also would still be depreciation on the assets that are being leased.

In the case of Eastern, we will look at each of the leases individually:1. Finance leases for the mining assets – Since the company already shows an obligation for these leases, the only change would be to represent the leased assets as a right under intangible assets, rather than as property, plant and equipment, This would result in moving the carrying value of the property leased of US$2,441 thousand to intangible assets and out of PP&E.2. Leases on the residential properties - Eastern is the lessor– In this case, if the leases are for longer than one year, the lease receivable and the related performance obligation should be recorded on the statement of financial position. However, the company does not disclose the lease payments and terms for these leases, so no adjustment can be made.3. Other operating leases as lessee - Again, under the contract based approach, the company would record leases that are longer than one year, as an intangible asset recognizing the right to use the asset and an offsetting obligation to make contractual payments. These amounts would reflect the present value of the lease payments to be made. However, once again, there is no disclosure of any commitments related to these leases and so no adjustment can be made.




RA20-2 CANADIAN NATIONAL RAILWAY COMPANY AND CANADIAN PACIFIC RAILWAY LIMITED

(a) Canadian National Railway (CNR) discloses the cost, accumulated depreciation, and net book value of properties held under capital leases in Note 5, ”Properties” totalling a net carrying value of $1,474million. This note also indicates that such properties consist primarily of track and roadway, rolling stock, building, information technology and other. As footnote to this schedule, CNR also indicates that included in track and roadway is the cost of land of which $108 million is a right of way and has been recorded as a capital lease.CNR discloses in Note 9 an amount of “capital lease obligations and other” in its long-term debt note of $1,054million. In Note 17, CNR discloses the amount of future minimum lease payments for its operating leases, capital leases and in total in its major commitments and contingencies note. The note also identifies that the company has operating and capital leases, mainly for locomotives, freight cars, and intermodal equipment. It also discloses the amount of imputed interest on its capital leases ranging from 1.9% to 11.8% and the present value of the minimum lease payments at current rate included in debt. Also in this note, CNR indicates that under some of its capital leases, it has the option to purchase the asset at a fixed amount. We are also told that automotive equipment is leased under operating leases with one year, non-cancellable terms and that the estimated rental payment is $30 million. Finally, rent expense for all operating leases was $213 million for the 2009 fiscal year.

Canadian Pacific Railway (CPR) discloses in Note 16 the net amount of assets under capital lease and the amount of related accumulated depreciation in its net properties note totalling $391.3 million. CPR discloses in Note 21, the amount of obligations under capital leases of $322.7 million, the amount of minimum payments for its capital leases, the amount of related imputed interest and present value of these payments, and the related current portion of the obligations in its long-term debt note. Interest rates used for the capital lease obligations range from 5.2% to 9.38% In note 29, the amount of minimum payments for its operating leases is included in its commitments and contingencies note. Detailed accounts and amounts for both companies are presented below.




RA20-2 (Continued)

CNR ( $ in millions)

Capital Lease ArrangementsCapital leases included in properties, cost $ 1,845Accumulated depreciation 371 Net book value of assets under capital lease 1,474 Capital lease obligations and other 1,054

Minimum lease payments - capital 1,468Imputed interest on capital leases 417

Present value of minimum lease payments at current rate included in debt 1,051

Operating Lease ArrangementsMinimum lease payments - operating $ 713

CPR in millions of $'s

Capital Lease ArrangementsNet properties under capital lease $ 530.3Related accumulated depreciation 139.0Net book value 391.3

Obligations under capital leases 319.7 Obligations under capital leases CDN$ 3.0Total minimum lease payments (capital) 512.4 Imputed interest 189.7Present value of minimum lease payments - capital 322.7 Current portion 9.6 Long-term portion 313.1

Operating Lease ArrangementsMinimum payments under operating leases $ 940.3




RA20-2 (Continued)

(a)Yes, they appear to have provided all the lease disclosures required by the accounting standards.

(b) The leases of both companies are long term. CNR’s operating and capital leases extend at least seven years from the balance sheet date, since the note refers to “2015 and thereafter”. CPR’s operating leases extend to 2014and the capital leases extend to 2026 and 2031.

(c)The future minimum annual rental commitments under each type of lease for each company are presented below. Even though the companies are in the same industry, there is a difference with respect to how they provide for capacity as evidenced by the fact that they have different proportions of operating versus capital leases measured in terms of minimum lease payments. CNR has a higher proportion of capital leases than CPR, and CPR has a higher proportion of operating leases than does CNR.

