LePage
Manufacturing Ltd. agrees to lease machinery to Labonté Corporation on July 15,
2011. Both LePage and Labonté use private enterprise GAAP. The following
information relates to the lease agreement.
1.
The lease term is seven years, with no renewal option, and the machinery has an
estimated economic life of nine years.
2.
The machinery’s cost is $420,000 and the asset’s fair value on July 15, 2011,
is $560,000.
3.
At the end of the lease term, the asset reverts to LePage, the lessor. The
asset is expected to have a residual value of $80,000 at this time, and this
value is guaranteed by Labonté. Labonté depreciates all of its equipment on a
straight-line basis.
4.
The lease agreement requires equal annual rental payments, beginning on July
15, 2011.
5.
LePage usually sells its equipment to customers who buy the product outright,
but Labonté was unable to get acceptable financing for an outright purchase.
LePage’s credit investigation on Labonté revealed that the company’s financial
situation was deteriorating. Because Labonté had been a good customer many
years ago, LePage agreed to enter into this lease agreement, but used a higher
than usual 15% interest rate in setting the lease payments. Labonté is aware of
this rate.
6.
LePage is uncertain about what additional costs it might have to incur in
connection with this lease during the lease term, although Labonté has agreed
to pay all executory costs directly to third parties.
7.
LePage incurred legal costs of $4,000 in early July 2011 in finalizing the lease
agreement.
Instructions
(a)
Discuss the nature of this lease for both the lessee and the lessor.
(b)
Using time value of money tables, a financial calculator, or computer
spreadsheet functions, calculate the amount of the annual rental payment that is
required.
(c)
Prepare the journal entries that Labonté would make in 2011 and 2012 related to
the lease arrangement, assuming that the company has a December 31 fiscal year
end and that it does not use reversing entries.
(d)
From the information you have calculated and recorded, identify all balances
related to this lease that would be reported on Labonté’s December 31, 2011
balance sheet and income statement, and where each amount would be reported.
(e)
Prepare the journal entries that LePage would make in 2011 and 2012 related to
the lease arrangement, assuming that the company has a December 31 fiscal year
end and does not use reversing entries.
(f)
From the information you have calculated and recorded, identify all balances
related to this lease that would be reported on LePage’s December 31, 2011
balance sheet and income statement, and where each amount would be reported.
(g)
Comment briefly on the December 31, 2011 reported results in (d) and (f) above.
(a) This is a capital lease to Labonté since the
lease term is greater than 75% of the economic life of the leased asset. The
lease term is 78% (7 ÷ 9) of the asset’s economic life.
For LePage, the
collectibility of the lease payments is not reasonably predictable, and there
are important uncertainties surrounding the costs yet to be incurred.
Accordingly, the earnings process is not considered complete and, in spite of
the fact that the fair value ($560,000) of the equipment exceeds the lessor’s
cost ($420,000), the lease cannot be recorded as a sales-type lease by LePage
and must be recorded as an operating lease.
(b) Calculation
of annual rental payment:
To calculate
the amount of the payments using Tables:
560,000 - (80,000 x .37594*)/4.78448** = $110,759
**Present value of $1 at 15% for 7 periods.
**Present
value of an annuity due at 15% for 7 periods.
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Excel formula =PMT(rate,nper,pv,fv,type)
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Using a financial calculator:
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PV
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$ (560,000.00)
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I
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15%
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N
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7
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PMT
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$
?
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Yields $110,759
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FV
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$
80,000
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Type
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1
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(c)
7/15/11 Leased
Machinery............. 560,000
Lease
Obligation......... 560,000
Lease
Obligation............. 110,759
Cash..................... 110,759
12/31/11 Depreciation
Expense......... 31,429
Accumulated
Depreciation. 31,429
($560,000 - $80,000) ÷ 7 X 5.5/12
Interest
Expense............. 30,885
Interest
Payable......... 30,885
($560,000 – $110,759) X .15 X 5.5/12
7/15/12 Lease
Obligation............. 43,373
Interest
Expense*............ 36,501
Interest
Payable............. 30,885
Cash..................... 110,759
*($560,000 – $110,759) X .15 X 6.5/12
12/31/12 Depreciation
Expense......... 68,571
Accumulated
Depreciation. 68,571
($560,000
- $80,000) ÷ 7
Interest
Expense............. 27,903
Interest
Payable......... 27,903
[($560,000
– $110,759 – $43,373) X .15 X 5.5/12]
(e)
7/15/11 Machinery
Leased to Others... 420,000
Inventory................ 420,000
Cash ................. 110,759
Unearned
Rental Income... 110,759
Legal
Fees Expense*.......... 4,000
Cash..................... 4,000
12/31/11 Unearned
Rental Income....... 50,765
Rental
Income............ 50,765
($110,759
X 5.5/12)
Depreciation
Expense......... 22,262
Accumulated
Depreciation. 22,262
($420,000 - $80,000) ÷ 7 X 5.5/12
7/15/12 Unearned
Rental Income....... 59,994
Rental
Income............ 59,994
($110,759
X 6.5/12)
Cash ................. 110,759
Unearned
Rental Income... 110,759
12/31/12 Depreciation
Expense......... 48,571
Accumulated
Depreciation. 48,571
($420,000
- $80,000) ÷ 7
12/31/12 Unearned
Rental Income....... 59,994
Rental
Income............ 59,994
($110,759
X 6.5/12)
* If the
amounts are significant, these costs might be capitalized and amortized to
expense to achieve better matching with revenues.
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(d)
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(f)
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Labonté
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LePage
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Capital
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Operating
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Lease
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Lease
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Balance sheet:
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Property Plant &
Equipment:
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Machinery under capital
lease
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$560,000
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Machinery leased to others
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$ 420,000
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Less: Accumulated depreciation
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(31,429)
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(22,262)
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528,571
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397,738
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Current Liabilities:
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Interest payable
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30,885
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Current portion of lease
obligation
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43,373
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Unearned rental income
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59,994
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Long term liabilities:
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Lease obligation
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449,241
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Less: Current portion
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(43,373)
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405,868
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Statement of income:
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Rental income
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$ 50,765
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Depreciation expense
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$ 31,429
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22,262
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Interest expense
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30,885
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Legal fees expense
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4,000
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(g) Although it
might seem odd that the same asset is reported on two different balance sheets,
the collection risks under which the lessor, LePage, is operating do not
justify the recognition of income under a sales type lease. There are too many uncertainties surrounding
the related costs and collections under the terms of its lease with
Labonté. Should Labonté default on the
lease, LePage might have to rent the used machinery to another lessee. It is
not unreasonable, also, to consider that the “guarantee” of the residual value
by the lease, Labonté, should not be considered in the calculations (e.g. for
depreciation) as that company’s financial situation may make them unable to
“make good” on the guarantee.
