Jennings
Inc., which uses IFRS, manufactures an X-ray machine with an estimated life of
12 years and leases it to SNC Medical Centre for a period of 10 years. The
machine’s normal selling price is $343,734, and the lessee guarantees a
residual value at the end of the lease term of $15,000. The medical centre will
pay rent of $50,000 at the beginning of each year and all maintenance,
insurance, and taxes. Jennings incurred costs of $210,000 in manufacturing the
machine and $14,000 in negotiating and closing the lease. Jennings has
determined that the collectibility of the lease payments is reasonably
predictable, that there will be no additional costs incurred, and that its
implicit interest rate is 10%.
Instructions
Answer
the following questions, rounding all numbers to the nearest dollar.
(a)
Discuss the nature of this lease in relation to the lessor and calculate the
amount of each of the following items:
1.
Gross investment
2.
Sales price
3.
Unearned interest income
4.
Cost of sales
(b)
Prepare a 10-year lease amortization schedule for the lease obligation.
(c)
Prepare all of the lessor’s journal entries for the first year.
(d)
Identify the amounts to be reported on Jennings’s balance sheet, income
statement, and statement of cash flows one
year
after signing the lease, and prepare any required note disclosures.
(e)
Assume that SNC Medical Centre’s incremental borrowing rate is 12% and that the
centre knows that 10% is the rate implicit in the lease. Determine the
depreciation expense that SNC will recognize in the first full year that it leases
the machine.
(f)
Assuming instead that the residual value is not guaranteed, what changes, if
any, are necessary in parts (a) to (d) for the lessor and in part (e) for the
lessee?
(g)
Discuss how Jennings would have determined the classification of the lease if
the company were using private enterprise GAAP for its financial reporting.
(a) Jennings,
the lessor, considers the same factors as SNC Medical, the lessee, in
determining whether the risks and benefits of ownership of the leased property
are transferred. These factors include:
1. There is reasonable assurance that the lessee will
obtain ownership of the leased property, including through a bargain purchase
option.
2. The lessee will benefit from most of the asset use
due to the length of the lease term which is substantially all of the leased
property's economic life.
3. The lessor recovers substantially all of its
investment and earns a return on that investment
Jennings is a manufacturer and consequently the
signing of the lease involves the sale of inventory and the financing of their
customer’s purchase. The lease is therefore a manufacturer or dealer lease to
Jennings.
Present value of minimum lease payments:
1. Present
value of annual payments of
$50,000 made at the beginning of each
period for 10 years, $50,000 X 6.75902
(PV of an annuity due at 10%) $337,951
2. Present
value of guaranteed residual value,
$15,000 X .38554 (PV of $1, 10 years at 10%) 5,783
Present
value of minimum lease payments $343,734
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Excel formula =PV(rate,nper,pmt,fv,type)
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Using a financial calculator:
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PV
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$
?
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Yields $343,734
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I
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10%
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N
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10
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PMT
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$
(50,000)
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FV
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$
(15,000)
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Type
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1
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1. Gross
investment:
Lease
payments of $50,000 made at the
beginning of each year for 10 years $500,000
Guaranteed
residual value due at the end
of 10 years 15,000
Gross
investment $515,000
2. Unearned
interest income:
Gross
investment $515,000
Less: Fair market value of the X-ray
machine 343,734
Unearned
interest income $171,266
3. Sales price
is the same as the present value of
minimum lease payments $343,734
4. Cost of
sales is the cost of manufacturing the
X-ray machine $210,000
(b) JENNINGS INC. (Lessor)
Lease Amortization
Schedule
(Annuity due basis,
guaranteed residual value)
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Beginning
of Year
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Annual Lease
Payment Plus
Residual Value
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Interest
(10%) on Net
Investment
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Net
Investment
Recovery
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Net
Investment
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Initial PV
1
2
3
4
5
6
7
8
9
10
End of 10
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$ 50,000
50,000
50,000
50,000
50,000
50,000
50,000
50,000
50,000
50,000
15,000
$515,000
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—
*$ 29,373*
* 27,311*
* 25,042*
* 22,546*
* 19,801*
* 16,781*
* 13,459*
* 9,805*
* 5,785*
* 1,363*
*$171,266*
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$ 50,000
20,627
22,689
24,958
27,454
30,199
33,219
36,541
40,195
44,215
13,637
$343,734
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$343,734
293,734
273,107
250,418
225,460
198,006
167,807
134,588
98,047
57,852
13,637
0
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*Rounding error is $1.
