Cuomo Mining Corporation, a public company whose stock trades on the Toronto Stock Exchange, uses IFRS. The Vice-President of Finance has asked you, the assistant controller, to prepare a comparison of the company’s current accounting of a lease with the contract-based approach, which is expected to be implemented in the near future. The lease you are going to use for this comparison was signed by Cuomo on April 1, 2011, with Bertrand Ltd. for a piece of excavation equipment. The following information relates to the agreement.
1. The term of the non-cancellable lease is three years, with a renewal option of one additional year at the annual rate of 125% of the initial payment. The equipment has an estimated economic life of 10 years.
2. The asset’s fair value at April 1, 2011, is approximately $1 million.
3. The asset will revert to Bertrand at the end of the initial term of the lease, or at the end of the renewal period should Cuomo exercise that option. The excavation equipment is expected to have a fair value of $600,000 on March 31, 2013, and $500,000 on March 31, 2014, which is not guaranteed.
4. Cuomo assumes direct responsibility for all executory costs for the excavation equipment.
5. The initial term of the lease agreement requires equal annual rental payments of $135,000 to Bertrand, beginning on April 1, 2011.
6. The lessee’s incremental borrowing rate is 9%. Bertrand’s implicit rate is 8% and is known to Cuomo.
7. Cuomo has a calendar year end. You have established that it has always been Cuomo’s intention to exercise the renewal period on account of the nature of the asset. Cuomo’s operations manager says that there is a 70% chance that the renewal period will be exercised.
Instructions
Answer the following, rounding all numbers to the nearest dollar.
Part 1
Using the current accounting under IFRS:
(a) Determine the accounting treatment of the lease agreement and obligation to Cuomo. What were the conditions that would need to be in place for the lease to be classified as a financing lease?
(b) Record all transactions concerning the lease for Cuomo for the fiscal year 2011.
Part 2
Using the proposed contract-based approach:
(c) Determine the amount of lease obligation at the signing of the lease.
(d) Use a computer spreadsheet to prepare an amortization schedule for Cuomo for the lease term including the expected lease renewal.
(e) Prepare all of Cuomo’s journal entries for fiscal years 2011 and 2012 to record the lease agreement and the lease pay-ments.
Part 3
Prepare a table of Cuomo’s balance sheet disclosure of all of the amounts that would appear concerning the right and the obligation at December 31, 2012. Follow with the statement of income disclosure for the fiscal year ending December 31, 2012. Be specific concerning classifications. Include a second column to show the amounts Cuomo reports for the same period following IFRS.
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 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, they are of use only to the lessee.
(b)
April 1, 2011
Rent Expense ($135,000 ÷ 12 X 9)...... 101,250
Prepaid Rent ($135,000 ÷ 12 X 3)...... 33,750
Cash.............................. 135,000
An alternate to the above:
April 1, 2011
Prepaid Rent ......................... 135,000
Cash.............................. 135,000
December 31, 2011
Rent 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
| Excel formula =PV(rate,nper,pmt,fv,type) |
| Using a financial calculator: | ||
| PV | $ ? | Yields $509,699.93 |
| I | 8% | |
| N | 3 | |
| PMT | $( 135,000) | |
| FV | $( 168,750) | |
| Type | 1 | |
(b) Cuomo Mining Corporation
Lease Amortization Schedule
| Date | | Annual Lease Payments | | Interest (8%) on Unpaid Obligation | | Reduction of Lease Obligation | | Balance of Lease Obligation | |||||||||
| | | | | | | | | $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........ 509,700
Contractual Lease Obligations 509,700
Contractual Lease Obligations... 135,000
Cash ...................... 135,000
December 31, 2011
Interest Expense................ 22,482
Interest Payable........... 22,482
($29,976 X 9 ÷ 12 = $22,482)
Amortization Expense............ 95,569
Contractual Lease Rights... 95,569
($509,700 ÷ 4 years X 9 ÷ 12 = $95,569)
April 1, 2012
Interest Expense................ 7,494*
Interest Payable................ 22,482
Contractual Lease Obligations... 105,024
Cash ...................... 135,000
*($29,976 X 3 ÷ 12 = $7,494)
December 31, 2012
Interest Expense................ 16,181
Interest Payable........... 16,181
($21,574 X 9 ÷ 12 = $16,181)
Amortization Expense............ 127,425
Contractual Lease Rights... 127,425
($509,700 ÷ 4 years = $127,425)
Part 3
Cuomo Mining Corporation
December 31, 2012
| Balance Sheet – Partial | Contract | | Operating |
| | Based | | Lease |
| Current assets | | | |
| Prepaid rent | | | $33,750 |
| | | | |
| Intangible assets | | | |
| Contractual 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 statement | | | |
| Amortization expense | $127,425 | | |
| Interest expense | 23,675 | | |
| Rent expense | | | 135,000 |
| | $151,100 | | $ 135,000 |
| | | | |
| | Contract | | Operating |
| Total expense - 4 years | Based | | Lease |
| Amortization expense | $509,700 | | |
| Interest expense | 64,050 | (2) | |
| Rent expense | | (3) | $573,750 |
| | $ 573,750 | | $ 573,750 |
(1) Sum of amortization 2010........ $95,569
And 2012........................ 127,425
Total........................... $222,994
(2) Refer to total interest expense on amortization table.
(3) Rent expense
($135,000 X3) + $168,750 = 573,750
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