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Kieso, Weygandt, Warfield, Young, Wiecek , McConomy Intermediate Accounting, Tenth Canadian Edition

CHAPTER 20

LEASES

ASSIGNMENT CLASSIFICATION TABLE

TopicsBrief

Exercises Exercises ProblemsWriting

Assignments

*1. Rationale for leasing. 2, 3, 4

*2. Lessees: classificationof leases; accountingby lessees.

1, 2, 3, 4,5, 6, 7, 8,9, 11

1, 2, 3, 4,5, 6, 7, 8,9, 10, 11,12, 13, 14,15, 16, 17,18, 19, 21

1, 2, 3, 5,6, 7, 10,11, 12, 14,15, 16, 17,18, 20

1, 2

*3. Disclosure of leases. 4, 8, 9, 15 3, 5, 6, 7,8, 10, 11,12, 18, 20

*4. Lessors: classificationof leases; accounting

by lessors.

10, 12, 13,14, 15, 16,

17

6, 7, 10,11, 14, 15,

16, 17, 18,19, 20, 21

3, 4, 5, 6,9, 10, 11,

13, 15, 16,18, 20

3, 6

5. Differences betweenIFRS and ASPE

1, 2 6, 10, 11 6, 7, 8, 9,14, 16

*5. Sale and leaseback. 18, 19 22, 23, 24 22, 23 4

*6. Real estate leases. 19, 20 25 22

*7. Contract-basedapproach

22, 23 13 19, 20 3

*This material is dealt with in an Appendix to the chapter.

NOTE: If your students are solving the end-of-chapter material using a financialcalculator or an Excel spreadsheet as opposed to the PV tables, please note thatthere will be a difference in amounts. Excel and financial calculators yield a moreprecise result as opposed to PV tables. The amounts used for the preparation of

journal entries in solutions have been prepared from the results of calculationsarrived at using the PV tables.

Solutions Manual 20-1 Chapter 20

Copyright © 2013 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited




ASSIGNMENT CHARACTERISTICS TABLE

Item DescriptionLevel ofDifficulty

Time(minutes)

E20-1 Lessee entries; capital lease withunguaranteed residual value. Moderate 15-20

E20-2 Lessee Entries; operating lease; comparison Moderate 20-25E20-3 Lessee calculations and entries; capital lease

with guaranteed residual value.Moderate 20-25

E20-4 Lessee entries; capital lease with executorycosts and unguaranteed residual values.

Moderate 20-30

E20-5 Lessee entries; capital lease with executorycosts and unguaranteed residual, lease andfiscal year differ.

Moderate 25-35

E20-6 Type of lease; Lessee entries with bargainpurchase option.

Moderate 20-30

E20-7 Lessor entries with bargain purchase option. Moderate 20-30E20-8 Lessee calculations and entries; capital lease

disclosure.E20-9 Amortization schedule and journal entries for

lessee.Moderate 20-30

E20-10 Capital lease payment; Lessee-lessor entries;capital/sales-type lease.

Moderate 20-25

E20-11 Type of lease; amortization schedule. Simple 15-20E20-12 Operating lease versus capital lease. Moderate 25-35E20-13 IFRS compared to contract based approach Moderate 30-35E20-14 Calculation of rental; journal entries for lessor. Moderate 15-25

IFRS compared to contract based approach Moderate 20-30E20-15 Lessor entries, determine type of lease, capital

lease payments.Moderate 20-25

E20-16 Lessor entries; capital lease with option topurchase; lessee capitalizable amount.

Moderate 25-35

E20-17 Lessor entries; disclosure, direct financing withunguaranteed residual

Moderate 25-35

E20-18 Accounting for an operating lease anddisclosure: lessee and lessor

Simple 15-20

E20-19 Accounting for an operating lease. Simple 10-20E20-20 Lessor entries; sales-type lease. Moderate 15-20E20-21 Operating lease for lessee and lessor. Simple 15-20

*E20-22 Lessee-lessor, sale-leaseback. Moderate 20-30*E20-23 Land lease; lessee and lessor. Moderate 15-20*E20-24 Sale and leaseback; lessee and lessor entries. Moderate 20-30*E20-25 Real estate lease. Moderate 20-25






ASSIGNMENT CHARACTERISTICS TABLE (Continued)


Time(minutes)

P20-1 Operating and capital lease alternatives,statement disclosure—lessee and rationale.

Complex 45-50

P20-2 Leasing alternative comparison—lessee,comparison including cash flows.

Moderate 45-50

P20-3 Lessee entries and statement of financialposition, income and cash flow presentation;capital lease.

Moderate 45-50

P20-4 Lessor entries and statement of financialposition, income and cash flow presentation;direct financing lease.

Moderate 40-45

P20-5 Capital lease to lessee and operating lease tolessor; entries and financial statements.

Complex 40-45

P20-6 Operating lease; lessee-lessor entries. Simple 20-30P20-7 Capital lease, lessee with bargain purchase

option.Moderate 30-35

P20-8 Statement of financial position and incomestatement disclosure—lessee.

Moderate 30-40

P20-9 Statement of financial position and incomestatement disclosure—lessor.

Moderate 30-40

P20-10 Basic lessee accounting with difficult PVcalculation.

Moderate 40-50

P20-11 Lessee-lessor entries; statement of financialposition and cash flow presentation; sales-typelease.

Moderate 35-45

P20-12 Lessee entries and statement of financial

position and cash flow presentation; capitaland operating lease.

Moderate 25-35

P20-13 Lessor calculations and entries; sales-typelease with unguaranteed residual value.

Complex 35-45

P20-14 Lessee calculations and entries; capital leasewith guaranteed and unguaranteed residualvalue and bargain option.

Complex 40-50

P20-15 Lessor calculations and entries; sales-typelease with guaranteed and unguaranteedresidual value, with disclosure, depreciationcalculations for lessee.

Complex 40-45

P20-16 Lessee-lessor accounting for residual value. Complex 30-40

P20-17 Contrasting capital and operating lease choice Moderate 30-35P20-18 Lease accounting and reporting – operatinglease to lessee and capital lease to lessor.

Complex 40-45

P20-19 Contract-based approach, including revision ofestimates for guaranteed residual value.

Moderate 30-35

P20-20 Lease vs. purchase including financing,options to purchase, contract-based approachand summaries—lessee

Complex 50-80






ASSIGNMENT CHARACTERISTICS TABLE (Continued)


Time(minutes)

P20-21 Lessor of P20-20 Moderate 20-25*P20-22 Sale and leaseback arrangement Complex 40-45

*P20-23 Sale and leaseback of real estate Complex 40-45






SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 20-1

The lease does not meet the transfer of ownership test, (thebargain purchase test), or the economic life test [(5 years ÷ 8years) < 75%] used for ASPE. However, it does pass therecovery of investment test. The present value of the minimumlease payments ($32,000 X 4.31213 = $137,988) (or using thealternatives below) is greater than 90% of the fair value of theasset (90% X $140,000 = $126,000). Therefore, Piper shouldclassify the lease as a capital lease.

Excel formula =PV(rate,nper,pmt,fv,type)

Using a financial calculator:

PV $ ? Yields $137,988

I 8%

N 5

PMT $ (32,000)

FV $ 0

Type 1






BRIEF EXERCISE 20-2

(a) IFRS

The lease does not meet the transfer of ownership test (there isno transfer of ownership or bargain purchase option), howeverthe lease term is for the major part of the economic life of theleased asset [(5 years ÷ 8 years) = 63%]. In addition, the presentvalue of minimum lease payments may be considered torepresent substantially all of the fair value of the leased asset[($215,606.50 ÷ $250,000) = 86%]. Therefore, Blane shouldclassify the lease as a finance lease.

(b) ASPE

The lease does not meet the transfer of ownership test, (there isno bargain purchase option or transfer of ownership), or theeconomic life test [(5 years ÷ 8 years) < 75%], or the recovery ofinvestment test [($215,606.50 ÷ $250,000) < 90%] used for ASPE.Therefore, Blane should classify the lease as an operating lease.






BRIEF EXERCISE 20-3

(a) IFRS

For finance leases, the lessee uses the rate implicit in the leasewhenever it can be reasonably determined; otherwise theincremental borrowing rate is used. In this case, the rate implicitin the lease is 9%.

Using Table A-5 Present Value of an annuity due, 6 periods at9% of 4.88965, the capitalized amount of the leased asset =$30,000 X 4.88965 = $146,689.50.



PV $ ? Yields $146,689.54

I 9%

N 6

PMT $ (30,000)

FV $ 0

Type 1

(b) ASPE

For capital leases, the lessee uses the lower of the lessee’sincremental borrowing rate and the rate implicit in the lease. Inthis case, the lower of the lessee’s incremental borrowing rateand the rate implicit in the lease is 8%.

Using Table A-5 Present Value of an annuity due, 6 periods at

8% of 4.99271, the capitalized amount of the leased asset =$30,000 X 4.99271 = $149,781.30.






BRIEF EXERCISE 20-3 (Continued)

(b) (Cont inued)



PV $ ? Yields $149,781.30

I 8%

N 6

PMT $ (30,000)

FV $ 0

Type 1

BRIEF EXERCISE 20-4

Equipment under Lease .................................. 112,400Obligations under Lease ......................... 112,400

(Using Table A-5 Present Value of an annuity due and 5 periodsat 6% of 4.46511, present value of minimum lease payments =$25,173 X 4.46511= $112,400.21.)



PV $ ? Yields $112,400.10

I 6%

N 5

PMT $ (25,173)

FV $ 0

Type 1

Obligations under Lease ................................. 25,173Cash .......................................................... 25,173






BRIEF EXERCISE 20-5

Using Excel or a financial calculator solve the payment amount:

Excel formula =PMT(rate,nper,pv,fv,type)

Using a financial calculator

PV $ 112,400

RATE 6%

NPR 5

PMT ? Yields $25,173

FV $ 0

Type 1

Using Table A-5 Present Value of an annuity due, 5 periods at6% of 4.46511, payment = $112,400 / 4.46511= $25,172.95.

BRIEF EXERCISE 20-6

Interest Expense ................................................ 8,296Interest Payable

[($150,000 – $25,561) X 10% X 8/12].... 8,296

Depreciation Expense ........................................ 12,500 Accumulated Depreciation-Leased Equipment

($150,000 X 1/8 X 8/12) ......................... 12,500

BRIEF EXERCISE 20-7

Interest Payable .................................................. 8,296Interest Expense ................................................ 4,148

Obligations under Lease .................................... 13,117Cash ............................................................. 25,561($150,000 – $25,561) X 10% X 4/12 = $4,148






BRIEF EXERCISE 20-8

Equipment under Lease ..................................... 147,047Obligations under Lease ............................ 147,047

Using tables:PV of rentals $28,000 X 4.88965 $136,910

[PV of guar. RV $17,000 X .59627 10,137$147,047



PV $ ? Yields $147,047

I 9%

N 6

PMT $ 28,000

FV $ 17,000

Type 1

Obligations under Lease .................................... 28,000

Cash ............................................................. 28,000






BRIEF EXERCISE 20-9

Equipment under Lease ..................................... 136,910Obligations under Lease ............................ 136,910

Using tables:PV of rentals $28,000 X 4.88965 $136,910



PV $ ? Yields $136,910

I 9%

N 6PMT $( 28,000)

FV 0

Type 1

Obligations under Lease .................................... 28,000Cash ........................................................... 28,000






BRIEF EXERCISE 20-10

Lease Receivable ............................................... 185,000Sales Revenue ............................................ 147,047Unearned Interest Income .......................... 37,953

[($28,000 X 4.88965) + ($17,000 X .59627) = $147,047]($28,000 X 6) + $17,000 = $185,000

Payments are assumed to be at the beginning of each year



PV $ ? Yields $(147,047)

I 9%

N 6

PMT $ 28,000

FV $ 17,000

Type 1

Cost of Goods Sold ............................................ 121,000Inventory ..................................................... 121,000

Cash .................................................................... 28,000Lease Receivable ........................................ 28,000







August 15, 2014Rent Expense ($31,500 ÷ 12 X 3.5) .................... 9,188Prepaid Rent ($31,500 ÷ 12 X 8.5) ...................... 22,312

Cash ............................................................. 31,500

An alternate to the above: August 15, 2014

Prepaid Rent ...................................................... 31,500Cash ............................................................. 31,500

November 30, 2014Rent Expense ($31,500 ÷ 12 X 3.5) .................... 9,188

Prepaid Rent .............................................. 9,188


August 15, 2014Cash .................................................................... 31,500

Unearned Rent Revenue ............................ 31,500

June 30, 2015

Unearned Rent Revenue ................................... 27,563Rent Revenue ($31,500 ÷ 12 X 10.5) .......... 27,563


Lease Receivable ............................................... 202,920Equipment Acquired for Lessee ................ 175,000Unearned Interest Income .......................... 27,920

Lease payments receivable $202,920[ (5 X $40,584)PV of rentals (4.31213 X $40,584) 175,000Unearned interest $ 27,920








Lease Receivable ............................................... 202,920Sales Revenue ............................................ 175,000Unearned Interest Income ......................... 27,920



Unearned Interest Income ................................. 10,753Interest Income ........................................... 10,753

[($175,000 – $40,584) X 8%]



[($175,000 – $40,584) X 8%]







Lease Receivable ............................................... 519,650Sales Revenue ............................................ 410,000Unearned Interest Income .......................... 109,650

[(95,930 X 4.03735) + (40,000 X .56743)] = 410,000(95,930 X 5) + 40,000 = 519,650

Payments are assumed to be at the beginning of each year



PV $ ? Yields $(410,000)

I 12%

N 5

PMT $ 95,930

FV $ 40,000

Type 1









Lease Receivable ............................................... 519,650Cost of Goods Sold ($265,000 – $22,697*) ........ 242,303

Sales Revenue ($410,000 – $22,697) ......... 387,303Unearned Interest Income .......................... 109,650Inventory ..................................................... 265,000

* ($40,000 X .56743) = $22,697($95,930 X 4.03735) = $387,303($95,930 X 5) + $40,000 = $519,650


*BRIEF EXERCISE 20-18

Deferred profit on sale-leaseback = $200,000 – ($300,000 –$120,000) = $20,000

(a) IFRS

Under IFRS, the deferred gain on sale is recognized over the

lease term. In this case, amortization of the deferred gain on saleto be recorded at the end of 2014 is $4,000 ($20,000 ÷ 5 years).

(b) ASPE

Under ASPE, the deferred gain on sale is amortized on the samebasis as the depreciation of the leased asset. In this case,amortization of the deferred gain on sale to be recorded at theend of 2014 is $8,000 ($20,000 X 2 ÷ 5 years).







Cash .................................................................... 65,000 Accumulated Depreciation - Trucks ................. 26,000

Trucks .......................................................... 79,000Deferred Profit on Sale-Leaseback ............ 12,000

Vehicles under Lease ......................................... 65,000Obligations under Lease ............................ 65,000

($17,147 X 3.79079)



PV $ ? Yields $65,000

I 10%

N 5

PMT $ (17,147)

FV $ 0

Type 0

Depreciation Expense ........................................ 13,000 Accumulated Depreciation-Vehicles under Lease($65,000 X 1/5) ............................................ 13,000

Deferred Profi t on Sale-Leaseback ................... 2,400Depreciation Expense ($12,000 X 1/5) ....... 2,400

Interest Expense ($65,000 X 10%) ..................... 6,500Obligations under Lease .................................... 10,647

Cash ............................................................. 17,147







January 1, 2014:Land under Lease ............................................ 100,000.00Buildings under Lease .................................... 150,000.00

Obligations under Lease ......................... 250,000.00

Obligations under Lease ................................. 23,576.90Cash .......................................................... 23,576.90



PV $ ? Yields $ 250,000

I 8%

N 20

PMT $ 23,576.90

FV $ 0

Type 1

December 31, 2014:Interest Expense ................................................ 18,113.85

Interest Payable[($250,000.00 – $23,576.90) X 8%] ....... 18,113.85

Depreciation Expense ........................................ 7,500.00 Accumulated Depreciation – Leased Bui ldings

($150,000 / 20) ...................................... 7,500.00







January 1, 2014Buildings under Lease .................................... 150,000.00

Obligations under Lease ......................... 150,000.00

Obligations under Lease ................................. 14,146.14Rent Expense (Land) ...................................... 9,430.76

Cash .......................................................... 23,576.90[($23,576.90 X $150,000 / $250,000) = $14,146.14]

December 31, 2014:Interest Expense ................................................ 10,868.31

Interest Payable .......................................... 10,868.31

[($150,000.00 – $14,146.14) X 8%]

Depreciation Expense ........................................ 7,500.00 Accumulated Depreciation – Leased Bui ldings……7,500.00($150,000 / 20)


For the contract-based approach, the probability-weightedexpected value of the residual guarantee must be used in thepresent value calculation of the lease payments liabili ty.

Probability-weighted expected value

$16,000 X 50% = $8,000$12,000 X 30% = 3,600$10,000 X 20% = 2,000 $13,600







(a) ASPE

The lease does not meet the transfer of ownership test, (the

bargain purchase test), or the economic life test [(4 years ÷ 8years) < 75%], or the recovery of investment test [($116,025 ÷$150,000) < 90%] used for ASPE. Therefore, Quong shouldclassify the lease as an operating lease.

(b) IFRS – classification approach

The lease does not meet the transfer of ownership test (thebargain purchase test), or the economic life test [(4 years ÷ 8years) = 50%]. It may also be considered that the present value

of minimum lease payments does not represent substantially allof the fair value of the leased asset [($116,025 ÷ $150,000) =77%]. Therefore, Quong should classify the lease as anoperating lease.

(c) IFRS – contract-based approach

Because the contractual right to use the asset is transferredfrom Zareiga to Quong over the non-cancellable lease term, atlease inception, Quong should measure and recognize the right-of-use asset and the liability (obligation) to make leasepayments.






SOLUTIONS TO EXERCISES

EXERCISE 20-1 (15-20 minutes)

(a) This is a capital lease to Wong since the lease term (5years) is greater than 75% of the economic life (6 years) ofthe leased asset. The lease term is 83⅓% (5 ÷ 6) of theasset’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%.



PV $ ? Yields $56,994

I 10%

N 5

PMT $ (13,668)

FV $ 0

Type 1

(c)

9/1/14 Equipment under Lease .................... 56,994Obligations under Lease ............ 56,994

Obligations under Lease .................. 13,668Cash ........................................... 13,668






EXERCISE 20-1 (Continued)

12/31/14 Depreciation Expense ....................... 3,800 Accumulated Depreciation—

Leased Equipment .................. 3,800[($56,994/ 5) X 4/ 12 = $3,800]

Interest Expense ............................... 1,444Interest Payable .......................... 1,444

[($56,994 – $13,668) X .10 X 4/ 12 = $1,444]

9/1/15 Obligations under Lease .................. 9,335Interest Payable ................................. 1,444Interest 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 situationsnormally indicates that the risks and rewards of ownership aretransferred to the lessee, and supports classification as afinance lease:

• There is reasonable assurance that the lessee will obtain

ownership of the leased property by the end of the leaseterm. If there is a bargain purchase option in the lease, it isassumed that the lessee will exercise it and obtainownership of the asset.

• The lease term is long enough that the lessee will receivesubstantially all of the economic benefits that are expectedto be derived from using the leased property over its l ife.

• The lease allows the lessor to recover substantially all ofits investment in the leased property and to earn a returnon the investment. Evidence of this is provided if the

present value of the minimum lease payments is close tothe fair value of the leased asset.

• The leased assets are so specialized that, without majormodification, and/or significant cost to the lessor, they areof use only to the lessee.







Other indicators include situations where the lessee absorbs thelessor’s losses if the lessee cancels the lease, or the lesseeassumes the risk associated with the amount of the residualvalue of the asset at the end of the lease, or where there is abargain renewal option—when the lessee can renew the leasefor an additional term at significantly less than the market rent.

The standard also states that these indicators are not alwaysconclusive. The decision has to be made on the substance ofeach specific transaction. If the lessee determines that the risksand benefits of ownership have not been transferred to it, thelease is c lassi fied as an operating lease.

It is likely the lease would be classified as a capital lease underIFRS.






EXERCISE 20-2(20-25 minutes)

(a) This is an operating lease to Wong since the lease term (5years) is less than 75% of the economic life (7 years) of theleased asset. The lease term is 71.4% (5 ÷ 7) of the asset’seconomic life. There is no bargain purchase option and thepresent value of minimum lease payments of $56,994represent 72% of the fair value at September 1 of $79,000falling short of the criteria of 90% to treat the lease as acapital lease.

(b)September 1, 2014Prepaid Rent ............................................... 13,668

Cash ................................................... 13,668

December 31, 2014Rent Expense ............................................. 4,556

Prepaid Rent ..................................... 4,556($13,668 X 4 / 12 = $4,556)

September 1, 2015Prepaid Rent ............................................... 13,668

Cash ................................................... 13,668

December 31, 2015Rent Expense ............................................. 13,668

Prepaid Rent ...................................... 13,668

Al ternately, the September 1, 2015 payment can be recordedto rent expense, in which case no adjusting journal entry isneeded at December 31, 2015.







(c) and (d)

E20-2 E20-1

Operating CapitalLease Lease

Statement of Financial Position:

Current assets:

Prepaid rent $9,112

Property Plant & Equipment:

Equipment under lease $ 56,994

Less: Accumulated depreciation (3,800)

53,194Current Liabilities

Interest payable 1,444

Current portion of obligations under

lease 9,335

Long term liabilities

Obligations under lease 43,326

Less: Current portion (9,335)

33,991Income Statement:

Depreciation expense $ 3,800

Interest expense 1,444

Rent expense $ 4,556







(a) To New Bay, the lessee, this lease is a capital lease becausethe terms satisfy the following criteria:

1. The lease term is greater than 75% of the economic l ife ofthe leased asset; that is, the lease term is 76.4% (55/72)of the economic life.

2. The present value of the minimum lease payments isgreater than or equal to 90% of the fair value of theleased asset; that is, the present value of $19,356 is 90%of the fair value of the leased asset: ($19,356 / $21,500 =90%)

(b) The minimum lease payments, in the case of a residualvalue guaranteed by the lessee include the guaranteedresidual value. The present value therefore is:

PV of monthly payment of $425 for 55 months ..... $17,910PV of residual value of $2,500 ................................. 1,446Present value of minimum lease payments ........... $19,356



PV $ ? Yields $19,358.88

I 1%

N 55

PMT $ (425)

FV $ (2,500)

Type 0

(c) Vehicles under Lease ................................. 19,356Obligations under Lease .................... 19,356







(d) Depreciation Expense ................................ 306.47 Accumulated Depreciation—Vehicles under Lease…306.47

[($19,356 – $2,500) ÷ 55 months = 306.47]

(e) Obligations under Lease ............................ 231.44Interest Expense (1% X $19,356) ............... 193.56

Cash ..................................................... 425.00

(f) Rather than using quantitative factors such as the 75percent and the 90 percent hurdles often referred to as thebright lines used in ASPE, the IFRS criteria use qualitative

factors to establish whether or not the risks and rewards ofownership are transferred to the lessee, and supportsclassification as a finance lease:1. There is reasonable assurance that the lessee will

obtain ownership of the leased property by the end ofthe lease term. If there is a bargain purchase option inthe lease, it is assumed that the lessee will exercise itand obtain ownership of the asset.

2. The lease term is long enough that the lessee willreceive substantially all of the economic benefits that

are expected to be derived from using the leasedproperty over its life.

3. The lease allows the lessor to recover substantially allof its investment in the leased property and to earn areturn on the investment. Evidence of this is provided ifthe present value of the minimum lease payments isclose to the fair value of the leased asset.

4. The leased assets are so specialized that, without majormodif ication, they are of use only to the lessee.

None of the numerical thresholds need be applied, as wasthe case in ASPE, and so the treatment of the lease by thelessee would be the same, although it would be referred toas a finance lease, rather than a capital lease.







(a)Capitalized amount of the lease:

Yearly payment $73,580.00Executory costs 2,470.29Minimum annual lease payment $71,109.71

Present value of minimum lease payments$71,109.71 X 6.32825 = $450,000.00



PV $ ? Yields $450,000

I 12%

N 10

PMT $ (71,109.71)

FV $ 0

Type 1







FINE CORP.Lease Amortization Schedule

(Lessee)

Date

Annual Pmt.Excl.

Exec. Costs

Interest(12%)

on UnpaidObligation

Reductionof Lease

Obligation

Balanceof Lease

Obligation

$450,000.00

Jan. 1, 2014 $71,109.71 $71,109.71 378,890.29

Jan. 1, 2015 71,109.71 $45,466.83 25,642.88 353,247.41

Jan. 1, 2016 71,109.71 42,389.69 28,720.02 324,527.39Jan. 1, 2017 71,109.71 38,943.29 32,166.42 292,360.97

Jan. 1, 2018 71,109.71 35,083.32 36,026.39 256,334.58

Jan. 1, 2019 71,109.71 30,760.15 40,349.56 215,985.02

Jan. 1, 2020 71,109.71 25,918.20 45,191.51 170,793.51

Jan. 1, 2021 71,109.71 20,495.22 50,614.49 120,179.02

Jan. 1, 2022 71,109.71 14,421.48 56,688.23 63,490.79

Jan. 1, 2023 71,109.71 7,618.92 63,490.79 0

711,097.10 261,097.10 450,000.00

(b)1/1/14 Equipment under Lease ................. 450,000.00

Obligations under Lease .... 450,000.00

1/1/14 Insurance Expense ......................... 2,470.29Obligations under Lease ................ 71,109.71

Cash ..................................... 73,580.00

12/31/14 Depreciat ion Expense .................... 45,000.00 Accumulated Depreciation—

Leased Equipment .......... 45,000.00($450,000 ÷ 10)







12/31/14 Interest Expense(See Schedule 1) ....................... 45,466.83

Interest Payable .................. 45,466.83

1/1/15 Insurance Expense ....................... 2,470.29Interest Payable ............................. 45,466.83Obligations under Lease .............. 25,642.88

Cash ..................................... 73,580.00

12/31/15 Depreciation Expense ................... 45,000.00 Accumulated Depreciation—

Leased Equipment ......... 45,000.00

12/31/15 Interest Expense ........................... 42,389.69Interest Payable .................. 42,389.69

(c) Note X:The following is a schedule of future minimum leasepayments under the finance lease expiring December 31,2023 together with the balance of the obligation underfinance lease.

Year ending December 312016 $73,5802017 73,5802018 73,5802019 73,5802020 73,5802021 and beyond 220,740

Total minimum lease payments 588,640

Less amount representing executory costs 19,763568,877Less amount representing interest at 12% 215,630Balance of the obligation $353,247







Addi tional disclosures would also be required aboutmaterial lease arrangements including contingent rents,sub-lease payments and lease-imposed restrictions. Thesedo not apply in this case.







