sm ch (20).doc

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LEASES

ASSIGNMENT CLASSIFICATION TABLE

Topics Exercises Exercises ProblemsBrief AssignmentsWriting

*1. Rationale for leasing. 2, 3, 4

*2. Lessees: classification of leases; accounting by lessees. 1, 2, 3, 4, 5, 6, 7, 8, 9, 11 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19, 21 1, 2, 3, 5, 6, 7, 10, 11, 12, 14, 15, 16, 17, 18, 20 1, 2 *3. Disclosure of leases. 4, 8, 9, 15 3, 5, 6, 7, 8, 10, 11, 12, 18, 20 *4. Lessors: classification of leases; accounting by lessors. 10, 12, 13, 14, 15, 16, 17 6, 7, 10, 11, 14, 15, 16, 17, 18, 19, 20, 21 3, 4, 5, 6, 9, 10, 11, 13, 15, 16, 18, 20 3, 6 5. Differences between

IFRS and ASPE 1, 2 6, 10, 11 6, 7, 8, 9, 14, 16 *5. Sale and leaseback. 18, 19 22, 23, 24 22, 23 4 *6. Real estate leases. 19, 20 25 22

*7. Contract-based

approach 22, 23 13 19, 20 3 *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

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ASSIGNMENT CHARACTERISTICS TABLE

Item Description DifficultyLevel of (minutes)Time

E20-1 Lessee entries; capital lease with

unguaranteed residual value. Moderate 15-20 E20-2 Lessee Entries; operating lease; comparison Moderate 20-25 E20-3 Lessee calculations and entries; capital lease

with guaranteed residual value. Moderate 20-25 E20-4 Lessee entries; capital lease with executory

costs and unguaranteed residual values. Moderate 20-30 E20-5 Lessee entries; capital lease with executory

costs and unguaranteed residual, lease and fiscal year differ.

Moderate 25-35 E20-6 Type of lease; Lessee entries with bargain

purchase option. Moderate 20-30 E20-7 Lessor entries with bargain purchase option. Moderate 20-30 E20-8 Lessee calculations and entries; capital lease

disclosure.

E20-9 Amortization schedule and journal entries for

lessee. Moderate 20-30

E20-10 Capital lease payment; Lessee-lessor entries;

capital/sales-type lease. Moderate 20-25 E20-11 Type of lease; amortization schedule. Simple 15-20 E20-12 Operating lease versus capital lease. Moderate 25-35 E20-13 IFRS compared to contract based approach Moderate 30-35 E20-14 Calculation of rental; journal entries for lessor. Moderate 15-25 IFRS compared to contract based approach Moderate 20-30 E20-15 Lessor entries, determine type of lease, capital

lease payments. Moderate 20-25 E20-16 Lessor entries; capital lease with option to

purchase; lessee capitalizable amount. Moderate 25-35 E20-17 Lessor entries; disclosure, direct financing with

unguaranteed residual Moderate 25-35 E20-18 Accounting for an operating lease and

disclosure: lessee and lessor Simple 15-20 E20-19 Accounting for an operating lease. Simple 10-20 E20-20 Lessor entries; sales-type lease. Moderate 15-20 E20-21 Operating lease for lessee and lessor. Simple 15-20 *E20-22 Lessee-lessor, sale-leaseback. Moderate 20-30 *E20-23 Land lease; lessee and lessor. Moderate 15-20 *E20-24 Sale and leaseback; lessee and lessor entries. Moderate 20-30 *E20-25 Real estate lease. Moderate 20-25

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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 statement of financial

position, income and cash flow presentation; capital lease.

Moderate 45-50 P20-4 Lessor entries and statement of financial

position, 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 20-30 P20-7 Capital lease, lessee with bargain purchase

option. Moderate 30-35

P20-8 Statement of financial position and income

statement disclosure—lessee. Moderate 30-40 P20-9 Statement of financial position 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; statement of financial

position and cash flow presentation; sales-type lease.

