Jennings Inc., which uses IFRS, manufactures an X-ray machine with an estimated life of 12 years and leases it to SNC Medical Centre for a period of 10 years. The machine’s normal selling price is $343,734, and the lessee guarantees a residual value at the end of the lease term of $15,000. The medical centre will pay rent of $50,000 at the beginning of each year and all maintenance, insurance, and taxes. Jennings incurred costs of $210,000 in manufacturing the machine and $14,000 in negotiating and closing the lease. Jennings has determined that the collectibility of the lease payments is reasonably predictable, that there will be no additional costs incurred, and that its implicit interest rate is 10%.
Instructions
Answer the following questions, rounding all numbers to the nearest dollar.
(a) Discuss the nature of this lease in relation to the lessor and calculate the amount of each of the following items:
1. Gross investment
2. Sales price
3. Unearned interest income
4. Cost of sales
(b) Prepare a 10-year lease amortization schedule for the lease obligation.
(c) Prepare all of the lessor’s journal entries for the first year.
(d) Identify the amounts to be reported on Jennings’s balance sheet, income statement, and statement of cash flows one
year after signing the lease, and prepare any required note disclosures.
(e) Assume that SNC Medical Centre’s incremental borrowing rate is 12% and that the centre knows that 10% is the rate implicit in the lease. Determine the depreciation expense that SNC will recognize in the first full year that it leases the machine.
(f) Assuming instead that the residual value is not guaranteed, what changes, if any, are necessary in parts (a) to (d) for the lessor and in part (e) for the lessee?
(g) Discuss how Jennings would have determined the classification of the lease if the company were using private enterprise GAAP for its financial reporting.
(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
| Excel formula =PV(rate,nper,pmt,fv,type) |
| Using a financial calculator: | ||
| PV | $ ? | Yields $343,734 |
| I | 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 $500,000
Guaranteed residual value due at the end
of 10 years 15,000
Gross investment $515,000
2. Unearned interest income:
Gross investment $515,000
Less: Fair market value of the X-ray
machine 343,734
Unearned 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)
| Beginning of Year | | Annual Lease Payment Plus Residual Value | | Interest (10%) on Net Investment | | Net Investment Recovery | | Net Investment |
| | | | | | | | | |
| Initial PV 1 2 3 4 5 6 7 8 9 10 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 |
*Rounding error is $1.
(c) Lessor’s journal entries:
Beginning of the Year
Lease Payments Receivable.............. 515,000
Cost of Sales.......................... 210,000
Sales.............................. 343,734
X-ray Machine Inventory............ 210,000
Unearned Interest Income—Leases.... 171,266
(To record the sale and the cost of
sales in the lease transaction)
Selling Expense......................... 14,000
Cash/Payable........................ 14,000
(To record the incurrence of initial direct
costs relating to the lease)
Cash .............................. 50,000
Lease Payments Receivable........... 50,000
(To record receipt of the first lease
payment)
End of the Year
Unearned 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%).
| Excel formula =PV(rate,nper,pmt,fv,type) |
| Using a financial calculator: | ||
| PV | $ ? | Yields $5,783 |
| I | 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.
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