1/1/14 Equipment under Lease ................. 450,000.00Obligations under Lease .... 450,000.00

1/1/14 Insurance Expense * ....................... 1,029.29Prepaid Insurance ** ....................... 1,441.00Obligations under Lease ................ 71,109.71

Cash ..................................... 73,580.00* ($2,470.29 X 5/12)** ($2,470.29 X 7/12)

05/31/14 Depreciation Expense ................... 18,750.00 Accumulated Depreciation—

Leased Equipment .......... 18,750.00($450,000 ÷ 10 X 5/12)

05/31/14 Interest Expense * ...................... 18,944.51Interest Payable .................. 18,944.51

* ($45,466.83 x 5/12)

12/31/14 Insurance Expense ..................... 1,441.00Prepaid Insurance ............... 1,441.00

Note: This entry could also be done at May 31, 2015as a year-end adjust ing entry.

1/1/15 Insurance Expense ....................... 1,029.29Prepaid Insurance ......................... 1,441.00Interest Expense * ......................... 26,522.32Interest Payable ............................. 18,944.51Obligations under Lease .............. 25,642.88

Cash ................................. 73,580.00

* ($45,466.83 – $18,944.51)







05/31/15 Depreciation Expense ................ 45,000.00 Accumulated Depreciation—

Leased Equipment .......... 45,000.00

05/31/15 Interest Expense ......................... 17,662.37Interest Payable .................. 17,662.37

($42,389.69 X 5/12)

12/31/15 Insurance Expense ..................... 1,441.00Prepaid Insurance ............... 1,441.00

Note: This entry could also be done at May 31, 2016as a year-end adjust ing entry.







(a) The lease agreement has a bargain purchase option andthus meets the criteria to be classified as a capital leasefrom the viewpoint of the lessee. The present value of theminimum lease payments exceeds 90% of the fair value ofthe assets.

(b) The lease agreement has a bargain purchase option. Thecollectability of the lease payments is reasonablypredictable, and there are no important uncertaintiessurrounding the costs yet to be incurred by the lessor. Theinitial amount of net investment (which in this case equalsthe present value of the minimum lease payments, $88,000)exceeds the lessor’s cost ($60,000), the lease is a sales-type

lease to the lessor.

(c) Net investment calculation:$20,066.26 Annual rental paymentX 4.23972 PV of annuity due of 1 for n = 5, i = 9%$85,075.32 PV of periodic rental payments

$ 4,500.00 Bargain purchase optionX .64993 PV of 1 for n= 5, i = 9%

$ 2,924.69 PV of bargain purchase option

$85,075.32 PV of periodic rental payments+ 2,924.69 PV of bargain purchase option$88,000.01 Net investment at inception of lease



PV $ ? Yields $ 88,000 I 9%

N 5

PMT $ (20,066.26)

FV $ (4,500)

Type 1







Russell Corporation (Lessee)Lease Amortization Schedule

Date

AnnualLease

PaymentPlus BPO

Interest (9%)on UnpaidObligation

Reductionof Lease

Obligation

BalanceLease

Obligation

7/1/147/1/147/1/157/1/167/1/17

7/1/186/30/19

$ 20,066.2620,066.2620,066.2620,066.26

20,066.264,500.00

$104,831.30

*$ 6,114.04* * 4,858.34* * 3,489.62*

* 1,997.73* * 371.58**$16,831.30*

$20,066.2613,952.2215,207.9216,576.64

18,068.534,128.42

$88,000.00

$88,000.0067,933.7453,981.5238,773.5922,196.96

4,128.420.00

*Rounding error is $.02 cents.

(d)7/1/14 Equipment under Lease ................ 88,000.00

Obligations under Lease ....... 88,000.00

Obligations under Lease ................ 20,066.26Cash ...................................... 20,066.26

12/31/14 Interest Expense ........................... 3,057.02Interest Payable .................... 3,057.02

($6,114.04 X 6/12 = ($3,057.02)

Depreciat ion Expense .................... 4,400.00 Accumulated Depreciation

—Leased Equipment ........ 4,400.00($88,000.00 ÷ 10 =($8,800.00; $8,800.00 X 6/12 = $4,400)







7/1/15 Interest Payable ............................. 3,057.02Interest Expense* .......................... 3,057.02

Obligations under Lease ............... 13,952.22Cash ..................................... 20,066.26* ($6,114.04 – $3,057.02)

12/31/15 Interest Expense ............................ 2,429.17Interest Payable .................. 2,429.17($4,858.34 X 6/12 = ($2,429.17)

12/31/15 Depreciation Expense ................... 8,800.00 Accumulated Depreciation

—Leased Equipment .. 8,800.00($88,000.00 ÷ 10 years = ($8,800.00)

(Note to instructor: Because a bargain purchase option wasinvolved, the leased asset is depreciated over its economicli fe rather than over the lease term.)

(e) For Russell Corporation—(the lessee):

Rather than using quantitative factors such as the 75percent and the 90 percent hurdles often referred to as thebright lines used in ASPE, the IFRS criteria use qualitativefactors to establish whether or not the risks and rewards ofownership are transferred to the lessee, and supportsclassification as a finance lease:1. There is reasonable assurance that the lessee will


2. The lease term is long enough that the lessee willreceive substantially all of the economic benefits thatare expected to be derived from using the leasedproperty over its life.









None of the numerical thresholds need be applied, as wasthe case in ASPE, and so the treatment of the lease by thelessee would be the same, although it would be referred toas a finance lease, rather than a direct financing lease.

For Hebert Corporation—(the lessor):Under IFRS, the lease would receive the same treatment asunder ASPE except the criteria need not include the tworevenue recognition-based tests concerning collectabilityand estimating unreimbursable costs. Instead of beingreferred to as a sales-type lease, the lease would be referredto as a finance lease—manufacturer or dealer.







Note as determined in Exercise 20-6, part (b):The lease agreement has a bargain purchase option. Thecollectability of the lease payments is reasonably predictable,and there are no important uncertainties surrounding the costsyet to be incurred by the lessor. The lease also qualifies as acapital lease from the viewpoint of the lessee.

Due to the fact that the init ial amount of net investment (which inthis case equals the present value of the minimum leasepayments, $88,000) exceeds the lessor’s cost ($60,000), thelease is a sales-type lease.

(a) Gross investment = Minimum lease payments + anyunguaranteed residual value.

The minimum lease payments associated with this lease arethe periodic annual rents plus the bargain purchase option.There is no residual value relevant to the lessor’saccounting in this lease.

Calculation: 5 X $20,066.26 =$100,331.30+ 4,500.00

Gross investment at inception $104,831.30(b) The net investment equals the present value of the

components of the gross investment calculation.Net investment calculation:

$20,066.26 Annual rental paymentX 4.23972 PV of annuity due of 1 for n = 5, i = 9%$85,075.32 PV of periodic rental payments

$ 4,500.00 Bargain purchase option

X .64993 PV of 1 for n = 5, i = 9%$ 2,924.69 PV of bargain purchase option

$85,075.32 PV of periodic rental payments+ 2,924.69 PV of bargain purchase option$88,000.01 Net investment at inception








Using a financial calculator:PV $ ? Yields $88,000

I 9%

N 5

PMT $ 20,066.26

FV $ 4,500

Type 1

(c)

Herbert Leasing Corporation (Lessor)Lease Amortization Schedule

Date

AnnualLease

PaymentPlus BPO

Interest (9%)on Net

Investment

NetInvestmentRecovery

BalanceNet

Investment

7/1/147/1/14

7/1/157/1/167/1/177/1/186/30/19

$ 20,066.26

20,066.2620,066.2620,066.2620,066.264,500.00

$104,831.30

*$ 6,114.04* * 4,858.34* * 3,489.62* * 1,997.73* * 371.58**$16,831.30*

$20,066.26

13,952.2215,207.9216,576.6418,068.53

4,128.42$88,000.00

$88,000.0067,933.74

53,981.5238,773.5922,196.964,128.42

0.00

*Rounding error is $.02 cents.(d)

7/1/14 Lease Receivable .......................... 104,831.30

Cost of Goods Sold ....................... 60,000.00Sales Revenue ...................... 88,000.00Unearned Interest Income ... 16,831.30Inventory ............................... 60,000.00







7/1/14 Cash ............................................... 20,066.26Lease Receivable ................. 20,066.26

12/31/14 Unearned Interest Income ............ 3,057.02Interest Income ..................... 3,057.02

($6,114.04 X 6/12 = $3,057.02)



($6,114.04 – $3,057.02)


($4,858.34 X 6/12 = ($2,429.17)


Unearned Interest Income ............ 2,429.17Interest Income ..................... 2,429.17

($4,858.34 – $2,429.17)


($3,489.62 X 6/12 = $1,744.81)







(a)Capitalized amount of the lease:



PV $ ? Yields $164,995

I 10.5%

N 8

PMT $ (28,500.00)

FV $ 0

Type 1

(b) This is a capital lease to Xu since the lease term (8 years)is greater than 75% of the economic life (8 years) of theleased asset. The lease term is 100% (8 ÷ 8) of the asset’seconomic life. This also meets the requirements of IFRS,under which i t is referred to as a financing lease.

The present value of the minimum lease payments is

greater than 90% of the fair value of the leased asset; thatis, the present value of $164,995 is 99% of the fair value ofthe leased asset: ($164,995 / $166,000 = 99.4%). Thiscriteria for treating the lease as a capital lease has alsobeen met. Note that meeting just one of the criteria issufficient for classification as a capital lease.

There is no bargain purchase option in this case.







(c) Xu Ltd.Lease Amortization Schedule

(Lessee)

Date

AnnualLease

Payments

Interest(10.5%)

on UnpaidObligation

Reductionof Lease

Obligation

Balanceof Lease

Obligation

$164,995.00

Jan. 1, 2015 $28,500.00 $28,500.00 136,495.00

Jan. 1, 2016 28,500.00 $14,331.98 14,168.03 122,326.97

Jan. 1, 2017 28,500.00 12,844.33 15,655.67 106,671.30Jan. 1, 2018 28,500.00 11,200.49 17,299.51 89,371.79

Jan. 1, 2019 28,500.00 9,384.04 19,115.96 70,255.83

Jan. 1, 2020 28,500.00 7,376.86 21,123.14 49,132.70

Jan. 1, 2021 28,500.00 5,158.93 23,341.07 25,791.63

Jan. 1, 2022 28,500.00 2,708.37 25,791.63 (0.00)

$228,000.00 $63,005.00 $164,995.00

(d)

1/1/15 Equipment under Lease ............. 164,995Obligations under Lease .... 164,995

1/1/15 Obligations under Lease ............ 28,500Cash ..................................... 28,500

12/31/15 Depreciation Expense ................ 20,624 Accumulated Depreciation—

Leased Equipment .......... 20,624

($164,995 ÷ 8)







(d) (Cont inued)

12/31/15 Interest Expense ......................... 14,332

Interest Payable .................. 14,332

1/1/16 Interest Payable .......................... 14,332Obligations under Lease ............ 14,168

Cash ..................................... 28,500

12/31/16 Depreciation Expense ................ 20,624 Accumulated Depreciation—

Leased Equipment ......... 20,624

12/31/16 Interest Expense ......................... 12,844Interest Payable .................. 12,844

(e)Xu Ltd.

Statement of Financial Position (partial)December 31,

2016 2015Non-current assets

Property plant and equipmentEquipment under lease $164,995 $164,995Less accumulated depreciation 41,248 _20,624

123,747 144,371Current liabili ties

Interest payable 12,844 14,332Obligations under lease 15,656 14,168

Non-current liabilitiesObligations under lease (Note X) 122,327 136,495

Current portion (15,656) (14,168)







(f) Note X:The following is a schedule of future minimum leasepayments under the capital lease expiring December 31,2022 together with the balance of the obligation undercapital lease.

Year ending December 312017 $28,5002018 28,5002019 28,5002020 28,5002021 28,5002022 28,500

Total minimum lease payments 171,000Less amount representing interest at 10.5% 48,673Balance of the obligation $122,327

(g) When negotiating a lease arrangement, the lessor sets thelease payments receivable to obtain the appropriate returnfor the asset leased. The amounts arrived at are negotiable.In this case, the lessor likely tried to obtain an amount nearto or exceeding the resale price of the equipment andarrived at annual payments in round amounts ($28,500).The present value of the minimum lease paymentapproximated the resale price without being exactly equal(99.4% in this case). This is a natural outcome from thenegotiations process between the parties involved.







Note: This lease is a capital lease to the lessee because thelease term (five years) exceeds 75% of the economic life of theasset (six years). Also, the present value of the minimum leasepayments exceeds 90% of the fair value of the asset.

$18,142.95 Annual rental paymentX 4.16986 PV of an annui ty due of 1 for n = 5, i = 10%$75,653.56 PV of minimum lease payments



PV $ ? Yields $75,654

I 10%N 5

PMT $ (18,142.95)

FV $ 0

Type 1

(a)LeBlanc Limited (Lessee)

Lease Amortization Schedule

Date

AnnualLease

Payment

Interest(10%)1

on UnpaidObligation

Reductionof Lease

Obligation

Balanceof Lease

Obligation

1/1/141/1/141/1/151/1/16

1/1/171/1/18

$18,142.9518,142.9518,142.95

18,142.9518,142.95$90,714.75

*$ 5,751.06* * 4,511.87*

* 3,148.76** 1,649.50**$15,061.19*

$18,142.9512,391.8913,631.08

14,994.1916,493.45$75,653.56

$75,653.5657,510.6145,118.7231,487.64

16,493.450.00

*Rounding error is 15 cents.

1 The impl icit rate is known and is lower than the lessee’sincremental borrowing rate of 11%







(b)

1/1/14 Equipment under Lease ................. 75,653.56

Obligations under Lease .... 75,653.56

1/1/14 Obligations under Lease ................ 18,142.95Cash ..................................... 18,142.95

During 2014Insurance Expense ......................... 900.00

Cash ..................................... 900.00

Property Tax Expense .................... 1,600.00

Cash ..................................... 1,600.00

12/31/14 Interest Expense ............................. 5,751.06Interest Payable................... 5,751.06

Depreciation Expense .................... 15,130.71 Accumulated Depreciation

—Leased Equipment ....... 15,130.71($75,653.56 ÷ 5 = $15,130.71)

1/1/15 Interest Payable* ............................ 5,751.06Interest Expense ................. 5,751.06

Interest Expense ............................. 5,751.06Obligations under Lease ................ 12,391.89

Cash ..................................... 18,142.95

* Note to instructor:The use of reversing entries is opt ional







During 2015Insurance Expense ......................... 900.00

Cash ..................................... 900.00

Property Tax Expense .................... 1,600.00Cash ..................................... 1,600.00

12/31/15 Interest Expense ............................. 4,511.87Interest Payable ................. 4,511.87

Depreciat ion Expense ................... 15,130.71 Accumulated Depreciation

—Leased Equipment . 15,130.71

Note to instructor:

The lessor sets the annual rental payment as fo llows:Fair value of leased asset to lessor $80,000.00Less: Present value of unguaranteed

residual value $7,000 X .62092(present value of 1 at 10% for 5 periods) 4,346.44

Amount to be recovered through lease payments $75,653.56Five periodic lease payments

$75,653.56 ÷ 4.16986* $18,142.95

*Present value of annuity due of 1 for 5 periods at 10%.



PV $ (80,000)

I 10%

N 5PMT $ ? Yields $18,142.92

FV $ 7,000

Type 1







(c) Note X:The following is a schedule of future minimum leasepayments under the capital lease expiring December 31,2018 together with the balance of the obligation undercapital lease.

Year ending December 312016 $18,1432017 18,1432018 18,143

Total minimum lease payments 54,429Less amount representing interest at 10% 9,310Balance of the obligation $45,119

(d) Rather than using quantitative factors such as the 75percent and the 90 percent hurdles often referred to as thebright lines used in ASPE, the IFRS criteria use qualitativefactors to establish whether or not the risks and rewards ofownership are transferred to the lessee, and supportsclassification as a finance lease:1. There is reasonable assurance that the lessee will



3. The lease allows the lessor to recover substantially allof its investment in the leased property and to earn areturn on the investment. Evidence of this is provided if

the present value of the minimum lease payments isclose to the fair value of the leased asset.









As for the note disc losure provided in part (c) above,additional disclosures would also be required aboutmaterial lease arrangements including contingent rents,sub-lease payments and lease-imposed restrictions. Thesedo not apply in this case.







(a) This is a capital lease to Flynn since the lease term is 75%(6 ÷ 7) of the asset’s economic life. In addition, the presentvalue of the minimum lease payments is more than 90% ofthe fair value of the asset.

This is a sales-type lease to Lavery since the lease is acapital lease to Flynn, the lessee, and because thecollectability of the lease payments is reasonablypredictable, there are no important uncertaintiessurrounding the unreimbursable costs yet to be incurred bythe lessor and the fair value of the equipment ($144,000)exceeds the lessor’s cost ($111,000).

(b) Calculation of annual rental payment:

$144,000 – $6,000 X 0.59627*= $28,718

4.8897**

**Present value of $1 at 9% for 6 periods.**Present value of an annuity due at 9% for 6 periods.



PV $ (144,000)

I 9%

N 6

PMT $ ? Yields $28,718

FV $ 6,000

Type 1







(c)1/1/11 Equipment under Lease ...................... 137,582

Obligations under Lease ............ 137,582($28,718 X 4.79079)***

Obligations under Lease ..................... 28,718Cash ............................................ 28,718

***Present value of an annuity due at 10% for 6 periods.



I 10%

N 6

PMT $ (28,718)

FV $ 0

Type 1

12/31/14 Depreciation Expense ........................ 22,930 Accumulated Depreciation

– Leased Equipment ........ 22,930($137,582 ÷ 6 years)

Interest Expense ................................. 10,886Interest Payable ....................... 10,886[($137,582 – $28,718) X .10]







(d)1/1/11 Lease Receivable ........................... 178,308*

Cost of Goods Sold ........................ 107,422Sales Revenue ...................... 140,422Inventory ............................... 111,000Unearned Interest Income ... 34,308**

*($28,718 X 6) + $6,000**$178,308 – $144,000

Since the residual value is not guaranteed, the present value ofthe residual value of $6,000 is excluded from both sales and cost

of goods sold.

Sales Revenue $144,000Less present value of residual value 3,578*

$140,422

Cost of Goods Sold $111,000Less present value of residual value 3,578*

$107,422*($6,000 X .59627**)

**Present value of $1 at 9% for 6 periods.

Cash ............................................... 28,718Lease Receivable ................. 28,718

12/31/14 Unearned Interest Income ............. 10,375Interest Income .................... 10,375[($144,000 – $28,718) X .09]







(c) For Lavery Corporation—(the lessee):Rather than using quantitative factors such as the 75percent and the 90 percent hurdles often referred to as thebright lines used in ASPE, the IFRS criteria use qualitativefactors to establish whether or not the risks and rewards ofownership are transferred to the lessee, and supportsclassification as a finance lease:1. There is reasonable assurance that the lessee will





None of the numerical thresholds need be applied, as wasthe case in ASPE, and so the treatment of the lease by thelessee would be the same, although it would be referred toas a finance lease, rather than a direct financing lease.

For Flynn Corporation—(the lessor):Under IFRS, the lease would receive the same treatment as

under ASPE except the criteria need not include the tworevenue recognition-based tests concerning collectabilityand estimating unreimbursable costs. Instead of beingreferred to as a sales-type lease, the lease would be referredto as a finance lease—manufacturer or dealer.







(a) When using ASPE, because the lease term is longer than75% of the economic li fe of the asset and the present value

of the minimum lease payments is more than 90% of the fairvalue of the asset, it is a capital lease to the lessee.

Assuming collect ib ility of the rents is reasonably assured,no important uncertainties surround the amount of un-reimbursable costs yet to be incurred by the lessor, andequal cost and fair value to Victoria Leasing, the lease is adirect financing lease to the lessor.

Black Corporation, the lessee should adopt the capital leasemethod and record the leased asset and obligations under

capital leases at the present value of the minimum leasepayments using the lessee’s incremental borrowing rate orthe interest rate implicit in the lease, if it is lower than theincremental rate and is known to the lessee. The lessee’sdepreciation depends on whether ownership transfers tothe lessee or i f there is a bargain purchase option. If one ofthese conditions is fulfilled, depreciation would be over theeconomic life of the asset. Otherwise, the asset would bedepreciated over the lease term. Because both the

economic life of the asset and the lease term are threeyears, the leased asset should be depreciated over thisperiod.

The Victoria Leasing Corporation— If a lease, in substance,transfers the risks and benefits of ownership of the leasedasset to the lessee (decided in the same way as for BlackCorporation, the lessee) and revenue recognition criteriarelated to col lectabili ty and ability to estimate any remainingun-reimbursable costs are met, the lessor accounts for the

lease as either a direct financing or a sales-type lease.Victoria is not a manufacturer or dealer trying to make asale and so the lease will be a direct financing lease toVictoria.






EXERCISE 20-11(Continued)

In this case, the credit risks associated with the lease arenormal and there are no unreimbursable costs that cannotbe estimated by the lessor. Victoria will replace the assetcost of $95,000 with Lease Receivable of $112,590 andUnearned Interest Income of $17,590. (See schedule in part(c) below.) Interest would be recognized annually at aconstant rate applied to the unrecovered net investment.

(b) The present value of minimum lease payments would beequal to the amount to be recovered by the lessor through leasepayments, which equals $95,000. The annual lease paymentcalculated below equals $37,530, and the factor for present value

of an annuity (Table A-4) at 9% for 3 periods is 2.53130. So thepresent value of minimum lease payments is $95,000 ($37,530 X2.53130). In summary:

Cost (fair value of leased asset) ............................... $95,000

Amount to be recovered by lessor through leasepayments ................................................................ $95,000

Three annual lease payments: $95,000 ÷ 2.53130* . $37,530

Lease Receivable = $37,530 X 3 ....................................... $112,590

*Present value of an ordinary annuity of 1 for 3 periods at 9%.



PV $ (95,000)

I 9%

N 3


FV $ 0

Type 0







(c)Schedule of Interest and Amort ization

RentReceipt/Payment

InterestIncome/Expense

Reductionof Principal

Investment/Obligation

1/1/1412/31/1412/31/1512/31/16

—$37,53037,53037,530

—**$8,550** ** 5,942** ** 3,098**

—$28,980

31,58834,432

$95,00066,02034,432

0

**$95,000 X .09 = $8,550

**rounding difference

(d) For Black Corporation—(the lessee):Rather than using quantitative factors such as the 75percent and the 90 percent hurdles often referred to as thebright lines used in ASPE, the IFRS criteria use qualitativefactors to establish whether or not the risks and rewards ofownership are transferred to the lessee, and supportsclassification as a finance lease:







1. There is reasonable assurance that the lessee willobtain ownership of the leased property by the end ofthe lease term. If there is a bargain purchase option inthe lease, it is assumed that the lessee will exercise itand obtain ownership of the asset.


3. The lease allows the lessor to recover substantially allof its investment in the leased property and to earn areturn on the investment. Evidence of this is provided if

the present value of the minimum lease payments isclose to the fair value of the leased asset.

4. The leased assets are so specialized that, without majormodification and/or significant cost to the lessor, theyare of use only to the lessee.


For Victoria Leasing Corporation—(the lessor):Under IFRS, the lease would receive the same treatment asunder ASPE except the cri teria need not specifically includethe two revenue recognition-based tests concerningcollectability and estimating unreimbursable costs. Theseare general recognition tests that would have to be metregardless. The lease would be a financing lease sinceVictoria is not a manufacturer or dealer.







Memorandum Prepared by: (Your Initials)Date:

DENG, INC.December 31, 2014

Reclassification of Leased Auto As a Capital Lease

While performing a routine inspection of the client’s garage, Ifound a 2013 Shirk automobile, which was not listed among thecompany’s assets in the equipment subsidiary ledger. I askedthe plant manager about the vehicle, and she indicated thatbecause the Shirk was only being leased, it was not l isted alongwith other company assets. Having accounted for thisagreement as an operating lease, Deng, Inc. had charged $2,640to 2014 rent expense.

Examining the lease agreement entered into with Quick DealNew and Used Cars on January 1, 2014, I determined that theShirk should be capitalized because its lease term (50 months)

is greater than 75% of i ts estimated useful l ife (60 months).

I advised the client to capitalize this lease at the present value ofits minimum lease payments: $8,623 (the present value of themonthly payments), plus $1,277 (the present value of theguaranteed residual). The following journal entry wassuggested:

Vehicles under Lease .................................... 9,900

Obligations under Lease ....................... 9,900

To account for the first year’s payments as well as to reverse theoriginal entries, I advised the client to make the following entry:







Obligations under Lease ............................... 1,535Interest Expense ........................................... 1,105*

Rent Expense ......................................... 2,640


Month

MonthlyLease

Payment

Interest(1%)

Expense

Reductionof Lease

Obligation

Balanceof Lease

Investment

$9,900.00

1 $220.00 $99.00 $121.00 9,779.00

2 220.00 97.79 122.21 9,656.79

3 220.00 96.57 123.43 9,533.36

4 220.00 95.33 124.67 9,408.69

5 220.00 94.09 125.91 9,282.78

6 220.00 92.83 127.17 9,155.61

7 220.00 91.56 128.44 9,027.16

8 220.00 90.27 129.73 8,897.43

9 220.00 88.97 131.03 8,766.41

10 220.00 87.66 132.34 8,634.0711 220.00 86.34 133.66 8,500.41

12 220.00 85.00 135.00 8,365.42

$2,640.00 $1,105.42 * $1,534.58

Finally, this Shirk must be depreciated over i ts lease term. Usingstraight-line, I calculated monthly depreciation of $156 (thecapitalized amount, $9,900, minus the estimated residual, $2,100,divided by the 50-month lease term). The client was advised to

make the following entry to record 2014 depreciation:

Depreciation Expense ........................... 1,872

Accumulated Depreciation-Vehicles 1,872 under Lease







Part 1 – Using IFRS

(a)

In spite of Cuomo’s intention to exercise the one year renewaloption on the lease of the excavation equipment, the risks andrewards of ownership have not been transferred at the time ofsigning the lease and so the lease is treated as an operatinglease. The maximum term of the lease is four years and theasset is expected to have an economic li fe of ten years.

Under IFRS, meeting any one or a combination of the following

criteria normally indicates that the risks and rewards ofownership are transferred to the lessee, and supportsclassification as a f inance lease:

• There is reasonable assurance that the lessee will obtainownership of the leased property by the end of the leaseterm. If there is a bargain purchase option in the lease, it isassumed that the lessee will exercise it and obtainownership of the asset.

• The lease term is long enough that the lessee will receive

substantially all of the economic benefits that are expectedto 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 returnon the investment. Evidence of this is provided if thepresent value of the minimum lease payments is close tothe fair value of the leased asset.

• The leased assets are so specialized that, without majormodification, they are of use only to the lessee.

