The
head office of North Central Ltd. has operated in the western provinces for
almost 50 years. North Central uses IFRS. In 1995, new offices were constructed
on the same site at a cost of $9.5 million. The new building was opened on
January 4, 1996, and was expected to be used for 35 years, at which time it
would have a value of approximately $2 million.
In
2011, as competitors began to consider merger strategies among themselves,
North Central felt that the time was right to expand the number of its offices
throughout the province. This plan required significant financing and, as a
source of cash, North Central looked into selling the building that housed its
head office. On June 29, 2011, Rural Life Insurance Company Ltd. purchased the
building (but not the land) for $8 million and immediately entered into a
20-year lease with North Central to lease back the occupied space. The terms of
the lease were as follows:
1.
It is non-cancellable, with an option to purchase the building at the end of
the lease for $1 million.
2.
The annual rental is $838,380, payable on June 29 each year, beginning on June
29, 2011.
3.
Rural Life expects to earn a return of 10% on its net investment in the lease,
the same as North Central’s incremental borrowing rate.
4.
North Central is responsible for maintenance, insurance, and property taxes.
5.
Estimates of useful life and residual value have not changed significantly
since 1993.
Instructions
(a)
Prepare all entries for North Central Ltd. from June 29, 2011, to December 31, 2012.
North Central has a calendar year fiscal period.
(b)
Assume instead that there was no option to purchase, that $8 million represents
the building’s fair value on June 29, 2011, and that the lease term was 12
years. Prepare all entries for North Central from June 29, 2011, to December 31,
2012.
(c)
Besides the increase in cash that it needs from the sale of the building, what
effect should North Central expect to see on the net assets appearing on its
balance sheet immediately after the sale and leaseback?
(a)
29/6/11 Cash....................... 8,000,000
Building
............... 9,500,000
Accumulated
Depreciation... 3,321,429*
Deferred
Profit on Sale-
Leaseback............. 1,821,429
*($9,500,000
- $2,000,000) / 35 X 15.5 years)
29/6/11 Building
Under Capital
Leases................... 8,000,000
Obligations
Under Capital
Leases................ 8,000,000
($838,380 X 9.36492*) +
($1,000,000 X .14864**)
* Present
value of annuity due for 20 periods at 10%
** Present value of single payment for 20 periods at
10%
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Excel formula
=PV(rate,nper,pmt,fv,type)
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PV
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$
?
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Yields $8,000,005
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I
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10%
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N
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20
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PMT
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$
(838,380)
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FV
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$
(1,000,000)
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Type
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1
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29/6/11 Lease
Obligation............... 838,380
Cash.................... 838,380
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Partial Lease Amortization Schedule
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Date
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Annual
Lease
Payment
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Interest
(10%)
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Amortization
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Balance
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29/06/11
29/06/11
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$838,380
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$838,380
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$8,000,000
7,161,620
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29/06/12
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838,380
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$716,162
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122,218
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7,039,402
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12/31/11 Deferred
Profit on Sale-
Leaseback.................. 45,536
Depreciation
Expense**... 45,536
($1,821,429 ÷ 20 X 6/12)
**The
credit could also be to a gain account.
The deferred profit on the sale-leaseback should be
amortized on the same basis that the asset is being amortized.
Maintenance, insurance and property taxes would also
have been paid during the year.
12/31/11 Depreciation
Expense........ 150,000
Accumulated
Depreciation. 150,000
(($8,000,000 - $2,000,000) ÷ 20 X 6/12)
12/31/11 Interest
Expense............ 358,081
Interest
Payable......... 358,081
($7,161,620
X 10% X 6/12)
29/6/12 Lease
Obligation............. 122,218
Interest
Payable............. 358,081
Interest
Expense............. 358,081
Cash..................... 838,380
12/31/12 Deferred
Profit on Sale-
Leaseback.................. 91,071
Depreciation
Expense..... 91,071
($1,821,429 ÷ 20)
PROBLEM
20-22* (Continued)
12/31/12 Depreciation
Expense........ 300,000
Accumulated
Depreciation. 300,000
(($8,000,000
- $2,000,000) ÷ 20)
12/31/12 Interest
Expense............ 351,970
Interest
Payable......... 351,970
($7,039,402
X 10% X 6/12)
(b) The lease must now be recorded as an
operating lease as it is no longer a capital lease because: (1) the lease term
is for 60% (12 ÷ 20) of the economic life of the leased asset and (2) the
present value of the minimum lease payments is 79% ($6,283,709 / $8,000,000) of
the fair market value of the leased asset and (3) there is no longer a bargain
purchase option. Maintenance, insurance
and property tax expenses would also be incurred.
The present value of the minimum lease payments:
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Using a financial calculator:
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PV
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$
?
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Yields $ 6,283,709
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I
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10%
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N
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12
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PMT
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$
(838,380)
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FV
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$
0
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Type
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1
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29/6/11 Cash......................... 8,000,000
Building
................. 9,500,000
Accumulated
Depreciation..... 3,321,429*
Deferred
Profit on Sale
of
Building............. 1,821,429
*($9,500,000
- $2,000,000) / 35 X 15.5 years)
29/6/11 Rent
Expense................. 838,380
Cash...................... 838,380
31/12/11 Prepaid
Rent ................ 419,190
Rent
Expense.............. 419,190
31/12/11 Deferred
Profit on Sale
of
Building ............... 75,893
Rent
Expense.............. 75,893
*($1,821,429 / 12 X 6/12)
29/6/12 *Rent
Expense................. 419,190
Prepaid Rent.............. 419,190
29/6/12 Rent
Expense................. 838,380
Cash...................... 838,380
31/12/12 *Prepaid
Rent............. 419,190
Rent
Expense.............. 419,190
31/12/12 Deferred
Profit on Sale
of
Building ............... 151,786
Rent
Expense.............. 151,786
($1,821,429 / 12)
(c) The
net assets amount (or equity) on the balance sheet of North Central will be
very similar after the completion of the sale and leaseback as it was before. Any
excess of the capitalized amount of the building over the carrying value at the
time of the sale (i.e. the gain) will be deferred and amortized over the term
of the lease, or the life of the asset.
Eventually this gain will be realized to equity. Over the term of the
lease, the additional costs related to the borrowing will affect equity but
this is no different, for example, than if a loan had been obtained in exchange
for a mortgage obligation.
