LePage Manufacturing Ltd. agrees to lease machinery to Labonté Corporation on July 15, 2011. Both LePage and Labonté use private enterprise GAAP. The following information relates to the lease agreement.
1. The lease term is seven years, with no renewal option, and the machinery has an estimated economic life of nine years.
2. The machinery’s cost is $420,000 and the asset’s fair value on July 15, 2011, is $560,000.
3. At the end of the lease term, the asset reverts to LePage, the lessor. The asset is expected to have a residual value of $80,000 at this time, and this value is guaranteed by Labonté. Labonté depreciates all of its equipment on a straight-line basis.
4. The lease agreement requires equal annual rental payments, beginning on July 15, 2011.
5. LePage usually sells its equipment to customers who buy the product outright, but Labonté was unable to get acceptable financing for an outright purchase. LePage’s credit investigation on Labonté revealed that the company’s financial situation was deteriorating. Because Labonté had been a good customer many years ago, LePage agreed to enter into this lease agreement, but used a higher than usual 15% interest rate in setting the lease payments. Labonté is aware of this rate.
6. LePage is uncertain about what additional costs it might have to incur in connection with this lease during the lease term, although Labonté has agreed to pay all executory costs directly to third parties.
7. LePage incurred legal costs of $4,000 in early July 2011 in finalizing the lease agreement.
Instructions
(a) Discuss the nature of this lease for both the lessee and the lessor.
(b) Using time value of money tables, a financial calculator, or computer spreadsheet functions, calculate the amount of the annual rental payment that is required.
(c) Prepare the journal entries that Labonté would make in 2011 and 2012 related to the lease arrangement, assuming that the company has a December 31 fiscal year end and that it does not use reversing entries.
(d) From the information you have calculated and recorded, identify all balances related to this lease that would be reported on Labonté’s December 31, 2011 balance sheet and income statement, and where each amount would be reported.
(e) Prepare the journal entries that LePage would make in 2011 and 2012 related to the lease arrangement, assuming that the company has a December 31 fiscal year end and does not use reversing entries.
(f) From the information you have calculated and recorded, identify all balances related to this lease that would be reported on LePage’s December 31, 2011 balance sheet and income statement, and where each amount would be reported.
(g) Comment briefly on the December 31, 2011 reported results in (d) and (f) above.
(a) This is a capital lease to Labonté since the lease term is greater than 75% of the economic life of the leased asset. The lease term is 78% (7 ÷ 9) of the asset’s economic life.
For LePage, the collectibility of the lease payments is not reasonably predictable, and there are important uncertainties surrounding the costs yet to be incurred. Accordingly, the earnings process is not considered complete and, in spite of the fact that the fair value ($560,000) of the equipment exceeds the lessor’s cost ($420,000), the lease cannot be recorded as a sales-type lease by LePage and must be recorded as an operating lease.
(b) Calculation of annual rental payment:
To calculate the amount of the payments using Tables:
560,000 - (80,000 x .37594*)/4.78448** = $110,759
**Present value of $1 at 15% for 7 periods.
**Present value of an annuity due at 15% for 7 periods.
Excel formula =PMT(rate,nper,pv,fv,type) |
Using a financial calculator: | ||
PV | $ (560,000.00) | |
I | 15% | |
N | 7 | |
PMT | $ ? | Yields $110,759 |
FV | $ 80,000 | |
Type | 1 |
(c)
7/15/11 Leased Machinery............. 560,000
Lease Obligation......... 560,000
Lease Obligation............. 110,759
Cash..................... 110,759
12/31/11 Depreciation Expense......... 31,429
Accumulated Depreciation. 31,429
($560,000 - $80,000) ÷ 7 X 5.5/12
Interest Expense............. 30,885
Interest Payable......... 30,885
($560,000 – $110,759) X .15 X 5.5/12
7/15/12 Lease Obligation............. 43,373
Interest Expense*............ 36,501
Interest Payable............. 30,885
Cash..................... 110,759
*($560,000 – $110,759) X .15 X 6.5/12
12/31/12 Depreciation Expense......... 68,571
Accumulated Depreciation. 68,571
($560,000 - $80,000) ÷ 7
Interest Expense............. 27,903
Interest Payable......... 27,903
[($560,000 – $110,759 – $43,373) X .15 X 5.5/12]
(e)
7/15/11 Machinery Leased to Others... 420,000
Inventory................ 420,000
Cash ................. 110,759
Unearned Rental Income... 110,759
Legal Fees Expense*.......... 4,000
Cash..................... 4,000
12/31/11 Unearned Rental Income....... 50,765
Rental Income............ 50,765
($110,759 X 5.5/12)
Depreciation Expense......... 22,262
Accumulated Depreciation. 22,262
($420,000 - $80,000) ÷ 7 X 5.5/12
7/15/12 Unearned Rental Income....... 59,994
Rental Income............ 59,994
($110,759 X 6.5/12)
Cash ................. 110,759
Unearned Rental Income... 110,759
12/31/12 Depreciation Expense......... 48,571
Accumulated Depreciation. 48,571
($420,000 - $80,000) ÷ 7
12/31/12 Unearned Rental Income....... 59,994
Rental Income............ 59,994
($110,759 X 6.5/12)
* If the amounts are significant, these costs might be capitalized and amortized to expense to achieve better matching with revenues.
| (d) | (f) |
| Labonté | LePage |
| Capital | Operating |
| Lease | Lease |
Balance sheet: | | |
Property Plant & Equipment: | | |
Machinery under capital lease | $560,000 | |
Machinery leased to others | | $ 420,000 |
Less: Accumulated depreciation | (31,429) | (22,262) |
| 528,571 | 397,738 |
Current Liabilities: | | |
Interest payable | 30,885 | |
Current portion of lease obligation | 43,373 | |
Unearned rental income | | 59,994 |
| | |
Long term liabilities: | | |
Lease obligation | 449,241 | |
Less: Current portion | (43,373) | |
| 405,868 | |
| | |
Statement of income: | | |
Rental income | | $ 50,765 |
Depreciation expense | $ 31,429 | 22,262 |
Interest expense | 30,885 | |
Legal fees expense | | 4,000 |
(g) Although it might seem odd that the same asset is reported on two different balance sheets, the collection risks under which the lessor, LePage, is operating do not justify the recognition of income under a sales type lease. There are too many uncertainties surrounding the related costs and collections under the terms of its lease with Labonté. Should Labonté default on the lease, LePage might have to rent the used machinery to another lessee. It is not unreasonable, also, to consider that the “guarantee” of the residual value by the lease, Labonté, should not be considered in the calculations (e.g. for depreciation) as that company’s financial situation may make them unable to “make good” on the guarantee.
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