In millions of C$ CNR % CPR %

Minimum lease payments - operating

713.0 32.7%

940.3 64.7%

Minimum lease payments - capital

1,468.0 67.3%

512.9 35.3%

(d)The debt-to-equity ratios for each company at December 31, 2009, are presented below.

CNR CPRTotal Liabilities $13,943 9,523.0Total Equity 11,233 4,720.8Debt/Equity ratio 1.24 2.0




RA20-2 (Continued)

(e) Using a 7% discount rate, the capitalized value of the off-balance-sheet operating leases is presented below for each company. (Note: the schedule below assumes that all of the “thereafter payments” would be made in year 2016, which is likely not correct.)

year period CNR

CNR PV of

payments @7% CPR

CPR PV of payments@7%

payments Payments

2010 1.0 $131 122.4 $149.4 139.6

2012 2.0 112 97.8 129.4 113.02013 3.0 90 73.5 118.6 96.82014 4.0 66 50.3 103.6 79.02015 5.0 42 29.9 78.7 56.1

Thereafter 6.0 272 181.2 360.6 240.3Total payments $713.0 $555.1 $940.3 $724.8

(f) These operating leases would be recorded as: Increase to intangible assets for the right of use and an increase to contractual lease obligations. To make more accurate adjustments for the contract-based approach, we would have needed the payments for each year after 2016. Some of these leases may mature much later than 2016, which would change the calculation of the present values. We have also had to make assumptions about the effective interest rates that might not be correct. Also, the contract based approach would include any renewal terms that were likely to be used and any contingent rents. Finally, we were unable to make adjustments on the statement of earnings. In this case, the annual lease expense would be eliminated, and its place would be amortization of the to the intangible asset on a straight-line basis over the term of the lease and the interest charge on the lease obligation for the year.

(g) The debt-to-equity ratios, recalculated to include the capitalized value of the

operating leases, are presented below. By including the capitalized amount of the operating leases in the liabilities calculation, the debt-to-equity ratios of both companies are significantly higher. For CNR, the ratio has increased from 1.24 to 1.29, which is only a 4% increase. However,




for CPR, that uses predominantly more operating lease than CNR, the ratio has increased from 2.0 to 2.17, which represents an 8.5% increase.

RA20-2 (Continued)

CNR CPRLiabilities as reported $13,943 9,523.0Capitalized value of operating leases 555 724.8Revised Liabilities (including capitalized value of operating leases) 14,498 10,247.8Total Equity 11,233 4,720.8Debt/Equity ratio 1.29 2.17

(h) In the case of CNR and CPR above, the companies use different percentages of owned versus leased assets. In order to properly compare the companies with respect to debt ratios and asset turnover ratios, it is important to reflect all the assets being used along with the obligations incurred to use those assets. Consequently, the contract based approach would ensure that the assets and related obligations are recognized and measured appropriately on the statement of financial position. In trying to make the adjustments from the current notes for CNR and CPR, some assumptions were made as to the lease terms and the interest rates which might not be correct. And as noted above, we are also missing information to make all of the adjustments required. If the companies adopted contract based approaches, these adjustments would no longer be required.




RA20-3 INDIGO BOOKS & MUSIC INC.

(a) As disclosed in Note 2, the company explains that it “conducts a substantial amount of its business from leased premises”. These leases have renewal terms, over which the company depreciates the leasehold improvements and also determines the classification of the lease as capital or operating. From note 2, we also see that the leasehold improvements are depreciated over a maximum term of 10 years. Finally, any lease inducements are amortized over the lease term. The lease arrangements indicated in the company’s financial statements are the operating leases for stores, offices, and equipment identified in Note 12, “Commitments and Contingencies”. The operating leases expire between 2010 and 2020 and are subject to renewal terms in some cases (although the term and amounts are not disclosed). There are also contingent rents based on sales as part of some of these operating leases. As disclosed in Note 12, the company has capital lease obligations outstanding of $5 million at March 28, 2009 which are included in long term debt. For the capital leases related to equipment, Note 4 4, “Property, Plant and Equipment” discloses that the cost and accumulated depreciation to date for this leased equipment is $13,760 thousands and $7,748 thousands, respectively for a net balance of $6,012 thousands. This equipment is depreciated over 3 to 5 years (see Note 2).

