New Bay Corporation leases an automobile with a fair value of $21,500 from Simon Motors, Inc. on the following lease terms:
1. It is a non-cancellable term of 55 months.
2. The rental is $425 per month at the end of each month (the present value at 1% per month is $17,910).
3. The estimated residual value after 55 months is $2,500 (the present value at 1% per month is $1,446). New Bay Corporation guarantees the residual value of $2,500.
4. The automobile’s estimated economic life is 72 months.
5. New Bay Corporation’s incremental borrowing rate is 12% a year (1% a month). Simon’s implicit rate is unknown.
Instructions
(a) Assuming that New Bay Corporation reports under private enterprise standards, explain why this is a capital lease.
(b) What is the present value of the minimum lease payments for New Bay?
(c) Record the lease on New Bay Corporation’s books at the date of inception.
(d) Record the first month’s depreciation on New Bay Corporation’s books (assume the straight-line depreciation method).
(e) Record the first month’s lease payment.
(f) Would this lease be considered a capital lease if the company reported under IFRS?
(a) To New Bay, the lessee, this lease is a capital lease because the terms satisfy the following criteria:
1. The lease term is greater than 75% of the economic life of the leased asset; that is, the lease term is 76.4% (55/72) of the economic life.
2. The present value of the minimum lease payments is greater than or equal to 90% of the fair value of the leased asset; that is, the present value of $19,356 is 90% of the fair value of the leased asset: ($19,356 / $21,500 = 90%)
(b) The minimum lease payments, in the case of a residual value guaranteed by the lessee include the guaranteed residual value. The present value therefore is:
PV of monthly payment of $425 for 55 months $17,910
PV of residual value of $2,500............. 1,446
Present value of minimum lease payments.... $19,356
| Excel formula =PV(rate,nper,pmt,fv,type) |
| Using a financial calculator: | ||
| PV | $ ? | Yields $19,358.88 |
| I | 1% | |
| N | 55 | |
| PMT | $ (425) | |
| FV | $ (2,500) | |
| Type | 0 | |
(c) Leased Property..................... 19,356
Lease Obligation................ 19,356
(d) Depreciation Expense................ 306.47
Accumulated Depreciation—Leased
Property...................... 306.47
[($19,356 – $2,500) ÷ 55 months = $306.47]
(e) Lease Obligation.................... 231.44
Interest Expense (1% X $19,356)..... 193.56
Cash............................ 425.00
(f) Rather than using quantitative factors such as the 75 percent and the 90 percent hurdles often referred to as the bright lines used in PE GAAP, the IFRS criteria use qualitative factors to establish whether or not the risks and rewards of ownership are transferred to the lessee, and supports classification as a finance lease:
1. 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.
2. 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.
3. 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.
4. The leased assets are so specialized that, without major modification, they are of use only to the lessee.
None of the numerical thresholds need be applied, as was the case in PE GAAP, and so the treatment of the lease by the lessee would be the same, although it would be referred to as a finance lease, rather than a capital lease.
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