Lee
Industries and Lor Inc. enter into an agreement that requires Lor Inc. to build
three diesel-electric engines to Lee’s specifications. Both Lee and Lor follow
private enterprise GAAP. Upon completion of the engines, Lee has agreed to
lease them for a period of 10 years and to assume all costs and risks of
ownership. The lease is non-cancellable, becomes effective on January 1, 2011,
and requires annual rental payments of $620,956 each January 1, starting
January 1, 2011.
Lee’s
incremental borrowing rate is 10%, and the implicit interest rate used by Lor
Inc. is 8% and is known to Lee.
The
total cost of building the three engines is $3.9 million. The engines’ economic
life is estimated to be 10 years, with residual value expected to be zero. Lee
depreciates similar equipment on a straight-line basis. At the end of the
lease, Lee assumes title to the engines. Collectibility of the lease payments
is reasonably certain and there are no uncertainties about unreimbursable
lessor costs.
Instructions
Answer
the following questions, rounding all numbers to the nearest dollar.
(a)
Discuss the nature of this lease transaction from the viewpoints of both the
lessee (Lee Industries) and lessor (Lor Inc.).
(b)
Prepare the journal entry or entries to record the transactions on January 1,
2011, on the books of Lee Industries.
(c)
Prepare the journal entry or entries to record the transactions on January 1,
2011, on the books of Lor Inc.
(d)
Prepare the journal entries for both the lessee and lessor to record interest
expense (income) at December 31, 2011.
(Prepare
a lease amortization schedule for the lease obligation for two years using a
computer spreadsheet.)
(e)
Show the items and amounts that would be reported on the balance sheet (ignore
the notes) at December 31, 2011, for both the lessee and the lessor.
(f)
Identify how the lease transactions would be reported on each company’s
statement of cash flows in 2011.
(g)
Provide the note disclosure concerning the lease that would be required for the
lessee, Lee Industries, on its financial statements for the fiscal year ending
December 31, 2011.
(h)
Provide the note disclosure concerning the lease that would be required for the
lessor, Lor Inc., on its financial statements for the fiscal year ending
December 31, 2011.
(a) The lease should be treated as a capital lease
by Lee Industries, requiring the lessee to capitalize the leased asset. The
lease qualifies for capital lease accounting by the lessee because: (1) title
to the engines transfers to the lessee, (2) the lease term is equal to the
estimated life of the asset, and (3) the present value of the minimum lease
payments exceeds 90% of the fair value of the leased engines. The transaction
represents a purchase financed by instalment payments over a 10-year period.
For Lor Inc. the transaction is a sales-type
lease because a manufacturer’s profit accrues to Lor Inc. This lease
arrangement also represents the manufacturer’s financing of the transaction
over a period of 10 years.
Lease
Payment Receivable
Payment
per period $ 620,956
Periods X 10
Lease
payments receivable $6,209,560
Present
Value of Lease Payments
$620,956
X 7.24689* $4,500,000
*Present
value of an annuity due at 8% for 10 years.
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Excel formula =PV(rate,nper,pmt,fv,type)
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Using a financial calculator:
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||
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PV
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$
?
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Yields $4,499,999
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I
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8%
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|
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N
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10
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PMT
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$
(620,956)
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|
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FV
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$
0
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|
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Type
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1
|
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Unearned
Interest Income
Lease
payments receivable $6,209,560
Less: Present value of lease payments 4,500,000
Unearned
interest income $1,709,560
Dealer
Profit
Sales
(present value of lease payments) $4,500,000
Less
cost 3,900,000
Profit
on sale $ 600,000
(b) Leased
Engines..................... 4,500,000
Lease
Obligation............... 4,500,000
Lease Obligation................. 620,956
Cash......................... 620,956
(c) Lease
Payments Receivable........ 6,209,560
Cost of
Goods Sold............... 3,900,000
Sales........................ 4,500,000
Inventory.................... 3,900,000
Unearned
Interest Income—Leases 1,709,560
Cash............................. 620,956
Lease
Payments Receivable.... 620,956
(d) Lee Industries
Lor
Inc.
Lease
Amortization Schedule
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Date
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Annual
Lease
Payment/
Receipt
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Interest
Income/
Expense
at 8%
|
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Reduction
in Present
Value of
Lease
|
|
Present
Value of
Lease
|
|
|
|
|
|
|
|
|
|
|
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1/1/11
1/1/11
1/1/12
1/1/13
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620,956
620,956
620,956
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310,324
285,473
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|
620,956
310,632
335,483
|
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4,500,000
3,879,044
3,568,412
3,232,929
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Lessee (December 31, 2011)
Interest
Expense................. 310,324
Interest
Payable............. 310,324
Lessor (December 31, 2011)
Unearned
Interest Income—Leases.. 310,324
Interest
Income—Leases....... 310,324
(e) LEE INDUSTRIES
Balance sheet
December 31,
2011
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Property, plant, and equipment:
Property
under
capital leases
$4,500,000
Less
accumulated
depreciation 450,000 *
$4,050,000
|
|
Current liabilities:
Interest
payable $ 310,324
Obligations
under
capital leases 310,632 ***
Long-term liabilities:
Obligations
under
capital leases 3,568,412**
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***$4,500,000 ÷ 10 = $450,000
*** taken from amortization schedule above
LOR INC.
Balance sheet
December 31,
2011
Assets:
Current assets:
Net
investment in sales-type leases $ 310,632*
Noncurrent
assets:
Net
investment in sales-type leases $3,568,412 *
* from amortization schedule
(f) The transaction securing the equipment using the
capital lease would not be reported on the statement of cash flows for the year
ending December 31, 2011 of Lee, the lessee. This is a non-cash financing and
investing transaction to Lee. These transactions would be described in the
notes to the respective financial statements. The only cash transaction between
the parties during 2011 is the January 1, 2011 lease payment in the amount of
$620,956. This transaction is an operating activity inflow to Lor and is a
financing outflow to Lee. For Lee, the annual depreciation for 2011 would be an
adjustment to determine cash flow from operations under the indirect approach.
For Lor, the operating cash flows would be included in the adjustments to net
income under the indirect approach and would be shown as part of cash collected
from customers under the direct approach.
(g) Note X: (on Lee’s financial statements:)
The following is a schedule of future minimum
lease payments under the capital lease expiring December 31, 2020 together with
the balance of the obligation under capital lease.
Year
ending December 31
2012 $620,956
2013 620,956
2014 620,956
2015 620,956
2016 620,956
2017 and beyond 2,483,824
Total minimum lease payments 5,588,604
Less amount representing interest at 8% 1,709,560
Balance of the obligation $3,879,044
(h) Note Y: (on Lor’s financial statements:)
The company's future
minimum lease payments receivable under the sales-type lease and the net
investment in lease are as follows:
Year
ending December 31
2012 $620,956
2013 620,956
2014 620,956
2015 620,956
2016 620,956
2017 and beyond 2,483,824
Total
minimum lease payments receivable $5,588,604
Unearned
income 1,709,560
Net
investment in lease $3,879,044