(b) For the operating leases, the only amounts on Indigo’s balance sheet would be prepaid or accrued lease payments, which are not separately identified. On the income statement, the annual lease payments would be included in the “costs of product, purchasing, selling, and administration” expense line. For the capital leases, equipment under capital leases at an amount of $6,012 thousands is included in the capital assets line of the financial statements (net of accumulated amortization). There is an offsetting amount of $2.7 million being shown as current portion of long-term debt, and $2.3 million being shown as long-term debt.On the income statement, there is a lease expense for the operating leases, and interest expense on the capital lease.




RA20-3 (Continued)

(c) Ratios for Indigo are presented below.

( $ in thousands) Amount

A Property, plant and equipment 72,137B Total Assets 487,506C Total Liabilities 256,616D Total Equity 230,890E Revenue 940,399F Net earnings 30,6501 Debt/Equity ratio (C/D) 1.112 Capital asset turnover ratio (E/A) 13 X3 Total asset turnover ratio (E/B) 1.93X4 Return on investment (F/B) 6.3%

(d) To adopt the contract based approach, the following adjustments are required:

1. Capital leases – Under the contract based approach, one of the differences in this analysis would be if there were contingent rents to be paid. Since the notes make no mention of this with respect to the capital leases, we can assume that there are none. The only other adjustment would be to move the leased asset from the property, plant and equipment to intangible assets. There are no adjustments required on the income statement provided we assume that the amortization of the intangible asset would be consistent with the depreciation of the equipment, which is likely the case.

2. To capitalize the operating lease commitments, one needs the following:

a) The amount and timing of the annual payments and the effective interest rate for capitalization for the opening balance and the closing balance of the obligation:

b) Assuming an interest rate of 5.2%, which is consistent with the weighted average rate disclosed for the capital leases, and using the minimum operating lease payment amounts disclosed in Note 12, an estimate of the capitalized value is provided below for the opening and closing balances for the 2009 fiscal year. Although there are contingent rents, without some information on these amounts, the value of these have not been included in the present value of the




RA20-3 (Continued)

obligation. Furthermore, although we know that some of the leases have renewal periods, without adequate information, we were unable to include these in the following calculations. Consequently, we have assumed no renewal periods and no contingent rents.

c) We have assumed that the lease expense for 2009 was the same as the forecasted payment for 2009 from the 2008 note disclosure which is $58.3 million.

d) We have assumed that the lease term is 6 years (based on the forecasted cash flows) and therefore the intangible right of use will be amortized over the remaining lease term of 6 years.

(millions of $)

year 2008

payments

2008 Present

value@ 5.2%

2009 payments

2009 present

value @5.2%

2009 58.3 55.42010 52.0 47.0 60.8 57.82011 43.4 37.3 54.0 48.82012 37.7 30.8 48.2 41.42013 28.1 21.8 38.4 31.42014 47.5 35.0 25.3 19.62015 38.9 28.7Total 267.0 227.3 265.6 227.7

Based on the above information, the next step is to calculate the implied interest charge for the year and reconcile the contractual lease obligation account from the opening to the closing balance.

From the above analysis, the obligation account has changed as follows:




RA20-3 (Continued)

(in millions $)Opening balance – Mar 2008 227.3

Interest see below (at 5.2%) 11.8

Payment -58.3

New leases- assumed 46.9

Closing balance – Mar 2009 227.7

The implied interest charge is: 227.3 X 5.2% = 11.8 million.

Finally, the amortization of the intangible asset for the 2009 fiscal year.

Assuming that the new leases arose half way through the year, the amortization on the intangible asset is assumed to be: (227.3/ 6 ) + (46.9/6 X 50%) = 37.9+ 3.9 = 41.8 million. Net book value of intangible assets at 2009 would be:

227.3 + 46.9 – 41.8 = 232.4

Impact on net earnings will be:Add back lease payment +58.3Deduct Amortization on new intangible assets -41.8Deduct Interest on lease obligation -11.8Net change +4.7

Impact on cash flows:On operating activities:Add back lease payment from operating activities +58.3Deduct interest charge on lease obligation - 11.8Net change 46.5

Since the new leases are non-cash activities, there would be no impact on investing activities – just note disclosure

