On December 31, 2011, Xu Ltd., which uses private enterprise GAAP, entered into an eight-year lease agreement for a conveyor machine. Annual lease payments are $28,500 at the beginning of each lease year, which ends December 31, and Xu made the first payment on January 1, 2012. At the end of the lease, the machine will revert to the lessor. However, conveyor machines are only expected to last for eight years and have no residual value. At the time of the lease agreement, conveyor machines could be purchased for approximately $166,000 cash. Equivalent financing for the machine could have been obtained from Xu’s bank at 10.5%. Xu’s fiscal year coincides with the calendar year and Xu uses straight-line depreciation for its conveyor machines.
Instructions
(a) Calculate the present value of the minimum lease payments using a financial calculator or work sheet functions.
(b) Explain why this is a capital lease to Xu Ltd. Document your calculations in arriving at your explanation.
(c) Prepare an amortization schedule for the term of the lease to be used by Xu Ltd. Use a computer spreadsheet.
(d) Prepare the journal entries on Xu Ltd.’s books to reflect the signing of the lease agreement and to record the payments and expenses related to this lease for the years 2012 and 2010 as well as any adjusting journal entries at its fiscal year ends of December 31, 2012, and 2010.
(e) Prepare a partial comparative balance sheet at December 31, 2010, and 2012, for all of the accounts related to this lease for Xu Ltd. Be specific about the classifications that should be used.
(f) Provide Xu Ltd.’s required note disclosure concerning the lease for the fiscal year ending December 31, 2010.
(g) What is the significance of the difference between the amount of the present value of the minimum lease payments calculated in part (a) and the approximate selling price of the machine of $166,000?
(a)
Capitalized amount of the lease:
| Excel formula =PV(rate,nper,pmt,fv,type) |
| Using a financial calculator: | ||
| PV | $ ? | Yields $164,995 |
| I | 10.5% | |
| N | 8 | |
| PMT | $ (28,500.00) | |
| FV | $ 0 | |
| Type | 1 | |
(b) This is a capital lease to Xu since the lease term (8 years) is greater than 75% of the economic life (8 years) of the leased asset. The lease term is 100% (8 ÷ 8) of the asset’s economic life. This also meets the requirements of IFRS, under which it is referred to as a financing lease.
The present value of the minimum lease payments is greater than 90% of the fair value of the leased asset; that is, the present value of $164,995 is 99% of the fair value of the leased asset: ($164,995 / $166,000 = 99.4%). This criteria for treating the lease as a capital lease has also been met. Note that meeting just one of the criteria is sufficient for classification as a capital lease.
There is no bargain purchase option in this case.
(c) Xu Ltd.
Lease Amortization Schedule
(Lessee)
| Date | | Annual Lease Payments | | Interest (10.5%) on Unpaid Obligation | | Reduction of Lease Obligation | | Balance of Lease Obligation | |||||||||||||
| | | | | | | | | | |||||||||||||
| | | | | | | | | $164,995.00 | |||||||||||||
| Jan. 1, | 2012 | $28,500.00 | | | | $28,500.00 | | 136,495.00 | |||||||||||||
| Jan. 1, | 2013 | 28,500.00 | | $14,331.98 | | 14,168.03 | | 122,326.97 | |||||||||||||
| Jan. 1, | 2014 | 28,500.00 | | 12,844.33 | | 15,655.67 | | 106,671.30 | |||||||||||||
| Jan. 1, | 2015 | 28,500.00 | | 11,200.49 | | 17,299.51 | | 89,371.79 | |||||||||||||
| Jan. 1, | 2016 | 28,500.00 | | 9,384.04 | | 19,115.96 | | 70,255.83 | |||||||||||||
| Jan. 1, | 2017 | 28,500.00 | | 7,376.86 | | 21,123.14 | | 49,132.70 | |||||||||||||
| Jan. 1, | 2018 | 28,500.00 | | 5,158.93 | | 23,341.07 | | 25,791.63 | |||||||||||||
| Jan. 1, | 2019 | 28,500.00 | | 2,708.37 | | 25,791.63 | | (0.00) | |||||||||||||
| | | $228,000.00 | | $63,005.00 | | $164,995.00 | | | |||||||||||||
(d)
1/1/12 Leased Equipment............ 164,995
Lease Obligation........ 164,995
1/1/12 Lease Obligation............ 28,500
Cash.................... 28,500
12/31/12 Depreciation Expense........ 20,624
Accumulated Depreciation—
Leased Equipment...... 20,624
($164,995 ÷ 8)
12/31/12 Interest Expense............ 14,332
Interest Payable........ 14,332
1/1/13 Interest Payable............ 14,332
Lease Obligation ........... 14,168
Cash.................... 28,500
12/31/13 Depreciation Expense........ 20,624
Accumulated Depreciation—
Leased Equipment..... 20,624
12/31/13 Interest Expense............ 12,844
Interest Payable........ 12,844
(e)
Xu Ltd.
Balance sheet (partial)
December 31,
2013 2012
Non-current assets
Property plant and equipment
Leased equipment $164,995 $164,995
Less accumulated depreciation 41,248 _20,624
123,747 144,371
Current liabilities
Interest payable 12,844 14,332
Lease obligation 15,656 14,168
Non-current liabilities
Lease obligation (Note X) 122,327 136,495
Current portion (15,656) (14,168)
(f) Note X:
The following is a schedule of future minimum lease payments under the capital lease expiring December 31, 2019 together with the balance of the obligation under capital lease.
Year ending December 31
2013 $28,500
2014 28,500
2015 28,500
2016 28,500
2017 28,500
2018 28,500
Total minimum lease payments 171,000
Less amount representing interest at 10.5% 48,673
Balance of the obligation $122,327
(g) When negotiating a lease arrangement, the lessor sets the lease payments receivable to obtain the appropriate return for the asset leased. The amounts arrived at are negotiable. In this case, the lessor likely tried to obtain an amount near to or exceeding the resale price of the equipment and arrived at annual payments in round amounts ($28,500). The present value of the minimum lease payment approximated the resale price without being exactly equal (99.4% in this case). This is a natural outcome from the negotiations process between the parties involved.
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