Moderate 35-45 P20-12 Lessee entries and statement of financial

position 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 30-40 P20-17 Contrasting capital and operating lease choice Moderate 30-35 P20-18 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, Complex 50-80

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ASSIGNMENT CHARACTERISTICS TABLE (Continued)

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

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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 ASPE. 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 fair value 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 $137,988 I 8% N 5 PMT $ (32,000) FV $ 0 Type 1

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(a) IFRS

The lease does not meet the transfer of ownership test (there is no transfer of ownership or bargain purchase option), however the lease term is for the major part of the economic life of the leased asset [(5 years ÷ 8 years) = 63%]. In addition, the present value of minimum lease payments may be considered to represent substantially all of the fair value of the leased asset [($215,606.50 ÷ $250,000) = 86%]. Therefore, Blane should classify the lease as a finance lease.

(b) ASPE

The lease does not meet the transfer of ownership test, (there is no bargain purchase option or transfer of ownership), or the economic life test [(5 years ÷ 8 years) < 75%], or the recovery of investment test [($215,606.50 ÷ $250,000) < 90%] used for ASPE. Therefore, Blane should classify the lease as an operating lease.

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(a) IFRS

For finance leases, the lessee uses the rate implicit in the lease whenever it can be reasonably determined; otherwise the incremental borrowing rate is used. In this case, the rate implicit in the lease is 9%.

Using Table A-5 Present Value of an annuity due, 6 periods at 9% of 4.88965, the capitalized amount of the leased asset = $30,000 X 4.88965 = $146,689.50.

PV $ ? Yields $146,689.54 I 9% N 6 PMT $ (30,000) FV $ 0 Type 1 (b) ASPE

For capital leases, the lessee uses the lower of the lessee’s incremental borrowing rate and the rate implicit in the lease. In this case, the lower of the lessee’s incremental borrowing rate and the rate implicit in the lease is 8%.

Using Table A-5 Present Value of an annuity due, 6 periods at 8% of 4.99271, the capitalized amount of the leased asset = $30,000 X 4.99271 = $149,781.30.

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BRIEF EXERCISE 20-3 (Continued) (b) (Continued)

PV $ ? Yields $149,781.30 I 8% N 6 PMT $ (30,000) FV $ 0 Type 1 BRIEF EXERCISE 20-4

Equipment under Lease... 112,400 Obligations under Lease... ...112,400

(Using Table A-5 Present Value of an annuity due and 5 periods at 6% of 4.46511, present value of minimum lease payments = $25,173 X 4.46511= $112,400.21.)

PV $ ? Yields $112,400.10 I 6% N 5 PMT $ (25,173) FV $ 0 Type 1

Obligations under Lease... 25,173 Cash... ... 25,173

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

Using a financial calculator

PV $ 112,400 RATE 6% NPR 5 PMT ? Yields $25,173 FV $ 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 20-6 Interest Expense... 8,296 Interest Payable [($150,000 – $25,561) X 10% X 8/12].... 8,296 Depreciation Expense... 12,500 Accumulated Depreciation-Leased Equipment

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

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

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

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Equipment under Lease... 147,047

Obligations under Lease... 147,047

Using tables:

PV of rentals $28,000 X 4.88965 $136,910

[PV of guar. RV $17,000 X .59627 10,137

$147,047 Excel 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

Obligations under Lease... 28,000

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Equipment under Lease... 136,910

Using tables:

PV of rentals $28,000 X 4.88965 $136,910

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

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Lease Receivable... 185,000

Sales Revenue... 147,047

Unearned Interest Income... 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 year Excel formula =PV(rate,nper,pmt,fv,type)

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

Cost of Goods Sold... 121,000

Inventory... 121,000 Cash... 28,000

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August 15, 2014

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

Cash... 31,500 An alternate to the above:

August 15, 2014 Prepaid Rent ... 31,500 Cash... 31,500 November 30, 2014 Rent Expense ($31,500 ÷ 12 X 3.5)... 9,188 Prepaid Rent ... 9,188 ... BRIEF EXERCISE 20-12 August 15, 2014 Cash... 31,500

Unearned Rent Revenue... 31,500

June 30, 2015

Unearned Rent Revenue ... 27,563

Rent Revenue ($31,500 ÷ 12 X 10.5)... 27,563

Equipment Acquired for Lessee... 175,000

Lease payments receivable $202,920

[ (5 X $40,584)

PV of rentals (4.31213 X $40,584) 175,000

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Sales Revenue... 175,000

Unearned Interest Income ... 27,920

Inventory... 137,500 Cash... 40,584

Lease Receivable... 40,584

Unearned Interest Income... 10,753

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

Unearned Interest Income... 10,753

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

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Sales Revenue... 410,000

[(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)

