Refer to the data and other information provided in E20–2. In E On September 1, 2011, Wong Corporation, which uses private enterprise GAAP

Refer to the data and other information provided in E20–2.

In E 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.

Assume that the machine has an estimated economic life of seven years and that its fair value on September 1, 2011, is $79,000.

Instructions

(a) Explain why this lease is now considered an operating lease.

(b) Prepare all necessary journal entries for Wong Corporation for this lease, including any year-end adjusting entries through December 31, 2012.

(c) Identify what accounts will appear on Wong’s December 31, 2011 statement of financial position and income statement relative to this lease.

(d) How would Wong’s December 31, 2011 statement of financial position and income statement differ from your answer to (c) if the lease were a capital lease as described in E20–2?

(e) What major financial statement ratios would be different if Wong accounted for this lease as an operating lease rather than as a capital lease? Explain.

(a) This is an operating lease to Wong since the lease term (5 years) is less than 75% of the economic life (7 years) of the leased asset. The lease term is 71.4% (5 ÷ 7) of the asset’s economic life. There is no bargain purchase option and the present value of minimum lease payments of $56,994 represent 72% of the fair value at September 1 of $79,000 falling short of the criteria of 90% to treat the lease as a capital lease.

(b)  

September 1, 2011

Prepaid Rent........................  13,668

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

December 31, 2011

Rent Expense........................   4,556

     Prepaid Rent..................             4,556

     ($13,668 X 4 / 12 = $4,556)

September 1, 2012

Prepaid Rent........................  13,668

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

December 31, 2012

Rent Expense........................ 13,668

Prepaid Rent...................            13,668

    Alternately, the September 1, 2012 payment can be recorded to rent expense, in which case no adjusting journal entry is needed at December 31, 2012.

(c) and (d)

	E20-3	E20-2
	Operating	Capital
	Lease	Lease
Statement of Financial Position:
Current assets:
Prepaid rent	$9,112
Property Plant & Equipment:
Machine under capital lease		$ 56,994
Less:  Accumulated depreciation		(3,800)
		53,194
Current Liabilities
Interest payable		1,444
Current portion of lease obligation		9,335
Long term liabilities
Obligation under capital lease		43,326
Less:  Current portion		(9,335)
		33,991
Income Statement:
Depreciation expense		$ 3,800
Interest expense		1,444
Rent expense	$ 4,556

 (e) The amounts appearing on the financial statement in part (c) and (d) above lead to the conclusion that net income would be lower and therefore earnings per share would be lower if the lease were treated as a capital lease, although this difference would decrease over time as the total cash paid out over the life of the asset is the same under either alternative.  As well, using statement of financial position information, we can see that liquidity ratios would be adversely affected since the equivalent of one lease payment appears as a current liability when the lease is treated as a capital lease.  Debt to total asset ratios will be affected by the presence of the long-term debt obligation and the additional property, plant and equipment.