The head office of North Central Ltd. has operated in the western provinces for almost 50 years. North Central uses IFRS. In 1995, new offices were constructed on the same site at a cost of $9.5 million. The new building was opened on January 4, 1996, and was expected to be used for 35 years, at which time it would have a value of approximately $2 million.
In 2011, as competitors began to consider merger strategies among themselves, North Central felt that the time was right to expand the number of its offices throughout the province. This plan required significant financing and, as a source of cash, North Central looked into selling the building that housed its head office. On June 29, 2011, Rural Life Insurance Company Ltd. purchased the building (but not the land) for $8 million and immediately entered into a 20-year lease with North Central to lease back the occupied space. The terms of the lease were as follows:
1. It is non-cancellable, with an option to purchase the building at the end of the lease for $1 million.
2. The annual rental is $838,380, payable on June 29 each year, beginning on June 29, 2011.
3. Rural Life expects to earn a return of 10% on its net investment in the lease, the same as North Central’s incremental borrowing rate.
4. North Central is responsible for maintenance, insurance, and property taxes.
5. Estimates of useful life and residual value have not changed significantly since 1993.
Instructions
(a) Prepare all entries for North Central Ltd. from June 29, 2011, to December 31, 2012. North Central has a calendar year fiscal period.
(b) Assume instead that there was no option to purchase, that $8 million represents the building’s fair value on June 29, 2011, and that the lease term was 12 years. Prepare all entries for North Central from June 29, 2011, to December 31, 2012.
(c) Besides the increase in cash that it needs from the sale of the building, what effect should North Central expect to see on the net assets appearing on its balance sheet immediately after the sale and leaseback?
(a)
29/6/11 Cash....................... 8,000,000
Building ............... 9,500,000
Accumulated Depreciation... 3,321,429*
Deferred Profit on Sale-
Leaseback............. 1,821,429
*($9,500,000 - $2,000,000) / 35 X 15.5 years)
29/6/11 Building Under Capital
Leases................... 8,000,000
Obligations Under Capital
Leases................ 8,000,000
($838,380 X 9.36492*) +
($1,000,000 X .14864**)
* Present value of annuity due for 20 periods at 10%
** Present value of single payment for 20 periods at 10%
| Excel formula =PV(rate,nper,pmt,fv,type) |
| PV | $ ? | Yields $8,000,005 |
I | 10% | |
| N | 20 | |
| PMT | $ (838,380) | |
| FV | $ (1,000,000) | |
| Type | 1 |
29/6/11 Lease Obligation............... 838,380
Cash.................... 838,380
| Partial Lease Amortization Schedule | ||||||||
| | | | | | | | | |
| Date | | Annual Lease Payment | | Interest (10%) | | Amortization | | Balance |
| | | | | | | | | |
| 29/06/11 29/06/11 | | $838,380 | | | | $838,380 | | $8,000,000 7,161,620 |
| 29/06/12 | | 838,380 | | $716,162 | | 122,218 | | 7,039,402 |
12/31/11 Deferred Profit on Sale-
Leaseback.................. 45,536
Depreciation Expense**... 45,536
($1,821,429 ÷ 20 X 6/12)
**The credit could also be to a gain account.
The deferred profit on the sale-leaseback should be amortized on the same basis that the asset is being amortized.
Maintenance, insurance and property taxes would also have been paid during the year.
12/31/11 Depreciation Expense........ 150,000
Accumulated Depreciation. 150,000
(($8,000,000 - $2,000,000) ÷ 20 X 6/12)
12/31/11 Interest Expense............ 358,081
Interest Payable......... 358,081
($7,161,620 X 10% X 6/12)
29/6/12 Lease Obligation............. 122,218
Interest Payable............. 358,081
Interest Expense............. 358,081
Cash..................... 838,380
12/31/12 Deferred Profit on Sale-
Leaseback.................. 91,071
Depreciation Expense..... 91,071
($1,821,429 ÷ 20)
PROBLEM 20-22* (Continued)
12/31/12 Depreciation Expense........ 300,000
Accumulated Depreciation. 300,000
(($8,000,000 - $2,000,000) ÷ 20)
12/31/12 Interest Expense............ 351,970
Interest Payable......... 351,970
($7,039,402 X 10% X 6/12)
(b) The lease must now be recorded as an operating lease as it is no longer a capital lease because: (1) the lease term is for 60% (12 ÷ 20) of the economic life of the leased asset and (2) the present value of the minimum lease payments is 79% ($6,283,709 / $8,000,000) of the fair market value of the leased asset and (3) there is no longer a bargain purchase option. Maintenance, insurance and property tax expenses would also be incurred.
The present value of the minimum lease payments:
| Using a financial calculator: | ||
| PV | $ ? | Yields $ 6,283,709 |
| I | 10% | |
| N | 12 | |
| PMT | $ (838,380) | |
| FV | $ 0 | |
| Type | 1 | |
29/6/11 Cash......................... 8,000,000
Building ................. 9,500,000
Accumulated Depreciation..... 3,321,429*
Deferred Profit on Sale
of Building............. 1,821,429
*($9,500,000 - $2,000,000) / 35 X 15.5 years)
29/6/11 Rent Expense................. 838,380
Cash...................... 838,380
31/12/11 Prepaid Rent ................ 419,190
Rent Expense.............. 419,190
31/12/11 Deferred Profit on Sale
of Building ............... 75,893
Rent Expense.............. 75,893
*($1,821,429 / 12 X 6/12)
29/6/12 *Rent Expense................. 419,190
Prepaid Rent.............. 419,190
29/6/12 Rent Expense................. 838,380
Cash...................... 838,380
31/12/12 *Prepaid Rent............. 419,190
Rent Expense.............. 419,190
31/12/12 Deferred Profit on Sale
of Building ............... 151,786
Rent Expense.............. 151,786
($1,821,429 / 12)
(c) The net assets amount (or equity) on the balance sheet of North Central will be very similar after the completion of the sale and leaseback as it was before. Any excess of the capitalized amount of the building over the carrying value at the time of the sale (i.e. the gain) will be deferred and amortized over the term of the lease, or the life of the asset. Eventually this gain will be realized to equity. Over the term of the lease, the additional costs related to the borrowing will affect equity but this is no different, for example, than if a loan had been obtained in exchange for a mortgage obligation.
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