PV $ ? Yields $(410,000) I 12% N 5 PMT $ 95,930 FV $ 40,000 Type 1

Inventory... 265,000 Cash... 95,930

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

Sales Revenue ($410,000 – $22,697)... 387,303

Inventory... 265,000 * ($40,000 X .56743) = $22,697 ($95,930 X 4.03735) = $387,303 ($95,930 X 5) + $40,000 = $519,650 Cash... 95,930 Lease Receivable... 95,930 *BRIEF EXERCISE 20-18

Deferred profit on sale-leaseback = $200,000 – ($300,000 – $120,000) = $20,000

(a) IFRS

Under IFRS, the deferred gain on sale is recognized over the lease term. In this case, amortization of the deferred gain on sale to be recorded at the end of 2014 is $4,000 ($20,000 ÷ 5 years). (b) ASPE

Under ASPE, the deferred gain on sale is amortized on the same basis as the depreciation of the leased asset. In this case, amortization of the deferred gain on sale to be recorded at the end of 2014 is $8,000 ($20,000 X 2 ÷ 5 years).

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*BRIEF EXERCISE 20-19

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

Trucks... 79,000

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

Vehicles under Lease... 65,000

($17,147 X 3.79079)

PV $ ? Yields $65,000 I 10% N 5 PMT $ (17,147) FV $ 0 Type 0 Depreciation Expense... 13,000 Accumulated Depreciation-Vehicles under Lease

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

Deferred Profit on Sale-Leaseback... 2,400

Depreciation Expense ($12,000 X 1/5)... 2,400

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

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January 1, 2014:

Land under Lease...100,000.00 Buildings under Lease...150,000.00

Obligations under Lease... ...250,000.00 Obligations under Lease... 23,576.90

Cash... ... 23,576.90 Excel formula =PV(rate,nper,pmt,fv,type)

PV $ ? Yields $ 250,000 I 8% N 20 PMT $ 23,576.90 FV $ 0 Type 1 December 31, 2014: Interest Expense... 18,113.85 Interest Payable [($250,000.00 – $23,576.90) X 8%]... 18,113.85 Depreciation Expense... 7,500.00 Accumulated Depreciation – Leased Buildings

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*BRIEF EXERCISE 20-21 January 1, 2014

Buildings under Lease...150,000.00

Obligations under Lease... ...150,000.00 Obligations under Lease... 14,146.14

Rent Expense (Land) ... 9,430.76

Cash... ... 23,576.90 [($23,576.90 X $150,000 / $250,000) = $14,146.14] December 31, 2014: Interest Expense... 10,868.31 Interest Payable... 10,868.31 [($150,000.00 – $14,146.14) X 8%] Depreciation Expense... 7,500.00

Accumulated Depreciation – Leased Buildings……7,500.00

($150,000 / 20) *BRIEF EXERCISE 20-22

For the contract-based approach, the probability-weighted

expected value of the residual guarantee must be used in the present value calculation of the lease payments liability.

Probability-weighted expected value

$16,000 X 50% = $8,000

$12,000 X 30% = 3,600

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(a) ASPE

The lease does not meet the transfer of ownership test, (the bargain purchase test), or the economic life test [(4 years ÷ 8 years) < 75%], or the recovery of investment test [($116,025 ÷ $150,000) < 90%] used for ASPE. Therefore, Quong should classify the lease as an operating lease.

(b) IFRS – classification approach

The lease does not meet the transfer of ownership test (the bargain purchase test), or the economic life test [(4 years ÷ 8 years) = 50%]. It may also be considered that the present value of minimum lease payments does not represent substantially all of the fair value of the leased asset [($116,025 ÷ $150,000) = 77%]. Therefore, Quong should classify the lease as an operating lease.

(c) IFRS – contract-based approach

Because the contractual right to use the asset is transferred from Zareiga to Quong over the non-cancellable lease term, at lease inception, Quong should measure and recognize the right-of-use asset and the liability (obligation) to make lease payments.

