Dubois Steel Corporation, as lessee, signed a lease agreement for equipment for five years, beginning January 31, 2011. Annual rental payments of $41,000 are to be made at the beginning of each lease year (January 31). The taxes, insurance, and maintenance costs are the lessee’s obligation. The interest rate used by the lessor in setting the payment schedule is 9%; Dubois’ incremental borrowing rate is 10%. Dubois is unaware of the rate being used by the lessor. At the end of the lease, Dubois has the option to buy the equipment for $4,000, which is considerably below its estimated fair value at that time. The equipment has an estimated useful life of seven years with no residual value. Dubois uses straight-line depreciation on similar equipment that it owns, and follows IFRS.
Instructions
Answer the following questions, rounding all numbers to the nearest dollar.
(a) Prepare the journal entry or entries, with explanations, that should be recorded on January 31, 2011, by Dubois.
(b) Prepare any necessary adjusting journal entries at December 31, 2011, and the journal entry or entries, with explanations, that should be recorded on January 31, 2012, by Dubois. (Prepare the lease amortization schedule for the lease obligation using a computer spreadsheet for the minimum lease payments.) Dubois does not use reversing entries.
(c) Prepare any necessary adjusting journal entries at December 31, 2012, and the journal entry or entries, with explanations, that should be recorded on January 31, 2013, by Dubois.
(d) What amounts would appear on Dubois’ December 31, 2012 balance sheet relative to the lease arrangement?
(e) What amounts would appear on Dubois’ statement of cash flows for 2011 relative to the lease arrangement? Where would the amounts be reported?
(f) Assume that the leased equipment had a fair value of $200,000 at the inception of the lease, and that no bargain purchase option is available at the end of the lease. Determine what amounts would appear on Dubois’ December 31, 2012 balance sheet and what amounts would appear on the 2012 statement of cash flows relative to the leasing arrangements.
(a) January 31, 2011
Leased Equipment.................... 173,448
Lease Obligation................ 173,448
(To record leased asset and
related obligation)
PV of monthly payment of $41,000 X 4.16987*.... $170,964
PV 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%)
| Excel formula =PV(rate,nper,pmt,fv,type) |
| Using a financial calculator: | ||
| PV | $ ? | Yields $ 173,448.17 |
| I | 10% | |
| N | 5 | |
| PMT | $ (41,000) | |
| FV | $ (4,000) | |
| Type | 1 | |
January 31, 2011
Lease Obligation.................... 41,000
Cash............................ 41,000
(To record the first rental payment)
(b) December 31, 2011
Depreciation 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, 2011
Interest Expense........................ 12,141
Interest Payable.................... 12,141
(To record accrual of interest on lease
obligation $13,245 X 11 / 12)
January 31, 2012
Interest Payable........................ 12,141
Interest Expense........................ 1,104
Lease Obligation........................ 27,755
Cash................................ 41,000
(To record annual payment on lease
obligation)
During year
Property Tax Expense................... XXX
Insurance Expense...................... XXX
Maintenance Expense.................... XXX
Cash................................ XXX
(To record payment for executory costs)
Dubois Steel Corporation (Lessee)
Lease Amortization Schedule
(Annuity Due Basis)
| Date | | Annual Lease Payment | | Interest (10%) on Unpaid Obligation | | Reduction of Lease Obligation | | Balance of Lease Obligation |
| | | | | | | | | |
| 1/31/11 1/31/11 1/31/12 1/31/13 1/31/14 1/31/15 | | — $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, 2012
Depreciation Expense.................. 24,778
Accumulated Depreciation—Leased
Equipment....................... 24,778
(To record annual depreciation
on assets leased $173,448 ÷ 7)
December 31, 2012
Interest Expense...................... 9,597
Interest Payable.................. 9,597
(To record accrual of interest on lease
obligation $10,469 X 11 ÷ 12)
January 31, 2013
Interest Payable........................ 9,597
Interest Expense........................ 872
Lease Obligation........................ 30,531
Cash................................ 41,000
(To record annual payment on lease
obligation)
(d) Dubois Steel Corporation
Balance Sheet
December 31, 2012
| Property, plant, and equipment: Leased equipment $173,448 Less: Accumulated depreciation 47,491 $125,957 | | Current liabilities: Interest payable $9,597 Lease 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.
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