Financing activities Repayment of obligation -58.3 + 11.8 = -46.5




RA20-3 (Continued)

Adjustments required to the balance sheet, income statement and cash flow statement are as follows:

(in millions $)As reported Adjustments Revised balance

Total Assets 487.5 232.4 719.9

Total liabilities 256.6 227.7 484.3

Total equity 230.9 4.7 235.6

Net earnings 30.7 +4.7 35.4

Operating cash flows

93.9 46.5 140.4

Investing cash flows

-49.2 -49.2

Financing cash flows

-8.5 -46.5 -55.0




RA20-3 (Continued)

($ in thousands)Original amount Revised

1 Debt/Equity ratio 1.11 2.06

2Total asset turnover ratio(no change in revenue) 1.93X 1.31X

3Return on investment (F/B) 6.2% 4.9%

1. As can be seen from the above table, all of the ratios have worsened once the operating leases are recognized under the contract based approach. On the other hand, the operating cash flows have improved since the payments are now cash flows related to financing rather than operating.. This example illustrates how significantly the capitalization of leases can affect the financial statements and emphasizes why there is sometimes an incentive for management to keep leases “off the balance sheet”. To compare Indigo’s financial statements with competitors who purchase their buildings and equipment outright, one should use the revised figures presented above to enhance the comparability of the companies. Without doing so, Indigo’s results might appear more favourable than they really are which could be misleading. As a result, adopting the contract based approach would make all the companies comparative without the need to make numerous assumptions in order the make the appropriate adjustments.




RA20-4 RESEARCH AN AUTOMOBILE LEASE

(a) The terms and conditions associated with the lease of a vehicle include:1. Lease costs which include

a) leased vehicle price, which include price of accessories, dealer installed options, freight and pre-delivery inspection, and all applicable taxes such as federal air conditioning tax, provincial gas consumption tax, tire tax, etc., but excludes GST and PST;

b) optional extended warranty;c) optional life insurance;d) optional disability insurance;e) other (specify);f) less cash down payment;g) less trade-in allowance (net of amount owing on trade-in);

andh) less end value of vehicle, to arrive at the amount to be

amortized. (See item 8 below)

2. Total lease charges, representing interest, and annual lease rate, stated as a percentage (the latter being provided in the majority of cases).

3. The lease term, expressed in the number of months.

4. Amount of monthly payments (annuity due) including:a) number of monthly payments,b) base monthly payment (which is the amount to be amortized

[see item 1 h] above) plus total lease charges (interest) divided by the number of monthly payments,

c) plus GST,d) plus PST, to arrive at the total monthly payment.

5. Total of monthly payments arrived at by multiplying the monthly payment by the number of monthly payments.

6. Summary of amounts due on delivery including:a) net cash down payment,b) net trade-in allowance,c) GST, PST or HSTd) vehicle licence fee,e) registration fee,f) other (specified), g) first monthly payment, andh) refundable security deposit.




RA20-4 (Continued)

7. Specification concerning the kilometre charge for kilometres driven beyond a set limit negotiated and specified in the lease to fit the customer’s particular needs.

8. Lease end purchase based on the estimated fair market value of the vehicle at the end of the term of the lease. This option price would have GST and PST added as well as licence fee, registration fee, and charges related to certification of the vehicle.

9. Other conditions of the lease include:a) insurance;b) maintenance repairs and operating expenses;c) taxes, registration and other charges;d) excess wear clauses;e) fines, liens and encumbrances;f) early termination clauses;g) defaults;h) warranties;i) guarantees; andj) clauses concerning modification or relocation of the vehicle.

(b) The cash flows associated with the lease include the amounts specified under the amounts due on delivery of the vehicle (item 6 of part (a) above); the monthly payments under the lease, as calculated above; and “the lease end purchase” (described in item 8 above), should the lessee choose the option price at the end of the term of the lease, to purchase the vehicle.

(c) The purchase option is the better choice. In the car lease, all of the risks associated with ownership are passed on to the lessee. The amount provided as the option price to purchase the vehicle at the end of the term of the lease is a conservative amount arrived at by the lessor to reduce the risk to them from the realization of the value of the vehicle through resale or through an additional lease transaction, should the option to purchase not be exercised.




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Documents

lessee entries capital

type of lease lessee

land lease lessee

lessor entries disclosure

capital lease payments

lessee calculations

leaseback lessee

lessee capitalizable