Lee Industries and Lor Inc. enter into an agreement that requires Lor Inc. to build three diesel-electric engines to Lee’s specifications. Both Lee and Lor follow private enterprise GAAP. Upon completion of the engines, Lee has agreed to lease them for a period of 10 years and to assume all costs and risks of ownership. The lease is non-cancellable, becomes effective on January 1, 2011, and requires annual rental payments of $620,956 each January 1, starting January 1, 2011.
Lee’s incremental borrowing rate is 10%, and the implicit interest rate used by Lor Inc. is 8% and is known to Lee.
The total cost of building the three engines is $3.9 million. The engines’ economic life is estimated to be 10 years, with residual value expected to be zero. Lee depreciates similar equipment on a straight-line basis. At the end of the lease, Lee assumes title to the engines. Collectibility of the lease payments is reasonably certain and there are no uncertainties about unreimbursable lessor costs.
Instructions
Answer the following questions, rounding all numbers to the nearest dollar.
(a) Discuss the nature of this lease transaction from the viewpoints of both the lessee (Lee Industries) and lessor (Lor Inc.).
(b) Prepare the journal entry or entries to record the transactions on January 1, 2011, on the books of Lee Industries.
(c) Prepare the journal entry or entries to record the transactions on January 1, 2011, on the books of Lor Inc.
(d) Prepare the journal entries for both the lessee and lessor to record interest expense (income) at December 31, 2011.
(Prepare a lease amortization schedule for the lease obligation for two years using a computer spreadsheet.)
(e) Show the items and amounts that would be reported on the balance sheet (ignore the notes) at December 31, 2011, for both the lessee and the lessor.
(f) Identify how the lease transactions would be reported on each company’s statement of cash flows in 2011.
(g) Provide the note disclosure concerning the lease that would be required for the lessee, Lee Industries, on its financial statements for the fiscal year ending December 31, 2011.
(h) Provide the note disclosure concerning the lease that would be required for the lessor, Lor Inc., on its financial statements for the fiscal year ending December 31, 2011.
(a) The lease should be treated as a capital lease by Lee Industries, requiring the lessee to capitalize the leased asset. The lease qualifies for capital lease accounting by the lessee because: (1) title to the engines transfers to the lessee, (2) the lease term is equal to the estimated life of the asset, and (3) the present value of the minimum lease payments exceeds 90% of the fair value of the leased engines. The transaction represents a purchase financed by instalment payments over a 10-year period.
For Lor Inc. the transaction is a sales-type lease because a manufacturer’s profit accrues to Lor Inc. This lease arrangement also represents the manufacturer’s financing of the transaction over a period of 10 years.
Lease Payment Receivable
Payment per period $ 620,956
Periods X 10
Lease payments receivable $6,209,560
Present Value of Lease Payments
$620,956 X 7.24689* $4,500,000
*Present value of an annuity due at 8% for 10 years.
| Excel formula =PV(rate,nper,pmt,fv,type) |
| Using a financial calculator: | ||
| PV | $ ? | Yields $4,499,999 |
| I | 8% | |
| N | 10 | |
| PMT | $ (620,956) | |
| FV | $ 0 | |
| Type | 1 | |
Unearned Interest Income
Lease payments receivable $6,209,560
Less: Present value of lease payments 4,500,000
Unearned interest income $1,709,560
Dealer Profit
Sales (present value of lease payments) $4,500,000
Less cost 3,900,000
Profit on sale $ 600,000
(b) Leased Engines..................... 4,500,000
Lease Obligation............... 4,500,000
Lease Obligation................. 620,956
Cash......................... 620,956
(c) Lease Payments Receivable........ 6,209,560
Cost of Goods Sold............... 3,900,000
Sales........................ 4,500,000
Inventory.................... 3,900,000
Unearned Interest Income—Leases 1,709,560
Cash............................. 620,956
Lease Payments Receivable.... 620,956
(d) Lee Industries
Lor Inc.
Lease Amortization Schedule
| Date | | Annual Lease Payment/ Receipt | | Interest Income/ Expense at 8% | | Reduction in Present Value of Lease | | Present Value of Lease |
| | | | | | | | | |
| 1/1/11 1/1/11 1/1/12 1/1/13 | | 620,956 620,956 620,956 | | 310,324 285,473 | | 620,956 310,632 335,483 | | 4,500,000 3,879,044 3,568,412 3,232,929 |
Lessee (December 31, 2011)
Interest Expense................. 310,324
Interest Payable............. 310,324
Lessor (December 31, 2011)
Unearned Interest Income—Leases.. 310,324
Interest Income—Leases....... 310,324
(e) LEE INDUSTRIES
Balance sheet
December 31, 2011
| Property, plant, and equipment: Property under capital leases $4,500,000 Less accumulated depreciation 450,000 * $4,050,000 | | Current liabilities: Interest payable $ 310,324 Obligations under capital leases 310,632 *** Long-term liabilities: Obligations under capital leases 3,568,412** |
***$4,500,000 ÷ 10 = $450,000
*** taken from amortization schedule above
LOR INC.
Balance sheet
December 31, 2011
Assets:
Current assets:
Net investment in sales-type leases $ 310,632*
Noncurrent assets:
Net investment in sales-type leases $3,568,412 *
* from amortization schedule
(f) The transaction securing the equipment using the capital lease would not be reported on the statement of cash flows for the year ending December 31, 2011 of Lee, the lessee. This is a non-cash financing and investing transaction to Lee. These transactions would be described in the notes to the respective financial statements. The only cash transaction between the parties during 2011 is the January 1, 2011 lease payment in the amount of $620,956. This transaction is an operating activity inflow to Lor and is a financing outflow to Lee. For Lee, the annual depreciation for 2011 would be an adjustment to determine cash flow from operations under the indirect approach. For Lor, the operating cash flows would be included in the adjustments to net income under the indirect approach and would be shown as part of cash collected from customers under the direct approach.
(g) Note X: (on Lee’s financial statements:)
The following is a schedule of future minimum lease payments under the capital lease expiring December 31, 2020 together with the balance of the obligation under capital lease.
Year ending December 31
2012 $620,956
2013 620,956
2014 620,956
2015 620,956
2016 620,956
2017 and beyond 2,483,824
Total minimum lease payments 5,588,604
Less amount representing interest at 8% 1,709,560
Balance of the obligation $3,879,044
(h) Note Y: (on Lor’s financial statements:)
The company's future minimum lease payments receivable under the sales-type lease and the net investment in lease are as follows:
Year ending December 31
2012 $620,956
2013 620,956
2014 620,956
2015 620,956
2016 620,956
2017 and beyond 2,483,824
Total minimum lease payments receivable $5,588,604
Unearned income 1,709,560
Net investment in lease $3,879,044
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