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SOLUTIONS TO EXERCISES

EXERCISE 20-1 (15-20 minutes)

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

PV $ ? Yields $56,994 I 10% N 5 PMT $ (13,668) FV $ 0 Type 1 (c)

9/1/14 Equipment under Lease... 56,994

Obligations under Lease... 56,994 Obligations under Lease... 13,668

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12/31/14 Depreciation Expense... 3,800 Accumulated Depreciation— Leased Equipment ... 3,800 [($56,994/ 5) X 4/ 12 = $3,800] Interest Expense... 1,444 Interest Payable... 1,444 [($56,994 – $13,668) X .10 X 4/ 12 = $1,444]

9/1/15 Obligations under Lease... 9,335

Interest Payable... 1,444 Interest 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.

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EXERCISE 20-1 (Continued)

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.

It is likely the lease would be classified as a capital lease under IFRS.

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(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, 2014 Prepaid Rent... 13,668 Cash... 13,668 December 31, 2014 Rent Expense... 4,556 Prepaid Rent... 4,556 ($13,668 X 4 / 12 = $4,556) September 1, 2015 Prepaid Rent... 13,668 Cash... 13,668 December 31, 2015 Rent Expense... 13,668 Prepaid Rent... 13,668

Alternately, the September 1, 2015 payment can be recorded to rent expense, in which case no adjusting journal entry is needed at December 31, 2015.

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EXERCISE 20-2 (Continued) (c) and (d)

E20-2 E20-1

Operating Capital

Lease Lease

Statement of Financial Position: Current assets:

Prepaid rent $9,112

Property Plant & Equipment:

Equipment under lease $ 56,994

Less: Accumulated depreciation (3,800)

53,194 Current Liabilities

Interest payable 1,444

Current portion of obligations under

lease 9,335

Long term liabilities

Obligations under lease 43,326

Less: Current portion (9,335)

33,991 Income Statement:

Depreciation expense $ 3,800

Interest expense 1,444

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(e) The amounts appearing on the financial statements 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 obligation and the additional property, plant and equipment. An investor should review the notes to the financial statements discussing how the company has accounted for this lease, and note the effect on the company’s financial statements and ratios.

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(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... $17,910 PV of residual value of $2,500... 1,446 Present value of minimum lease payments... $19,356 Excel formula =PV(rate,nper,pmt,fv,type)

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

(c) Vehicles under Lease... 19,356

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(d) Depreciation Expense... 306.47

Accumulated Depreciation—Vehicles under Lease… 306.47

[($19,356 – $2,500) ÷ 55 months = 306.47] (e) Obligations under Lease... 231.44

Interest 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 ASPE, 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, they are of use only to the lessee.

None of the numerical thresholds need be applied, as was the case in ASPE, 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.

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(a)

Capitalized amount of the lease:

Yearly payment $73,580.00

Executory costs 2,470.29

Minimum annual lease payment $71,109.71

Present value of minimum lease payments $71,109.71 X 6.32825 = $450,000.00 Excel formula =PV(rate,nper,pmt,fv,type) Using a financial calculator:

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

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FINE CORP.

Lease Amortization Schedule (Lessee) Dat e Annu al Pmt. Excl. Exec. Costs Interest (12%) on Unpaid Obligation Reducti on of Lease Obligation Bala nce of Lease Obligation $450,000.00 Jan. 1, 2014 $71,109.71 $71,109.71 378,890.29 Jan. 1, 2015 71,109.71 $45,466.83 25,642.88 353,247.41 Jan. 1, 2016 71,109.71 42,389.69 28,720.02 324,527.39 Jan. 1, 2017 71,109.71 38,943.29 32,166.42 292,360.97 Jan. 1, 2018 71,109.71 35,083.32 36,026.39 256,334.58 Jan. 1, 2019 71,109.71 30,760.15 40,349.56 215,985.02 Jan. 1, 2020 71,109.71 25,918.20 45,191.51 170,793.51 Jan. 1, 2021 71,109.71 20,495.22 50,614.49 120,179.02 Jan. 1, 2022 71,109.71 14,421.48 56,688.23 63,490.79 Jan. 1, 2023 71,109.71 7,618.92 63,490.79 0 711,097.10 261,097.10 450,000.00 (b)

1/1/14 Equipment under Lease... 450,000.00

Obligations under Lease... 450,000.00

1/1/14 Insurance Expense... 2,470.29 Obligations under Lease... 71,109.71

Cash... 73,580.00 12/31/14 Depreciation Expense... 45,000.00 Accumulated Depreciation— Leased Equipment ... 45,000.00 ($450,000 ÷ 10)

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EXERCISE 20-4 (Continued) 12/31/14 Interest Expense (See Schedule 1) ... 45,466.83 Interest Payable... 45,466.83 1/1/15 Insurance Expense... 2,470.29 Interest Payable... 45,466.83

Cash... 73,580.00 12/31/15 Depreciation Expense... 45,000.00 Accumulated Depreciation— Leased Equipment ... 45,000.00 12/31/15 Interest Expense... 42,389.69 Interest Payable... 42,389.69 (c) Note X:

The following is a schedule of future minimum lease payments under the finance lease expiring December 31, 2023 together with the balance of the obligation under finance lease.

