On September 1, 2011, Wong Corporation, which uses private enterprise GAAP, signed a five-year, non-cancellable lease for a machine

On September 1, 2011, Wong Corporation, which uses private enterprise GAAP, signed a five-year, non-cancellable lease for a machine. The terms of the lease called for Wong to make annual payments of $13,668 at the beginning of each lease year, starting September 1, 2011. The machine has an estimated useful life of six years and a $9,000 unguaranteed residual value. The machine reverts back to the lessor at the end of the lease term. Wong uses the straight-line method of depreciation for all of its plant assets, has a calendar year end, prepares adjusting journal entries at the end of the fiscal year, and does not use reversing entries. Wong’s incremental borrowing rate is 10%, and the lessor’s implicit rate is unknown.

Instructions

(a) Explain why this is a capital lease to Wong.

(b) Using time value of money tables, a financial calculator, or computer spreadsheet functions, calculate the present value of the minimum lease payments for the lessee.

(c) Prepare all necessary journal entries for Wong for this lease, including any year-end adjusting entries through September 1, 2012.

(d) Would this also be a capital lease if the lessee reported under IFRS?

(a) This is a capital lease to Wong since the lease term (5 years) is greater than 75% of the economic life (6 years) of the leased asset. The lease term is 83⅓% (5 ÷ 6) of the asset’s economic life.

(b) Calculation of present value of minimum lease payments:

        $13,668 X 4.16986* = $56,994

*Present value of an annuity due of 1 for 5 periods at 10%.

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

Using a financial calculator:
PV	$  ?	Yields $56,994
I	10%
N	5
PMT	$  (13,668)
FV	$  0
Type	1

(c)

9/1/11   Leased Machine................. 56,994

             Lease Obligation...........            56,994

         Lease Obligation...............  13,668

             Cash ......................            13,668

12/31/11 Depreciation Expense...........  3,800

             Accumulated Depreciation—

               Leased Machine............             3,800

               [($56,994/ 5) X 4/ 12 = $3,800]

         Interest Expense...............  1,444

             Interest Payable...........             1,444

          [($56,994 – $13,668) X .10 X 4/ 12 = $1,444]

9/1/12   Lease Obligation...............  9,335

         Interest Payable...............  1,444

         Interest Expense...............   2,889

             Cash ......................            13,668

          [($56,994 – $13,668) X .10 X 8/ 12 = $2,889]

(d)

Under IFRS, any one or a combination of the following situations normally indicates that the risks and rewards of ownership are transferred to the lessee, and supports classification as a finance lease:

·         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/or significant cost to the lessor, they are of use only to the lessee.

Other indicators include situations where the lessee absorbs the lessor’s losses if the lessee cancels the lease, or the lessee assumes the risk associated with the amount of the residual value of the asset at the end of the lease, or where there is a bargain renewal option—when the lessee can renew the lease for an additional term at significantly less than the market rent.

The standard also states that these indicators are not always conclusive. The decision has to be made on the substance of each specific transaction. If the lessee determines that the risks and benefits of ownership have not been transferred to it, the lease is classified as an operating lease.