Lanier
Dairy Ltd. leases its milk cooling equipment from Green Finance Corporation.
Both companies use IFRS. The lease has the following terms.
1.
The lease is dated May 30, 2011, with a lease term of eight years. It is
non-cancellable and requires equal rental payments of $30,000 due each May 30,
beginning in 2011.
2.
The equipment has a fair value and cost at the inception of the lease of
$211,902, an estimated economic life of 10 years, and a residual value (which
is guaranteed by Lanier Dairy) of $23,000.
3.
The lease contains no renewal options and the equipment reverts to Green
Finance Corporation on termination of the lease.
4.
Lanier Dairy’s incremental borrowing rate is 6% per year; the implicit rate is
also 6%.
5.
Lanier Dairy uses straight-line depreciation for similar equipment that it
owns.
6.
Collectibility of the payments is reasonably predictable, and there are no
important uncertainties about costs that have not yet been incurred by the
lessor.
Instructions
(a)
Describe the nature of the lease and, in general, discuss how the lessee and
lessor should account for the lease transaction.
(b)
Prepare the journal entries for the lessee and lessor at May 30, 2011, and at
December 31, 2011, which are the lessee’s and lessor’s year ends, respectively.
(c)
Prepare the journal entries at May 30, 2012, for the lessee and lessor. Assume
reversing entries are not used.
(d)
What amount would have been capitalized by the lessee upon inception of the
lease if:
1.
the residual value of $23,000 had been guaranteed by a third party, not the
lessee?
2.
the residual value of $23,000 had not been guaranteed at all?
(e)
On the lessor’s books, what amount would be recorded as the net investment at
the inception of the lease, assuming:
1.
Green Finance had incurred $1,200 of direct costs in processing the lease?
2.
the residual value of $23,000 had been guaranteed by a third party?
3.
the residual value of $23,000 had not been guaranteed at all?
(f)
Assume that the milk cooling equipment’s useful life is 20 years. How large
would the residual value have to be at the end of 10 years in order for the
lessee to qualify for the operating method? Assume that the residual value
would be guaranteed by a third party.
(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) Green
Finance Corporation, the lessor, considers the same factors as Lanier Dairy
Ltd., the lessee, in determining whether the risks and benefits of ownership of
the leased property are transferred. These factors include:
·
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.
·
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.
·
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.
·
The
leased assets are so specialized that, without major modification and
significant cost to the lessor they are of use only to the lessee.
In this case, Lanier Dairy Ltd., the lessee, would
record the lease as a financing lease. Green Finance Corporation is not a
manufacturer or dealer and consequently the lease is a finance lease to Green
Finance Corporation.
(b) May
30, 2011
Lessee:
Leased Equipment..................... 211,902
Lease
Obligation................. 211,902
$30,000 X 6.58238* = $197,471.40)
($23,000 X .62741** = 14,430.43)
= $211,901.83
* PV factor of
annuity due at 6% for 8 years
** PV factor of
$1 at 6% for 8 years
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Excel formula =PV(rate,nper,pmt,fv,type)
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Using a financial calculator:
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PV
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$
?
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Yields $211,901.93
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I
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6%
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|
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N
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8
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|
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PMT
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$
(30,000)
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|
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FV
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$
(23,000)
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Type
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1
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Lease Obligation..................... 30,000
Cash............................. 30,000
May
30, 2011
Lessor:
Lease Payments Receivable............ 263,000
Equipment........................ 211,902
Unearned
Interest Income—Leases.. 51,098
($263,000 = 8 X $30,000; add $23,000
for residual value)
Cash .......................... 30,000
Lease
Payments Receivable........ 30,000
December
31, 2011
Lessee:
Interest Expense..................... 6,367
Interest
Payable................. 6,367
[($211,902 – $30,000) X .06 X 7/12]
Depreciation Expense................. 13,774
Accumulated
Depreciation.........
13,774
[($211,902 – $23,000) ÷ 8 X 7/12]
December
31, 2011
Lessor:
Unearned Interest Income—Leases...... 6,367
Interest
Income—Leases........... 6,367
(c) May
30, 2012
Lessee:
Lease Obligation..................... 19,086
Interest Expense..................... 4,547*
Interest Payable..................... 6,367
Cash............................. 30,000
*[($211,902 – $30,000) X .06 X 5/12]
Depreciation Expense................. 9,839
Accumulated
Depreciation.........
9,839
[($211,902 – $23,000) ÷ 8 X 5/12]
Lessor:
Unearned Interest Income—Leases...... 4,547
Interest
Income—Leases...........
4,547
Cash .......................... 25,250
Lease
Payments Receivable........ 25,250
(d) (1) and (2) are both $197,471, as the lessee
has no obligation to pay the residual value.
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Using a financial calculator:
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PV
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$
?
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Yields $197,471.44
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I
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6%
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N
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8
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|
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PMT
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$
(30,000)
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|
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FV
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$
0
|
|
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Type
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1
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(e) In the case of (1) the amount of the net
investment at the inception of the lease would be $211,902 + $1,200 or
$213,102. For (2) and (3) both would be
$211,902, as the estimated residual value exists whether or not it is
guaranteed.
(f) Since 90% of $197,471 is $177,724, the
difference of $19,747 is the present value of the residual amount. The future
value of $19,747 for n = 8, i = .06 is $31,474 ($19,747 X 1.59385). Therefore,
the residual value would have had to be greater than $31,474.
(g) Had Green
been using private enterprise GAAP:
The lease agreement satisfies both the 75%
and 90% quantitative requirements, collectability is reasonably predictable,
and there are no important uncertainties surrounding the costs yet to be
incurred by the lessor. For Lanier Dairy Ltd., the lessee, it is a capital
lease, and for Green Finance Corporation, the lessor, it is a direct financing
lease (since cost equals fair value).