(b) Apri l 1, 2014

Rent Expense ($135,000 ÷ 12 X 9) ................. 101,250Prepaid Rent ($135,000 ÷ 12 X 3) ................... 33,750

Cash ......................................................... 135,000







An alternate to the above: April 1, 2014

Prepaid Rent .................................................. 135,000Cash ......................................................... 135,000

December 31, 2014Rent Expense ($135,000 ÷ 12 X 9) ..................... 101,250

Prepaid Rent .............................................. 101,250

Part 2 – Contract-based Approach

When using this approach, the longest possible lease term that

is “more likely than not” to occur, is used in the calculations ofthe discounted contractual lease payments l iability.

Because the payments under the renewal are 125% of theoriginal lease payment ($135,000 X 125% = $168,750), twocalculations need to be made.

The first will be for the first term of the lease involving anannuity due of $135,000 for three years at 8%, the implicit rate inthe lease, known to Cuomo.

$135,000 Annual rental paymentX 2.78326 PV of annuity due of 1 for n = 3, i = 8%

$375,740.10 PV of periodic rental payments

$ 168,750 PV of renewal option rental in 3 yearsX .79383 PV of 1 for n = 3, i = 8%$133,958.81 PV of renewal option rental

$375,740.10 PV of periodic rental payments+133,958.81 PV of renewal option rental$509,698.91 PV of contractual lease payments liabili ty









PV $ ? Yields $509,699.93

I 8%

N 3

PMT $( 135,000)

FV $( 168,750)

Type 1

(b) Cuomo Mining CorporationLease Amortization Schedule

Date

AnnualLease

Payments

Interest(8%)

on UnpaidLiability

Reductionof LeaseLiability

Balanceof LeaseLiability

$509,700

Apr. 1 2014 $135,000 $135,000 374,700

Apr. 1 2015 135,000 $29,976 105,024 269,676 Apr. 1 2016 135,000 21,574 113,426 156,250

Apr. 1 2017 168,750 12,500 156,250 0

$573,750 $64,050

(c) April 1, 2014

Right-of-use Asset ............................... 509,700Obligations under Lease ............ 509,700








December 31, 2014Interest Expense .................................. 22,482

Interest Payable .......................... 22,482($29,976 X 9 ÷ 12 = $22,482)

Amortization Expense ......................... 95,569Right-of-use Asset ..................... 95,569($509,700 ÷ 4 years X 9 ÷ 12 = $95,569)

April 1, 2015Interest Expense .................................. 7,494*Interest Payable ................................... 22,482

Obligations under Lease ..................... 105,024Cash ............................................ 135,000*($29,976 X 3 ÷ 12 = $7,494)


Interest Payable .......................... 16,181($21,574 X 9 ÷ 12 = $16,181)

Amortization Expense ......................... 127,425Right-of-use Asset ..................... 127,425($509,700 ÷ 4 years = $127,425)







Part 3Cuomo Mining Corporation

Statement of Financial Posit ion – Partial

December 31, 2015

Contract Operating

Based Lease

Current assets

Prepaid rent $33,750

Intangible assets

Right-of-use asset $509,700

Amortization to date (222,994) (1)Net 286,706

Liabilities:

Current liabilities:



Non-current liabilities:


Total liabil it ies $285,857

Income statement

Amortization expense $127,425


Rent expense ________ 135,000

$151,100 $ 135,000

Contract Operating

Total expense - 4 years Based Lease


Interest expense 64,050 (2)

Rent expense _______ (3) $573,750

$ 573,750 $573,750







(1) Sum of amort ization 2014 ................... $ 95,569

And 2015 .............................................. 127,425Total ..................................................... $222,994

(2) Refer to total interest expense on amortization table.

(3) Rent expense

($135,000 X 3) + $168,750 = $573,750







(a)Fair value of leased asset to lessor $305,000.00

Less: Present value of unguaranteedresidual value $45,626 X .56447(present value of 1 at 10% for 6 periods) 25,754.51

Amount to be recovered through lease payments $279,245.49

Six periodic lease payments $279,245.49 ÷ 4.79079* $58,288**

*Present value of annuity due of 1 for 6 periods at 10%.**Rounded to the nearest dollar.



PV $ (305,000)

I 10%

N 6


FV $ 45,626

Type 1







(b) Zoppas Leasing Corporation (Lessor)Lease Amortization Schedule

Date

AnnualLease

PaymentPlus URV

Interest(10%) on NetInvestment


Balanceof Net

Investment

1/1/141/1/141/1/151/1/16

1/1/171/1/181/1/1912/31/19

$ 58,28858,28858,288

58,28858,28858,28845,626

$395,354

$24,67121,310

17,61213,544

9,0704,147*

$90,354

$ 58,28833,61736,978

40,67644,74449,21841,479

$305,000

$305,000246,712213,095176,117

135,44190,69741,479

0

* rounding of $1

(c)1/1/14 Lease Receivable .......................... 395,354

Equipment Acquired for Lessee 305,000Unearned Interest Income .... 90,354

1/1/14 Cash ............................................... 58,288Lease Receivable .................. 58,288

31/10/14 Unearned Interest Income ............ 20,559Interest Income ...................... 20,559

($24,671 ÷ 12 X 10)

1/1/15 Cash ............................................... 58,288Lease Receivable .................. 58,288







(a)

The lessor sets the annual rental payment as fo llows:Fair value of leased asset to lessor $28,500.00*Less: Present value of bargain purchase

option $5,000 X .62026(present value of 1 at 1% for 48 periods) 3,101.30

Amount to be recovered through lease payments $25,398.70Forty-eight periodic lease payments

$25,398.70 ÷ 38.3538** $662.22

* Fair value of $29,500.00 less down payment of $1,000.00

**Present value of annuity due of 1 for 48 periods at 1%.



PV $ (28,500)

I 1%

N 48

PMT $ ? Yields $662.22 FV $ 5,000

Type 1

(b)The lease agreement has a bargain purchase option. The lease,therefore, qualifies as a capital lease from the viewpoint of thelessee. The collectability of the lease payments is reasonablypredictable, and there are no important uncertaintiessurrounding the costs yet to be incurred by the lessor. Due tothe fact that the initial amount of net investment (which in thiscase equals the present value of the minimum lease payments,($28,500 + the down payment of $1,000) exceeds the lessor’scost ($21,200), the lease is a sales-type lease to the lessor.







(c)Turpin Corp. (Lessor)


Month

AnnualLease

PaymentPlus RV



Balanceof Net

Investment

$28,500.00

1 $662.22 $662.22 27,837.78

2 662.22 $278.38 383.84 27,453.94

3 662.22 274.54 387.68 27,066.26

4 662.22 270.66 391.56 26,674.70

5 662.22 266.75 395.47 26,279.23

6 662.22 262.79 399.43 25,879.80

7 662.22 258.80 403.42 25,476.38

8 662.22 254.76 407.46 25,068.92

9 662.22 250.69 411.53 24,657.39

10 662.22 246.57 415.65 24,241.74

11 662.22 242.42 419.80 23,821.94

12 662.22 238.22 424.00 23,397.9413 662.22 233.98 428.24 22,969.70

14 662.22 229.70 432.52 22,537.18

15 662.22 225.37 436.85 22,100.33

16 662.22 221.00 441.22 21,659.11

17 662.22 216.59 445.63 21,213.48

18 662.22 212.13 450.09 20,763.40

19 662.22 207.63 454.59 20,308.81

20 662.22 203.09 459.13 19,849.6821 662.22 198.50 463.72 19,385.96

22 662.22 193.86 468.36 18,917.60

23 662.22 189.18 473.04 18,444.55







Month

AnnualLease

Payment

Plus RV

Interest(1%) on Net

Investment

NetInvestment

Recovery

Balanceof Net

Investment

24 662.22 184.45 477.77 17,966.78

25 662.22 179.67 482.55 17,484.23

26 662.22 174.84 487.38 16,996.85

27 662.22 169.97 492.25 16,504.60

28 662.22 165.05 497.17 16,007.42

29 662.22 160.07 502.15 15,505.28

30 662.22 155.05 507.17 14,998.11

31 662.22 149.98 512.24 14,485.8732 662.22 144.86 517.36 13,968.51

33 662.22 139.69 522.53 13,445.97

34 662.22 134.46 527.76 12,918.21

35 662.22 129.18 533.04 12,385.18

36 662.22 123.85 538.37 11,846.81

37 662.22 118.47 543.75 11,303.06

38 662.22 113.03 549.19 10,753.87

39 662.22 107.54 554.68 10,199.1940 662.22 101.99 560.23 9,638.96

41 662.22 96.39 565.83 9,073.13

42 662.22 90.73 571.49 8,501.64

43 662.22 85.02 577.20 7,924.43

44 662.22 79.24 582.98 7,341.46

45 662.22 73.41 588.81 6,752.65

46 662.22 67.53 594.69 6,157.96

47 662.22 61.58 600.64 5,557.32

48 662.22 55.57 606.65 4,950.67

5,000.00 49.33 * 4,950.67 -

$8,286.56 $28,500.00

* rounding by $.18







(d) A journal entry would be required on December 31, 2014 byTurpin Corp. to accrue the interest in the amount of$254.76 related to payment no. 8, which is due January 1,2015.

Unearned Interest Income ....................... 254.76Interest Income ................................... 254.76

(e) The income to be reported on the income statement ofTurpin Corp. for the fiscal year ending December 31, 2014concerning this lease wil l be as follows:

Sales revenue $29,500Cost of goods sold 21,200Gross prof it 8,300Interest income - lease 1,867

(Interest income represents the sum of the interest forthe first 7 payments from the table above and an accrualof interest for the 8th payment)

(f) At December 31, 2014, the statement of financial posi tionwould have reported as a current asset, the amount of theprincipal reduction that will be obtained in the next twelvemonths. Based on the table above the sum of the principalreduction for monthly payment 8 through 19 total $5,168.The remaining amount of the balance of the investment atDecember 31, 2014 ($25,476 less the current portion of$5,168) of $20,308 will be reported as a long-term leasereceivable.







(a) Calculation of annual payments

Cost (fair value) of leased asset

to lessor $135,000.00Less: Present value of residual value$13,000 X .82645(Present value of 1 at 10% for 2 periods) (10,743.85)


Two periodic lease payments$124,256.15 ÷ 1.73554* $71,595.09

*Present value of an ordinary annuity of 1 for 2 periods at 10%



PV $ (135,000)

I 10%

N 2

PMT $ ? Yields $71,595.24

FV $ 13,000Type 0

Calculation of lease receivable

Annual payments ($71,595.09 X 2) $143,190.18Residual value 13,000.00Lease receivable $156,190.18

Calculation of unearned interest incomeGross investment by lessee $156,190.18 Asset cost (fair value) 135,000.00Unearned interest income $ 21,190.18







(b) Castle Leasing Corporation should classify the lease as afinance lease because it is not a manufacturer or dealer.Wai Corporation, the lessee, will treat the lease as a financelease.

The IFRS criteria use qualitative factors to establishwhether or not the risks and rewards of ownership aretransferred to the lessee, and supports classification as afinance lease:1. There is reasonable assurance that the lessee will

obtain ownership of the leased property by the end ofthe lease term. If there is a bargain purchase option in

the lease, it is assumed that the lessee will exercise itand obtain ownership of the asset.



4. The leased assets are so specialized that, without majormodification, they are of use only to the lessee.

(c) For ASPE, rather than using qualitative factors describedunder part (b) above for IFRS, quantitative criteria such asany one of the following are used:

1. the term of the lease exceeding 75% of the remainingeconomic life of the asset,

2. the present value of the minimum lease paymentsexceeding 90% of the fair value of the asset, or3. the transfer of ti tle to the asset, perhaps represented

by the presence of a bargain purchase option will beapplied as the basis for the classification of the leaseas a capital lease for Wai Corporation.







For Castle Leasing, the lessor, the lease would receive thesame treatment as under IFRS, as long as the two revenuerecognition-based tests concerning collectability andestimating unreimbursable costs are passed.

(d)CASTLE LEASING CORPORATION (Lessor)


Date

Annual Pmt.Excl. Exec.

Costs

Intereston Net

Investment


NetInvestment

1/1/1412/31/1412/31/15

$71,595.0971,595.09

*$13,500.00* * 7,690.18**$21,190.18*

$58,095.0963,904.91

$135,000.0076,904.9113,000.00

*Difference of $.31 due to rounding.

(e)

1/1/14 Lease Receivable ........................ 156,190.18Equipment Acquired for Lessee 135,000.00

Unearned InterestIncome .............................. 21,190.18

12/31/14 Cash ($71,595.09 + $5,000) ......... 76,595.09 Accounts Payable (Executory Costs) 5,000.00Lease Receivable ................. 71,595.09

Unearned Interest Income .......... 13,500.00Interest Income ..................... 13,500.00







12/31/15 Cash ............................................. 76,595.09 Accounts Payable (Executory Costs) 5,000.00

Lease Receivable ................. 71,595.09

Unearned Interest Income .......... 7,690.18Interest Income ..................... 7,690.18

(f) 12/31/15 Cash ..................................... 13,000.00Lease Receivable ........ 13,000.00

(g) Upon signing the lease, Wai Corporation should capitalize

the present value of the minimum lease payments in theamount of $71,595.09 excluding the present value of theoption to purchase the equipment for $13,000. This wil lyield an amount of $124,256.15 as calculated in part (a). Thelessee excludes this last payment, as i t is not a guaranteedpayment by the lessee, Wai to the lessor, Castle Leasing.Correspondingly, the obligation under finance lease shouldbe recorded at $124,256.15.

Using a financial calculator:PV $ ? Yields $ 124,255.94

I 10%

N 2

PMT $ 71,595.09

FV $ 0

Type 0







(a) Part 1. Annuit y Due:

Fair value of leased asset to lessor $415,000.00Less: Present value of unguaranteed

residual value $25,000 X .68058(present value of 1 at 8% for 5 periods) 17,014.50


Five periodic lease payments $397,985.50 ÷ 4.31213* $92,294.41




PV $ (415,000)

I 8%

N 5


FV $ 25,000

Type 1







(a) Part 2. Ordinary Annui ty:

Fair value of leased asset to lessor $415,000.00Less: Present value of unguaranteedresidual value $25,000 X .68058(present value of 1 at 8% for 5 periods) 17,014.50


Five periodic lease payments $397,985.50 ÷ 3.99271* $99,678.04





PV $ (415,000)

I 8%

N 5


FV $ 25,000

Type 0







(c)

1/1/14 Equipment Acquired for Lessee ... 415,000.00

Cash ...................................... 415,000.00

Lease Receivable .......................... 486,470.00Unearned Interest Income ... 71,470.00Equipment Acquired for Lessee 415,000.00

1/1/14 Cash ............................................... 96,294.00Maintenance and Repairs Expense 4,000.00Lease Receivable ................. 92,294.00

during Maintenance and Repairs Expense 6,000.002014 Cash ...................................... 6,000.00

12/31/14 Unearned Interest Income ......... 25,816.48Interest Income .................. 25,816.48

1/1/15 Cash ............................................... 96,294.00Maintenance and Repairs Expense 4,000.00

Lease Receivable ................. 92,294.00

during Maintenance and Repairs Expense 6,000.002015 Cash ...................................... 6,000.00

12/31/15 Unearned Interest Income ......... 20,498.28Interest Income .................. 20,498.28







(d) Note X: (on Vick Leasing Inc.’s financial statements:)The company's net investment in a financing lease includesthe following:Total minimum lease receivable $301,882Unearned income 45,654

$256,228

Future minimum lease payments receivable under thefinancing lease are as follows:

Year ending December 312016 $92,2942017 92,294

2018 92,294Total minimum lease payments receivable 276,882Unguaranteed residual value 25,000

$301,882

Vick Leasing would also need to disclose any contingentrental income in the year, the allowance for doubtfulreceivables and general information about their leasingarrangement with Rock Corporation.







(a) Annual rental income ($480,000 X 8/12) $320,000Less maintenance and other operating costs (61,000)

Depreciation ($1,750,000 ÷ 8 X 8/12) (145,833)Income before income tax $113,167

Note that any interest expense incurred by Pomeroy would alsobe fully deductible for income tax purposes.

(b) Rent expense $320,000

Note: Both the rent security deposit and the last month’s rentprepayment should be reported as a non-current asset on

St. Isidor’s books and as a non-current liability onPomeroy’s books.

(c) Under ASPE:

The disclosure requirements for operating leases from thepoint of view of the lessee are few and include:

1. The future minimum lease payments, in total and foreach of the next f ive years.

2. A descript ion of the nature of other commitments suchas this lease.

For the lessor, the disclosure recommended includes:

1. A description of the cost of property held for leasingpurposes and the amount of the accumulateddepreciation.

2. The amount of rental income from operating leases.

3. Any impairment information.

(d) Under IFRS

For the lessee, additional disclosures are required aboutmaterial lease arrangements including contingent rents,sub-lease payments and lease-imposed restrictions.







(d) (Continued)

For IFRS for operating leases, the lessor reportsinformation about the future minimum lease payments duewithin one year, years two to five and after five years, aswell as about the entity’s leasing arrangements.

As well , the property interest under an operat ing lease maybe recognized as an investment property and accountedfor under the fair value model.







(a) Entries for Morrison Corp. are as follows:

1/7/14 Buildings ...................................... 5,500,000Cash ...................................... 5,500,000

Property Tax Expense ................... 57,000Insurance Expense ........................ 11,000

Cash ...................................... 68,000

12/31/14 Rent Receivable ............................. 162,500Rent Revenue ....................... 162,500($325,000 X 6 / 12 = $162,500)

Depreciation Expense ................... 68,750 Accumulated Depreciation

—Buildings ...................... 68,750[($5,500,000 ÷ 40) X 6 / 12 = $68,750]

(b) Entries for Wisen Inc. are as fol lows:

12/31/14 Rent Expense ................................ 162,500

Rent Payable ......................... 162,500

(c) The real estate broker’s fee should be amort ized equallyover the 10-year period. As a result , real estate fee expenseof $1,500 ($30,000 ÷ 10 X 6 ÷ 12) should be reported as anexpense in 2014 and $3,000 per year for each of the nextnine years until the last year of the lease when the expensewill be $1,500.

(d) None of the accounting treatment above would change ifMorrison were to use ASPE.







(a) (1) Calculation of gross investment:$24,736 X 6 = $148,416

(2) Calculation of unearned interest income:Gross investment $148,416Less: Fair value of machine 123,500*

Unearned interest income $ 24,916

*$24,736 X 4.99271 (PV factor of annuity due at 8% for 6 periods)



PV $ ? Yields $123,499.68

I 8%

N 6

PMT $ 24,736

FV $ 0

Type 1

(3) Net investment in lease:

Lease receivable $148,416Less: Unearned interest income 24,916$123,500







(b)

1/1/14 Lease Receivable ................................ 148,416

Cost of Goods Sold ............................. 99,000Sales Revenue ............................ 123,500Inventory ..................................... 99,000Unearned Interest Income ......... 24,916

1/1/14 Cash .................................................... 24,736Lease Receivable ...................... 24,736

12/31/14 Unearned Interest Income .................. 7,901

Interest Income ......................... 7,901[($123,500 – $24,736) X .08]







(a)Densmore Corporation

Rent ExpenseFor the Year Ended December 31, 2014

Monthly rental $26,500Lease period in 2014 (March–December) X 10 months

$265,000(b)

Sigouin Inc.Income or Loss from Lease before Tax

For the Year Ended December 31, 2014

Rent revenue ($26,500 X 10 months) $265,000Less expenses

Depreciation $133,333** Commission 7,500** 140,833

Income from lease before taxes $124,167

**$1,600,000 cost ÷ 10 years = $160,000/year$160,000 X 10/12 = $133,333

**(Note to instructor: Under princ iples of accrualaccounting, the commission should be amortized over thelife of the lease: $36,000 ÷ 4 years = $9,000 X 10/12 =$7,500.)

(c) The amounts reported in (a) and (b) above would notchange if IFRS had been used by either company.






*EXERCISE 20-22 (20-30 minutes)

Hein Corporation (Lessee)*

1/1/14 Cash .......................................... 720,000.00

Equipment (net) .................. 640,000.00Deferred Prof it on Sale-Leaseback ....................... 80,000.00

Equipment under Lease ........... 720,000.00Obligations under Lease .... 720,000.00

($117,176.68 X 6.14457**)**Present value of annuity of 1 for 10 periods at 10%


PV $ ? Yields $720,000

I 10%

N 10

PMT $ (117,176.68)

FV $ 0

Type 0

Throughout 2014Operating Expenses ................. 11,000.00 Accounts Payable (or Cash) 11,000.00

12/31/14 Deferred Profit on Sale-Leaseback 8,000.00Depreciation Expense*** .... 8,000.00

($80,000 ÷ 10)

**Lease should be treated as a capital lease because presentvalue of minimum lease payments equals the fair value of the

computer. The lease term is greater than 75% of the economicli fe of the asset, and ti tle transfers at the end of the lease.***The credit could also be to a gain account.






*EXERCISE 20-22 (Continued)

12/31/14 Depreciation Expense .............. 72,000.00 Accumulated Depreciation

- Leased Equipment ...... 72,000.00($720,000 ÷ 10)

Interest Expense ....................... 72,000.00Obligations under Lease* ........ 45,176.68

Cash ..................................... 117,176.68

Note to instructor:1. The present value of an ordinary annuity at 10% for 10

periods should be used to capitalize the asset. In this case,

Hein would use the implicit rate of the lessor because it islower than its own incremental borrowing rate and known toHein.

2. The deferred profit on the sale-leaseback should beamortized on the same basis that the asset is beingdepreciated.

Partial Lease Amortization Schedule

Date

AnnualLease

PaymentInterest(10%) Amortization Balance

1/1/1412/31/14 $117,176.68 $72,000.00 $45,176.68*

$720,000.00674,823.32

Liquidity Finance Corp. (Lessor)*

1/1/14 Equipment Acquired for Lessee 720.000.00Cash ................................... 720,000.00

Lease Receivable ....................... 1,171,766.80($117,176.68 X 10)

Unearned Interest Income…….. 451,766.80Equipment Acquired for Lessee 720,000.00







12/31/14 Cash ............................................ 117,176.68Lease Receivable .............. 117,176.68

Unearned Interest Income ......... 72,000.00Interest Income .................. 72,000.00

* Lease should be treated as a direct financing lease becausethe present value of the minimum lease payments equals thefair value of the equipment, and (1) collectability of thepayments is reasonably assured, (2) no importantuncertainties surround the costs yet to be incurred by the

lessor, and (3) the cost to the lessor equals the fair value ofthe asset at the inception of the lease.

(b) The primary reason for Hein to enter into a sale andleaseback arrangement for its equipment is to borrowcash. This transaction is similar to the purchase of newequipment using capital leases, except that in this case,Hein is using an asset it is already using and is familiarwith. Hein wishes to obtain some leverage by borrowing

funds for an amount that exceeds the carrying value of theasset at the time of the sale.

Since the carrying value of the equipment on the books ofHein at the time of the sale represents the depreciated costof the asset in use, this value is not intended to correspondto its fair value. Hein can continue with its intention to usethe asset to the completion of its planned useful life. Thesale and leaseback arrangement will not disturb this plan.Hein is taking advantage of the increase in value to obtain

additional financing at preferential rates. Creditors will notview this action as a desperate measure since the gain onthe sale is being deferred and amortized.







(a) Sale-leaseback arrangements are treated as though twotransactions were a single financing transaction if the lease

qualifies as a capital lease. Any gain or loss on the sale isconsidered unearned and is deferred and amortized over thelease term (if possession reverts to the lessor) or theeconomic life (if ownership transfers to the lessee). In thiscase, the lease qualifies as a capital lease because the leaseterm (10 years) is 83% of the remaining economic life of theleased property (12 years). Therefore, at 12/31/14, all of thegain of $120,000 ($520,000 – $400,000) would be deferredand amortized over 10 years. Since the sale took place on12/31/14, there is no depreciation for 2014.

(b) A sale-leaseback is usually treated as a single financingtransaction in which any profit on the sale is consideredunearned and is deferred and amortized by the seller.However, the lease does not meet any of the criteria of acapital lease for the property sold. In this case, the sale andthe leaseback are accounted for as separate transactions.Therefore, the full gain ($480,000 – $420,000, or $60,000) isrecognized.

(c) The profit on the sale of $121,000 should be deferred andamortized over the lease term. The lease qualifies as acapital lease. Since the leased asset is being depreciatedusing the straight-line depreciation method, the deferredgain should also be reported in the same manner. Therefore,in the first year, $12,100 ($121,000 ÷ 10) of the gain would berecognized.

(d) In this case, Barnes Corp. would report a loss of $87,300

($300,000 – $212,700) for the difference between the bookvalue and lower fair value. The CICA Handbook requires thatwhen the fair value of the asset is less than the book value(carrying amount), a loss must be recognized immediately.In addition, rent expense of $72,000 ($6,000 per month X 12months) should be reported.







(a)September 15, 2014

Prepaid Rent ....................................................... 30,000Cash ............................................................. 30,000

December 31, 2014Rent Expense ..................................................... 8,750

Prepaid Rent ............................................... 8,750($30,000 X 3.5 / 12) = $8,750

(b) The rental of land can only be accounted for as a capitallease by the lessee if the rental of the property contains a

bargain purchase option or if the lease transfers ownershipof the property to the lessee. Since this is not the case here,the lease of the land had to be treated as an operatinglease. In the case of equipment, the possibility ofaccounting for the lease as a capital lease is more likely todepend on the terms of the lease in relation to thecapitalization criteria.

(c)

September 15, 2014Cash .................................................................... 30,000Unearned Rent Revenue ............................ 30,000

December 31, 2014Unearned Rent Revenue .................................... 8,750

Rent Revenue .............................................. 8,750($30,000 X 3.5 / 12) = $8,750







(a)March 30, 2014

Land under Lease * .............................................. 43,358Buildings under Lease ......................................... 86,717

Obligations under Lease** ........................... 130,075* (1/3 X $130,075** = $43,358)

Obligations under Lease ...................................... 10,000Cash ............................................................... 10,000


**Using a financial calculator:

PV $ ? Yields $ 130,075

I 7%

N 15

PMT $ (10,000)

FV $ (90,000)

Type 1

Note: the $90,000 payment at the end of the lease is assumed tobe a bargain purchase option. At the end of the lease term, thefair value of the land (2 X $50,000) and the building ($100,000 X40%) combined is expected to be $140,000.

