P21-2` Cleveland inc. leased a new crane to Abriendo construction under 5-year noncancelable contract staring june1, 2011. Terms of the lease require payments of $33,000 each June 1, starting June 1, 2011. Cleveland will pay insurants, taxes, and maintenance charges on the crane, which has an estimate life of 12 years, a fair value of $240,000, and a cost to Cleveland of $240,000. The estimated fair value of crane is expected to be $45,000 at the end of the lease term. No bargain-purchase or renewal options are included in the contract. Both Cleveland Abriendo adjust and close books annually at December 31. Collectability of lease payments is reasonably certain, and no uncertainties exist relative to unreimbursable lesson costs. Abriendo’s incremental borrowing rate is 10%, and Cleveland’s implicit interest rate of 9% is known to Abriendo. Instructions
(a) Identify the type of lease involved and give reasons for your classification. Discuss the accounting treatment that should be applied by both lessee and lessor.
The lease is an operating lease to the lessee and lessor because:
1.it does not transfer ownership,
2.it does not contain a bargain purchase option,
3.it does not cover at least 75% of the estimated economic life of the crane, and
4.the present value of the lease payments is not at least 90% of the fair value of the leased crane.
$33,000 Annual Lease Payments X PV of annuity due at 9% for 5 years
$33,000 X 4.23972 = $139,910.76, which is less than $216,000.00 (90% X
$240,000.00).
At least one of the four criteria would have had to be satisfied for the lease to be classified as other than an operating lease.
(b) Prepare all entries related to the lease contract and leased asset for the year 2011 for lessee and lessor, assuming the following amounts. (1) Insurance $500 (2) Taxes $2,000 (3) Maintenance $650 (4) Straight –line depreciation and salvage value $15,000.
Lessee’s Entries
Rent Expense...... 33,000
Cash...... 33,000
Lessor’s Entries
Insurance Expense...... 500
Tax Expense...... 2,000
Maintenance Expense...... 650
Cash or Accounts Payable...... 3,150
Depreciation Expense...... 18,750
Accumulated Depreciation—Crane
[($240,000 – $15,000) ÷ 12]...... 18,750
Cash...... 33,000
Rental Revenue...... 33,000
(c) Discuss what should be presented in the balance sheet, the income statement, and related notes of both the lessee and the lessor at December 31, 2011.
(c)Abriendo as lessee must disclose in the income statement the $33,000 of rent expense and in the notes the future minimum rental payments required as of January 1 (in total, $132,000) and for each of the succeeding four years: 2012—$33,000; 2013—$33,000; 2014—$33,000; 2015— $33,000. Nothing relative to this lease would appear on the lessee’s balance sheet.
Cleveland as lessor must disclose in the balance sheet or in the notes the cost of the leased crane ($240,000) and the accumulated depreciation of $18,750 separately from assets not leased. Additionally, Clevelandmust disclose in the notes the minimum future rentals as a total of $132,000, and for each of the succeeding four years: 2012—$33,000; 2013—$33,000; 2014—$33,000; 2015—$33,000.
The income statement for the lessor reports rental revenue and expenses for insurance, taxes, maintenance, and depreciation expense.
P21-3 Winston Industries and Ewing inc. enter into an agreement that requires Ewing inc. to build three diesel-electric engines to Winston’s specifications. Upon completion of the engines Winston has agreed to lease them for a period of 10 years and to assume all costs and risks of ownership. The lease is noncancelable, becomes effective on January 1, 2011, and requires annual rental payments of $413,917 each January 1, starting January 1, 2011. Winston’s incremental borrowing rate is 10%. The implicit interest rate used by Ewing inc.
(a)The lease should be treated as a capital lease by Winston Industries requiring the lessee to capitalize the leased asset. The lease qualifies for capital lease accounting by the lessee because: (1) title to the engines transfers to the lessee, (2) the lease term is equal to the estimated life of the asset, and (3) the present value of the minimum lease payments exceeds 90% of the fair value of the leased engines. The transaction represents a purchase financed by installment payments over a 10-year period.
For Ewing Inc. the transaction is a sales-type lease because a manu-facturer’s profit accrues to Ewing. This lease arrangement also represents the manufacturer’s financing the transaction over a period of 10 years.
Present Value of Lease Payments
$413,971 X 7.24689*...... $3,000,000
*Present value of an annuity due at 8% for 10 years, rounded by $2.
Dealer Profit
Sales (present value of lease payments)...... $3,000,000
Less cost of engines...... 2,600,000
Profit on sale...... $ 400,000
(b)Leased Engines Under Capital Leases...... 3,000,000
Lease Liability...... 3,000,000
(c)Lease Receivable...... 3,000,000
Cost of Goods Sold...... 2,600,000
Sales...... 3,000,000
Inventory...... 2,600,000
(d)Lessee (January 1, 2011)
Lease Liability...... 413,971
Cash...... 413,971
Lessor (January 1, 2011)
Cash 413,971
Lease Receivable...... 413,971
(e)WINSTON INDUSTRIES
Lease Amortization Schedule
Date / Annual Lease Receipt/ Payment / Interest on Receivable/ Liability at 8% / Reduction in Receivable/ Liability / Lease Receivable/ Liability1/1/11 / 3,000,000
1/1/11 / 413,971 / 413,971 / 2,586,029
1/1/12 / 413,971 / 206,882 / 207,089 / 2,378,940
1/1/13 / 413,971 / 190,315 / 223,656 / 2,155,284
Lessee (December 31, 2011)
Interest Expense...... 206,882
Interest Payable...... 206,882
Lessor (December 31, 2011)
Interest Receivable...... 206,882
Interest Revenue...... 206,882
(f)WINSTON INDUSTRIES
Balance Sheet
December 31, 2011
Property, plant, and equipment: / Current liabilities:Leased property under capital leases / $3,000,000 / Interest payable / $ 206,882
Less accumulated depreciation / 300,000* / Lease liability / 207,089**
Long-term liabilities:
$2,700,000 / Lease liability (See schedule) / 2,378,940***
*$3,000,000 ÷ 10 = $300,000
**($413,971 – $206,882)
***No portion of this amount paid within the next year.
Note: The title Obligations under Capital Leases is often used instead of lease liability.
EWING INC.
Balance Sheet
December 31, 2011
Assets
Current assets:
Interest receivable...... $ 206,882
Lease receivable...... 207,089
Noncurrent assets:
Lease receivable...... $2,378,940*
Note: The title Net Investment in Sales-Type Leases is often shown instead of lease receivable.
*See balance on amortization schedule at 1/1/12.