Lanier Dairy Ltd. leases its milk cooling equipment from Green Finance Corporation. Both companies use IFRS. The lease has the following terms

Lanier Dairy Ltd. leases its milk cooling equipment from Green Finance Corporation. Both companies use IFRS. The lease has the following terms.

1. The lease is dated May 30, 2011, with a lease term of eight years. It is non-cancellable and requires equal rental payments of $30,000 due each May 30, beginning in 2011.

2. The equipment has a fair value and cost at the inception of the lease of $211,902, an estimated economic life of 10 years, and a residual value (which is guaranteed by Lanier Dairy) of $23,000.

3. The lease contains no renewal options and the equipment reverts to Green Finance Corporation on termination of the lease.

4. Lanier Dairy’s incremental borrowing rate is 6% per year; the implicit rate is also 6%.

5. Lanier Dairy uses straight-line depreciation for similar equipment that it owns.

6. Collectibility of the payments is reasonably predictable, and there are no important uncertainties about costs that have not yet been incurred by the lessor.

Instructions

(a) Describe the nature of the lease and, in general, discuss how the lessee and lessor should account for the lease transaction.

(b) Prepare the journal entries for the lessee and lessor at May 30, 2011, and at December 31, 2011, which are the lessee’s and lessor’s year ends, respectively.

(c) Prepare the journal entries at May 30, 2012, for the lessee and lessor. Assume reversing entries are not used.

(d) What amount would have been capitalized by the lessee upon inception of the lease if:

1. the residual value of $23,000 had been guaranteed by a third party, not the lessee?

2. the residual value of $23,000 had not been guaranteed at all?

(e) On the lessor’s books, what amount would be recorded as the net investment at the inception of the lease, assuming:

1. Green Finance had incurred $1,200 of direct costs in processing the lease?

2. the residual value of $23,000 had been guaranteed by a third party?

3. the residual value of $23,000 had not been guaranteed at all?

(f) Assume that the milk cooling equipment’s useful life is 20 years. How large would the residual value have to be at the end of 10 years in order for the lessee to qualify for the operating method? Assume that the residual value would be guaranteed by a third party.

(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)  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 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 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, 2011

Lessee:

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

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

Using a financial calculator:
PV	$   ?	Yields $211,901.93
I	6%
N	8
PMT	$  (30,000)
FV	$  (23,000)
Type	1

Lease Obligation.....................     30,000

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

                       May 30, 2011

Lessor:

Lease Payments Receivable............    263,000

    Equipment........................             211,902

    Unearned Interest Income—Leases..              51,098

      ($263,000 = 8 X $30,000; add $23,000

       for residual value)

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

    Lease Payments Receivable........              30,000

                    December 31, 2011

Lessee:

Interest Expense.....................      6,367

    Interest Payable.................               6,367

      [($211,902 – $30,000) X .06 X 7/12]

Depreciation Expense.................     13,774

    Accumulated Depreciation.........               13,774

      [($211,902 – $23,000) ÷ 8 X 7/12]

                    December 31, 2011

Lessor:

Unearned Interest Income—Leases......      6,367

    Interest Income—Leases...........              6,367

(c)                    May 30, 2012

Lessee:

Lease Obligation.....................     19,086

Interest Expense.....................     4,547*

Interest Payable.....................      6,367

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

  *[($211,902 – $30,000) X .06 X 5/12]

Depreciation Expense.................      9,839

    Accumulated Depreciation.........                   9,839

      [($211,902 – $23,000) ÷ 8 X 5/12]

Lessor:

Unearned Interest Income—Leases......      4,547

    Interest Income—Leases...........              4,547

Cash ..........................  25,250         

    Lease 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 $197,471.44
I	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).