(b)December 31, 2014:Interest Expense ................................................ 6,304

Interest Payable .......................................... 6,304[($130,075 – $10,000) X 7% X 9/12 = $6,304]

Depreciation Expense ........................................ 2,877 Accumulated Depreciation

– Leased Bui ldings ………… ............. 2,877(($86,717-$10,000) / 20 year X 9/12 = $2,877)







March 31, 2015Interest Expense * .............................................. 2,101Interest Payable .................................................. 6,304Obligations under Lease ..................................... 1,595

Cash ............................................................. 10,000* [($130,075 – $10,000) X 7% X 3/12]

December 31, 2015:Interest Expense ................................................ 6,220

Interest Payable .......................................... 6,220[($130,075 – $10,000 - $1,595) X 7% X 9/12 = $6,220]

Depreciat ion Expense ........................................ 3,836 Accumulated Depreciation

Leased Buildings ................................... 3,836(($86,717-$10,000) / 20 year = $$3,836)






TIME AND PURPOSE OF PROBLEMS

Problem 20-1 (Time 45-50 minutes)

Purpose—to provide an opportunity for the student to contrast two alternativemeans by which a business can acquire software for its business by usingleasing. Along with preparing all the necessary calculations, and journal entries,the student must also contrast the financial statement effect of the two differentleasing alternatives. Finally the qualitative considerations and the short and long-term implications of each option must be outlined by the student.


Purpose—to provide an opportunity for the student to contrast two alternativemeans by which a business can acquire equipment and software for its businessby using leasing. Along with preparing all the necessary calculations, the student

must also contrast the financial statement effect of the two different leasingalternatives for the first year and for the overall term of lease plus a renewalperiod under one option. Finally the qualitative considerations and the short andlong-term implications of each option must be outlined by the student,emphasizing the effects on cash flow.


Purpose—to provide the student with a lease situation involving monthlypayments made for a truck. The lease has a residual value guaranteed by thelessee. Along with preparing all the necessary calculations, and journal entries,

the student must also prepare the statement of financial position, the income andcash flow statements on a comparative basis as well as any required notedisclosures. The must also prepare the journal entry at the completion of theterm of the lease involving the disposal of the truck and the lessee’s involvementconcerning the guaranteed residual value.


Purpose—to provide the student with a lease situation described in Problem 20-2but from the perspective of the lessor. The requirement for comparative financialstatement disclosure is included in the problem.


Purpose—to provide an opportunity for the student to contrast the entries andcorresponding financial statements of the lessor and lessee when the conditionscall for the accounting of the lease as a capital lease to the lessee but as anoperating lease to the lessor. The odd result is that the asset is reported on bothstatements of financial position.






TIME AND PURPOSE OF PROBLEMS (CONTINUED)


Purpose—to develop an understanding of the accounting treatment for operatingleases. The student is required to identify the type of lease involved, explain therespective reasons for their classification, and discuss the accounting treatmentthat should be applied for both the lessee and lessor. The student is also askedto record executory costs paid by the lessor and prepare the journal entries toreflect the first year of this lease contract for both the lessee and lessor and todiscuss the disclosures required of the lessee and lessor. Included in thisproblem is a requirement to compare the factors and criteria for classificationdifferences between IFRS and ASPE.


Purpose—to provide the student with a lease situation containing a bargainpurchase option and both an implicit rate and a stated interest rate betweenwhich the student must choose. The student must first discuss the conditions ofthe case that support the argument to capitalize the lease and list specificevidence to demonstrate that the transfer of risks and rewards of ownership hastaken place. The student must then calculate the appropriate amount at which tocapitalize the lease and, in a last requirement, given different interest rates,prepare the statement of financial position and income statement presentation ofthis lease by the lessee.


Purpose—to provide an understanding of how lease information is reported onthe statement of financial position and income statement for two different years inregard to the lessee. In addition, the year-end month is changed in order to helpprovide an understanding of the complications involved with partial periods.Included in this problem is a requirement to compare the factors and criteria forclassification differences between IFRS and ASPE.


Purpose—to provide an understanding of how lease information is reported on

the statement of financial position and income statement for two different years inregard to the lessor. In addition, the year-end month is changed in order to helpprovide an understanding of the complications involved with partial periods.Included in this problem is a requirement to compare the factors and criteria forclassification differences between IFRS and ASPE.








Purpose—to develop an understanding of the accounting for capital leaseswhere the lease payments for the first half of the lease term differ from those forthe latter half. The student is required to calculate for the lessee the discountedpresent value of the leased property and the related obligation at the lease’sinception date. The student is also asked to prepare journal entries for thelessee.


Purpose—to develop an understanding of the accounting procedures involved ina sales-type leasing arrangement. The student is required to discuss the natureof this lease transaction from the viewpoint of both the lessee and lessor. Thestudent is also requested to prepare the journal entries to record the lease forboth the lessee and lessor plus illustrate the items and amounts that would bereported on the statement of financial position and statement of cash flows at theend of the first year for the lessee and the lessor.


Purpose—to develop an understanding of the accounting for a capital lease bythe lessee in an annuity due arrangement. The student is required to prepare thelease amortization schedule for the entire term of the lease and all the necessary

journal entries for the lease through the first two lease payments. The student is

also asked to indicate the amounts that would be reported on the lessee’sstatement of financial position and statement of cash flows. Finally the studentmust contrast the financial statement reporting with that obtained for a new set ofconditions leading to the treatment of the lease as an operating lease.


Purpose—to develop an understanding of the accounting treatment accorded asales-type lease involving an unguaranteed and guaranteed residual value. Thestudent is required to discuss the nature of the lease with regard to the lessorand to calculate the amount of the gross investment, the unearned interestincome, the sale price, and the cost of goods sols. The student is also required to

construct a 10-year lease amortization schedule for the leasing arrangement, andto prepare the lessor’s journal entries for the first year of the lease contract.Finally disclosure of the net investment must be prepared.








Purpose—to develop an understanding of a capital lease with an unguaranteed

and guaranteed residual value, with and without a bargain purchase option. Thestudent explains why it is a capital lease and calculates the amount of the initialobligation. The student prepares a 10-year amortization schedule and all of thelessee’s journal entries for the first year under each of the different assumptions.Included in this problem is a requirement to compare the factors and criteria forclassification differences between IFRS and ASPE.


Purpose—to develop an understanding of a sales-type lease with a guaranteedand unguaranteed residual value. The student discusses the classification of the

lease and calculates the gross investment, unearned interest income, salesprice, and cost of sales. The student prepares a 10-year amortization scheduleand all of the lessor’s journal entries for the first year. The problem then goes onto require the student to calculate the amount of depreciation to be recorded bythe lessee under conditions where the residual value is and is not guaranteed bythe lessee. The financial statement disclosure requirements to the lessor mustalso be outlined based on these two conditions. Included in this problem is arequirement to compare the factors and criteria for classification differencesbetween IFRS and ASPE.


Purpose—to develop an understanding of how residual values and direct costs inprocessing the lease affect the accounting for the lessee and the lessor. Thestudent must understand both the accounting for a guaranteed andunguaranteed residual value and determine how large the residual value must beto have operating lease treatment. Included in this problem is a requirement tocompare the factors and criteria for classification differences between IFRS and

ASPE.


Purpose—to provide the student with the opportunity to contrast the financialimplications of two alternative leases offered to a business with liquidityproblems. The student must perform the necessary analysis to conclude as tohow the leases would be accounted for and provide a basis for therecommendation in a formal report. The student will need to eliminate someunnecessary minor factors (such as small differences in lease term dates) inorder to quickly zero in on the essential issues surrounding the choices offered.








Purpose—to provide the student with the opportunity to contrast the financialimplications and reporting when a lease is treated as an operating lease by thelessee and a capital lease by the lessor, on account of the involvement of a thirdparty when a guaranteed residual value exists. The student must prepare theentries and the financial statement disclosure of both parties in the leaseagreement. This problem highlights the unsolved issue of the equipment notbeing reported on either statement of financial position.


Purpose—to provide the student with the opportunity to prepare the accounting

for lease using the contract-based approach. Included in the instructions is arevision of estimate concerning the guaranteed residual value of the leasedasset. Journal entries, adjusting journal entries and a revised amortizationschedule must also be prepared by the student.


Purpose—to provide the student with the opportunity to contrast three differentoptions to obtain a luxury vehicle, including: finance a purchase, lease and renewa lease and lease and exercise the option to purchase. A fourth option must beprepared suing the contract-based approach. Several calculations, amortization

tables and journal entries are also required in this problem. Finally, a summaryfor the first year’s statement of financial position and income statement for alloptions as well as a summary of all expenses for the 5 years use of the vehiclemust be summarized. Additional considerations in making choices must also beprovided by the student.


Purpose—to provide the student with the lessor’s accounting of one of theoptions discussed in P20-20.

Problem 20-22*(Time 40-45 minutes) Purpose—to develop an understanding of how to handle a sale and leasebacktransaction, including the preparation of the lessee’s journal entries. A second setof assumptions is used to arrive at a different conclusion, which is to account forthe lease as an operating lease.







Problem 20-23*(Time 40-45 minutes)

Purpose—to provide an opportunity for the student to account for a sale andleaseback transaction where land and buildings are involved. The student mustapply the capitalization criteria to the building but leave the land as an operatinglease. The lease payments must therefore be disaggregated. This problem alsoinvolves the financial statement disclosure required at the end of the first year ofthe lease.






SOLUTIONS TO PROBLEMS

PROBLEM 20-1

(a) Option No. 1 - Precision Inc.

Calculation of present value of minimum lease payments: The$5,000 option to buy the software at the end of the lease of fiveyears is not considered a bargain purchase option in view of the$200 price offered by Graphic Design Inc. in Option No. 2.

The lease payments are in the amount of $3,500 as the $1,000annual l icensing fee is an executory cost.

$3,500 X 3.79079* = $13,268*Present value of an ordinary annuity of 1 for 5 periods at 10%.



PV $ ? Yields $13,268

I 10%

N 5

PMT $ (3,500)

FV $ 0

Type 0

Total lease payments: At incept ion of lease – January 1, 2014 $12,000Present value of minimum lease payments 13,268Total $25,268

This is an operating lease to Interior Design Inc. since the lease

term (5 years) is less than 75% of the economic life (8 years) ofthe leased asset. The lease term is 62.5% (5 ÷ 8) of the asset’seconomic life. There is no bargain purchase option and thepresent value of minimum lease payments of $25,268 represent84% of the fair value at January 1, 2014 of $30,000 falling shortof the criteria of 90% to treat the lease as a capital lease under

ASPE.






PROBLEM 20-1 (Continued)

(a) Option No. 2 – Graphic Design Inc.

Calculation of present value of minimum lease payments:

The minimum lease payments in the case include the bargainpurchase option of $200. The present value therefore is:

PV of monthly payment * .......................................... $27,104PV of bargain purchase opt ion of $200 ** ................ 124Present value of minimum lease payments ............ $27,228

* Present value of an annuit y due of 1 for 5 periods at 10%.$6,500 X 4.16986 = $27,104

** Present value of a single payment of 1 for 5 periods at 10%

$200 X .62092 = $124



PV $ ? Yields $27,228

I 10%

N 5

PMT $ (6,500)

FV $ (200)Type 1

To Interior Design Inc., this lease is a capital lease because theterms satisfy the following criteria:

1. Although as in Option No. 1, the lease term is not greaterthan 75% of the economic li fe of the leased asset; that is, thelease term is 62.5% (5/8) of the economic life, there is a

bargain purchase option.

2. The present value of the minimum lease payments is greaterthan 90% of the fair value of the leased asset; that is, thepresent value of $27,228 is 91% of the fair value of theleased asset of $30,000: ($27,228 / $30,000 = 90.76%)







(b)January 1, 2015

Prepaid Rent ............................................... 12,000Cash ................................................... 12,000

The first payment wi ll be amortized straight-line over theterm of the lease.

December 31, 2015Rent Expense (Software) ........................... 3,500Operating Expenses ................................... 1,000

Cash ................................................... 4,500

December 31, 2015Rent Expense (Software) ........................... 2,400

Prepaid Rent ........................................ 2,400($12,000 / 5 = $2,400)

(c)Interior Design Inc.

Lease Amortization Schedule with Graphic Design Inc.

Date

AnnualLease

Payment

Interest

(10%)on UnpaidObligation

Reductionof Lease

Obligation

Balanceof Lease

Obligation

1/1/151/1/151/1/161/1/171/1/181/1/19

1/1/19

$6,5006,5006,5006,5006,500

200$32,700

*$2,073* 1,630* 1,143

605607

18*$5,471

$6,5004,4274,8705,3575,893

182$27,229

$27,22820,72816,30111,431

6,074181

0







(d)January 1, 2015

Software under Lease ................................. 27,228Obligations under Lease .................... 27,228

January 1, 2015

Obligations under Lease ............................. 6,500Cash ..................................................... 6,500

December 31, 2015

Interest Expense .................................... 2,073

Interest Payable .................... 2,073

December 31, 2015

Depreciat ion Expense ................................. 3,404 Accumulated Depreciation—

Software under Lease ................... 3,404($27,228 ÷ 8 years = $3,404)

Use 8 years, as opt ion to purchase will be exercised asit is a bargain pr ice.

January 1, 2016

Interest Payable ..................................... 2,073Obligations under Lease ....................... 4,427

Cash ..................................... 6,500







(f) Among Interior’s paramount concerns will be ensuring thatit continues to meet its debt to equity covenant. Since allfinancing is done with the bank, Interior Design Inc. may beperceived to be of high risk by the bank. Entering into thePrecision Inc. lease (Option No. 1) would provide off balancesheet financing, keeping the obligations under capital leasesoff the balance sheet. Equity would be reduced by the leasepayments expensed each period.

In contrast the Graphic Design Inc. (Option No. 2) leasewould increase Interior’s liabilities by the present value ofthe minimum lease payments. Interest expense each period

and depreciation of the leased asset will decrease netincome and therefore equity each period.

To maintain their debt to equity covenant, Interior wouldprobably choose to enter into the Precision lease (operatinglease Option No. 1) to minimize debt on their statement offinancial position.

(g) In the long term, Option No. 2 presents the better option.The software will be owned and used by Interior over theeight-year useful life of the asset, instead of the five-yearterm of lease under the operating lease, Option No. 1. Theother immediate disadvantage to the operating lease optionNo. 1 is the large immediate (January 1, 2014) cash outflowrequired by the prepayment clause under the operatinglease of $12,000. This payment could create an importantliquidity problem over the term of the lease, especially in thefirst year.







(g) (Continued)

The conclusion to be drawn from this study is that choicesare often made by businesses for reasons outside whatmakes economic sense overall. The FASB and IASBmovement towards removing the distinction betweenoperating and capital leases will eliminate this problem aschoices between leases will not be made based on theobjective to reduce or eliminate the presence of liabilities onthe statement of financial posi tion.

Note to instructor:

The two alternatives are not, strictly speaking, comparable in acapital budgeting sense as the dif ference in the purchase optionleaves option 1 with a 5 year life and option 2 with an 8 year life.The present value of the purchase option in Option 1 (although anon-GAAP treatment) is needed to make the two optionscomparable (PV is $3,100). Option 2 is therefore superior in apresent value sense. It is important to mention that comparingthe accounting treatment without considering the impact oncash flows is inadequate when evaluating management’sdecisions.






PROBLEM 20-2

Memorandum Prepared by: (Your Initials)

TO: President of SWTDate:

I have summarized the information regarding the two leases forthe customer service telecommunications and computerequipment that you left with me.

Both leases are considered capital leases under generallyacceptable accounting principles, and I have indicated why thisis in the following chart, followed by my detailed calculations.

Capital lease arrangements are considered to be purchases froman accounting standpoint, and accordingly, the costs that willaffect the income statement each year include: interest expense,depreciation expense and any annual operating costs.

The following table shows that Lease Two has less of an impacton income than Lease One in the 2014 year, and on average overthe number of years we wil l be using the leased equipment. Asboth leases provide the SWT with similar equipment that meets

our requirement, it is my recommendation that we sign LeaseTwo. From a cash flow standpoint, the lease payments of LeaseOne are made in advance every year, whi le Lease Two paymentsare made at the end of the year which gives us more liquidity.Please keep in mind that with Lease One, the equipment wi ll notbelong to us at the end of the lease term of five years, it willrevert to the lessor, and we are required to guarantee the valueat that time of $85,000. If we are interested in keeping theequipment, we can decide at the end of the lease term if we wishto purchase the equipment for $85,000; if we do not acquire it,

we may be required to make up any deficiency in its fair valueand this introduces considerable uncertainty. With Lease Two,we will acquire the equipment over the seven year term of thelease and cash flows are clearly defined. Accordingly, I amrecommending Lease Two.







Lease One Lease TwoInterest rate used in

calculations

10% -

implicitrateunknown

8% - lower of

impl icit rate andincrementalborrowing rate

Number of years ofuse by SWT

5 years 7 years

Present value ofminimum leasepayments

$487,697 (1) $444,404 (2)

Type of Lease Capital (3) Capital (4)

Total cash outflowfrom minimum leasepayments

$606,500 (5) $557,000 (6)

Average per year $121,300 $79,571

Income statement effect first yearInterest expense $38,339 (7) $35,552 (8)Depreciation expense $80,539 (9) $63,486 (10)

Operating expenses $23,500 $26,500Total expenses $142,378 $125,538

Total income statement effect over life of lease and renewalInterest expense $118,805 (11) $112,596 (12)Depreciation expense $402,694 (13) $444,404 (14)Operating expenses $117,500 (15) $185,500 (16)Total expenses $638,999 $742,500

Average per year $127,800 $106,071

Refer to Appendix A for details of calculations referenced to theabove.







Appendix A:

(1) $104,300 Annual rental payment

X 4.16986 PV of an annuity due 5 years at 10% (Table A-5)$434,916.40 PV of minimum lease payments

$85,000 Guaranteed residual value (or purchase price)X .62092 PV of 1 in 5 years at 10% (Table A-2)

$52,778.20 Present value of guaranteed residual value$487,694.60 Total present value of minimum lease

payments



PV $ ? Yields $487,695.28

I 10%

N 5

PMT $ (104,300)

FV $ (85,000)

Type 1

(2) $111,000 Annual rental payments ($137,500 – $26,500)X 3.99271 PV, ordinary annuity 5 years at 8% (Table A-4)

$443,190.81 PV of minimum lease payments$1,000 Annual rental renewal period ($27,500 –

$26,500)X 1.78326 PV, ordinary annuity 2 years at 8% (Table A-4)

1,783.26X .68058 PV of 1 in 5 years at 8% (Table A-2)

$1,213.65 PV of lease renewal payments$444,404.46 Total present value of minimum leasepayments








Using a financial calculator:PV $ ? Yields $443,190.81

I 8%

N 5

PMT $ 111,000*

FV $ 0

Type 0*($137,500 – $26,500)


I 8%

N 2

PMT $ 1,000*

FV $ 0

Type 0* ($27,500 − $26,500)


PV $ ? Yields $1,213.66

I 8%

N 5

PMT $ 0

FV $ 1,783.26

Type 0

(3) The lease term is greater than 75% of the economic life ofthe leased asset; that is, the lease term is 83% (5/6) of theeconomic l ife.The present value of the minimum lease payments equal thefair value of the equipment—see calculation







(4) The present value of the minimum lease payments is equalto the fair value of the equipment.

(5) $104,300 x 5 + $85,000 = $606,500

(6) [($137,500 – $26,500)*5] + [($27,500 – $26,500) x 2)] =$557,000

(7) ($487,694 – 104,300) x 10% = $38,339

(8) $444,404 x 8% = $35,552

(9) ($487,694 – $85,000) ÷ 5 years = $80,539

(10) $444,404 ÷ 7 = $63,486

(11) Cash outflows from lease (item 5) less PV min. leasepayments (item 1)($606,500 – $487,695 = $118,805)

(12) Cash outflows from lease (item 6) less PV min. leasepayments (item 2)($557,000 – $444,404 = $112,596)

(13) $487,694 – $85,000 = $402,694 or i tem 9 X 5

(14) Capitalized amount of the lease or Item 10 X 7 = $444,404

(15) $23,500 X 5 = $117,500

(16) $26,500 X 7 = 185,500






PROBLEM 20-3

(a) This is a finance lease to Hunter Ltd. The IFRS cri teria use

qualitative factors to establish whether or not the risks andrewards of ownership are transferred to the lessee, andsupports classification as a finance lease:1. There is reasonable assurance that the lessee will


2. The lease term is long enough that the lessee will

receive substantially all of the economic benefits thatare expected to be derived from using the leasedproperty over its life.


4. The leased assets are so specialized that, without majormodification and/or significant cost to the lessor, they

are of use only to the lessee.

Other indicators include situations where the lesseeabsorbs the lessor’s losses i f the lessee cancels the lease,or the lessee assumes the risk associated with the amountof the residual value of the asset at the end of the lease, orwhere there is a bargain renewal option—when the lesseecan renew the lease for an additional term at significantlyless than the market rent.

The standard also states that these indicators are notalways conclusive. The decision has to be made on thesubstance of each specific transaction. If the lesseedetermines that the risks and benefits of ownership havenot been transferred to it, the lease is classified as anoperating lease.







For Situ Ltd. the lessor, under IFRS, the lease would receivethe same treatment as under ASPE except the criteria neednot include the two revenue recognition-based testsconcerning collectability and estimating unreimbursablecosts. Situ is not a manufacturer or dealer and so this isfinance lease.

(b) Calculation of annual rental payment:(Hint when using a financial calculator: ensure that thecompounding is done monthly, P/Y = 1)



PV $ 20,691

I 1%

N 36

PMT $ ? Yields ($600)

FV $ (3,500)

Type 1

This confirms that the interest rate used to calculate the leasepayment was 12% or 1% per month. Alternatively, the RATEfunction could have been used directly. (The lease paymentsinclude the executory costs of $20 per month and are thereforein the amount of $620.)







(c)


Date

MonthlyLease

PaymentPlus GRV


Reductionof Lease

Obligation

BalanceLease

Obligation

$20,691

Jan. 1 2014 $ 600 $600 20,091

Feb. 1 2014 600 $ 201 399 19,692

Mar. 1 2014 600 197 403 19,289

Apr. 1 2014 600 193 407 18,882May 1 2014 600 189 411 18,471

June 1 2014 600 185 415 18,055

July 1 2014 600 181 419 17,636

Aug. 1 2014 600 176 424 17,212

Sep. 1 2014 600 172 428 16,784

Oct. 1 2014 600 168 432 16,352

Nov. 1 2014 600 164 436 15,916

Dec. 1 2014 600 159 441 15,475Jan. 1 2015 600 155 445 15,030

Feb. 1 2015 600 150 450 14,580

Mar. 1 2015 600 146 454 14,126

Apr. 1 2015 600 141 459 13,667

May 1 2015 600 137 463 13,204

Jun. 1 2015 600 132 468 12,736

July 1 2015 600 127 473 12,263

Aug. 1 2015 600 123 477 11,786Sep. 1 2015 600 118 482 11,303

Oct. 1 2015 600 113 487 10,816

Nov. 1 2015 600 108 492 10,325

Dec. 1 2015 600 103 497 9,828








Date

MonthlyLease

PaymentPlus GRV


Reductionof Lease

Obligation

BalanceLease

Obligation

Jan. 1 2016 $600 $98 $502 $9,326

Feb. 1 2016 600 93 507 8,819

Mar. 1 2016 600 88 512 8,308

Apr. 1 2016 600 83 517 7,791

May 1 2016 600 78 522 7,269Jun. 1 2016 600 73 527 6,741

July 1 2016 600 67 533 6,209

Aug. 1 2016 600 62 538 5,671

Sep. 1 2016 600 57 543 5,127

Oct . 1 2016 600 51 549 4,579

Nov. 1 2016 600 46 554 4,025

Dec. 1 2016 600 40 560 3,465

Dec. 31 2016 3,500 36* 3,464 0

$25,100 $4,409 $ 20,691* Rounding $1

(d)January 1, 2014

Vehicles under Lease ..................................... 20,691Obligations under Lease ........................ 20,691

(To record the lease of equipmentusing finance lease method)

Obligations under Lease ................................ 600Insurance Expense ......................................... 20

Cash ......................................................... 620(To record the fi rst rental payment)







(d) (Continued)

December 31, 2014Interest Expense ............................................ 155

Interest Payable ...................................... 155(To record accrual of Dec/2014 interest on

obligation under finance lease)

Depreciation Expense .................................... 5,730 Accumulated Depreciation—Vehicles ... 5,730under Lease (To record depreciation expense for

first year [$20,691 - $3,500] ÷ 3)

January 1, 2015Obligations under Lease ................................ 445Interest Payable .............................................. 155Insurance Expense ......................................... 20

Cash ......................................................... 620

(e)Hunter Ltd.

Statement of Financial PositionDecember 31,

2015 2014Non-current assetsProperty plant and equipment

Vehicles under lease $20,691 $20,691Less accumulated depreciation 11,460 5,730

9,231 14,961Current liabili ties

Interest payable 98 155Obligations under lease* 9,828 5,704Non-current liabilities

Obligations under lease (Note X) 15,475Current portion (5,704)







(e) (Continued)

(Note X)The following is a schedule of future minimum payments underfinance lease expiring December 31, 2016, together with thepresent balance of the obligation under the lease.

2015 2014 Amounts due in 2015 $7,440 Amounts due in 2016 $10,940 10,940

10,940 18,380 Amount representing executory costs (240) (480)

Amount representing interest (774) (2,270)Balance of obl igation $9,926 $15,630

From lease amortization schedule:Balance at December 31 $9,828 $15,475

Add accrued interest 98 155Balance $9,926 $15,630

Hunter Ltd.Income Statement

For the Year Ended December 31,

2015 2014

Administrative expenseDepreciation expense $5,730 $5,730Insurance expense 240 240

Other expensesInterest expense* 1,497 2,139

* from lease amortization schedule part (c)







(f)December 21, 2016

Interest Expense ............................................ 36Obligations under Lease ................................ 3,465*

Accumulated Depreciation—Vehicles

under Lease ......................................................... 17,190

Loss on Lease ................................................ 300

Vehicles under Lease ............................. 20,691Cash ......................................................... 300

* rounding $1

(g)

Hunter Ltd.Statement of Cash Flows


2015 2014

Indirect Format:Cash flows from operating activi ties

Depreciation expense $5,730 $5,730Increase (decrease) in interest payable (57)* 155

Financing Activities:Lease payment ** (5,646) (5,216)

* ($155 – $98)** from lease amortization schedule part (c)

In the notes to the financial statements:Non-cash Investing and Financing Activi ties:Purchase of vehicle under lease $20,691

Direct Format:Cash flows from operating activities

Cash paid for interest ($1,554) ($1,984)Cash paid for insurance (240) (240)






PROBLEM 20-4

(a)January 1, 2014

Lease Receivable .......................................... 25,100Equipment Acquired for Lessee ........... 20,691Unearned Interest Income ..................... 4,409

Cash .............................................................. 620Insurance Expense ................................ 20Lease Receivable ................................... 600

December 31, 2014

Unearned Interest Income ............................ 1,984Interest Income ...................................... 1,984

Interest Receivable ......................................... 155Interest Income ....................................... 155

(b)Situ Ltd.

