Victoria Leasing Corporation, which uses private enterprise GAAP, leases a new machine that has a cost and fair value of $95,000 to Black Corporation

Victoria Leasing Corporation, which uses private enterprise GAAP, leases a new machine that has a cost and fair value of $95,000 to Black Corporation on a three-year, non-cancellable contract. Black Corporation agrees to assume all risks of normal ownership, including such costs as insurance, taxes, and maintenance. The machine has a three-year useful life and no residual value. The lease was signed on January 1, 2011, and Victoria Leasing Corporation expects to earn a 9% return on its investment. The annual rentals are payable on each December 31, beginning December 31, 2011. Black Corporation has an excellent credit rating and so Victoria Leasing is reasonably assured of the collections under the lease.

Instructions

(a) Discuss the nature of the lease arrangement and the accounting method that each party to the lease should apply.

(b) Use a computer spreadsheet to prepare an amortization schedule that would be suitable for both the lessor and the lessee and that covers all the years involved.

(c) Discuss the differences, if any, in the classification of the lease to Victoria Leasing Corporation (the lessor) or to Black Corporation (the lessee) if both were using IFRS in their financial reporting.

(a) When using private enterprise GAAP, because the lease term is longer than 75% of the economic life of the asset and the present value of the minimum lease payments is more than 90% of the fair value of the asset, it is a capital lease to the lessee. Assuming collectibility of the rents is reasonably assured, no important uncertainties surround the amount of un-reimbursable costs yet to beincurred by the lessor, and equal cost and fair value to Victoria Leasing, the lease is a direct financing lease to the lessor.

    Black Corporation, the lessee should adopt the capital lease method and record the leased asset and lease obligation at the present value of the minimum lease payments using the lessee’s incremental borrowing rate or the interest rate implicit in the lease, if it is lower than the incremental rate and is known to the lessee. The lessee’s depreciation depends on whether ownership transfers to the lessee or if there is a bargain purchase option. If one of these conditions is fulfilled, depreciation would be over the economic life of the asset. Otherwise, the asset would be amortized over the lease term. Because both the economic life of the asset and the lease term are three years, the leased asset should be amortized over this period.

    The Victoria Leasing Corporation— If a lease, in substance, transfers the risks and benefits of ownership of the leased asset to the lessee (decided in the same way as for Black Corporation, the lessee) and revenue recognition criteria related to collectability and ability to estimate any remaining un-reimbursable costs are met, the lessor accounts for the lease as either a direct financing or a sales-type lease. Victoria is not a manufacturer or dealer trying to make a sale and so the lease will be a direct financing lease to Victoria.

    In this case, the credit risks associated with the lease are normal and there are no unreimbursable costs that cannot be estimated by the lessor. Victoria will replace the asset cost of $95,000 with Lease Payments Receivable of $112,590 and Unearned Interest Income of $17,590. (See schedule below.) Interest would be recognized annually at a constant rate applied to the unrecovered net investment.

    Cost (fair market value of leased asset).... $95,000

    Amount to be recovered by lessor through lease

      payments................................... $95,000

    Three annual lease payments: $95,000 ÷ 2.53130*            $37,530

   

Lease Payments Receivable = $37,530 X 3 ........  $112,590

*Present value of an ordinary annuity of 1 for 3 periods at 9%.

Excel formula =PMT(rate,nper,pv,fv,type)

Using a financial calculator:
PV	$  (95,000)
I	9%
N	3
PMT	$  ?	Yields $37,530
FV	$  0
Type	0

(b)

Schedule of Interest and Amortization

		Rent Receipt/ Payment		Interest Income/ Expense		Reduction of Principal		Investment/ Obligation
1/1/11 12/31/11 12/31/12 12/31/13		— $37,530  37,530  37,530		— **$8,550** ** 5,942** ** 3,098**		— $28,980  31,588  34,432		$95,000  66,020  34,432       0

    **$95,000 X .09 = $8,550

    **rounding difference

(c) For Black 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 and/or significant cost to the lessor, 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 capital lease.

    For Victoria Leasing Corporation—(the lessor):

    Under IFRS, the lease would receive the same treatment as under PE GAAP except the criteria need not specifically include the two revenue recognition-based tests concerning collectability and estimating unreimbursable costs. These are general recognition tests that would have to be met regardless. The lease would be a financing lease since Victoria is not a manufacturer or dealer.