Zhou
Ltd. is a private corporation, which uses private enterprise GAAP, and whose
operations rely considerably on a group of technology companies that
experienced operating difficulties from 2008 to 2010. As a result, Zhou suffered
temporary cash flow problems that required it to look for innovative means of
financing. In 2011, Zhou’s management therefore decided to enter into a sale
and leaseback agreement with a major Canadian leasing company, Intranational
Leasing.
Immediately
after its September 30, 2011 year end, Zhou sold one of its major manufacturing
sites to Intranational Leasing for $1,750,000, and entered into a 15-year
agreement to lease back the property for $175,000 per year. The lease payment
is due October 1 of each year, beginning October 1, 2011.
Zhou’s
carrying amount of the property when sold was $250,000. The lease agreement
gives Zhou the right to purchase the property at the end of the lease for its
expected fair value at that time of $2.5 million. In 2011, the land is estimated
to be worth 40% of the total property value, and the building, 60%. Zhou uses a
10% declining-balance method of amortizing its buildings, and has a 7%
incremental borrowing rate.
Instructions
(a)
Prepare all entries that are needed by Zhou to recognize the sale and leaseback
transaction on October 1, 2011; any adjusting entries that are required on
September 30, 2012; and the October 1, 2012 transaction. Reversing entries are not
used.
(b)
Prepare all necessary note disclosures and amounts that are to be reported on
Zhou’s September 30, 2012 balance sheet, income statement, and statement of
cash flows for its year ended September 30, 2012.
(a)
To the lessee, this lease of the building is accounted for
as a capital lease and the lease of the land is treated an operating lease,
since there is no bargain purchase option for the property and because the
terms of the lease satisfy at least one of the quantitative criteria for
capitalization.
The present value of the minimum lease payments is greater than 90% of the fair value of the
leased property; that is, the present value of $1,705,457 (see below) is 97.5%
of the fair value of the leased property ($1,705,457 / $1,750,000).
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Using a financial
calculator:
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PV
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$
?
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Yields $1,705,457
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I
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7%
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N
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15
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PMT
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$ (175,000)
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FV
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$
0
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Type
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1
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The land and building must be considered separately
for the purpose of classifying the lease. The minimum lease payments must be
allocated between the land and the building in proportion to their fair values.
The portion of the gain related to the lease of the
land, which is an operating lease, is amortized over the term of the lease. The
portion of the gain related to the building must be deferred and amortized in
proportion to the depreciation of the leased asset.
October 1, 2011
Cash................................... 1,750,000
Land and
Building (net)............ 250,000
Deferred
Gain on Sale of Land (40%) 600,000
Deferred
Gain on Sale of Building (60%) 900,000
Leased Building........................ 1,023,274
Lease
Obligation................... 1,023,274
($1,705,457 X 60% = $1,023,274)
Lease Obligation........................ 105,000
Land Rental Expense..................... 70,000
Cash................................ ... 175,000
[($175,000 X 40 % = $70,000]
September 30, 2012:
Interest Expense........................ 64,279
Interest
Payable
[($1,023,274 – $105,000) X 7%] 64,279
Depreciation Expense – Building Under Lease 102,327
Accumulated
Depreciation - Building
($1,023,274 X 10%).......... 102,327
Deferred Gain on Sale of Land .......... 40,000
Gain on Sale
of Land................ 40,000
($600,000
/ 15)
Deferred Gain on Sale of Building ...... 90,000
Gain on Sale
of Building............ 90,000
($900,000
X 10%)
October 1, 2012:
Interest Payable........................ 64,279
Lease Obligation........................ 40,721
Land Rental Expense.....................
70,000
Cash................................ ... 175,000
PROBLEM 20-23* (Continued)
(b) Financial Statement disclosure at September 30, 2012:
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Balance sheet:
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Property Plant &
Equipment:
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Leased building
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$
1,023,274
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Less: Accumulated depreciation
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(102,327)
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920,947
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Current Liabilities
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Interest payable
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64,279
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Current portion of lease
obligation
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40,721
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Deferred gain in sale of land and building
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121,000
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Long term liabilities
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Deferred gain in sale of land and
building
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1,249,000
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Lease obligation
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918,274
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Less: Current portion
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(40,721)
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877,553
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Land
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Building
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Total
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Deferred gain on sale of land and building
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$ 600,000
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$ 900,000
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Depreciation - Fiscal
year 2012
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(40,000)
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(90,000)
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Balance September 30, 2012
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560,000
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810,000
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Current Portion
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40,000
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81,000
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$ 121,000
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Non- Current Portion
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520,000
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729,000
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$1,249,000
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Statement of Income:
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Gain on sale of property
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$130,000
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Land rent expense
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70,000
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Depreciation expense
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102,327
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Interest expense
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64,279
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Statement of cash flows: -
indirect format
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Operating Activities:
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Gain on disposal of
property
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$ (1,500,000)
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Increase in interest
payable
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64,279 *
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Financing activities:
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Payment of long term lease
obligation
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(105,000)
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* would likely be combined with other amounts of interest
The sale and leaseback transaction is a non-cash financing
and investing activity, which would be reported in the notes to the financial
statements and not on the face of the statement of cash flows.
The disclosure requirements for the operating lease for the
land includes the future minimum lease payments, in total and for each of the
next five years.