Income Statement


2015 2014

RevenueInterest Income (leases)* $1,497 $2,139

Other expenses(Recovery) of insurance expense (240) (240)

* from lease amortization schedule part (c) of P20-3







(b) (Continued)

Situ Ltd.Statement of Financial Position

December 31,

2015 2014Current assets

Interest receivable $ 98 $ 155Net investment in vehicle leases 9,828 5,647

Non-current assetsNet investment in vehicle leases 9,828

Balance $9,926 $15,630

Net investment in lease : 2015 2014Beginning balance ......................................... $15,475 $20,691Less recovery in year (see table P20-3) ........ (5,647) (5,216)Ending balance ............................................... $9,828 15,475Recoverable within 12 months ...................... (5,647)Non-current portion of net investment ......... $9,828

Reconci liation of balance:From lease amortization schedule P20-3:

Balance at December 31 $9,828 $15,475 Add accrued interest 98 155Balance $9,926 $15,630







(c)Situ Ltd.

Statement of Cash Flows


2015 2014

Indirect Format:Cash flows from operating activi ties

(Increase) decrease in interest receivable $57 ($155)

Investing Activities:Collected on investment in lease* 5,646 5,216

Increase in investment in lease (net) (20,691)Direct Format:

Cash flows from operating activitiesCash collected for interest** $1,554 $1,984Cash col lected for insurance expense 240 240

* Amounts are the same as Cash paid on lease – financingactiv ity of Hunter Ltd. P20-3 part (g)

** Amounts are the same as Cash paid for interest – operating

activ ity of Hunter Ltd. P20-3 part (g)






PROBLEM 20-5

(a) This is a capital lease to Labonté since the lease term is

greater than 75% of the economic life of the leased asset.The lease term is 78% (7 ÷ 9) of the asset’s economic li fe.

For LePage, the collectibility of the lease payments is notreasonably predictable, and there are importantuncertainties surrounding the costs yet to be incurred.

Accordingly, the earnings process is not consideredcomplete and, in spite of the fact that the fair value($560,000) of the equipment exceeds the lessor’s cost

($420,000), the lease cannot be recorded as a sales-typelease by LePage and must be recorded as an operatinglease.

(b) Calculation of annual rental payment:

To calculate the amount of the payments using Tables:

**4.78448

.37594*)X($80,000 –$560,000 = $110,759

**Present value of $1 at 15% for 7 periods.**Present value of an annuity due at 15% for 7 periods.



PV $ (560,000.00)

I 15%

N 7

PMT $ ? Yields $110,759

FV $ 80,000

Type 1







(c)7/15/14 Equipment under Lease ................ 560,000

Obligations under Lease ........ 560,000

Obligations under Lease ............... 110,759Cash ........................................ 110,759

12/31/14 Depreciation Expense ................... 31,429 Accumulated Depreciation

-Leased Equipment ............ 31,429

($560,000 - $80,000) ÷ 7 X 5.5/12

Interest Expense ............................ 30,885Interest Payable ...................... 30,885

($560,000 – $110,759) X .15 X 5.5/12

7/15/15 Obligations under Lease ............... 43,373Interest Expense* .......................... 36,501Interest Payable ............................. 30,885

Cash ........................................ 110,759*($560,000 – $110,759) X .15 X 6.5/12


-Leased Equipment ............ 68,571($560,000 - $80,000) ÷ 7

Interest Expense ............................ 27,903Interest Payable ...................... 27,903

[($560,000 – $110,759 – $43,373) X .15 X 5.5/12]






PROBLEM 20-5 (Continued)(e)7/15/14 Rental Equipment ......................... 420,000

Inventory ................................. 420,000

Cash ............................................... 110,759Unearned Rent Revenue ........ 110,759

Legal Expense* .............................. 4,000Cash ........................................ 4,000

12/31/14 Unearned Rent Revenue ............... 50,765Rent Revenue ......................... 50,765($110,759 X 5.5/12)

Depreciation Expense ................... 22,262 Accumulated Depreciation

-Rental Equipment ............. 22,262($420,000 - $80,000) ÷ 7 X 5.5/12

7/15/15 Unearned Rent Revenue ............... 59,994Rent Revenue ......................... 59,994($110,759 X 6.5/12)

Cash ............................................... 110,759Unearned Rent Revenue ........ 110,759


-Rental Equipment ............. 48,571($420,000 - $80,000) ÷ 7

12/31/15 Unearned Rent Revenue ............... 50,765Rent Revenue ......................... 50,765

($110,759 X 5.5/12)

* If the amounts are signi ficant, these costs might be capitalizedand amortized to expense to achieve better matching withrevenues.







(d) (f)

Labonté LePage

Capital OperatingLease Lease

Statement of financial position:


Equipment under lease $560,000

Rental equipment $ 420,000

Less: Accumulated depreciation (31,429) (22,262)

528,571 397,738

Current Liabili ties:Interest payable 30,885Current portion of obligations underlease 43,373Unearned rent revenue 59,994

Long term liabilities:


Less: Current portion (43,373)

405,868

Statement of income:

Rent revenue $ 50,765

Depreciation expense $ 31,429 22,262


Legal expense 4,000







(g) Although it might seem odd that the same asset is reportedon two different statements of financial position, the

collection risks under which the lessor, LePage, isoperating do not justify the recognition of income under asales type lease. There are too many uncertaintiessurrounding the related costs and collections under theterms of its lease with Labonté. Should Labonté default onthe lease, LePage might have to rent the used equipment toanother lessee. It is not unreasonable, also, to consider thatthe “ guarantee” of the residual value by the lease, Labonté,should not be considered in the calculations (e.g. fordepreciation) as that company’s financial situation may

make them unable to “ make good” on the guarantee.






PROBLEM 20-6

(a)

Under IFRS, meeting any one or a combination of the followingcriteria normally indicates that the risks and rewards ofownership are transferred to the lessee, and supportsclassification as a finance lease:

1. There is reasonable assurance that the lessee wil l obtainownership of the leased property by the end of the leaseterm. If there is a bargain purchase option in the lease, it isassumed that the lessee will exercise it and obtainownership of the asset.

2. The lease term is long enough that the lessee wil l receivesubstantially all of the economic benefits that areexpected to be derived from using the leased propertyover its l ife.

3. The lease allows the lessor to recover substantially all ofits investment in the leased property and to earn a returnon the investment. Evidence of this is provided if thepresent value of the minimum lease payments is close tothe 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 areof use only to the lessee.None of these condi tions have been met and so the lease is anoperating lease to both Synergetics and Gumowski.

(b)Under ASPE, the lease is an operating lease to the lessee andlessor 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 estimatedeconomic life of the crane, and

3. the present value of the lease payments is not at least90% of the fair value of the leased crane.







(b) (Cont inued)

$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 cr iter ia would have had to besatisfied for the lease to be classified as other than anoperating lease. The property is recorded as a rentalproperty to the lessor and will be treated as a payment ofrent by the lessee under the operating lease.

(c) Lessee’s EntriesFebruary 1, 2014

Prepaid Rent ............................................. 21,500

Cash ................................................... 21,500

December 31, 2014

Rent Expense ............................................ 19,708Prepaid Rent ...................................... 19,708

($21,500 X 11/12)

Lessor’s Entries

February 1, 2014Cash ............................................................... 21,500

Unearned Rent Revenue ....................... 21,500

February 1, 2014

Prepaid Insurance ......................................... 450Prepaid Expenses (other) ($1,200 + 200).... 1,400

Cash or Accounts Payable ................... 1,850







December 31, 2014

Unearned Rent Revenue .......................... 19,708

Rent Revenue .................................... 19,708($21,500 X 11/12)

Insurance Expense ($450 X 11/12) ........... 413Maintenance and Repairs Expense

($1,200 X 11/12) ............................. 1,100Other Expenses ($200 X 11/11) ................ 200

Prepaid Insurance ......................... 413Prepaid Expenses (other) ............. 1,300

Depreciat ion Expense .............................. 10,694 Accumulated Depreciation—

Rental Equipment .................... 10,694[($160,000 – $20,000) ÷ 12 X 11/12]

(d) Gumowski Construction as lessee must disclose in theincome statement the $19,708 of rent expense and in thenotes the total future minimum rental payments required of

$107,500, and for each of the following periods: in 2015 -$21,500; 2016 to 2019 - $86,000. Additional disclosures arerequired about material lease arrangements includingcontingent rents, sub-lease payments and lease-imposedrestrictions. No information regarding this lease wouldappear on the lessee’s statement of f inancial posi tion.

Synergetics Inc. as lessor must disclose in the statementof financial position or in the notes the cost of the leasedcrane ($160,000) and the accumulated depreciation of

$10,694 separately from assets not leased. Additionally,Synergetics discloses in the notes the future minimumlease payments to be received as a total of $107,500, andfor each of the fol lowing periods: in 2015 - $21,500; 2016 to2019 - $86,000.






PROBLEM 20-7

(a) Benefits of ownership are the abili ty to use the asset togenerate profits over its useful life, to benefit from anyappreciation in the asset’s value, and to realize its residualvalue at the end of its economic l ife. The risks, on the otherhand, are the exposure to uncertain costs and returns, andto risk of loss from use or idle capacity and fromtechnological obsolescence.

The IFRS criteria use qualitative factors to establishwhether or not the risks and rewards of ownership aretransferred to the lessee, and supports classification as afinance lease:1. There is reasonable assurance that the lessee will


2. The lease term is long enough that the lessee willreceive substantially all of the economic benefits that

are expected to be derived from using the leasedproperty over its life.3. The lease allows the lessor to recover substantially all

of its investment in the leased property and to earn areturn on the investment. Evidence of this is provided ifthe present value of the minimum lease payments isclose to the fair value of the leased asset.

4. The leased assets are so specialized that, without majormodification at significant cost to the lessor, they are ofuse only to the lessee.

No numerical thresholds are applied, as is the case with ASPE, and so the treatment of the lease by the lesseewould be the same, although it would be referred to as afinance lease, rather than a capital lease.







(b) The conditions of the lease lead us to conclude that therisks and benefits of ownership have passed from thelessor to the lessee. Evidence of this includes the bargainpurchase option of $44,440 compared to the residual value,which is estimated at $100,000 and will never fall below$75,000. This fact taken with the fact that the lease term is10 of the 15 years of the useful life of the airplane, it wouldbe foolish for Ramey not to exercise the option to purchasethe plane. Airplanes, when properly maintained, retain theirvalue. Since Ramey is already paying for the maintenance, itwill benefit from this investment in the increased resalevalue of the airplane once the bargain purchase option is

exercised. Ramey will consequently benefit from anyappreciation in value of this asset, beyond the term of thelease.

(c) The appropriate amount for the leased aircraft on RameyCorporation’s statement of financial position after the leaseis signed is $1,000,000, the fair value of the plane and thepresent value of the net rental payments and bargainpurchase option discounted at 8%.



PV $ ? Yields $1,000,001.22

I 8%

N 10

PMT $( 135,150)

FV $( 44,440)

Type 1







(d) The leased aircraft wi ll be reflected on Ramey Corporation’sstatement of financial position as follows:

Noncurrent assetsEquipment under lease $1,000,000

Less accumulated depreciation 59,097$ 940,903

Current liabili tiesObligations under lease (Note A):

Interest payable $ 74,366Principal – current portion 60,180

Non-current liabilitiesObligations under lease (Note A) $ 802,040

The following items relating to the leased aircraft wil l bereflected on Ramey Corporation’s income statement:

Depreciation expense (Note A) $59,097Interest expense 74,366*Maintenance and repairs expense 6,900Insurance and tax expense 4,000

*[($1,000,000 - $137,780) X 9% X 11.5/12]

Note AThe company leases a Viking turboprop aircraft under a financelease. The lease runs until January 15, 2024. The annual leasepayment is paid in advance on January 15 and amounts to$141,780, of which $4,000 is executory costs. The aircraft isbeing depreciated on the straight-line basis over the economiclife of the asset, estimated as 15 years. The depreciation on theaircraft included in the current year’s depreciation expense andthe accumulated depreciation on the aircraft amount to $59,097

($61,667 X 11.5/12).







CalculationsDepreciation expense:

Capitalized amount $1,000,000Residual value 75,000

$ 925,000

Economic li fe 15 years

Annual depreciation $61,667

Depreciation for the first year prorated to 11.5 months:$61,667 X 11.5/12 $59,097

Liability amounts:

Obligations under lease 1/15/14 $1,000,000Payment 1/15/14 ($141,780 - $4,000) 137,780

Obligations under lease 12/31/14 862,220

Reduction of principal* in next 12 months 60,180

Non-current obl igations under lease 12/31/14 $ 802,040

*Lease payment, Jan. 15/15 $137,780Interest: 9% X $862,220 = 77,600

Principal payment = $ 60,180






PROBLEM 20-8

(a) 1. Interest expense (See amort. schedule) $10,216Operating expenses $2,500Depreciation expense ($150,690 ÷ 6) $25,115

2. Property, plant, and equipment:Property under lease $150,690

Accumulated depreciation ($25,115)

Current liabili ties:

Obligations under lease $20,284Interest payable $10,216

Long-term liabilities:Obligations under lease $99,906

3. Interest expense (See amort. schedule) $8,492Operating expenses $2,500Depreciation expense ($150,690 ÷ 6) $25,115

4. Property, plant, and equipment:Property under lease $150,690


Current liabilities:Obligations under lease $22,008Interest payable $8,492








(b) 1. Interest expense ($10,216 X 3/12 ) $2,554

Operating expenses ($2,500 X 3/12) $625Depreciation expense $6,279

($150,690 ÷ 6 = $25,115 X 3/12)

2. Current assets:Prepaid expenses $1,875

($2,500 X 9/12 = $1,875)

Property, plant, and equipment:Property under lease $150,690


Current liabilities:Obligations under lease $20,284Interest payable $2,554


3. Interest expense $9,785[($10,216 – $2,554) + ($8,492 X 3/12) =

$7,662 + [$2,123 = $9,785]Operating expenses $2,500Depreciation expense ($150,690 ÷ 6) $25,115







4. Current assets:Prepaid expenses $1,875

($2,500 X 9/12 = $1,875)

Property, plant, and equipment:Property under lease $150,690


($6,279 + $25,115 = $31,394)


Obligations under lease $22,008Interest payable ($8,492 X 3/12) $2,123


(c) For McKee Electronics Ltd.—(the lessee):Rather than using quantitative factors such as the 75percent and the 90 percent hurdles often referred to as the

bright lines used in ASPE, IFRS criteria use qualitativefactors to establish whether or not the risks and rewards ofownership are transferred to the lessee, and supportsclassification as a finance lease:1. There is reasonable assurance that the lessee will










4. The leased assets are so specialized that, without majormodification and cost to the lessor, they are of use onlyto the lessee.






PROBLEM 20-9

(a) 1. Interest income $10,216

2. Current assets:Lease receivable $30,500Unearned interest income (0)Net investment in lease $30,500

Noncurrent assets:Lease receivable $122,000

($183,000 – $30,500 – $30,500)Unearned interest income (22,094)

($32,310 – $10,216)Net investment in lease $99,906

3. Interest income $8,492

4. Current assets:Lease receivable $30,500Unearned interest income (0)Net investment in lease $30,500


($183,000 – $30,500 – $30,500– $30,500)Unearned interest income (13,602)

($32,310 – $10,216 – $8,492)Net investment in lease $77,898

(b) 1. Interest income ($10,216 X 3/12 = $2,554) $2,554

2. Current assets:Lease receivable $30,500Unearned interest income (7,662)









($183,000 – $30,500 – $30,500)Unearned interest income (22,094)


3. Interest income $9,785[($10,216 – $2,554) + ($8,492 X 3/12) =$7,662 +$2,123]

4. Current assets:Lease receivable $30,500Unearned interest income (6,369)



($183,000 – $30,500 – $30,500 – 30,500)Unearned interest income (13,602)

($32,310 – $10,216 – $8,492)Net investment in lease $77,898

(c) Using IFRS, Woodhouse considers the same factors asMcKee, the lessee, in determining whether the risks andbenefits of ownership of the leased property are transferred.These factors include:

1. There is reasonable assurance that the lessee wi ll










4. The leased assets are so specialized that, without major

modification, and significant cost to the lessor, they areof use only to the lessee.

In this case, the lessor would record the lease as afinancing-type lease, as Woodhouse is not a manufactureror dealer.






PROBLEM 20-10

(a) YIN TRUCKING CORPORATIONSchedule to Calculate the Discounted Present Value of

Terminal Facilities and the Related ObligationsJanuary 1, 2012

Present value of first 10 payments:Present value of an annuity due for

10 years at 6% ($900,000 X 7.80169) $7,021,521

Present value of last 10 payments:

Present value of an annuity due for10 years at 6% ($320,000 X 7.80169) 2,496,541Discounted to January 1, 2012

($2,496,541 X .558395) 1,394,056

Present value of bargain purchase optionof ($1,000,000 X .31180) 311,800

Present value of terminalfacil ities and related obl igations $8,727,377

(Note to instructor: For the last ten periods, the present valueof an annuity due for 20 periods less the present value of anannuity due for 10 periods can be used as follows: ([12.15812 –7.80169] X $320,000 = $1,394,056).








Present value of the first ten years of annuity of $900,000 is$7,021,523


PV $ ? Yields $7,021,523.05

I 6%

N 10

PMT $ (900,000)

FV $ 0

Type 1

Present value (at end of first ten years) of the next ten yearannuity of $320,000 is $2,496,541


PV $ ? Yields $2,496,541

I 6%

N 10

PMT $ (320,000)

FV $ 0

Type 1

Calculate the present value of single amount of $2,496,541 forten years at 6% and obtain $1,394,056


PV $ ? Yields $1,394,056

I 6%

N 10PMT $ 0

FV $ (2,496,541)

Type 1







Calculate the present value of single amount of $1,000,000 fortwenty years at 6% and obtain $311,805


PV $ ? Yields $311,805

I 6%

N 20

PMT $ 0

FV $ (1,000,000)

Type 1

(b) YIN TRUCKING CORPORATIONJournal Entries

2014(1) 1/1/14

Interest Payable ............................................ 442,080

Obligations under Lease .............................. 457,920

Property Tax Expense .................................. 125,000

Insurance Expense ....................................... 23,000Cash ....................................................... 1,048,000

Partial Amortization Schedule(Annuity Due Basis)

DateLease

PaymentExecutory

CostsInterestat 6%

PrincipalReduction

PrincipalBalance

1/1/121/1/121/1/131/1/141/1/15

—$1,048,0001,048,0001,048,0001,048,000

—$148,000148,000148,000148,000

—$ 0468,000442,080414,605

—$900,000432,000457,920485,395

$8,700,0007,800,0007,368,0006,910,0806,424,685







(2) 12/31/14

Depreciation Expense .................................. 217,500

Accumulated Depreciation—Leased Terminals 217,500(To record annual depreciation expenseon assets under lease) ($8,700,000 ÷ 40)

(3) 12/31/14Interest Expense ........................................... 414,605

Interest Payable ..................................... 414,605(To record interest accrual at 6% onoutstanding debt of $6,910,080)

(c) Yin’s statement of financial posit ion at December 31, 2014would show the following:

Property plant and equipmentTerminals under lease $8,700,000

Accumulated depreciation 652,500*8,047,500


Interest payable $442,080Current portion of obligations under

lease 457,920

Long-term liabilities:Obligations under lease 6,910,080

* $217,500 X 3 years






PROBLEM 20-11

(a) The lease should be treated as a capital lease by LeeIndustries, requiring the lessee to capitalize the leased

asset. The lease qualifies for capital lease accounting by thelessee because: (1) title to the engines transfers to thelessee, and (2) the lease term is equal to the estimated lifeof the asset. While no mention is made of the amount of thefair value of the leased asset at January 1, 2014, it isreasonable to assume that it would be above the cost tomanufacture the engines. Lor Inc. is in business tomanufacture and sell its products, so Lor would want torecover the sales price of the engines, not just their cost.

The present value of the minimum lease payments (seebelow) is $4,500,000 and the assumption is that this is theselling price and fair value of the engines. The transactionrepresents a purchase financed by instalment paymentsover a 10-year period.

For Lor Inc. the transaction is a sales-type lease because amanufacturer’s profit accrues to Lor Inc. This leasearrangement also represents the manufacturer’s financingof the transaction over a period of 10 years.

Lease Payment ReceivablePayment per period $ 620,956Periods X 10Lease receivable $6,209,560

Present Value of Lease Payments$620,956 X 7.24689* $4,500,000

*Present value of an annuity due at 8% for 10 years.








Using a financial calculator:PV $ ? Yields $4,499,999

I 8%

N 10

PMT $ (620,956)

FV $ 0

Type 1

Unearned Interest IncomeLease receivable $6,209,560Less: Present value of lease payments 4,500,000Unearned interest income $1,709,560

Dealer ProfitSales revenue(present value of lease payments) $4,500,000

Less cost 3,900,000Prof it on sale $ 600,000

(b) Equipment under Lease .......................... 4,500,000Obligations under Lease ................. 4,500,000

Obligations under Lease ....................... 620,956Cash ................................................ 620,956

(c) Lease Receivable ................................... 6,209,560Cost of Goods Sold ............................... 3,900,000

Sales Revenue ................................ 4,500,000

Inventory ......................................... 3,900,000Unearned Interest Income ............. 1,709,560

Cash ........................................................ 620,956Lease Receivable ........................... 620,956







(d) Lee IndustriesLor Inc.


Date

AnnualLease

Payment/Receipt

InterestIncome/Expense

at 8%

Reductionin PresentValue ofLease

PresentValue ofLease

1/1/141/1/141/1/151/1/16

620,956620,956620,956

310,324285,473

620,956310,632335,483

4,500,0003,879,0443,568,4123,232,929

Lessee (December 31, 2014)

Interest Expense .................................... 310,324Interest Payable.............................. 310,324

Lessor (December 31, 2014)

Unearned Interest Income ..................... 310,324Interest Income............................... 310,324

(e) LEE INDUSTRIESStatement of Financial Position

December 31, 2014

Property, plant, and equipment:Equipment under

lease $4,500,000Less accumulated

depreciation 450,000*$4,050,000

Current liabilities:Interest payable $ 310,324Obligations under

lease 310,632**Long-term liabilities:

Obligations underlease 3,568,412**

***$4,500,000 ÷ 10 = $450,000*** taken f rom amortization schedule above







LOR INC.Statement of Financial Position

December 31, 2014

Assets:Current assets:

Net investment in leases $ 310,632*

Noncurrent assets:Net investment in leases $3,568,412*

* from amortization schedule

(f) The transaction securing the equipment using the capitallease would not be reported on the statement of cash flowsfor the year ending December 31, 2014 of Lee, the lessee.This is a non-cash financing and investing transaction toLee. These transactions would be described in the notes tothe respective financial statements. The only cashtransaction between the parties during 2014 is the January1, 2014 lease payment in the amount of $620,956. This

transaction is an operating activity inflow to Lor and is afinancing outflow to Lee. For Lee, the annual depreciationfor 2014 would be an adjustment to determine cash flowfrom operations under the indirect approach. For Lor, theoperating cash flows would be included in the adjustmentsto net income under the indirect approach and would beshown as part of cash collected from customers under thedirect approach.







(g) Note X: (on Lee’s financial statements:)The following is a schedule of future minimum leasepayments under the capital lease expiring December 31,2023 together with the balance of the obligations undercapital leases.

Year ending December 312015 $620,9562016 620,9562017 620,9562018 620,9562019 620,9562020 and beyond 2,483,824

Total minimum lease payments 5,588,604Less amount representing interest at 8% 1,709,560Balance of the obligations $3,879,044

(h) Note Y: (on Lor’s financial statements:)The company's future minimum lease payments receivableunder the sales-type lease and the net investment in leaseare as follows:

Year ending December 312015 $620,956

2016 620,9562017 620,9562018 620,9562019 620,9562020 and beyond 2,483,824

Total minimum lease payments receivable $5,588,604Unearned income 1,709,560Net investment in lease $3,879,044






PROBLEM 20-12

(a) January 31, 2014

Equipment under Lease ............................. 173,448Obligations under Lease .................... 173,448(To record leased asset and related obligations)

PV of monthly payment of $41,000 X 4.16987* .............. $170,964PV of residual value of $4,000 X .62092** ...................... 2,484Present value of minimum lease payments .................. $173,448* (PV factor for annui ty due for 5 years at 10%)** (PV factor for $1 for 5 years at 10%)



PV $ ? Yields $ 173,448.17

I 10%

N 5

PMT $ (41,000)

FV $ (4,000)

Type 1

January 31, 2014

Obligations under Lease ............................ 41,000Cash ..................................................... 41,000

(To record the first rental payment)

(b) December 31, 2014

Depreciation Expense ................................ 22,713 Accumulated Depreciation—Leased

Equipment ..................................... 22,713(To record depreciation of the leasedasset based upon a cost to Dubois of$173,448 and a life of 7 years X 11/ 12)







December 31, 2014

Interest Expense ................................................ 12,141

Interest Payable .......................................... 12,141(To record accrual of interest on finance leaseobligation $13,245 X 11 / 12)

January 31, 2015

Interest Payable .................................................. 12,141Interest Expense ................................................ 1,104Obligations under Lease.................................... 27,755

Cash ............................................................. 41,000

(To record annual payment on f inance leaseobligation)

During year

Property Tax Expense ...................................... XXX

Insurance Expense ........................................... XXX

Maintenance and Repairs Expense ................. XXXCash ........................................................... . XXX

(To record payment for executory costs)

Dubois Steel Corporation (Lessee)Lease Amortization Schedule

(Annuity Due Basis)

Date

AnnualLease

Payment


Reductionof Lease

Obligation

Balanceof Lease

Obligation

1/31/141/31/14

1/31/151/31/161/31/171/31/18

—$41,000

41,00041,00041,00041,000

—$ 0

13,24510,4697,4164,058

—$41,000

27,75530,53133,58436,942

$173,448132,448

104,69374,16240,578

3,6361/31/19 4,000 364* 3,636* rounded







(c) December 31, 2015Depreciation Expense .................................... 24,778

Accumulated Depreciation—LeasedEquipment ....................................... 24,778(To record annual depreciationon assets leased $173,448 ÷ 7)

December 31, 2015Interest Expense ............................................ 9,597

Interest Payable ...................................... 9,597(To record accrual of interest on finance leaseobl igation $10,469 X 11 ÷ 12)

January 31, 2016

Interest Payable .................................................. 9,597Interest Expense ................................................ 872Obligations under Lease .................................... 30,531

Cash ............................................................. 41,000(To record annual payment on finance leaseobligation)

(d) Dubois Steel CorporationStatement of Financial Position

December 31, 2015

Property, plant, and equipment:Equipment under

lease $173,448Less: Accumulated

depreciation 47,491$125,957

Current liabilities:Interest payable $9,597Obligations under

lease 30,531Long-term:

Obligations underlease 74,162







(e) The transaction securing the equipment using the financelease would not be reported on the statement of cash flows

for the year ending December 31, 2014. This is non-cashinvesting transaction, which should be described in thenotes to the financial statements. The first lease paymentwould appear as a cash outflow for the debt repayment inthe financing activi ties section of the statement.