(c) Lessor’s
journal entries:
Beginning
of the Year
Lease Payments Receivable.............. 515,000
Cost of Sales.......................... 210,000
Sales.............................. 343,734
X-ray
Machine Inventory............ 210,000
Unearned
Interest Income—Leases.... 171,266
(To record the sale and the cost of
sales in the lease transaction)
Selling Expense......................... 14,000
Cash/Payable........................ 14,000
(To record the incurrence of initial direct
costs relating to the lease)
Cash .............................. 50,000
Lease
Payments Receivable........... 50,000
(To record receipt of the first lease
payment)
End
of the Year
Unearned Interest Income—Leases......... 29,373
Interest
Income—Leases.............. 29,373
(To record interest earned during the first
year of the lease)
(d)
At
December 31, the end of the first year of the lease, Jennings Inc. will report on
the income statement the sales amount of $343,734 and cost of sales of
$210,000, indicating gross profit from the sale of the X-ray equipment in the
amount of $133,734. They will also
report the interest income on the lease of $29,373 and selling expenses of
$14,000.
The balance sheet
would report the current portion of the lease payments receivable of $50,000
and the non-current portion of $415,000, reduced by the current portion of the
unearned interest income on the lease in the amount of $27,311 and the
non-current portion for $114,582.
For the statement
of cash flows, using the indirect format for the cash flow from operations,
there will be an adjustment of an addition to income for the reduction of
inventory of $210,000 and an addition for the net increase in unearned income
of $141,893 ($171,266 – $29,373). For investing activities the statement will
show a net increase in lease payments receivable of $465,000 ($515,000 –
$50,000).
For the note
disclosure, the list of required and desirable disclosures include: the total
future minimum lease payments receivable, unguaranteed residual values,
unearned finance income, executory costs included in minimum lease payments,
contingent rentals taken into income, lease terms, and the amounts of minimum lease
payments receivable for each of the next five years.
(e) Since the
implicit rate in the lease of 10% is known to the lessee, SNC Medical Centre,
the interest rate used by SNC will be the same as that of the lessor, Jennings
Inc. Consequently, the machinery will be capitalized at the amount of $343,734,
the present value of the minimum lease payments as calculated in (a)
above. The depreciation of the machinery
will be based on the term of the lease as SNC has guaranteed the residual
value. The depreciation expense will
therefore be $32,873 (($343,734 - $15,000) / 10 years).
(f) Had the
residual value of the X-ray machine not been guaranteed, the amount of the sale
and the cost of goods sold recorded would have been reduced by the present
value of the residual value in the amount of $5,783 ($15,000 X .38554 for PV of
$1, for 10 years at 10%).
|
Excel formula =PV(rate,nper,pmt,fv,type)
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Using a financial calculator:
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PV
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$
?
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Yields $5,783
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I
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10%
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N
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10
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PMT
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$
0
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FV
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$ 15,000
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Type
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1
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From the
perspective of the lessor, the entries concerning the recording of the lease
payments receivable do not change, except as noted above since the lessor
assumes that they will recover the residual value whether that amount is
guaranteed by the lessee or not.
Consequently the amount of interest accrued at the end of the year will
be the same amount as given in (c). The financial statements of the lessor
remain unaffected with the exception of the reduction of $5,783 for the sales
and cost of goods sold amounts on the income statement.
From the
perspective of the lessee, the amount used to capitalize the machinery will
exclude the residual value, since the lessee does not guarantee that
amount. Using the same variables as in
(a) above but excluding the residual value yields an amount of $337,951. The
depreciation expense will therefore be $33,795 ($337,951 / 10 years).
(g) Had
Jennings been using private enterprise GAAP, quantitative factors would apply.
The lease is a sales-type lease because: (1) the lease term is for 83% (10 ÷
12) of the economic life of the leased asset, (2) the present value of the
minimum lease payments exceeds 90% of the fair market value of the leased
property, (3) the collectability of the lease payments is reasonably predictable
and no uncertainties exist as to unreimbursable costs yet to be incurred by the
lessor, and (4) the lease provides the lessor with manufacturer’s profit in
addition to interest income.
