The following facts are for a non-cancellable lease agreement between Hebert Corporation and Russell Corporation, a lessee:
Inception date July 1, 2011
Annual lease payment due at the
beginning of each year, starting July 1, 2011 $20,066.26
Bargain purchase option price at end of lease term $4,500.00
Lease term 5 years
Economic life of leased equipment 10 years
Lessor’s cost $60,000.00
Fair value of asset at July 1, 2011 $88,000.00
Lessor’s implicit rate 9%
Lessee’s incremental borrowing rate 9%
The collectibility of the lease payments is reasonably predictable, and there are no important uncertainties about costs that have not yet been incurred by the lessor. The lessee assumes responsibility for all executory costs. Both Russell and Hebert use private enterprise GAAP.
Instructions
Answer the following, rounding all numbers to the nearest cent.
(a) Discuss the nature of this lease to Russell Corporation, the lessee.
(b) Discuss the nature of this lease to Hebert Corporation, the lessor.
(c) Prepare a lease amortization schedule for the lease obligation using a computer spreadsheet for Russell Corporation for the five-year lease term.
(d) Prepare the journal entries on the lessee’s books to reflect the signing of the lease and to record the payments and expenses related to this lease for the years 2011 and 2012. Russell’s annual accounting period ends on December 31, and Russell does not use reversing entries.
(e) Discuss the differences, if any, in the classification of the lease to Russell Corporation (the lessor) or to Hebert Corporation (the lessee) if both were using IFRS in their financial reporting.
(a) The lease agreement has a bargain purchase option and thus meets the criteria to be classified as a capital lease from the viewpoint of the lessee. The present value of the minimum lease payments exceeds 90% of the fair value of the assets.
(b) The lease agreement has a bargain purchase option. The collectability of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. The initial amount of net investment (which in this case equals the present value of the minimum lease payments, $88,000) exceeds the lessor’s cost ($60,000), the lease is a sales-type lease to the lessor.
(c) Net investment calculation:
$20,066.26 Annual rental payment
X 4.23972 PV of annuity due of 1 for n = 5, i = 9%
$85,075.32 PV of periodic rental payments
$ 4,500.00 Bargain purchase option
X .64993 PV of 1 for n= 5, i = 9%
$ 2,924.69 PV of bargain purchase option
$85,075.32 PV of periodic rental payments
+ 2,924.69 PV of bargain purchase option
$88,000.01 Net investment at inception of lease
| Excel formula =PV(rate,nper,pmt,fv,type) |
| Using a financial calculator: | ||
| PV | $ ? | Yields $ 88,000 |
| I | 9% | |
| N | 5 | |
| PMT | $ (20,066.26) | |
| FV | $ (4,500) | |
| Type | 1 | |
Russell Corporation (Lessee)
Lease Amortization Schedule
| Date | | Annual Lease Payment Plus BPO | | Interest (9%) on Unpaid Obligation | | Reduction of Lease Obligation | | Balance Lease Obligation |
| | | | | | | | | |
| 7/1/11 7/1/11 7/1/12 7/1/13 7/1/14 7/1/15 6/30/16 | | $ 20,066.26 20,066.26 20,066.26 20,066.26 20,066.26 4,500.00 $104,831.30 | | *$ 6,114.04* * 4,858.34* * 3,489.62* * 1,997.73* * 371.58* *$16,831.30* | | $20,066.26 13,952.22 15,207.92 16,576.64 18,068.53 4,128.42 $88,000.00 | | $88,000.00 67,933.74 53,981.52 38,773.59 22,196.96 4,128.42 0.00 |
*Rounding error is $.02 cents.
(d)
7/1/11 Leased Equipment ............. 88,000.00
Lease Obligation......... 88,000.00
Lease Obligation.............. 20,066.26
Cash.................... 20,066.26
12/31/11 Interest Expense........ 3,057.02
Interest Payable........ 3,057.02
($6,114.04 X 6/12 = ($3,057.02)
Depreciation Expense.......... 4,400.00
Accumulated Depreciation
—Leased Equipment...... 4,400.00
($88,000.00 ÷ 10 =
($8,800.00; $8,800.00 X 6/12 = $4,400)
7/1/12 Interest Payable............. 3,057.02
Interest Expense*............ 3,057.02
Lease Obligation............. 13,952.22
Cash.................... 20,066.26
* ($6,114.04 – $3,057.02)
12/31/12 Interest Expense............. 2,429.17
Interest Payable........ 2,429.17
($4,858.34 X 6/12 = ($2,429.17)
12/31/12 Depreciation Expense......... 8,800.00
Accumulated Depreciation
—Leased Equipment... 8,800.00
($88,000.00 ÷ 10 years = ($8,800.00)
(Note to instructor: Because a bargain purchase option was involved, the leased asset is amortized over its economic life rather than over the lease term.)
(e) For Russell Corporation—(the lessee):
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 direct financing lease.
For Hebert Corporation—(the lessor):
Under IFRS, the lease would receive the same treatment as under PE GAAP except the criteria need not include the two revenue recognition-based tests concerning collectability and estimating unreimbursable costs. Instead of being referred to as a sales-type lease, the lease would be referred to as a finance lease—manufacturer or dealer.
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