When using the direct method, for the operating activitiesof the cash flow statement, no amounts need to appear. Onthe other hand using the indirect method, adjustments to

net income would include the adding back of depreciationexpense in the amount of $22,713 and the increase in theinterest payable in the amount of $9,597.

(f) Based on these new facts, the lease would be reported asan operating lease by Dubois as the risks and rewards ofownership are not transferred to the lessee.

Consequently, no balances would appear on the statementof financial position of Dubois at December 31, 2015. No

amount would appear on the statement of cash flows asthe amount of rent expense would correspond to the leasepayment made of $41,000.






PROBLEM 20-13

(a) The lease is a sales-type lease because: (1) the lease termexceeds 75% of the asset’s estimated economic life, (2)

collectability of payments is reasonably assured and thereare no further costs to be incurred, and (3) CHL Corporationrealized an element of profit aside from the financingcharge.

1. Gross investment is $265,000 (10 annual leasepayments of $25,000 each, plus the unguaranteedresidual value of $15,000).

2. Unearned interest income, $76,880, is the grossinvestment of $265,000 less $188,120, the initial presentvalue of the investment, calculated as follows:

Annual lease payment $ 25,000Present value of an annui ty due of $1 for

10 periods discounted at 8% 7.24689

Present value of the 10 rental payments 181,172

Add present value of estimated residualvalue of $15,000 in 10 years at 8%($15,000 X .46319) 6,948

Init ial present value $188,120



PV $ ? Yields $188,120

I 8%N 10

PMT $ (25,000)

FV $ (15,000)

Type 1







3. Sale price is $181,172 (the present value of the 10annual lease payments); i.e. the initial PV of $188,120

minus the PV of the unguaranteed residual value of$6,948.

4. Cost of goods sold is $98,052 (the $105,000 cost of theasset less the present value of the unguaranteedresidual value of $6,948).

(b) CHL CORPORATION (Lessor)Lease Amortization Schedule

Annuity Due Basis, Unguaranteed Residual Value

Beginningof Year

Annual LeasePayment Plus

ResidualValue



NetInvestment

Initial PV123

456789

10End of 10

(a)—

$ 25,00025,00025,000

25,00025,00025,00025,00025,00025,00025,00015,000

$265,000

(b)——

*$ 13,050* * 12,094*

* 11,061* * 9,946* * 8,742* * 7,441*

* 6,036* * 4,519* * 2,881* * 1,110**$76,880*

(c)—

$ 25,00011,95212,906

13,93915,05416,25817,55918,96420,48122,11913,890

$188,120

(d)$188,120163,120151,170138,264

124,325109,271

93,01375,45456,49036,00913,890

0

*Rounding error is $1.

(a) Annual lease payment required by lease contract.(b) Preceding balance of (d) X 8%, except beginning of first

year of lease term.(c) (a) minus (b).(d) Preceding balance minus (c).







(c) Beginning of Lease Year 1

Lease Receivable ............................................. 265,000

Cost of Goods Sold .......................................... 98,052Sales Revenue .......................................... 181,172Inventory ................................................... 105,000Unearned Interest Income ........................ 76,880

(To record the sales revenue and the cost of goods soldin the lease transaction)

Selling Expenses .............................................. 7,000Cash ........................................................... 7,000

(To record payment of the initial directcosts relating to the lease)

Cash .................................................................. 25,000Lease Receivable ...................................... 25,000

(To record receipt of the first leasepayment)

End of fiscal Year – 5 months after signing lease

Unearned Interest Income ............................... 5,438

Interest Income ......................................... 5,438(To record interest earned during thefirst year of the lease $13,050 X 5/12)

12 months after signing lease

Unearned Interest Income ............................... 7,612Interest Income ......................................... 7,612

(To record interest earned during theremainder of the first year of the lease $13,050 X 7/12)







(d) The balance of the net investment should be the netinvestment of $163,120 plus the interest earned to the endof the year of $5,438, for a total of $168,558. This should bereported as follows:Current portion $17,388*Non-current portion 151,170**Total ($188,120 – $25,000 + $5,438) $168,558

* Lease receivable $25,000Less unearned payment ($13,050 – $5,438) 7,612Current Port ion $17,388

** Non-current:

Total lease receivable $215,000Less unearned ($76,880 – $13,050) 63,830

$151,170

(e) Assuming the $15,000 residual value was guaranteed by thelessee, this would change the initial entry for the sale to beas follows:

Lease Receivable ............................................. 265,000Cost of Goods Sold .......................................... 105,000

Sales Revenue .......................................... 188,120Inventory ................................................... 105,000Unearned Interest Income ........................ 76,880

The sales revenue and cost of goods sold would not need to bereduced by the present value of the estimated residual valuecalculated in part (a) of $6,948.







(f) The present value of minimum lease payments would beequal to the estimated selling price of $210,482. The annual

lease payment would equal $X, and the factor for thepresent value of an annuity due (Table A-5) at 8% for 12periods is 8.13896. To obtain a present value of minimumlease payments of $210,482, the annual payment would = (X* 8.13896), so the annual payment would be $25,861.

Excel formula =PMT(nper,pmt,pv,fv,type)


PV $ 210,482I 8%

N 12

PMT $ ? Yields $25,861.03

FV $ -

Type 1






PROBLEM 20-14

(a) For the lessee under ASPE, rather than using quantitativefactors described under part (b) below for IFRS, quantitative

criteria such as:1. the term of the lease exceeding 75% of the remaining

economic life of the asset,2. the present value of the minimum lease payments

exceeding 90% of the fair value of the asset, or3. the presence of a bargain purchase option will be

applied as the basis for the classification of the lease.

(b) It wil l be classified as a capital lease for Provincial Airlines

Corp. because:(1) the lease term is 75% or more of the asset’s economiclife and (2) the present value of the minimum leasepayments exceeds 90% of the fair value of the leased asset.

(c) The IFRS criteria use qualitative factors to establishwhether or not the risks and rewards of ownership aretransferred to the lessee, and supports classification as afinance lease:1. There is reasonable assurance that the lessee will



3. The lease allows the lessor to recover substantially all

of its investment in the leased property and to earn areturn on the investment. Evidence of this is provided ifthe present value of the minimum lease payments isclose to the fair value of the leased asset.

4. The leased assets are so specialized that, without majormodification, they are of use only to the lessee.

The lease would be classif ied as a finance lease.







(d) Initial Obligations Under Leases:Minimum lease payments ($25,000) X PV of an

annuity due for 10 periods at 8% (7.24689) $181,172



PV $ ? Yields $181,172

I 8%

N 10

PMT $ (25,000)

FV $ 0

Type 1

(e) Provincial Airl ines Corp. (Lessee)Lease Amortization Schedule(Annuity due basis and URV)

Beginning

of Year

AnnualLease

Payment

Interest (8%)on Unpaid

Obligation

Reductionof Lease

Obligation

Lease

Obligation

Initial PV1234567

8910

(a)—

$25,00025,00025,00025,00025,00025,00025,000

25,00025,00025,000

$250,000

(b)——

*$12,494* * 11,493* * 10,413*

* 9,246* * 7,985*

* 6,624*

* 5,154* * 3,566* * 1,853**$68,828*

(c)—

$ 25,00012,50613,50714,58915,75417,01518,376

19,84621,43423,147

$181,172

(d)$181,172156,172143,666130,159115,57299,81882,80364,427

44,58123,147

0








(a) Annual lease payment required by lease contract.(b) Preceding balance of (d) X 8%, except beginning of first

year of lease term.(c) (a) minus (b).(d) Preceding balance minus (c).

(f) Lessee’s journal entries:

Beginning of the Year

Equipment under Lease ................................. 181,172Obligations under Lease ........................ 181,172

(To record the lease of equipmentusing capital lease method)

Obligations under Lease ................................ 25,000Cash ......................................................... 25,000


End of the YearInterest Expense ............................................ 12,494

Interest Payable ...................................... 12,494(To record accrual of annual interest on

lease obligation)

Depreciation Expense .................................... 18,117 Accumulated Depreciation—Leased Equipment 18,117

(To record depreciation expense forfirst year [$181,172 ÷ 10])







(g) Refer to the calculations and table of P20-13 for theamounts using the guaranteed residual value in thecalculations of payments made by the lessee Provincial

Airl ines Corp.



(To record the lease of equipmentusing capital lease method)

Obligations under Lease ................................ 25,000Cash ......................................................... 25,000




capital lease obl igation)


(To record depreciation expense forfi rst year [$188,120 - $15,000 ÷ 10])







(h) The residual value of $45,000 will not be included incalculation of the present value of the minimum leasepayments. Rather, the bargain purchase option of $15,000

will be the future outflow in the calculations below. Thebargain purchase option will permit depreciation of theequipment over its economic life of 12 years.



PV $ ? Yields $188,120

I 8%

N 10

PMT $ (25,000)

FV $ (15,000)

Type 1



(To record the lease ofequipment using capital lease method)

Obligations under Lease................................ 25,000Cash ......................................................... 25,000




lease obligation)

[($188,120 - $25,000) X 8%]


(To record depreciation expense forfirst year [$188,120 ÷ 12])






PROBLEM 20-15

(a) Jennings, the lessor, considers the same factors as SNC

Medical, the lessee, in determining whether the risks andbenefits of ownership of the leased property aretransferred. These factors include:1. There is reasonable assurance that the lessee will

obtain ownership of the leased property, includingthrough a bargain purchase option.

2. The lessee wil l benefit from most of the asset use due tothe length of the lease term which is substantially all ofthe leased property's economic l ife.

3. The lessor recovers substantially all of its investment

and earns a return on that investment

Jennings is a manufacturer and consequently the signingof the lease involves the sale of inventory and thefinancing of their customer’s purchase. The lease istherefore a manufacturer or dealer lease to Jennings.

Present value of minimum lease payments:

1. Present value of annual payments of$50,000 made at the beginning of eachperiod for 10 years, $50,000 X 6.75902

(PV of an annuity due at 10%) $337,951

2. Present value of guaranteed residual value,$15,000 X .38554 (PV of $1, 10 years at 10%) 5,783

Present value of minimum lease payments $343,734









I 10%

N 10

PMT $ (50,000)

FV $ (15,000)

Type 1

1. Gross investment:Lease payments of $50,000 made at the

beginning of each year for 10 years $500,000Guaranteed residual value due at the end

of 10 years 15,000Gross investment $515,000

2. Sale price is the same as the present value ofminimum lease payments $343,734

3. Unearned interest income:Gross investment $515,000Less: Fair value of the X-ray

machine 343,734Unearned interest income $171,266

4. Cost of goods sold is the cost of manufacturingthe X-ray machine $210,000







(b) JENNINGS INC. (Lessor)Lease Amortization Schedule

(Annuity due basis, guaranteed residual value)

Beginningof Year

Annual LeasePayment PlusResidual Value



NetInvestment

Initial PV1234

56789

10End of 10

$ 50,00050,00050,00050,00050,000

50,00050,00050,00050,00050,00015,000

$515,000

—*$ 29,373* * 27,311* * 25,042* * 22,546*

* 19,801* * 16,781* * 13,459* * 9,805* * 5,785* * 1,363**$171,266*

$ 50,00020,62722,68924,95827,454

30,19933,21936,54140,19544,21513,637

$343,734

$343,734293,734273,107250,418225,460198,006

167,807134,588

98,04757,85213,637

0


(c) Lessor’s journal entries:


Lease Receivable ............................................. 515,000Cost of Goods Sold .......................................... 210,000

Sales Revenue .......................................... 343,734Inventory ................................................... 210,000Unearned Interest Income ........................ 171,266

(To record the sales revenue and the cost of goods soldin the lease transaction)

Selling Expenses ................................................ 14,000Cash/Accounts Payable ............................. 14,000

(To record the incurrence of ini tial directcosts relating to the lease)








(To record receipt of the first leasepayment)

End of the Year


(To record interest earned during the firstyear of the lease)

(d) At December 31, the end of the first year of the lease,Jennings Inc. wil l report on the income statement the salesrevenue amount of $343,734 and cost of goods sold of$210,000, indicating gross profit from the sale of the X-rayequipment in the amount of $133,734. They will also reportthe interest income on the lease of $29,373 and sellingexpenses of $14,000.

The statement of financial position would report thecurrent portion of the lease receivable of $50,000 and the

non-current portion of $415,000, reduced by the currentportion of the unearned interest income on the lease in theamount of $27,311 and the non-current portion for$114,582.

For the statement of cash flows, using the indirect formatfor the cash flow from operations, there will be anadjustment of an addition to income for the reduction ofinventory of $210,000 and an addition for the net increasein unearned income of $141,893 ($171,266 – $29,373). For

investing activities the statement will show a net increasein lease payments receivable of $465,000 ($515,000 –$50,000).







(d) (Cont inued)

For the note disclosure, the list of required and desirabledisclosures include: the total future minimum leasepayments receivable, unguaranteed residual values,unearned finance income, executory costs included inminimum lease payments, contingent rentals taken intoincome, lease terms, and the amounts of minimum leasepayments receivable for each of the next five years.

(e) Since the impl icit rate in the lease of 10% is known to thelessee, SNC Medical Centre, the interest rate used by SNC

will be the same as that of the lessor, Jennings Inc.Consequently, the machinery will be capitalized at theamount of $343,734, the present value of the minimumlease payments as calculated in (a) above. Thedepreciation of the machinery will be based on the term ofthe lease as SNC has guaranteed the residual value. Thedepreciation expense will therefore be $32,873 (($343,734 -$15,000) / 10 years).

(f) Had the residual value of the X-ray machine not beenguaranteed, the amount of the sale and the cost of goodssold recorded would have been reduced by the presentvalue of the residual value in the amount of $5,783 ($15,000X .38554 for PV of $1, for 10 years at 10%).



PV $ ? Yields $5,783

I 10%

N 10

PMT $ 0

FV $ 15,000

Type 1







(f) (Continued)

From the perspective of the lessor, the entries concerningthe recording of the lease receivable do not change, exceptas noted above since the lessor assumes that they willrecover the residual value whether that amount isguaranteed by the lessee or not. Consequently the amountof interest accrued at the end of the year will be the sameamount as given in (c). The financial statements of thelessor remain unaffected with the exception of thereduction of $5,783 for the sales revenue and cost of goodssold amounts on the income statement.

From the perspective of the lessee, the amount used tocapitalize the machinery will exclude the residual value,since the lessee does not guarantee that amount. Using thesame variables as in (a) above but excluding the residualvalue yields an amount of $337,951. The depreciationexpense will therefore be $33,795 ($337,951 / 10 years).

(g) Had Jennings been using ASPE, quantitative factors wouldapply. The lease is a sales-type lease because: (1) the leaseterm is for 83% (10 ÷ 12) of the economic life of the leasedasset, (2) the present value of the minimum lease paymentsexceeds 90% of the fair value of the leased property, (3) thecollectability of the lease payments is reasonablypredictable and no uncertainties exist as to unreimbursablecosts yet to be incurred by the lessor, and (4) the leaseprovides the lessor w ith manufacturer’s profi t in addition tointerest income.






PROBLEM 20-16

(a) Green Finance Corporation, the lessor, considers the same

factors as Lanier Dairy Ltd., the lessee, in determiningwhether the risks and benefits of ownership of the leasedproperty are transferred. These factors include:• There is reasonable assurance that the lessee will


• The lease term is long enough that the lessee willreceive substantially all of the economic benefits thatare expected to be derived from using the leasedproperty over its life.

• The lease allows the lessor to recover substantially allof its investment in the leased property and to earn areturn on the investment. Evidence of this is provided ifthe present value of the minimum lease payments isclose to the fair value of the leased asset.

• The leased assets are so specialized that, without majormodification and significant cost to the lessor they are

of use only to the lessee.In this case, Lanier Dairy Ltd., the lessee, would record thelease as a finance lease. Green Finance Corporation is nota manufacturer or dealer and consequently the lease is afinance lease to Green Finance Corporation.

(b) May 30, 2014Lessee:

Equipment under Lease ................................ 211,902Obligations under Lease ....................... 211,902$30,000 X 6.58238* = $197,471.40)

($23,000 X .62741** = 14,430.43) = $211,901.83

* PV factor of annuity due at 6% for 8 years** PV factor of $1 at 6% for 8 years







(b) (Continued)



PV $ ? Yields $211,901.93

I 6%

N 8

PMT $ (30,000)

FV $ (23,000)

Type 1

Obligations under Lease ............................... 30,000Cash ........................................................ 30,000

May 30, 2014Lessor:

Lease Receivable .......................................... 263,000Equipment Acquired for Lessee ........... 211,902Unearned Interest Income ..................... 51,098

($263,000 = 8 X $30,000; add $23,000for residual value)

Cash ............................................................... 30,000Lease Receivable ................................... 30,000

December 31, 2014Lessee:

Interest Expense ........................................... 6,367

Interest Payable ..................................... 6,367[($211,902 – $30,000) X .06 X 7/12]

Depreciat ion Expense ................................... 13,774 Accumulated Depreciation-Leased

Equipment ......................................... 13,774[($211,902 – $23,000) ÷ 8 X 7/12]







December 31, 2014Lessor:


(c) May 30, 2015Lessee:Obligations under Lease ............................... 19,086Interest Expense ........................................... 4,547*Interest Payable ............................................. 6,367

Cash ........................................................ 30,000

*[($211,902 – $30,000) X .06 X 5/12]

Lessor:


Cash ............................................................... 30,000Lease Receivable .................................. 30,000

(d) (1) and (2) are both $197,471, as the lessee has noobligation to pay the residual value.


PV $ ? Yields $197,471.44

I 6%

N 8

PMT $ (30,000)

FV $ 0

Type 1







(e) In the case of (1) the amount of the net investment at theinception of the lease would be $211,902 + $1,200 or

$213,102. For (2) and (3) both would be $211,902, as theestimated residual value exists whether or not it isguaranteed.

(f) The present value of the residual would have to be at least10% of the fair value of the leased asset or 10% X $211,902 =$21,190.20. The future value of this lump sum (n=8, i=6) =$21,190.20 X 1.59385 or $21,190,190.20/.62741, both ofwhich = $33,774.

Using a financial calculator:PV $ 21,190

I 6%

N 8

PMT $ 0

FV $ ? Yields $33,773,64

Type 1

Excel formula: =FV(rate,nper,pmt,pv,type)

(g) Had Green been using ASPE:

The lease agreement satisfies both the 75% and 90%quantitative requirements, collectability is reasonablypredictable, and there are no important uncertaintiessurrounding the costs yet to be incurred by the lessor. ForLanier Dairy Ltd., the lessee, it is a capital lease, and forGreen Finance Corporation, the lessor, it is a directfinancing lease (since cost equals fair value).






PROBLEM 20-17

Memorandum Prepared by: (Your Initials)

Date:

Fram Fibreglass Corp. (FFC) Assessing Leasing Proposals

Industrial Development Bank (IDB) vs.Municipal Finance Corp. (MFC)

The purpose of this memorandum is to outline the analysis andrecommendations concerning leasing alternatives obtained from

IDB and MFC.

The objective is to lease equipment with a current selling priceof $50,000 for a term of 5 years. Both proposals require that theequipment be returned to the lessor at the end of the term. Bothlease terms start and end at approximately the same dates. Theterms of the leases differ in other respects, which will result inalternate account ing treatments on the books of FFC.

MFC – proposal:

To FFC, this lease is a capital lease because the terms satisfythe following criteria:

1. The present value of the minimum lease payments isslightly greater than 90% of the fair value of the leasedasset; that is, the present value of $45,030 (see below) is90.1% of the fair value of the leased asset ($45,030 /$50,000).

2. The lease fails in the second cri teria concerning thepresence of a bargain purchase option.

3. The lease also fails the third capitalization criteria in thatthe lease term is not greater than 75% of the economic lifeof the leased asset; that is, the lease term is 71% (5/7) ofthe economic l ife of the equipment.

Note that in this case, since there is no interest rate mentionedin the lease proposal, FFC must impute the company’sincremental borrowing rate of 15%.








PV $ ? Yields $ 45,030

I 15%N 5

PMT $ (11,681)

FV $ 0

Type 1

IDB - proposal:IDB is providing an operating lease to FFC since the lease term(5 years) is less than 75% of the economic life (7 years) of the

leased asset. The lease term is 71.4% (5 ÷ 7) of the asset’seconomic life. There is no bargain purchase option and thepresent value of minimum lease payments of $44,330 (seebelow) represents 88.7% of the fair value at April 23, 2014 of$50,000 falling short of the criteria of 90% to treat the lease as acapital lease.


PV $ ? Yields $ 44,330

I 12%N 5

PMT $ (10,980)*

FV $ 0

Type 1

* Rental payment of $12,000 less $1,020 in executory costs.







Let us contrast the charges to the income statement for a typicallease year as well as look at the cash outf lows and statement offinancial position balances at the end of the first lease year. Thetable below assumes a 12 month period from the inception ofthe lease to eliminate any differences caused by different startdates.

MFC IDB

Capital Operating

Lease Lease



Equipment under lease $ 45,030Less: Accumulated depreciation (9,006) (1)

36,024

Current Liabilities

Interest payable 5,002 (2)Current portion of obligationsunder lease 6,679 (3)

Long term liabilities

Obligations under lease 33,349 (4)Less: Current portion (6,679) (3)

26,670

Statement of income:


Depreciation expense $ 9,006


Other operating costs 300 1,020

$ 14,308 $12,000

Statement of cash flows:

Cash paid for lease $ (11,981) $ (12,000)







(1) $45,030 / 5 (2), (3), and (4) – See Amortization schedule

MFC LeaseLease Amortization Schedule

Yr.

Annual Pmt.Excl.

Exec. Costs

Interest(15%)

on UnpaidObligation

Reductionof Lease

Obligation

Balanceof Lease

Obligation

45,030.00

1 11,681.00 11,681.00 33,349.00 (4)

2 11,681.00 5,002.35(2)

6,678.65(3)

26,670.353 11,681.00 4,000.55 7,680.45 18,989.90

4 11,681.00 2,848.49 8,832.51 10,157.39

5 11,681.00 1,523.61 10,157.39 (0.00)

Based on the analysis above, my recommendation is for FFC tochoose the operating lease with IDB because:

1. Although the cash outflows are practically identical, thecharges to the income statement are 19% lower with theoperating lease.

2. Given the current financial situation of FFC concerningliquidity, the capital lease would adversely affect thecurrent ratio.

3. Additional debt on the statement of financial position willnot be viewed well by FFC’s creditors if the capital leasealternative offered by MFC were selected. Choosing thisalternative would be violating the stipulation of RoyalMontreal Bank that FFC not increase the debt-to-equity

ratio above the current levels.

Note to Instructor: Some students will treat this as a capitalbudgeting problem and compare the present value of the cashflows of the two alternatives. It may be useful when assigningthe problem to remind the students to write the report based onfinancial reporting considerations.






PROBLEM 20-18 (Continued)(c)

5/2/14 Lease Receivable* ............................... 606,387Cost of Goods Sold ............................. 327,500

Sales Revenue ............................ 415,000Inventory ..................................... 327,500Unearned Interest Income ......... 191,387* ($72,341 X 7) +$100,000


12/31/14 Unearned Interest Income .................. 27,413Interest Income ......................... 27,413

[($415,000 – $72,341) X .12 X 8/12]

5/2/15 Unearned Interest Income .................. 13,706Interest Income ......................... 13,706[($415,000 – $72,341) X .12 X 4/12]



[($415,000 – $72,341 - $31,222) X .12 X 8/12]


[($415,000 – $72,341 - $31,222) X .12 X 4/12]

5/2/16 Cash .................................................... 72,341

Lease Receivable ...................... 72,341







(d)

As at and for the period ending December 31, 2014

Statement of financial position:Current assets

Net investment in leases $ 72,341

Noncurrent assets (investments) 297,731 *

* ($342,659 + $27,413 - $72,341 current)

Statement of income:Sales revenue $ 415,000

Cost of goods sold 327,500

Gross profit 87,500

Interest income 27,413


Operating Activi ties:

Cash received for lease $ 72,341







(e) Mulholland Corp. would account for the lease as anoperating lease since:


PV $ ? Yields $369,764

I 12%

N 7

PMT $ 72,341

FV $ 0

Type 1

The lease term (7 years) is less than 75% of the economic l ife (10years) of the leased asset. The lease term is 70% (7 ÷ 10) of theasset’s economic li fe. There is no bargain purchase option andthe present value of minimum lease payments of $72,341represents 89% ($369,764 / $415,000) of the fair value at May 2,2014 of $415,000 falling short of the criteria of 90% to treat thelease as a capital lease.

Fiscal year ending December 31, 2014:

During 2014:Operating Expenses ..................... 14,000Cash .......................................... 14,000

5/2/14 Prepaid Rent ................................. 72,341Cash .......................................... 72,341

12/31/14 Rent Expense ................................ 48,227

Prepaid Rent ............................... 48,227($72,341 X 8/12)

Fiscal year ending December 31, 2015:During 2015:

Operating Expenses ...................... 14,400Cash .......................................... 14,400







5/2/15 Rent Expense ................................ 24,114

Prepaid Rent ............................... 24,114

($72,341 X 4/12)

5/2/15 Prepaid Rent ................................. 72,341Cash .......................................... 72,341

12/31/15 Rent Expense ................................ 48,227

Prepaid Rent ............................... 48,227($72,341 X 8/12)

Fiscal year ending December 31, 2016:

During 2013:Operating Expenses ..................... 14,950

Cash .......................................... 14,950

5/2/16 Rent Expense ................................ 24,114

Prepaid Rent ............................... 24,114($72,341 X 4/12)

5/2/16 Prepaid Rent ................................. 72,341

Cash .......................................... 72,341(f)

As at and for the period ending December 31, 2014


Current assets:

Prepaid rent $ 24,114

Statement of Income:


Other operating expenses 14,000



Cash paid for lease $ (72,341)







(g) In this set of circumstances, the equipment is on neitherthe lessor’s (Galt’s) nor the lessee’s (Mulholland’s)statements of financial position. The equipment shouldlikely be on the statement of financial posi tion of the lesseeas they have avoided recording the lease as an operatinglease by involving a third party in the guaranteed residualvalue. In this case, the present value of minimum leasepayments represents 89% of the fair value of the asset.This is very close to the 90% capitalization criteriaguideline. The 90% criteria is not an absolute rule andtherefore accountants should look beyond the numbers tothe substance of the transaction to determine the

accounting treatment of the lease; in this casecapitalization of the lease may be a more meaningfulpresentation.