Year ending December 31

2016 $73,580 2017 73,580 2018 73,580 2019 73,580 2020 73,580 2021 and beyond 220,740

Total minimum lease payments 588,640

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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.

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1/1/14 Insurance Expense *... 1,029.29 Prepaid Insurance **... 1,441.00

Cash... 73,580.00 * ($2,470.29 X 5/12) ** ($2,470.29 X 7/12) 05/31/14 Depreciation Expense... 18,750.00 Accumulated Depreciation— Leased Equipment ... 18,750.00 ($450,000 ÷ 10 X 5/12) 05/31/14 Interest Expense *... 18,944.51 Interest Payable... 18,944.51 * ($45,466.83 x 5/12) 12/31/14 Insurance Expense... 1,441.00 Prepaid Insurance... 1,441.00

Note: This entry could also be done at May 31, 2015 as a year-end adjusting entry.

1/1/15 Insurance Expense... 1,029.29

Prepaid Insurance... 1,441.00 Interest Expense *... 26,522.32 Interest Payable... 18,944.51

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05/31/15 Depreciation Expense... 45,000.00 Accumulated Depreciation— Leased Equipment ... 45,000.00 05/31/15 Interest Expense... 17,662.37 Interest Payable... 17,662.37 ($42,389.69 X 5/12) 12/31/15 Insurance Expense... 1,441.00 Prepaid Insurance... 1,441.00

Note: This entry could also be done at May 31, 2016 as a year-end adjusting entry.

(36)

(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 payment

X

4.23972 PV of annuity due of 1 for n = 5, i = 9%

$85,075.32 PV of periodic rental payments

$ 4,500.00 Bargain purchase option

X

.64993 PV of 1 for n= 5, i = 9%

$ 2,924.69 PV of bargain purchase option

+

2,924.69 PV of bargain purchase option

$88,000.01 Net investment at inception of lease

PV $ ? Yields $ 88,000

I 9%

N 5

(37)

Russell Corporation (Lessee) Lease Amortization Schedule

Date Annual Lease Payment Plus BPO Interest (9%) on Unpaid Obligation Reduction of Lease Obligation Balance Lease Obligation 7/1/14 7/1/14 7/1/15 7/1/16 7/1/17 7/1/18 6/30/19 $ 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)

7/1/14 Equipment under Lease ... 88,000.00

Obligations under Lease... 20,066.26

Cash... 20,066.26 12/31/14 Interest Expense... 3,057.02 Interest Payable... 3,057.02 ($6,114.04 X 6/12 = ($3,057.02) Depreciation Expense... 4,400.00 Accumulated Depreciation —Leased Equipment ... 4,400.00 ($88,000.00 ÷ 10 = ($8,800.00; $8,800.00 X 6/12 = $4,400)

(38)

7/1/15 Interest Payable... 3,057.02 Interest Expense*... 3,057.02 Obligations under Lease... 13,952.22

Cash... 20,066.26 * ($6,114.04 – $3,057.02) 12/31/15 Interest Expense... 2,429.17 Interest Payable... 2,429.17 ($4,858.34 X 6/12 = ($2,429.17) 12/31/15 Depreciation Expense... 8,800.00 Accumulated 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 depreciated 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 ASPE, 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:

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

(39)

None of the numerical thresholds need be applied, as was the case in ASPE, 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 ASPE 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.

