Castle
Leasing Corporation, which uses IFRS, signs a lease agreement on January 1,
2011, to lease electronic equipment to Wai Corporation, which also uses IFRS.
The term of the non-cancellable lease is two years and payments are required at
the end of each year. The following information relates to this agreement.
1.
Wai Corporation has the option to purchase the equipment for $13,000 upon the
termination of the lease.
2.
The equipment has a cost and fair value of $135,000 to Castle Leasing
Corporation. The useful economic life is two years, with a residual value of
$13,000.
3.
Wai Corporation is required to pay $5,000 each year to the lessor for executory
costs.
4.
Castle Leasing Corporation wants to earn a return of 10% on its investment.
5.
Collectibility of the payments is reasonably predictable, and there are no
important uncertainties surrounding the costs that have not yet been incurred
by the lessor.
Instructions
(a)
Using time value of money tables, a financial calculator, or computer
spreadsheet functions, calculate the lease payment that Castle Leasing would
require from Wai Corporation.
(b)
What classification will Wai Corporation give to the lease? What classification
will be given to the lease by Castle Leasing Corporation?
(c)
What classification would be adopted by Wai Corporation and Castle Leasing
Corporation had they both been using private enterprise GAAP?
(d)
Prepare a lease amortization table for Castle Leasing for the term of the
lease.
(e)
Prepare the journal entries on Castle Leasing’s books to reflect the payments
received under the lease and to recognize income for the years 2011 and 2012.
(f)
Assuming that Wai Corporation exercises its option to purchase the equipment on
December 31, 2012, prepare the journal entry to reflect the sale on Castle
Leasing’s books.
(g)
What amount would Wai Corporation capitalize and recognize as a liability on
signing the lease? Explain.
(a) Calculation of
annual payments
Cost (fair market value) of leased asset
to lessor $135,000.00
Less: Present
value of residual value
$13,000 X
.82645
(Present
value of 1 at 10% for 2 periods) (10,743.85 )
Amount to be recovered through lease payments $124,256.15
Two periodic lease payments
$124,256.15 ÷ 1.73554* $71,595.09
*Present value of an ordinary annuity of 1 for 2
periods at 10%
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Excel formula =PMT(rate,nper,pv,fv,type)
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Using a financial calculator:
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PV
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$
(135,000)
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I
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10%
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N
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2
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PMT
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$ ?
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Yields $71,595.24
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FV
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$ 13,000
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Type
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0
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Calculation of lease payments receivable
Annual payments ($71,595.09 X 2) $143,190.18
Residual value 13,000.00
Lease payments receivable $156,190.18
Calculation of unearned interest income
Gross investment by lessee $156,190.18
Asset cost (fair value) 135,000.00
Unearned interest income $ 21,190.18
(b) Castle
Leasing Corporation should classify the lease as a finance lease because it is
not a manufacturer or dealer. The
capitalization of the lease will also be done by Wai Corporation, the lessee
which will treat the lease as a finance lease.
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.
(c) For PE GAAP, rather than using qualitative
factors described under part (b) above for IFRS, quantitative criteria such as:
1. the term of the lease exceeding 75% of the remaining
economic life of the asset,
2. the present value of the minimum lease payments
exceeding 90% of the fair value of the asset, or
3. the presence of a bargain purchase option
will be applied as the basis for the classification
of the lease as a direct financing lease for Wai Corporation.
For Castle Leasing, the
lessor, the lease would receive the same
treatment as under IFRS, as long as the two revenue recognition-based tests concerning collectability
and estimating unreimbursable are passed.
(d)
CASTLE LEASING CORPORATION (Lessor)
Lease Amortization Schedule
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Date
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Annual Pmt.
Excl. Exec. Costs
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Interest
on Net
Investment
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Net
Investment
Recovery
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Net
Investment
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1/1/11
12/31/11
12/31/11
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$71,595.09
71,595.09
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*$13,500.00*
* 7,690.18*
*$21,190.18*
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$58,095.09
63,904.91
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$135,000.00
76,904.91
13,000.00
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*Difference of $.31 due to rounding.
(e)
1/1/11 Lease
Payments Receivable... 156,190.18
Equipment
Purchased
for Lease........... 135,000.00
Unearned
Interest
Income—Leases.......... 21,190.18
12/31/11 Cash
($71,595.09 + $5,000).. 76,595.09
Executory
Costs
Payable/Expense........ 5,000.00
Lease
Payments
Receivable............. 71,595.09
Unearned
Interest Income—
Leases.................... 13,500.00
Interest
Income—
Leases................. 13,500.00
12/31/12 Cash........................ 76,595.09
Executory
Costs
Payable/Expense........ 5,000.00
Lease
Payments
Receivable............. 71,595.09
Unearned
Interest Income—
Leases.................... 7,690.18
Interest
Income—
Leases................. 7,690.18
(f) 12/31/11 Cash.................... 13,000.00
Lease
Payments
Receivable........ 13,000.00
(g) Upon
signing the lease, Wai Corporation should capitalize the present value of the
minimum lease payments in the amount of $71,595.09 excluding the present value
of the option to purchase the equipment for $13,000. This will yield an amount of $124,256.15 as
calculated in part (a). The lessee excludes this last payment, as it is not a
guaranteed payment by the lessee, Wai to the lessor, Castle Leasing. Correspondingly the lease obligation should
be recorded at $124,256.15.
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Using a financial
calculator:
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PV
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$ ?
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Yields $ 124,255.94
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I
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10%
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N
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2
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PMT
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$ 71,595.09
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FV
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$ 0
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Type
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0
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