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	$ (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.