On
September 1, 2011, Wong Corporation, which uses private enterprise GAAP, signed
a five-year, non-cancellable lease for a machine. The terms of the lease called
for Wong to make annual payments of $13,668 at the beginning of each lease year,
starting September 1, 2011. The machine has an estimated useful life of six
years and a $9,000 unguaranteed residual value. The machine reverts back to the
lessor at the end of the lease term. Wong uses the straight-line method of
depreciation for all of its plant assets, has a calendar year end, prepares
adjusting journal entries at the end of the fiscal year, and does not use
reversing entries. Wong’s incremental borrowing rate is 10%, and the lessor’s
implicit rate is unknown.
Instructions
(a)
Explain why this is a capital lease to Wong.
(b)
Using time value of money tables, a financial calculator, or computer
spreadsheet functions, calculate the present value of the minimum lease
payments for the lessee.
(c)
Prepare all necessary journal entries for Wong for this lease, including any
year-end adjusting entries through September 1, 2012.
(d)
Would this also be a capital lease if the lessee reported under IFRS?
(a) This is a capital lease to Wong since the lease
term (5 years) is greater than 75% of the economic life (6 years) of the leased
asset. The lease term is 83⅓% (5 ÷ 6) of the asset’s economic life.
(b) Calculation of present value of minimum lease
payments:
$13,668 X 4.16986* = $56,994
*Present
value of an annuity due of 1 for 5 periods at 10%.
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Excel formula =PV(rate,nper,pmt,fv,type)
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Using a financial calculator:
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PV
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$
?
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Yields
$56,994
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I
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10%
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N
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5
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PMT
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$
(13,668)
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FV
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$
0
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Type
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1
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(c)
9/1/11 Leased
Machine................. 56,994
Lease
Obligation........... 56,994
Lease
Obligation............... 13,668
Cash ...................... 13,668
12/31/11 Depreciation
Expense........... 3,800
Accumulated
Depreciation—
Leased Machine............ 3,800
[($56,994/ 5) X 4/ 12 = $3,800]
Interest
Expense............... 1,444
Interest
Payable........... 1,444
[($56,994 – $13,668) X .10 X 4/ 12 = $1,444]
9/1/12 Lease
Obligation............... 9,335
Interest
Payable............... 1,444
Interest
Expense............... 2,889
Cash ...................... 13,668
[($56,994 – $13,668) X .10 X 8/ 12 = $2,889]
(d)
Under IFRS, any one or a combination of the following
situations normally indicates that the risks and rewards of ownership are
transferred to the lessee, and supports classification as a finance lease:
·
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.
·
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.
·
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.
·
The
leased assets are so specialized that, without major modification, and/or
significant cost to the lessor, they are of use only to the lessee.
Other indicators include situations where the lessee
absorbs the lessor’s losses if the lessee cancels the lease, or the lessee
assumes the risk associated with the amount of the residual value of the asset
at the end of the lease, or where there is a bargain renewal option—when the
lessee can renew the lease for an additional term at significantly less than
the market rent.
The standard also states that these indicators are not
always conclusive. The decision has to be made on the substance of each
specific transaction. If the lessee determines that the risks and benefits of
ownership have not been transferred to it, the lease is classified as an
operating lease.