(40)

Note as determined in Exercise 20-6, 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:

X

4.23972 PV of annuity due of 1 for n = 5, i = 9%

$ 4,500.00 Bargain purchase option

X

.64993 PV of 1 for n = 5, i = 9%

$ 2,924.69 PV of bargain purchase option

+

(41)

PV $ ? Yields $88,000 I 9% N 5 PMT $ 20,066.26 FV $ 4,500 Type 1 (c)

Herbert Leasing Corporation (Lessor) Lease Amortization Schedule

Date Annual Lease Payment Plus BPO Interest (9%) on Net Investment Net Investment Recovery Balance Net Investment 7/1/14 7/1/14 7/1/15 7/1/16 7/1/17 7/1/18 6/30/19 $ 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)

7/1/14 Lease Receivable... 104,831.30 Cost of Goods Sold... 60,000.00

Sales Revenue... 88,000.00

Unearned Interest Income.... 16,831.30

(42)

7/1/14 Cash ... 20,066.26

Lease Receivable... 20,066.26

12/31/14 Unearned Interest Income... 3,057.02

Interest Income... 3,057.02

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

7/1/15 Cash ... 20,066.26

7/1/15 Unearned Interest Income... 3,057.02

($6,114.04 – $3,057.02)

12/31/15 Unearned Interest Income... 2,429.17

($4,858.34 X 6/12 =

($2,429.17)

7/1/16 Cash ... 20,066.26

Unearned Interest Income... 2,429.17

($4,858.34 – $2,429.17)

12/31/16 Unearned Interest Income... 1,744.81

($3,489.62 X 6/12 = $1,744.81)

(43)

(a)

Capitalized amount of the lease:

PV $ ? Yields $164,995 I 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.

(44)

(c) Xu Ltd.

Lease Amortization Schedule (Lessee) Dat e Annu al Lease Payments Interest (10.5%) on Unpaid Obligation Reducti on of Lease Obligation Bala nce of Lease Obligation $164,995.00 Jan. 1, 2015 $28,500.00 $28,500.00 136,495.00 Jan. 1, 2016 28,500.00 $14,331.98 14,168.03 122,326.97 Jan. 1, 2017 28,500.00 12,844.33 15,655.67 106,671.30 Jan. 1, 2018 28,500.00 11,200.49 17,299.51 89,371.79 Jan. 1, 2019 28,500.00 9,384.04 19,115.96 70,255.83 Jan. 1, 2020 28,500.00 7,376.86 21,123.14 49,132.70 Jan. 1, 2021 28,500.00 5,158.93 23,341.07 25,791.63 Jan. 1, 2022 28,500.00 2,708.37 25,791.63 (0.00) $228,000.00 $63,005.00 $164,995.00 (d)

1/1/15 Equipment under Lease... 164,995

1/1/15 Obligations under Lease... 28,500

Cash... 28,500 12/31/15 Depreciation Expense... 20,624 Accumulated Depreciation— Leased Equipment ... 20,624 ($164,995 ÷ 8)

(45)

(d) (Continued)

12/31/15 Interest Expense... 14,332

Interest Payable... 14,332

1/1/16 Interest Payable... 14,332

Cash... 28,500 12/31/16 Depreciation Expense... 20,624 Accumulated Depreciation— Leased Equipment ... 20,624 12/31/16 Interest Expense... 12,844 Interest Payable... 12,844 (e) Xu Ltd.

Statement of Financial Position (partial) December 31,

2016 2015

Non-current assets

Property plant and equipment

Equipment under lease $164,995 $164,995

Less accumulated depreciation 41,248 _20,624

123,747 144,371

Current liabilities

Interest payable 12,844 14,332

Obligations under lease 15,656 14,168

Non-current liabilities

Obligations under lease (Note X) 122,327 136,495

(46)

(f) Note X:

The following is a schedule of future minimum lease payments under the capital lease expiring December 31, 2022 together with the balance of the obligation under capital lease.

2017 $28,500 2018 28,500 2019 28,500 2020 28,500 2021 28,500 2022 28,500

Less amount representing interest at 10.5% 48,673

Balance 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.

(47)

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.

