Zhou Ltd. is a private corporation, which uses private enterprise GAAP, and whose operations rely considerably on a group of technology companies that experienced operating difficulties from 2008 to 2010. As a result, Zhou suffered temporary cash flow problems that required it to look for innovative means of financing. In 2011, Zhou’s management therefore decided to enter into a sale and leaseback agreement with a major Canadian leasing company, Intranational Leasing.
Immediately after its September 30, 2011 year end, Zhou sold one of its major manufacturing sites to Intranational Leasing for $1,750,000, and entered into a 15-year agreement to lease back the property for $175,000 per year. The lease payment is due October 1 of each year, beginning October 1, 2011.
Zhou’s carrying amount of the property when sold was $250,000. The lease agreement gives Zhou the right to purchase the property at the end of the lease for its expected fair value at that time of $2.5 million. In 2011, the land is estimated to be worth 40% of the total property value, and the building, 60%. Zhou uses a 10% declining-balance method of amortizing its buildings, and has a 7% incremental borrowing rate.
Instructions
(a) Prepare all entries that are needed by Zhou to recognize the sale and leaseback transaction on October 1, 2011; any adjusting entries that are required on September 30, 2012; and the October 1, 2012 transaction. Reversing entries are not used.
(b) Prepare all necessary note disclosures and amounts that are to be reported on Zhou’s September 30, 2012 balance sheet, income statement, and statement of cash flows for its year ended September 30, 2012.
(a)
To the lessee, this lease of the building is accounted for as a capital lease and the lease of the land is treated an operating lease, since there is no bargain purchase option for the property and because the terms of the lease satisfy at least one of the quantitative criteria for capitalization.
The present value of the minimum lease payments is greater than 90% of the fair value of the leased property; that is, the present value of $1,705,457 (see below) is 97.5% of the fair value of the leased property ($1,705,457 / $1,750,000).
Using a financial calculator: | ||
PV | $ ? | Yields $1,705,457 |
I | 7% | |
N | 15 | |
PMT | $ (175,000) | |
FV | $ 0 | |
Type | 1 | |
The land and building must be considered separately for the purpose of classifying the lease. The minimum lease payments must be allocated between the land and the building in proportion to their fair values.
The portion of the gain related to the lease of the land, which is an operating lease, is amortized over the term of the lease. The portion of the gain related to the building must be deferred and amortized in proportion to the depreciation of the leased asset.
October 1, 2011
Cash................................... 1,750,000
Land and Building (net)............ 250,000
Deferred Gain on Sale of Land (40%) 600,000
Deferred Gain on Sale of Building (60%) 900,000
Leased Building........................ 1,023,274
Lease Obligation................... 1,023,274
($1,705,457 X 60% = $1,023,274)
Lease Obligation........................ 105,000
Land Rental Expense..................... 70,000
Cash................................ ... 175,000
[($175,000 X 40 % = $70,000]
September 30, 2012:
Interest Expense........................ 64,279
Interest Payable
[($1,023,274 – $105,000) X 7%] 64,279
Depreciation Expense – Building Under Lease 102,327
Accumulated Depreciation - Building
($1,023,274 X 10%).......... 102,327
Deferred Gain on Sale of Land .......... 40,000
Gain on Sale of Land................ 40,000
($600,000 / 15)
Deferred Gain on Sale of Building ...... 90,000
Gain on Sale of Building............ 90,000
($900,000 X 10%)
October 1, 2012:
Interest Payable........................ 64,279
Lease Obligation........................ 40,721
Land Rental Expense..................... 70,000
Cash................................ ... 175,000
PROBLEM 20-23* (Continued)
(b) Financial Statement disclosure at September 30, 2012:
Balance sheet: | |
Property Plant & Equipment: | |
Leased building | $ 1,023,274 |
Less: Accumulated depreciation | (102,327) |
| 920,947 |
Current Liabilities | |
Interest payable | 64,279 |
Current portion of lease obligation | 40,721 |
Deferred gain in sale of land and building | 121,000 |
| |
Long term liabilities | |
Deferred gain in sale of land and building | 1,249,000 |
Lease obligation | 918,274 |
Less: Current portion | (40,721) |
| 877,553 |
| Land | Building | Total |
Deferred gain on sale of land and building | $ 600,000 | $ 900,000 | |
Depreciation - Fiscal year 2012 | (40,000) | (90,000) | |
Balance September 30, 2012 | 560,000 | 810,000 | |
Current Portion | 40,000 | 81,000 | $ 121,000 |
Non- Current Portion | 520,000 | 729,000 | $1,249,000 |
Statement of Income: | |
Gain on sale of property | $130,000 |
Land rent expense | 70,000 |
Depreciation expense | 102,327 |
Interest expense | 64,279 |
| |
| |
Statement of cash flows: - indirect format | |
Operating Activities: | |
Gain on disposal of property | $ (1,500,000) |
Increase in interest payable | 64,279 * |
| |
Financing activities: | |
Payment of long term lease obligation | (105,000) |
* would likely be combined with other amounts of interest
The sale and leaseback transaction is a non-cash financing and investing activity, which would be reported in the notes to the financial statements and not on the face of the statement of cash flows.
The disclosure requirements for the operating lease for the land includes the future minimum lease payments, in total and for each of the next five years.
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