On
December 31, 2011, Xu Ltd., which uses private enterprise GAAP, entered into an
eight-year lease agreement for a conveyor machine. Annual lease payments are $28,500
at the beginning of each lease year, which ends December 31, and Xu made the
first payment on January 1, 2012. At the end of the lease, the machine will
revert to the lessor. However, conveyor machines are only expected to last for eight
years and have no residual value. At the time of the lease agreement, conveyor
machines could be purchased for approximately $166,000 cash. Equivalent
financing for the machine could have been obtained from Xu’s bank at 10.5%. Xu’s
fiscal year coincides with the calendar year and Xu uses straight-line
depreciation for its conveyor machines.
Instructions
(a)
Calculate the present value of the minimum lease payments using a financial
calculator or work sheet functions.
(b)
Explain why this is a capital lease to Xu Ltd. Document your calculations in
arriving at your explanation.
(c)
Prepare an amortization schedule for the term of the lease to be used by Xu
Ltd. Use a computer spreadsheet.
(d)
Prepare the journal entries on Xu Ltd.’s books to reflect the signing of the
lease agreement and to record the payments and expenses related to this lease
for the years 2012 and 2010 as well as any adjusting journal entries at its fiscal
year ends of December 31, 2012, and 2010.
(e)
Prepare a partial comparative balance sheet at December 31, 2010, and 2012, for
all of the accounts related to this lease for Xu Ltd. Be specific about the
classifications that should be used.
(f)
Provide Xu Ltd.’s required note disclosure concerning the lease for the fiscal
year ending December 31, 2010.
(g)
What is the significance of the difference between the amount of the present
value of the minimum lease payments calculated in part (a) and the approximate
selling price of the machine of $166,000?
(a)
Capitalized amount of the lease:
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Excel formula =PV(rate,nper,pmt,fv,type)
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Using a financial calculator:
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PV
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$
?
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Yields $164,995
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I
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10.5%
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N
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8
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PMT
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$ (28,500.00)
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FV
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$
0
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Type
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1
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(b)
This is a
capital lease to Xu since
the lease term (8 years) is greater than 75% of the economic life (8 years) of
the leased asset. The lease term is 100% (8 ÷ 8) of the asset’s economic life.
This also meets the requirements of IFRS, under which it is referred to as a financing
lease.
The present value of the minimum lease payments is
greater than 90% of the fair value of the leased asset; that is, the present
value of $164,995 is 99% of the fair value of the leased asset: ($164,995 /
$166,000 = 99.4%). This criteria for treating the lease as a capital lease has
also been met. Note that meeting just one of the criteria is sufficient for
classification as a capital lease.
There is no bargain purchase option in this case.
(c) Xu
Ltd.
Lease Amortization Schedule
(Lessee)
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Date
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Annual
Lease
Payments
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Interest (10.5%)
on Unpaid
Obligation
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Reduction
of Lease
Obligation
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Balance
of Lease
Obligation
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$164,995.00
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Jan. 1,
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2012
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$28,500.00
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$28,500.00
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136,495.00
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Jan. 1,
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2013
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28,500.00
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$14,331.98
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14,168.03
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122,326.97
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Jan. 1,
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2014
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28,500.00
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12,844.33
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15,655.67
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106,671.30
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Jan. 1,
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2015
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28,500.00
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11,200.49
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17,299.51
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89,371.79
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Jan. 1,
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2016
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28,500.00
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9,384.04
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19,115.96
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70,255.83
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Jan. 1,
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2017
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28,500.00
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7,376.86
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21,123.14
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49,132.70
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Jan. 1,
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2018
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28,500.00
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5,158.93
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23,341.07
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25,791.63
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Jan. 1,
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2019
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28,500.00
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2,708.37
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25,791.63
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(0.00)
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$228,000.00
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$63,005.00
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$164,995.00
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(d)
1/1/12 Leased
Equipment............ 164,995
Lease
Obligation........ 164,995
1/1/12 Lease
Obligation............ 28,500
Cash.................... 28,500
12/31/12 Depreciation
Expense........ 20,624
Accumulated
Depreciation—
Leased Equipment...... 20,624
($164,995 ÷ 8)
12/31/12 Interest
Expense............ 14,332
Interest
Payable........ 14,332
1/1/13 Interest
Payable............ 14,332
Lease
Obligation ........... 14,168
Cash.................... 28,500
12/31/13 Depreciation
Expense........ 20,624
Accumulated
Depreciation—
Leased Equipment..... 20,624
12/31/13 Interest
Expense............ 12,844
Interest
Payable........ 12,844
(e)
Xu Ltd.
Balance sheet (partial)
December 31,
2013 2012
Non-current assets
Property plant and equipment
Leased equipment $164,995 $164,995
Less accumulated
depreciation 41,248
_20,624
123,747 144,371
Current liabilities
Interest
payable 12,844 14,332
Lease
obligation 15,656 14,168
Non-current liabilities
Lease
obligation (Note X) 122,327 136,495
Current portion (15,656) (14,168)
(f) Note
X:
The following is a schedule of future minimum
lease payments under the capital lease expiring December 31, 2019 together with
the balance of the obligation under capital lease.
Year
ending December 31
2013 $28,500
2014 28,500
2015 28,500
2016 28,500
2017 28,500
2018 28,500
Total minimum lease payments 171,000
Less amount representing interest at 10.5%
48,673
Balance of the obligation $122,327
(g)
When
negotiating a lease arrangement, the lessor sets the lease payments receivable
to obtain the appropriate return for the asset leased. The amounts arrived at
are negotiable. In this case, the lessor likely tried to obtain an amount near
to or exceeding the resale price of the equipment and arrived at annual payments
in round amounts ($28,500). The present value of the minimum lease payment
approximated the resale price without being exactly equal (99.4% in this case).
This is a natural outcome from the negotiations process between the parties
involved.
