On
January 1, 2011, Lavery Corporation leased equipment to Flynn Corporation. Both
Lavery and Flynn use private enterprise GAAP and have calendar year ends. The
following information pertains to this lease.
1.
The term of the non-cancellable lease is six years, with no renewal option. The
equipment reverts to the lessor at the termination of the lease, at which time
it is expected to have a residual value (not guaranteed) of $6,000. Flynn Corporation
depreciates all its equipment on a straight-line basis.
2.
Equal rental payments are due on January 1 of each year, beginning in 2011.
3.
The equipment’s fair value on January 1, 2011, is $144,000 and its cost to
Lavery is $111,000.
4.
The equipment has an economic life of seven years.
5.
Lavery set the annual rental to ensure a 9% rate of return. Flynn’s incremental
borrowing rate is 10% and the lessor’s implicit rate is unknown to the lessee.
6.
Collectibility of lease payments is reasonably predictable and there are no
important uncertainties about any unreimbursable costs that have not yet been
incurred by the lessor.
Instructions
(a)
Explain clearly why this lease is a capital lease to Flynn and a sales-type
lease to Lavery.
(b)
Using time value of money tables, a financial calculator, or computer spreadsheet
functions, calculate the amount of the annual rental payment.
(c)
Prepare all necessary journal entries for Flynn for 2011.
(d)
Prepare all necessary journal entries for Lavery for 2011.
(e)
Discuss the differences, if any, in the classification of the lease to Lavery
Corporation (the lessor) or to Flynn Corporation (the lessee) if both were
using IFRS in their financial reporting.
(a) This is a capital lease to Flynn since the
lease term is 75% (6 ÷ 7) of the asset’s economic life. In addition, the
present value of the minimum lease payments is more than 90% of the fair value
of the asset.
This is a sales-type lease to Lavery since
the lease is a capital lease to Flynn, the lessee, and because the
collectability of the lease payments is reasonably predictable, there are no
important uncertainties surrounding the unreimbursable costs yet to be incurred
by the lessor and the fair value of the equipment ($144,000) exceeds the
lessor’s cost ($111,000).
(b) Calculation
of annual rental payment:
|
$144,000
|
–
|
$6,000
|
X
|
0.59627*
|
=
|
$28,718
|
|
4.8897**
|
||||||
**Present value of $1 at 9% for 6 periods.
**Present
value of an annuity due at 9% for 6 periods.
|
Excel formula =PMT(rate,nper,pv,fv,type)
|
|
Using a financial calculator:
|
||
|
PV
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$ (144,000)
|
|
|
I
|
9%
|
|
|
N
|
6
|
|
|
PMT
|
$
?
|
Yields $28,718
|
|
FV
|
$ 6,000
|
|
|
Type
|
1
|
|
(c)
1/1/08 Leased
Equipment................ 137,582
Lease
Obligation........... 137,582
($28,718 X 4.79079)***
Lease
Obligation................ 28,718
Cash....................... 28,718
***Present value of an annuity due at 10% for 6
periods.
|
Excel formula =PV(rate,nper,pmt,fv,type)
|
|
Using a financial calculator:
|
||
|
PV
|
$
?
|
Yields $137,582
|
|
I
|
10%
|
|
|
N
|
6
|
|
|
PMT
|
$ (28,718)
|
|
|
FV
|
$
0
|
|
|
Type
|
1
|
|
12/31/11
Depreciation Expense.......... 22,930
Accumulated
Depreciation.. 22,930
($137,582 ÷ 6 years)
Interest
Expense............... 10,886
Interest
Payable.......... 10,886
[($137,582
– $28,718) X .10]
(d)
1/1/08 Lease
Payments Receivable..... 178,308 *
Cost of Goods
Sold............ 107,422
Sales................... 140,422
Inventory............... 111,000
Unearned
Interest Income—
Leases............. 34,308 **
*($28,718
X 6) + $6,000
**$178,308
– $144,000
Since the residual value is not guaranteed, the
present value of the residual value of $6,000 is excluded from both sales and
cost of goods sold.
Sales $144,000
Less present value of residual value
3,578*
$140,422
Cost of Goods Sold $111,000
Less present value of residual value
3,578*
$107,422
*($6,000 X
.59627**)
**Present value of $1 at 9% for 6 periods.
Cash ........................ 28,718
Lease
Payments
Receivable........ 28,718
12/31/11 Unearned
Interest Income—
Leases................. 10,375
Interest
Income—Leases.. 10,375
[($144,000 – $28,718) X .09]
(c) For Lavery Corporation—(the lessee):
Rather than using quantitative factors such
as the 75 percent and the 90 percent hurdles often referred to as the bright
lines used in PE GAAP, the IFRS criteria use qualitative factors to establish
whether or not the risks and rewards of ownership are transferred to the
lessee, and supports classification as a finance lease:
1. 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.
2. 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.
3. 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.
4. The leased assets are so specialized that, without
major modification, they are of use only to the lessee.
None of the numerical thresholds need be applied, as
was the case in PE GAAP, and so the treatment of the lease by the lessee would
be the same, although it would be referred to as a finance lease, rather than a
direct financing lease.
For Flynn Corporation—(the lessor):
Under IFRS, the
lease would receive the same treatment as under PE GAAP except the criteria
need not include the two
revenue recognition-based tests concerning collectability and estimating
unreimbursable costs. Instead of being referred to as a sales-type lease, the
lease would be referred to as a finance lease—manufacturer or dealer.