PROBLEM 20-19

(a)

1. Contractual obligations and rights under lease, July 1, 2014.

Using tables:PV of lease payments $545,000 X 5.62288* $3,064,470

* Annuity due Table A-5 at 8%



PV $ ? Yields $3,064,469.42

I 8%

N 7

PMT $ 545,000

FV $ 0

Type 1

2. Wagner Inc.Lease Amortization Schedule

Date

AnnualLease

Payments

Interest(8%)

on UnpaidObligation

Reductionof Lease

Obligation

Balanceof Lease

Obligation$3,064,470

July 1 2014 $ 545,000 $545,000 2,519,470July 1 2015 545,000 $201,558 343,442 2,176,028July 1 2016 545,000 174,082 370,918 1,805,110July 1 2017 545,000 144,409 400,591 1,404,519

July 1 2018 545,000 112,361 432,639 971,880July 1 2019 545,000 77,750 467,250 504,630July 1 2020 545,000 40,369 * 504,631 (0)* one dollar rounding







3.July 1, 2014

Right-of-use Asset ............................... 3,064,470Obligations under Lease ............ 3,064,470



Interest Payable .......................... 100,779

($201,558 X 6 / 12 = $100,779)

Amortization Expense ......................... 218,891Right-of-use Asset ..................... 218,891($3,064,470 ÷ 7 years X 6/ 12 = $218,891)

July 1, 2015Interest Expense .................................. 100,779Interest Payable ................................... 100,779Obligations under Lease ..................... 343,442

Cash ............................................ 545,000

(b)1. Probabil ity-weighted expected value of residual

$400,000 X 60% = $240,000$300,000 X 40% = 120,000Probabil ity-weighted value 360,000Guaranteed value 450,000

Liabil ity July 1, 2021 $90,000







To calculate the present value of this additional cash outf low:



PV $ ? Yields $56,715

I 8%

N 6

PMT $ 0

FV $ 90,000

Type 1

2. July 1, 2015

Right-of-use Asset ..................................... 56,715Obligations under Lease ............ 56,715

The carrying amount of the lease obligation after the aboveentry is $2,232,743 (balance from the original amortizationschedule $2,176,028 after the July 1, 2015 payment +$56,715)

3. Wagner Inc.Lease Amort ization Schedule—Revised July 1, 2015

Date

AnnualLease

Payments

Interest(8%)

on UnpaidObligation

Reductionof Lease

Obligation

Balanceof Lease

Obligation

$ 2,232,743

July 1 2016 $ 545,000 $ 178,619 $366,381 1,866,362

July 1 2017 545,000 149,309 395,691 1,470,671July 1 2018 545,000 117,654 427,346 1,043,325

July 1 2019 545,000 83,466 461,534 581,791

July 1 2020 545,000 46,543 498,457 83,334

July 1 2021 90,000 6,666* 83,334 (0)* one dollar rounding







4.December 31, 2015

Interest Expense .................................. 89,310Interest Payable .......................... 89,310($178,619 X 6 ÷ 12 = $89,310)

Amortization Expense ......................... 483,716Right-of-use Asset ..................... 483,716($2,902,294* ÷ 6 years = $483,716)

* Original entry for the rights $3,064,470 Amortization recorded in 2014 (218,891)

Change in estimate: residual value 56,715 Amortizable balance $2,902,294






PROBLEM 20-20

(a) Option 1:

1.Excel formula =PMT(rate,nper,pv,fv,type)

PV $79,000

I 1.75%*

N 20

PMT ? Yields $4,715.61

FV $ 0

Type 1* 7 % ÷ 4

2.

Sanderson Inc.

Instalment Note Payable Amortization Schedule

Note Effective Principal Carrying

Payment Interest Reduction Amount1/1/2014

$79,000.001/4/2014 $4,715.61 $ 1,382.50 $3,333.11 75,666.891/7/2014 4,715.61 1,324.17 3,391.44 72,275.46

1/10/2014 4,715.61 1,264.82 3,450.79 68,824.671/1/2015 4,715.61 1,204.43 3,511.17 65,313.501/4/2015 4,715.61 1,142.99 3,572.62 61,740.881/7/2015 4,715.61 1,080.47 3,635.14 58,105.73

1/10/2015 4,715.61 1,016.85 3,698.76 54,406.981/1/2016 4,715.61 952.12 3,763.48 50,643.49

1/4/2016 4,715.61 886.26 3,829.35 46,814.151/7/2016 4,715.61 819.25 3,896.36 42,917.79

1/10/2016 4,715.61 751.06 3,964.55 38,953.241/1/2017 4,715.61 681.68 4,033.92 34,919.321/4/2017 4,715.61 611.09 4,104.52 30,814.80







Sanderson Inc.


Note Effective Principal Carrying

Payment Interest Reduction Amount1/7/2017 4,715.61 539.26 4,176.35 26,638.45

1/10/2017 4,715.61 466.17 4,249.43 22,389.021/1/2018 4,715.61 391.81 4,323.80 18,065.221/4/2018 4,715.61 316.14 4,399.47 13,665.751/7/2018 4,715.61 239.15 4,476.46 9,189.30

1/10/2018 4,715.61 160.81 4,554.79 4,634.50

1/1/2019 4,715.61 81.10 4,634.50 0.00$15,312.13

3.

January 1, 2014

Vehicles ..................................................... 79,000.00

Notes Payable ................................... 79,000.00

Apri l 1, 2014Interest Expense ....................................... 1,382.50

Notes Payable ........................................... 3,333.11

Cash ................................................... 4,715.61

December 31, 2014

Interest Expense ....................................... 1,204.43

Interest Payable................................. 1,204.43

December 31, 2014Depreciat ion Expense ............................ 13,800.00

Accumulated Depreciation – Vehicles 13,800.00

under Lease[($79,000 – $10,000) ÷ 5]







(b) Option 2:

1. BMW Canada calculates the lease payments using a two-step approach.

The first step involves the calculation of the lease paymentsfor the original lease period of 36 months beginningJanuary 1, 2014. For this lease, the recoverable amount of50% of the fair value of the car on January 1, 2014 is usedfor the future value, at the end of the three year period.



PV $(79,000)

I 0.5%*

N 36

PMT ? Yields $ 1,392.21

FV $39,500**

Type 1* 6% ÷ 12** ($79,000 X 50% = $39,500)

The second step is the calculation of the lease payments forthe lease renewal period of 24 months beginning January 1,2017.

Although the fai r value of the car at January 1, 2019 of$10,000 is not guaranteed, it is used in the calculation of thelease amortization schedule by the lessor, BMW Canada.

As well , although there is a small probabi lity that Sandersonwill incur additional kilometre charges for exceeding thelimits set in the lease, these penalties are not included inthe calculation.








PV $(39,500)

I 0. 5833%*

N 24


FV $10,000

Type 1* 7% ÷ 12

2. The lease is an operating lease to Sanderson because:

a) it does not transfer ownership, nor does it contain abargain purchase option,

b) it does not cover at least 75% of the estimated economicli fe of the car, (3 ÷ 8 = 37.5%) and

c) the present value of the lease payments of $45,992* is notat least 90% of the fair value of the car.



PV $ ? * Yields $45,992

I .5%

N 36

PMT $ 1,392.21

FV 0

Type 1

At least one of the three cri ter ia would have had to besatisfied for the lease to be classified as other than anoperating lease.







3. ASPE assumes that the risks and benefits of ownership arenormally transferred to the lessee, and the lessee shouldclassify and account for the arrangement as a capital leaseif any one or more of the following criteria is met:a) There is reasonable assurance that the lessee will

obtain ownership of the leased property, includingthrough a bargain purchase option.

b) The lessee will benefit from most of the asset benefitsdue to the length of the lease term. In addition, anumerical threshold is included: this is usually assumedto occur if the lease term is 75% or more of the leasedproperty's economic life.

c) The lessor recovers substantially all of its investmentand earns a return on that investment. In addition, anumerical threshold is included: this is usually assumedif the present value of the minimum lease payments isequal to 90% or more of the fair value of the leasedasset.

Including the renewal period, Sanderson is using the car for5 of its 8 years of economic life. This translates to 62.5%and so the 75% threshold is not reached.

There is no option to purchase that is a bargain during theini tial or renewal terms of the lease with BMW Canada.

The present value of the minimum lease payments paid bySanderson Inc. is $71,730.00 calculated as follows, in athree step approach:

The first step is for the renewal period of 2 years:









I 0.5833%*

N 24

PMT 1,371.00

FV $ 0

Type 1*7 % ÷ 12

The second step is to calculate the present value of theamount arrived in the fi rst step back to January 1, 2014 for aperiod of 3 years.



PV $ ? Yields $25,737.91

I 0.5%*

N 36

PMT 0

FV $ 30,800.05

Type 1* 6% ÷ 12

The third step is for the calculation of the present value ofthe initial lease payments by Sanderson Inc.









I 0.5%*

N 36

PMT $1,392.21

FV $ 0

Type 1* 6% ÷ 12

Add the present value of the lease renewal $25,737.91 to the present value of the ini tial lease 45,992.17Present value of the minimum lease payments $71,730.08 rounded

Present value of the minimum lease payments divided bythe fair value of the asset $71,730 ÷ $79,000 = 90.8% and sothe lease is a capital lease to Sanderson Inc.

4.

Sanderson Inc. LesseeLease Amortization Schedule

Annual Interest Reduction Balance

Lease on Unpaid of Lease of Lease

Date Payment Obligation Obligation Obligation

71,730.00

Jan. 1 2014 1,392.21 1,392.21 70,337.79

Feb. 1 2014 1,392.21 351.69 1,040.52 69,297.27

Mar 1 2014 1,392.21 346.49 1,045.72 68,251.55

Apr. 1 2014 1,392.21 341.26 1,050.95 67,200.59

May 1 2014 1,392.21 336.00 1,056.21 66,144.39

June 1 2014 1,392.21 330.72 1,061.49 65,082.90

July 1 2014 1,392.21 325.41 1,066.80 64,016.10









Date Payment Obligation Obligation Obligation Aug. 1 2014 1,392.21 320.08 1,072.13 62,943.97

Sep. 1 2015 1,392.21 314.72 1,077.49 61,866.48

Oct 1 2015 1,392.21 309.33 1,082.88 60,783.61

Nov. 1 2015 1,392.21 303.92 1,088.29 59,695.31

Dec. 1 2015 1,392.21 298.48 1,093.73 58,601.58

Jan. 1 2015 1,392.21 293.01 1,099.20 57,502.38

Feb. 1 2015 1,392.21 287.51 1,104.70 56,397.68

Mar 1 2015 1,392.21 281.99 1,110.22 55,287.46

Apr. 1 2015 1,392.21 276.44 1,115.77 54,171.69

May 1 2015 1,392.21 270.86 1,121.35 53,050.33

June 1 2015 1,392.21 265.25 1,126.96 51,923.38

July 1 2015 1,392.21 259.62 1,132.59 50,790.78

Aug. 1 2015 1,392.21 253.95 1,138.26 49,652.53

Sep. 1 2016 1,392.21 248.26 1,143.95 48,508.58

Oct 1 2016 1,392.21 242.54 1,149.67 47,358.91

Nov. 1 2016 1,392.21 236.79 1,155.42 46,203.50

Dec. 1 2016 1,392.21 231.02 1,161.19 45,042.30Jan. 1 2016 1,392.21 225.21 1,167.00 43,875.31

Feb. 1 2016 1,392.21 219.38 1,172.83 42,702.47

Mar 1 2016 1,392.21 213.51 1,178.70 41,523.77

Apr. 1 2016 1,392.21 207.62 1,184.59 40,339.18

May 1 2016 1,392.21 201.70 1,190.51 39,148.67

June 1 2016 1,392.21 195.74 1,196.47 37,952.20

July 1 2016 1,392.21 189.76 1,202.45 36,749.75

Aug. 1 2016 1,392.21 183.75 1,208.46 35,541.29

Sep. 1 2016 1,392.21 177.71 1,214.50 34,326.79

Oct 1 2016 1,392.21 171.63 1,220.58 33,106.21

Nov. 1 2016 1,392.21 165.53 1,226.68 31,879.53

Dec. 1 2016 1,392.21 159.40 1,232.81 30,646.72

Jan. 1 2017 153.41 (153.41) 30,800.13










Jan. 1 2017 1,371.00 1,371.00 29,429.13

Feb. 1 2017 1,371.00 171.67 1,199.33 28,229.80

Mar 1 2017 1,371.00 164.67 1,206.33 27,023.48

Apr. 1 2017 1,371.00 157.64 1,213.36 25,810.12

May 1 2017 1,371.00 150.56 1,220.44 24,589.67

June 1 2017 1,371.00 143.44 1,227.56 23,362.11

July 1 2017 1,371.00 136.28 1,234.72 22,127.39

Aug. 1 2017 1,371.00 129.08 1,241.92 20,885.47Sep. 1 2017 1,371.00 121.83 1,249.17 19,636.30

Oct 1 2017 1,371.00 114.55 1,256.45 18,379.85

Nov. 1 2017 1,371.00 107.22 1,263.78 17,116.06

Dec. 1 2017 1,371.00 99.84 1,271.16 15,844.91

Jan. 1 2018 1,371.00 92.43 1,278.57 14,566.33

Feb. 1 2018 1,371.00 84.97 1,286.03 13,280.31

Mar 1 2018 1,371.00 77.47 1,293.53 11,986.77

Apr. 1 2018 1,371.00 69.92 1,301.08 10,685.70

May 1 2018 1,371.00 62.33 1,308.67 9,377.03

June 1 2018 1,371.00 54.70 1,316.30 8,060.73

July 1 2018 1,371.00 47.02 1,323.98 6,736.75

Aug. 1 2018 1,371.00 39.30 1,331.70 5,405.05

Sep. 1 2018 1,371.00 31.53 1,339.47 4,065.58

Oct 1 2018 1,371.00 23.72 1,347.28 2,718.29

Nov. 1 2018 1,371.00 15.86 1,355.14 1,363.15

Dec. 1 2018 1,371.00 7.85 1,363.15 0.00

83,023.56 11,293.56







5.

January 1, 2014

Vehicles under Lease ........................... 71,730.00Obligations under Lease .................. 71,730.00

Obligations under Lease .......................... 1,392.21

Cash ................................................... 1,392.21

February 1, 2014


Interest Expense ....................................... 351.69

Cash ................................................... 1,392.21December 31, 2014


Interest Payable................................. 293.01

Depreciation Expense .............................. 12,346.00

Accumulated Depreciation —Vehicles

under Lease ....................................... 12,346.00

[($71,730 – $10,000) ÷ 5]

(c) Option 3:

1. Under this option, Sanderson Inc. must treat the lease as anoperating lease as none of the criteria for treatment as acapital lease is met.

2.

January 1, 2014

Rent Expense ............................................ 1,392.21Cash ................................................... 1,392.21

December 31, 2014

Rent Expense ............................................ 1,392.21

Rent Payable ..................................... 1,392.21







3.Excel formula =PMT(rate,nper,pv,fv,type)

PV $39,500

I 2%*

N 24


FV $0

Type 1* 8% ÷ 4

4.Sanderson Inc.


Effective Principal Carrying

Payment Interest Reduction Amount1/1/2017 $39,500.001/4/2017 $5,392.14 $790.00 $4,602.14 34,897.861/7/2017 5,392.14 697.96 4,694.18 30,203.68

1/10/2017 5,392.14 604.07 4,788.06 25,415.621/1/2018 5,392.14 508.31 4,883.82 20,531.801/4/2018 5,392.14 410.64 4,981.50 15,550.291/7/2018 5,392.14 311.01 5,081.13 10,469.16

1/10/2018 5,392.14 209.38 5,182.75 5,286.411/1/2019 5,392.14 105.73 5,286.41 0.00

$3,637.10

5.

January 1, 2017

Cash ........................................................... 39,500.00Notes Payable ................................... 39,500.00

Vehicles ..................................................... 39,500.00

Cash ................................................... 39,500.00







April 1, 2017


Notes Payable ........................................... 4,602.14

Cash ................................................... 5,392.14

December 31, 2017



Depreciation Expense ............................ 14,750.00

Accumulated Depreciation – Vehicles 14,750.00

[($39,500 – $10,000) ÷ 2]

(d) For the contract-based approach, the probabili ty-weightedexpected value of the excess mileage penalty must be usedin the present value calculation of the lease rights andobligations.

$0 X 75%10,000 ki lometres X 25 cents X 10%= $25020,000 ki lometres X 25 cents X 15%= 750

Probabil ity-weighted amount $1,000



PV $ ? Yields $835.64

I 0.5%*

N 36

PMT $ 0FV $ 1,000

Type 0* 6% ÷ 12







(d) (Continued)Consequently the capitalized amount of the right-of-useasset and the lease payments liability increases by $835.64.

The same lease amortization schedule for Option 2, item 4,except that the carrying amount at the inception will be$71,730.00 + $835.64 = $72,565.64 and a payment of $1,000is made January 1, 2017.

Lease Amortization Schedule —Contract Based Approach




$72,565.64

Jan. 1/14 $1,392.21 $1,392.21 71,173.43

Feb. 1/14 1,392.21 $355.87 1,036.34 70,137.09

Mar. 1/14 1,392.21 350.69 1,041.52 69,095.56

Apr. 1/14 1,392.21 345.48 1,046.73 68,048.83

May 1/14 1,392.21 340.24 1,051.97 66,996.86

Jun. 1/14 1,392.21 334.98 1,057.23 65,939.64

Jul . 1/14 1,392.21 329.70 1,062.51 64,877.13

Aug. 1/14 1,392.21 324.39 1,067.82 63,809.30

Sept.1/14 1,392.21 319.05 1,073.16 62,736.14

Oct . 1/14 1,392.21 313.68 1,078.53 61,657.61

Nov. 1/14 1,392.21 308.29 1,083.92 60,573.69

Dec. 1/14 1,392.21 302.87 1,089.34 59,484.35

Jan. 1/14 1,392.21 297.42 1,094.79 58,389.56

$3,922.66







(d) (Continued)

January 1, 2014Right-of-use Asset .................................. 72,565.64

Obligations under Lease .................. 72,565.64


Cash ................................................... 1,392.21

February 1, 2014


Interest Expense ....................................... 355.87Cash ................................................... 1,392.21

December 31, 2014



Amortization Expense ............................. 12,513.13

Right-of-use Asset ............................ 12,513.13[($72,565.64 – $10,000) ÷ 5]

(e) Assuming the entr ies in part (d), the $1,000 payment is thelast payment on the amortization schedule, and it will be acombination of the final payment on the principaloutstanding and interest on the outstanding obligationsince the last payment date a year earlier. Assuming theentries in part (b), the penalty would be recognized as aloss when it can first be estimated reliably.







(f) Contract

Option 1 Option 2 Option 3 Based

Statement of financial position

Assets:

Property plant and equipment

Vehicles $79,000Vehicles under lease $71,730

Accumulated depreciation (13,800) (12,346)

Net 65,200 59,384

Intangible assets

Right-of -use asset $72,566

Amortization of rights to date (12,513)

Net 60,053

Liabilities:

Current liabilities:Interest payable 1,204 293 297

Rent payable 1,392

Instalment note payable – current 14,418

Obligations under lease – current 13,559 13,505







Option 1 Option 2 Option 3Contract

Based

Non-current liabilities:

Instalment note payable 54,407

Obligations under lease 45,042 45,980

Total liabil it ies 70,029 58,894 1,392 59,782

Income statement - 2014

Depreciation expense $13,800 $12,346


Rent expense $16,707

Interest expense 5,176 3,871 3,923

$18.976 $16,666 $16,707 $16,436

(g)

Total expense - 5 years Option 1 Option 2 Option 3

Contract

BasedDepreciation expense $69,000 (1) $61,730 (3) $29,500 (5)

Amortization expense $62,565 (8)

Auto expense (excess km.) 1,000

Rent expense 50,120 (6)

Interest expense 15,312 (2) 11,294 (4) 3,637 (7) 11,459 (9)

$84,312 $74,024 $83,257 $74,024





Kieso, Weygandt, Warfield, Young, Wiecek, McConomy Intermediate Accounting, Tenth Canadian Edition


(1) Annual depreciation X 5 or Cost $79,000 less residualvalue $10,000

(2) Refer to Instalment note table Option 1 part 2

(3) Annual depreciation X 5 or capitalized amount $71,730less residual value $10,000

(4) Refer to lease amortization schedule Option 2 part 4(5) Annual depreciation $14,750 X 2 or Cost $39,500 less

residual value $10,000(6) Monthly rental of $1,392.21 X 36 months(7) Refer to Instalment note table Option 3 part 4(8) Annual amortization X 5 (=$62,565) or capitalized

amount $72,565 less residual value $10,000

(9) Same as item 4 of $11,294 plus the interest on thepenalty of $835.64 (dif ference between present value of$835.64 and future value of $1,000.00) = $11,459

(h) Not coincidently, the total expenses under Option 2 areequal to those for the accounting using the contract-basedapproach in part (c). The main difference in the choices canbe found in the choice between purchase Option 1 or leaseOption 2. Option 3 is somewhat of a hybrid between theOption 1 and 2 but what it has most in common with Option

1 is that the vehicle is purchased. Although the purchaseoption results in the highest total expense for five year,(Option 1 and 3) it also provides the highest potential for again from the sale of the vehicle at the end of the useful li fe,as the residual value employed in the calculations at leaseinception might be a conservative estimate.

The second major consideration is the difference in the wayin which income tax will be applied to the differentalternatives, particularly since the asset is a luxury vehicleand there are limits on deductibility under the Income Tax

Act.

Finally, cash flow consideration should be taken intoaccount as well as financial ratios that are of particularinterest to the creditors and investors of Sanderson Inc.






PROBLEM 20-21

(a) The lease is an operating lease to BMW Canada. The lease

1. does not transfer ownership, nor contain a bargainpurchase option,

2. does not cover at least 75% of the estimated economic lifeof the car, (3 ÷ 8 = 37.5%) and

3. the present value of the lease payments of $45,992* is notat least 90% of the fair value of the car.



PV $ ? * Yields $45,992

I .5%

N 36

PMT $ 1,392.21

FV 0

Type 1

At least one of the three cr iteria would have had to besatisfied for the lease to be classified as other than anoperating lease. The property is recorded as a rentalproperty to BMW and will be treated as a payment of rentby the lessee under the operating lease.

(b)

January 1, 2014

Cash ..................................................... 1,392.21Rent Revenue .............................. 1,392.21







(c) 1.

BMW Canada – Lessor

Lease Amortization Schedule Annual

Lease Interest Net Balance

Payment on Net Investment of Net

Date Plus URV Investment Recovery Investment

79,000.00

Jan. 1 2014 1,392.21 1,392.21 77,607.79

Feb. 1 2014 1,392.21 388.04 1,004.17 76,603.62

Mar 1 2014 1,392.21 383.02 1,009.19 75,594.43 Apr. 1 2014 1,392.21 377.97 1,014.24 74,580.19

May 1 2014 1,392.21 372.90 1,019.31 73,560.88

June 1 2014 1,392.21 367.80 1,024.41 72,536.47

July 1 2014 1,392.21 362.68 1,029.53 71,506.95

Aug. 1 2014 1,392.21 357.53 1,034.68 70,472.27

Sep. 1 2015 1,392.21 352.36 1,039.85 69,432.42

Oct 1 2015 1,392.21 347.16 1,045.05 68,387.38

Nov. 1 2015 1,392.21 341.94 1,050.27 67,337.10

Dec. 1 2015 1,392.21 336.69 1,055.52 66,281.58Jan. 1 2015 1,392.21 331.41 1,060.80 65,220.78

Feb. 1 2015 1,392.21 326.10 1,066.11 64,154.67

Mar 1 2015 1,392.21 320.77 1,071.44 63,083.23

Apr. 1 2015 1,392.21 315.42 1,076.79 62,006.44

May 1 2015 1,392.21 310.03 1,082.18 60,924.26

June 1 2015 1,392.21 304.62 1,087.59 59,836.67

July 1 2015 1,392.21 299.18 1,093.03 58,743.65

Aug. 1 2015 1,392.21 293.72 1,098.49 57,645.15Sep. 1 2016 1,392.21 288.23 1,103.98 56,541.17

Oct 1 2016 1,392.21 282.71 1,109.50 55,431.67

Nov. 1 2016 1,392.21 277.16 1,115.05 54,316.61

Dec. 1 2016 1,392.21 271.58 1,120.63 53,195.99







Annual




Jan. 1 2016 1,392.21 265.98 1,126.23 52,069.76

Feb. 1 2016 1,392.21 260.35 1,131.86 50,937.90

Mar 1 2016 1,392.21 254.69 1,137.52 49,800.38

Apr. 1 2016 1,392.21 249.00 1,143.21 48,657.17

May 1 2016 1,392.21 243.29 1,148.92 47,508.24

June 1 2016 1,392.21 237.54 1,154.67 46,353.57

July 1 2016 1,392.21 231.77 1,160.44 45,193.13

Aug. 1 2016 1,392.21 225.97 1,166.24 44,026.89Sep. 1 2016 1,392.21 220.13 1,172.08 42,854.81

Oct 1 2016 1,392.21 214.27 1,177.94 41,676.88

Nov. 1 2016 1,392.21 208.38 1,183.83 40,493.05

Dec. 1 2016 1,392.21 202.47 1,189.74 39,303.31

Jan. 1 2017 196.70 196.70 39,500.00

Jan. 1 2017 1,371.00 1,371.00 38,129.00

Feb. 1 2017 1,371.00 222.42 1,148.58 36,980.42

Mar 1 2017 1,371.00 215.72 1,155.28 35,825.14 Apr. 1 2017 1,371.00 208.98 1,162.02 34,663.12

May 1 2017 1,371.00 202.20 1,168.80 33,494.32

June 1 2017 1,371.00 195.38 1,175.62 32,318.71

July 1 2017 1,371.00 188.53 1,182.47 31,136.23

Aug. 1 2017 1,371.00 181.63 1,189.37 29,946.86

Sep. 1 2017 1,371.00 174.69 1,196.31 28,750.55

Oct 1 2017 1,371.00 167.71 1,203.29 27,547.26

Nov. 1 2017 1,371.00 160.69 1,210.31 26,336.95

Dec. 1 2017 1,371.00 153.63 1,217.37 25,119.59Jan. 1 2018 1,371.00 146.53 1,224.47 23,895.12

Feb. 1 2018 1,371.00 139.39 1,231.61 22,663.50

Mar 1 2018 1,371.00 132.20 1,238.80 21,424.71

Apr. 1 2018 1,371.00 124.98 1,246.02 20,178.69







Annual




May 1 2018 1,371.00 117.71 1,253.29 18,925.39

June 1 2018 1,371.00 110.40 1,260.60 17,664.79

July 1 2018 1,371.00 103.04 1,267.96 16,396.84

Aug. 1 2018 1,371.00 95.65 1,275.35 15,121.49

Sep. 1 2018 1,371.00 88.21 1,282.79 13,838.69

Oct 1 2018 1,371.00 80.73 1,290.27 12,548.42

Nov. 1 2018 1,371.00 73.20 1,297.80 11,250.62

Dec. 1 2018 1,371.00 65.71 1,305.29 9,945.33Jan. 1 2018 10,000.00 54.67* 9,945.33 0.00

$13,968.89*Rounded

2. The lease is a sales-type lease to BMW Canada. The presentvalue of the unguaranteed residual value is calculated asfollows using two steps:The first step is for the renewal period of 2 years:



PV $ ? Yields $8,734.39

I 7%

N 2

PMT 0

FV $ 10,000

Type 1

The second step is to calculate the present value of theamount arrived in the first step back to January 1, 2014 for aperiod of 3 years.









