Synergetics
Inc. leased a new crane to Gumowski Construction under a six-year,
non-cancellable contract starting February 1, 2011. The lease terms require
payments of $21,500 each February 1, starting February 1, 2011. Synergetics
will pay insurance, taxes, and maintenance charges on the crane, which has an
estimated life of 12 years, a fair value of $160,000, and a cost to Synergetics
of $160,000. The crane’s estimated fair value is $50,000 at the end of the
lease term. No bargain purchase or renewal options are included in the
contract. Both Synergetics and Gumowski adjust and close books annually at
December 31 and use IFRS. Collectibility of the lease payments is reasonably
certain and there are no uncertainties about unreimbursable lessor costs. Gumowski’s
incremental borrowing rate is 8% and Synergetics’ implicit interest rate of 7%
is known to Gumowski.
Instructions
(a)
Identify the type of lease that is involved and give reasons for your
classification. Also discuss the accounting treatment that should be applied by
both the lessee and the lessor.
(b)
Would the classification of the lease have been different if Synergetics and
Gumowski had been using private enterprise GAAP?
(c)
Prepare all the entries related to the lease contract and leased asset for the
year 2011 for the lessee and lessor, assuming the following executory costs:
insurance of $450 covering the period February 1, 2011, to January 31, 2012;
taxes of $200 for the remainder of calendar year 2011; and a one-year
maintenance contract beginning February 1, 2011, costing $1,200. Straight-line
depreciation is used for similar leased assets. The crane is expected to have a
residual value of $20,000 at the end of its useful life.
(d)
Identify what will be presented on the balance sheet and income statement, and
in the related notes, of both the lessee and the lessor at December 31, 2011.
(a)
Under IFRS, meeting any one or a combination of the
following criteria normally indicates that 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 and/or significant cost to the lessor they are of use only
to the lessee.
None of these conditions have been met and so the
lease is an operating lease to both Synergetics and Gumowski.
(b)
Under private enterprise GAAP, the lease is an operating
lease to the lessee and lessor because:
1. it does not transfer ownership, or it does not contain a
bargain
purchase option,
2. it
does not cover at least 75% of the estimated economic life of the crane, and
3. the
present value of the lease payments is not at least 90% of the fair value of
the leased crane.
$21,500 Annual Lease Payments X PV of
annuity due at 7% for 6 years $21,500
X 5.10020 = $109,654, which is less than $144,000.00 (90% X $160,000.00)
At least one of the three criteria would
have had to be satisfied for the lease to be classified as other than an
operating lease. The property is recorded as a rental property to the lessor
and will be treated as a payment of rent by the lessee under the operating
lease.
(c) Lessee’s
Entries
February 1,
2011
Prepaid Rent
Expense............... 21,500
Cash........................... 21,500
December 31,
2011
Rent Expense....................... 19,708
Prepaid
Rent Expense........... 19,708
($21,500
X 11/12)
Lessor’s Entries
February 1,
2011
Cash................................. 21,500
Unearned
Rental Income........... 21,500
February 1,
2011
Prepaid
Insurance Expense ($450 X 1/12) 38
Insurance
Expense ($450 X 11/12)..... 412
Tax Expense
(leased property)........ 200
Prepaid
Maintenance Expense ($1,200 X 1/12) 100
Maintenance
Expense ($1,200 X 11/12). 1,100
Cash or
Accounts Payable......... 1,850
December 31,
2011
Unearned
Rental Income............. 19,708
Rental
income.................. 19,708
($21,500
X 11/12)
Depreciation
Expense........... 10,694
Accumulated Depreciation—Crane 10,694
[($160,000 – $20,000) ÷ 12 X 11/12]
(d) Gumowski
Construction as lessee must disclose in the income statement the $19,708 of
rent expense and in the notes the future minimum rental payments required as of
January 1 (in total, $86,000) and for each of the succeeding four years:
2012—$21,500; 2013—$21,500; 2014—$21,500; 2015—$21,500. Additional disclosures
are required about material lease arrangements including contingent rents,
sub-lease payments and lease-imposed restrictions. No information regarding
this lease would appear on the lessee’s balance sheet.
Synergetics
Inc. as lessor must disclose in the balance sheet or in the notes the cost of
the leased crane ($160,000) and the accumulated depreciation of $10,694
separately from assets not leased. Additionally, Synergetics may disclose in
the notes the minimum future rental revenues as a total of $86,000, and for
each of the succeeding four years: 2012—$21,500; 2013—$21,500; 2014—$21,500;
2015—$21,500.