X

4.16986 PV of an annuity due of 1 for n = 5, i = 10%

$75,653.56 PV of minimum lease payments

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

LeBlanc Limited (Lessee) Lease Amortization Schedule

Dat e Annual Lease Payment Interest (10%)1 on Unpaid Obligation Reductio n of Lease Obligation Balance of Lease Obligation 1/1/14 1/1/14 1/1/15 1/1/16 1/1/17 1/1/18 $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

(48)

EXERCISE 20-9 (Continued) (b)

1/1/14 Obligations under Lease... 18,142.95

Cash... 18,142.95

During 2014

Insurance Expense... 900.00

Cash... 900.00

Property Tax Expense... 1,600.00

Cash... 1,600.00 12/31/14 Interest Expense... 5,751.06 Interest Payable... 5,751.06 Depreciation Expense... 15,130.71 Accumulated Depreciation —Leased Equipment ... 15,130.71 ($75,653.56 ÷ 5 = $15,130.71) 1/1/15 Interest Payable* ... 5,751.06 Interest Expense... 5,751.06 Interest Expense... 5,751.06 Obligations under Lease... 12,391.89

Cash... 18,142.95

* Note to instructor:

(49)

During 2015

Insurance Expense... 900.00

Cash... 900.00

Property Tax Expense... 1,600.00

Cash... 1,600.00 12/31/15 Interest Expense... 4,511.87 Interest Payable... 4,511.87 Depreciation Expense... 15,130.71 Accumulated Depreciation —Leased Equipment . . 15,130.71 Note to instructor:

The lessor sets the annual rental payment as follows:

Fair value of leased asset to lessor $80,000.00

Less: 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 $75,653.56 Five periodic lease payments

$75,653.56 ÷ 4.16986* $18,142.95

*Present value of annuity due of 1 for 5 periods at 10%. Excel formula =PMT(rate,nper,pv,fv,type)

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

(50)

EXERCISE 20-9 (Continued) (c) Note X:

The following is a schedule of future minimum lease payments under the capital lease expiring December 31, 2018 together with the balance of the obligation under capital lease.

2016 $18,143

2017 18,143

2018 18,143

Less amount representing interest at 10% 9,310

Balance 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 ASPE, 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:

(51)

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.

(52)

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

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

(53)

(c)

1/1/11 Equipment under Lease... 137,582

($28,718 X 4.79079)***

Cash... 28,718 ***Present value of an annuity due at 10% for 6 periods.

PV $ ? Yields $137,582 I 10% N 6 PMT $ (28,718) FV $ 0 Type 1 12/31/14 Depreciation Expense... 22,930 Accumulated Depreciation – Leased Equipment... 22,930 ($137,582 ÷ 6 years) Interest Expense... 10,886 Interest Payable... 10,886 [($137,582 – $28,718) X .10]

(54)

EXERCISE 20-10 (Continued) (d)

1/1/11 Lease Receivable... 178,308* Cost of Goods Sold... 107,422

Sales Revenue... 140,422

Inventory... 111,000

Unearned Interest Income.... 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 Revenue $144,000

Less present value of residual value 3,578*

$140,422

Cost of Goods Sold $111,000

Less present value of residual value 3,578*

$107,422 *($6,000 X .59627**)

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

Cash ... 28,718

Lease Receivable... 28,718

12/31/14 Unearned Interest Income... 10,375

Interest Income... 10,375

[($144,000 – $28,718) X .09]

(55)

(c) For Lavery Corporation—(the lessee):

None of the numerical thresholds need be applied, as was the case in ASPE, 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 ASPE 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.

(56)

(a) When using ASPE, 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 obligations under capital leases 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 depreciated over the lease term. Because both the economic life of the asset and the lease term are three years, the leased asset should be depreciated 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.

(57)

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 Receivable of $112,590 and Unearned Interest Income of $17,590. (See schedule in part (c) below.) Interest would be recognized annually at a constant rate applied to the unrecovered net investment. (b)The present value of minimum lease payments would be equal

to the amount to be recovered by the lessor through lease payments, which equals $95,000. The annual lease payment calculated below equals $37,530, and the factor for present value of an annuity (Table A-4) at 9% for 3 periods is 2.53130. So the present value of minimum lease payments is $95,000 ($37,530 X 2.53130). In summary:

Cost (fair 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 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)

PV $ (95,000)

I 9%

N 3

PMT $ ? Yields $37,530

(58)

EXERCISE 20-11 (Continued) (c)

Schedule of Interest and Amortization

Rent Receipt/ Payment Interest Income/ Expense Reduction of Principal Investment/ Obligation 1/1/14 12/31/14 12/31/15 12/31/16 — $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

(d) For Black Corporation—(the lessee):

(59)

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.

For Victoria Leasing Corporation—(the lessor):

Under IFRS, the lease would receive the same treatment as under ASPE 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