I 6%

N 3

PMT 0

FV $ 8,734.39

Type 1

Consequently the sale price is $79,000.00 less the present

value of the unguaranteed residual value of $7,333.56 or$71,666.44

The cost of goods sold is $70,000.00 less the present valueof the unguaranteed residual value of $7,333.56 or$62,666.44.

The amount of the lease payments receivable is the sum ofthe lease payments under the initial lease and the renewallease calculated as fol lows:

36 payments @ 1,392.21 = $50,119.5624 payments @ 1,371.00 = 32,904.00Unguaranteed residual value 10,000.00Total receivable $93,023.56

3.

January 1, 2014Lease Receivable ..................................... 93,023.56Cost of Goods Sold ................................. 62,666.44

Sales Revenue .................................. 71,666.44

Inventory ........................................... 70,000.00Unearned Interest Income ............... 14,023.56

Cash .......................................................... 1,392.21Lease Receivable ............................. 1,392.21







February 1, 2014Cash .......................................................... 1,392.21

Lease Receivable ............................. 1,392.21

December 31, 2014Unearned Interest Income ....................... 4,319.51

Interest Income................................. 4,319.51






PROBLEM 20-22*

(a)

29/6/14 Cash .......................................... 8,000,000Buildings ............................ 9,500,000 Accumulated Depreciation

-Buildings ......................... 3,321,429*Deferred Prof it on Sale-

Leaseback ....................... 1,821,429*($9,500,000 - $2,000,000) / 35 X 15.5 years)

29/6/14 Buildings under Lease ............. 8,000,000Obligations under Lease .... 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%


PV $ ? Yields $8,000,005

I 10%N 20

PMT $ (838,380)

FV $ (1,000,000)

Type 1

29/6/14 Obligations under Lease .......... 838,380Cash ..................................... 838,380






PROBLEM 20-22* (Continued)

Partial Lease Amortization Schedule

Date

Annual

LeasePayment

Interest(10%) Amortization Balance

29/06/1429/06/14 $838,380 $838,380

$8,000,0007,161,620

29/06/15 838,380 $716,162 122,218 7,039,402

12/31/14 Deferred Profit on Sale-Leaseback 45,536Depreciation 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 amortizedon the same basis that the asset is being depreciated.Maintenance, insurance and property taxes would also havebeen paid during the year.

12/31/14 Depreciation Expense .................. 150,000 Accumulated Depreciation

-Leased Buildings ............. 150,000

(($8,000,000 - $2,000,000) ÷ 20 X 6/12)

12/31/14 Interest Expense .......................... 358,081Interest Payable ..................... 358,081($7,161,620 X 10% X 6/12)

29/6/15 Obligations under Lease .......... 122,218Interest Payable.............................. 358,081Interest Expense ............................ 358,081

Cash ....................................... 838,380

12/31/15 Deferred Profit on Sale-Leaseback 91,071Depreciation Expense ........... 91,071

($1,821,429 ÷ 20)







12/31/15 Depreciation Expense .................. 300,000 Accumulated Depreciation

-Leased Buildings .............. 300,000(($8,000,000 - $2,000,000) ÷ 20)

12/31/15 Interest Expense .......................... 351,970Interest Payable ..................... 351,970($7,039,402 X 10% X 6/12)

(b) The lease must now be recorded as an operating lease as itis no longer a capital lease because: (1) the lease term is for60% (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 value of the leased assetand (3) there is no longer a bargain purchase option.Maintenance, insurance and property tax expenses wouldalso be incurred.

The present value of the minimum lease payments:


PV $ ? Yields $ 6,283,709

I 10%N 12

PMT $ (838,380)

FV $ 0

Type 1

29/6/14 Cash ............................................... 8,000,000Buildings ................................. 9,500,000

Accumulated Depreciation-Buildings .............................. 3,321,429*

Deferred Prof it on Sale-Leaseback ............................. 1,821,429

*($9,500,000 - $2,000,000) / 35 X 15.5 years)






PROBLEM 20-22* (Cont inued)

29/6/14 Rent Expense ................................. 838,380Cash .......................................... 838,380

31/12/14 Prepaid Rent ................................. 419,190Rent Expense ........................... 419,190

31/12/14 Deferred Profit on Sale-Leaseback ................................. 75,893

Rent Expense ........................... 75,893*($1,821,429 / 12 X 6/12)

29/6/15 *Rent Expense ................................ 419,190

Prepaid Rent ............................ 419,190

29/6/15 Rent Expense ................................. 838,380Cash .......................................... 838,380

31/12/15 *Prepaid Rent .................................. 419,190Rent Expense ........................... 419,190

31/12/15 Deferred Profit on Sale-Leaseback .................................. 151,786

Rent Expense ........................... 151,786($1,821,429 / 12)

*Note to instructor: these two entries cancel each other out andcould be omitted.






PROBLEM 20-22* (Cont inued)

(c) The net assets amount (or equity) on the statement offinancial position of North Central will be very similar afterthe completion of the sale and leaseback as it was before.

Any excess of the capital ized amount of the building overthe carrying value at the time of the sale (i.e. the gain) willbe deferred and amortized over the term of the lease, or thelife of the asset. Eventually this gain will be realized toequity. Over the term of the lease, the additional costsrelated to the borrowing will affect equity but this is nodifferent, for example, than if a loan had been obtained inexchange for a mortgage obligation.






PROBLEM 20-23*

(a)

To the lessee, this lease of the building is accounted for as acapital lease and the lease of the land is treated an operatinglease, since there is no bargain purchase option for the propertyand because the terms of the lease satisfy at least one of thequantitative cri teria for capitalization.

The present value of the minimum lease payments is greaterthan 90% of the fair value of the leased property; that is, thepresent value of $1,705,457 (see below) is 97.5% of the fair valueof the leased property ($1,705,457 / $1,750,000).


PV $ ? Yields $1,705,457

I 7%

N 15

PMT $ (175,000)

FV $ 0

Type 1

The land and building must be considered separately for thepurpose of classifying the lease. The minimum lease paymentsmust be allocated between the land and the building inproportion to their fair values.

The portion of the gain related to the lease of the land, which isan operating lease, is amortized over the term of the lease. Theportion of the gain related to the building must be deferred andamortized in proportion to the depreciation of the leased asset.







October 1, 2014Cash .................................................................. 1,750,000

Land and Building (net) ............................ 250,000Deferred Profit on Sale-Leaseback(Land) (40%) 600,000Deferred Profit on Sale-Leaseback(Building) (60%) 900,000

Buildings under Lease ..................................... 1,023,274Obligations under Lease .......................... 1,023,274

($1,705,457 X 60% = $1,023,274)

Obligations under Lease ..................................... 105,000Rent Expense ...................................................... 70,000

Cash .............................................................. 175,000[($175,000 X 40 % = $70,000]

September 30, 2015:Interest Expense ................................................ 64,279

Interest Payable[($1,023,274 – $105,000) X 7%] ............ 64,279

Depreciation Expense ........................................ 102,327 Accumulated Depreciation – Leased

Buildings($1,023,274 X 10%) .............................. 102,327

Deferred Profit on Sale-Leaseback(Land) ........ 40,000Gain on Sale of Land .................................. 40,000

($600,000 / 15)

Deferred Profit on Sale-Leasehold(Building) ... 90,000Gain on Sale of Bui ldings .......................... 90,000

($900,000 X 10%)

October 1, 2015:Interest Payable ................................................... 64,279Obligations under Lease ..................................... 40,721Rent Expense ...................................................... 70,000

Cash .............................................................. 175,000







(b) Financial Statement disclosure at September 30, 2015:


Property Plant & Equipment:Buildings under lease $ 1,023,274

Less: Accumulated depreciation (102,327)

920,947

Current Liabilities


Current portion of obligations under

lease 40,721Deferred profit on sale of land and

building 121,000

Long term liabilitiesDeferred profit on sale-leasehold of landand

building 1,249,000


Less: Current port ion (40,721)877,553

Land Building TotalDeferred profi t on sale-

leasehold of land andbuilding $ 600,000 $ 900,000

Depreciation - Fiscal year 2015 (40,000) (90,000)

Balance September 30, 2015 560,000 810,000

Current Portion 40,000 81,000 $ 121,000

Non- Current Portion 520,000 729,000 $1,249,000







Statement of Income:

Gain on sale of property $130,000Rent expense 70,000

Depreciation expense 102,327


Statement of cash flows: - indirect format


Depreciation expense $102,327Gain on sale of property 130,000

Increase in interest payable 64,279 *

Investing Activities:

Proceeds on sale of property 1,750,000

Financing Activities:

Payment of long term obligations under

lease (105,000)* would likely be combined with other amounts of interest

The sale and leaseback transaction is a non-cash financing andinvesting activity, which would be reported in the notes to thefinancial statements and not on the face of the statement of cashflows.

The disclosure requirements for the operating lease for the landincludes the future minimum lease payments, in total and foreach of the next f ive years.






CASES

Note: See the Case Primer on the Student website, as well as

the Summary of the Case Primer in the front of the text. Notethat the first few chapters in volume 1 lay the foundation forfinancial reporting decision making.

CA 20-1 CROWN INC.

Overview

- CI’s management has a financial reporting bias; that is, they do not wantto increase the debt that is presently on the balance sheet.

- Note that the company wants to know the differences between IFRS and ASPE.

- Since the company appears to have other debt, the creditors will be keyusers. They will want objective information and will be concerned with thedebt-to-equity ratio to assess how leveraged the company is, and therebyassess the company's ability to repay debt.

- As the auditor you will want conservative and transparent financialstatements.

Analysis and Recommendations

Issue: Whether the lease is a capital/finance lease or an operating lease

- There is no evidence that legal title passes to CI at the end of the lease.- There is no BPO since the purchase option allows CI to purchase at the

FV.- The term of the lease is only 12 years, which is less than 75% of the

economic life of 20 years.- The PVMLP is as follows:

$150,000 X 7.16073 = $1,074,110 $1,074,110/$1,900,000 = 56.5% which is less than 90%

Therefore, it would appear, on the surface that the lease was an operating lease.

On the other hand, given that the asset is manufactured specifically for CI, thereis no other possible use for the machine, and AL likely does not want themachine back, it would appear to be common sense that the lease is indeed acapital lease that represents a purchase in substance by CI. The writtenagreement should not be reviewed in isolation but rather within the context of the






CA 20-2 KELLY’S SHOES

Overview

- Not clear whether GAAP is a constraint but users will likely want GAAP

financial statements since they provide more useful information.Differences between IFRS and ASPE are provided as requested.

- Landlords in particular might want to see the financial statements in orderto help negotiate the restructuring.

- In addition, creditors and shareholders would be interested in transparentstatements.

- As management – would want to show a realistic picture of the state ofaffairs. May be biased to make the situation look at bit worse so as to bein a better negotiating situation.

Analysis and Recommendations

Issue: How to account for the three months bonus of free rent/costs ofcancellation. Not clear as to whether operating or capital leases (termination of acapital lease would result in removal of assets/liabilities with a gain/lossrecognized).

Accrue costs Do not- If likely that the costs would be

incurred and measurable. PerIAS 37 – present obligation as aresult of past transaction,

probable outflow andmeasurable (essentially thesame as ASPE).

- In this case— the leases arenon-cancellable and therefore, itis likely that there would becosts to break the lease.

- The key would be whether theseare measurable – would dependon stage that negotiations werein.

- Measurement may be an issuesince each landlord might makea different deal.

- Some landlords may even be

willing to provide financialsupport to the company to keepthe stores open as long aspossible— cannot accrue thisbenefit until received(contingency accounting).

- An exit plan by itself does notnecessarily create an obligation.

- Would wait until contracts areactually terminated.

Recommendation: It would appear that the negotiations were at a verypreliminary stage and that the landlords might have been willing to offer someinducements/concessions to the company to stay longer. Therefore, the outcomeof the uncertainty was not yet determinable and recognition would not be






CA 20-2 (CONTINUED)

recommended. This would be further supported since, even if it were argued thatthe costs were likely, it is difficult to measure the cost. At the one end of thespectrum, the landlords could require the full commitment to the end of the lease

be honoured. At the other end, the landlord might agree to a lesser amount, i.e.,the company would pay rent until a new tenant is found.






TIME AND PURPOSE OF WRITING ASSIGNMENTS

WA 20-1 (Time 15–25 minutes)

Purpose—to provide the student with an ethics case involving the capitalization

criteria applied to technology that is fast becoming obsolete for the capitalizationand contract-based approaches. The student must assess the validity of thearguments given for not capitalizing equipment and make recommendations.


Purpose—to provide the student with an understanding of the different impacts ofthe current ASPE and IFRS lease treatments on financial statements and theproposed contract-based approach. The student must describe the changes inbasic financial ratios under these different standards. The student is alsorequired to use the conceptual framework to explain the contract-based approachfor leases, which appears to gain more support from the joint FASB-IASB studygroup.


Purpose—to provide the student with an understanding of the two approachesbeing considered for lessor accounting – derecognition approach and theperformance obligation approach. It also requires students to demonstrate theirunderstanding of the initial recording of a lease under the two alternatives.

WA 20-4 (Time 40 – 45 minutes)

Purpose—to provide the student with an understanding of the theoretical reasonsfor requiring certain leases to be capitalized by the lessee. It also requiresstudents to demonstrate their understanding of the classification of three leases.The student determines how the lessee should classify each lease, what amountshould be recorded as a liability at the inception of each lease, and how thelessee should record each minimum lease payment for each lease.

WA 20-5 (Time 30 – 35 minutes)

Purpose—to provide the student with an opportunity to compare and contrast the

accounting for leases under ASPE, IFRS and the contract based approach andto understand the underlying concepts for these different treatments.






WA 20-1 (Continued)

(d) Under the contract-based approach, the contractual lease obligation will be

reported on the statement of financial position regardless of whether a

bargain purchase option is seen to exist or not. The only difference will behow the asset will be recognized. If the bargain purchase option does not

exist, based on Koba’s arguments, then the contractual lease rights are

recognized as an intangible asset. This intangible asset would be amortized

on some systematic pattern of usage over the lease term. If the bargain

purchase option is likely to be exercised, then the lease agreement is, in

substance, an acquisition, and the copiers would be recorded as

equipment. In this case, the equipment would be depreciated over their

useful lives.






WA 20-2

(a) The retail outlet leases: Based on the lease terms and conditions for theretail outlets noted in the question, these leases represent operatingleases. Leases that are operating leases are recognized and reported in

the same manner under both ASPE and IFRS: the monthly leasepayments and contingent rental payments are all expensed as incurred.

Building Lease: The information notes that the building lease has beenassessed against the capitalization criteria under private enterpriseaccounting standards, and found to qualify as an operating lease.However, there are a few differences in these criteria under IFRS thatmight change the final conclusion as noted below:

1. Transfer of benefits and risks: In assessing the transfer of risks andrewards, IFRS also requires an assessment of the degree to which anasset is specialized and of use only to the lessee without major expense

to the lessor. If it is found on review, that the new facility is so specializedthat the lessor would have difficulty leasing to another tenant without a lotof extra costs, then the lease contract transfers substantially all of thebenefits and risks of property ownership, and should be capitalized.Considering that the building was designed specifically for Sporon’sneeds, substantial amounts of benefits may be transferred to Sporon.Thus, careful review of the lease contract is required to identify anysubstantial transfer of risks, including the requirement to pay property taxincreases.

2. Depending on which interest rate was used to test the minimum leasepayment criterion, Sporon may need to account for the lease as a finance

lease under IFRS. While CICA Handbook Part II, Section 3065 specifiesthe use of the lower of the interest rate implicit in the lease and thelessee's incremental borrowing rate, IAS 17 specifies use of the interestrate implicit in the lease when it is practicably determinable; otherwise, thelessee's incremental borrowing rate is used.

(b) To Louise Bren,Subject: Accounting Treatment for Leases under the approach of theFASB-IASB joint project.

The IASB and FASB, through a Joint International Working Group, issuedan Exposure Draft changing the accounting for leases in 2010, and basedon the comments received are currently looking at a variety of optionsrelated to financial reporting for leases. As indicated in the 2010 ExposureDraft, the contract based approach is being considered as they intend tochoose a model that will rely on asset and liability definitions in theconceptual framework. This approach is based on the idea that allarrangements that provide one party the right to use an item of anotherparty should be accounted for similarly.






WA 20-2 (Continued)

The contract based approach is expected to be more useful to users assome entities are not recognizing a substantial amount of lease obligationsthat meet the definition of liabilities under the conceptual framework. Under

the contract based approach, the capital (or finance) and operating leasedistinction would disappear and most leases would qualify for recognition asassets and liabilities by the lessee.

Retail outlet leases:Based on feedback received, the IASB and FASB are considering allowingthe “straight-line” approach for leases in certain circumstances. Thisapproach would be similar to what is used for operating leases currently.However, if the lease is “for a major part of the economic life of underlyingasset” then the lease would need to be capitalized. If this latter approach isadopted, these leases will be shown on the statement of financial position.

An intangible asset for the contractual lease rights will be recognized, and

amortized over a systematic period, likely a straight-line basis over thelease term. A liability for the contractual lease obligation will be recognizedand amortized using the appropriate discount rate over the lease term. Aspayments are made, the obligation will be reduced and interest expensewill be recognized. There are three issues with respect to these leases thatwould have to be assessed:

1. What is the lease term? The lease term should be the “longest leaseterm that is more likely than not” to occur. This would be 10 years for thecurrent retail leases – the initial term and the renewal period.

2. What are the payments to be included in the contractual obligations? In

this case, the monthly payments and the contingent payments would beincluded in determining the value of the obligation. The value for thecontingent rental payments would be determined using probability weightedexpected values over the term of the lease. The value of these contingentpayments would have to be reassessed at each reporting period, with anychanges related to the current and past period contingencies beingreported immediately into income and any impact on future periods wouldchange the amount of the obligation.

3. What discount rate should be used in determining the amount of theobligation and asset? Sporon’s incremental borrowing rate would be usedto discount the payments to determine the contractual obligation.

Overall, if the Company is leasing relatively new buildings, it may end upbeing able to account for the retail outlet leases as “straight-line leases” asthey may not be long enough to represent a major part of the economic lifeof the property.






WA 20-2 (Continued)

Building lease: For the building lease, the first assessment that needs tobe made is whether substantially all of the risks and rewards have beentransferred since the building is unique to Sporon’s purposes and the

lease, by design, perhaps earns the lessor a fixed return. If this is thecase, then the lease would be seen to be a purchase in substance, and thevalue of the contractual obligation and the building as an asset would berecognised. The building would be depreciated over its useful life, and theobligation would be reduced as payments are made, and interest isexpensed. If it is found that the lease does not substantially transfer therisks and rewards, then an intangible asset is recognized instead andamortized over some systematic basis – likely straight-line over the 20 yearterm of the lease. The amount of the obligation would be the same ineither case. For this assessment, the lease term would be 20 years, andthe discount rate would be Sporon’s incremental borrowing rate. Lastly,depending on how long the overall life of the building is, the Company may

end up being able to account for the retail outlet leases as “straight-lineleases” as they may not be long enough to represent a major part of theeconomic life of the property. However, given a 20 year lease, the buildinglease is more likely to be required to be capitalized than the retail leases.

The impact of capitalization of the leases on the cash flow statement wouldbe to remove the lease payments from operating cash flows, and instead,the portion of the payment that represents interest would be shown aseither operating or financing (depending on the company’s policy) and thereduction in the obligation would be recorded as a financing activity. Thiswould cause the operating cash flow to be higher under the contract basedapproach.






WA 20-2 (Continued)

(c) Appendix: If the leases were all considered straight-line leases, than therewould be little or no impact on the Company’s ratios. However, if theleases are capitalized, it would have the following impact on these basic

ratios.

ProfitabilityProfit margin The ratio will be lower in the earlier years and

higher in the later years under the contract-basedlease treatment because 1) operating leasesrecognize lease expenses evenly during the leaseterm; and 2) interest expense and amortizationexpenses, which are recorded under a capitallease, are higher in the earlier years.

Return on

assets

Lower: Assets, the denominator, would increase by

the value of the intangible assets. The net incomewill be lower in the earlier years due to the higherinterest and amortization expenses. As a result,the return on assets will be lower. Over time, thiswill increase as the asset is reduced and netincome is higher with the lower amounts chargedfor interest and amortization expenses.

Return onequity

Lower: The return would decrease in the earlieryears and so would retained earnings in equity forthe same reasons noted above

RiskDebt-to-equity Higher: Debt would increase by the contractual

lease obligation amount while equity (retainedearnings) would decrease (in the earlier years).

Times interestearned

EBIT would increase because although there is anamortization expense this may be lower than therent expense that would disappear. However, thedenominator, interest expense, would increase aswell. So it is difficult to assess the overall impactwithout further details.

SolvencyOperating cashflows to total

debt

As cash outflows for the principal balance of thelease obligation would be reported under ”financing

activities”, the cash flow from operating activitieswould be higher. At the same time, the amount oftotal debt, which is the denominator of this ratio,would increase by the lease obligation and later getsmaller as the obligation gets repaid. So it isdifficult to assess the exact impact without furtherdetails.






WA 20-3

(a) The “performance obligation approach” is discussed in the text book underthe contract-based approach. In this approach, the lessor is granting theright to use the asset to the lessee over the term of the lease. The lessor

does not lose control of the asset, which continues to be reflected on thestatement of financial position. In this case, the lessor has the right toreceive the lease payments, and an unconditional obligation to permit theuse of the asset over the term of the lease. As a consequence, at the timethe lease is entered into, a lease receivable is recorded as an asset and aperformance obligation is recorded as the offsetting liability. The receivableand obligation are calculated to be the present value of the leasepayments. As the lessor discharges the performance obligation, leasingincome is recognized into income. As payments are received from thelessee, interest income is recognized and the receivable is reduced.Finally, the asset would continue to be depreciated over its useful life, On

the statement of financial position, the asset, the lease receivable and theperformance obligation are shown as a net liability or asset. On thestatement of comprehensive income, the lessor would report leasingincome, interest income and depreciation expense.

(b) The “derecognition approach” assumes that a portion of the leased asset issold when the rights of use are transferred to the lessee under the leaseagreement. This requires that the leased assets be derecognized. Thelease contract is a promise to transfer the asset to the lessee and so oncedelivery is completed, the performance obligation has been met and nolonger exists. In derecognizing the leased asset, a receivable for the

present value of the lease payments and a residual value are recognized.The residual value is a non-financial asset which represents the rights toeconomic benefits from the asset arising after the lease term. Theseeconomic benefits would arise from subsequent sale of the asset or re-leasing the asset under a new contract. The company will recognizerevenue on the sale of the asset, and then interest income on thereceivable as the lease payments are received. The impact on thestatement of financial position will be a receivable and a residual value asassets. The impact on the statement of comprehensive income will showrevenue from the sale of the leased asset, and interest income over theterm of the lease.






WA 20-3 (Continued)

(c) Using the information given, below is what would be shown on thestatement of financial position for assets and liabilities on initial recognitionof the lease:

Performance obligation Derecognition

Leased asset $100,000

Lease receivable $92,900 $92,900

Residual value $7,100

Performance obligation ($92,900)

Net assets $100,000 $100,000






WA 20-4

(a) In addition to triggering a gain, most likely Truttman was motivated to selland leaseback equipment to generate some much needed cash flow. Theinterest rate offered by the leasing company was most likely favourable

from the point of view of Truttman, in comparison to other sources offinancing.

(b) 1. A lease is categorized as a finance lease if, at the date of the leaseagreement, it meets any one of three criteria under ASPE or fourcriteria under IFRS. As the lease has no provision for Truttman toreacquire ownership of the equipment, it fails the criteria of transfer ofownership at the end of the lease under both IFRS and ASPE; there isno bargain purchase option. Truttman’s lease payments, with apresent value equalling 75% of the equipment’s fair value, fails thecriterion for a present value equalling or exceeding 90% of the

equipment’s fair value for ASPE. However, under IFRS, since thereare no “bright lines” one would have to judgementally determine if thepresent value of the payments allows the lessor to recoversubstantially all of its investment in the property with an appropriaterate of return. This criteria is likely not to be met under IFRS either.Under ASPE, the final criterion is whether its term allows the lessee tosubstantially use the building for its economic useful life. In this case,73% is below the 75% threshold and therefore the criteria would notbe met. In this case, under ASPE the lease would be classified as anoperating lease. However, under IFRS, since there are again no brightlies, one could conclude that 73% of the economic life is long enough

to receive substantially all of the economic benefits. In this case, thelease might be recorded as a finance lease. The final criteria underIFRS would look at whether or not the asset is specialized for thelessee’s use, which in this case, does not seem to be the case.

2. Comparisons of equipment’s fair value to its lease payments’ presentvalue, and of its useful life to the lease term, are used to determinewhether the lease is equivalent to an instalment sale and is therefore afinance lease. If the fair value test or the useful life test is met, there isan indication that the lessee is obtaining most of the benefits that theasset has to offer.






WA 20-4 (Continued)

(c) Operating lease treatment under ASPE: Truttman should account for thesale portion of the sale-leaseback transaction at October 31, 2014, byincreasing cash for the sale price for $13 million, decreasing building (and

related accumulated depreciation) by the carrying amount of $10 million,and recognizing a deferred gain on sale of $3 million for the excess of theequipment’s carrying amount over its sale price. The deferred gain will berecognized over the term of the lease. If the sale price is $1 million greaterthan the fair value, the total gain deferred would be $4 million. All of thegain over the carrying value is deferred and amortized over the operatinglease term. The operating lease payments are then recorded as anexpense as made.

Operating lease treatment under IFRS: IFRS recognizes that if an operatinglease is taken back, then the asset has been technically sold, and therefore

all of the gain of $3 million, representing the difference between fair value($13 million) and the carrying value ($10 million) is fully recognized intoincome at the time of the sale on October 31, 2014. If, as proposed in thequestion, the selling price was actually greater than its fair value, then theportion of the selling price greater than fair value of $1 million would berecognized as a deferred gain and amortized over the term of the lease,and the $3 million gain would be recognized immediately. The operatinglease payments are then recorded as an expense as made duringNovember and December, 2014.

(d) Capital lease treatment under ASPE: Truttman should account for the saleportion of the sale-leaseback transaction at October 31, 2014, byincreasing cash for the sale price for $13 million, decreasing building (andrelated accumulated depreciation) by the carrying amount of $10 million,and recognizing a deferred gain on sale of $3 million for the excess of theequipment’s carrying amount over its sale price. The deferred gain will berecognized on the same basis as depreciation of the leased asset. At thesame time, a capital leased asset and an offsetting capital lease obligationwill be recognized and will equal the present value of the lease payments.

At the end of the year, December 31, 2014, Truttman would recognizeinterest expense on the obligation at the effective interest rate, principalreduction in the obligation, and depreciation expense on the building(depreciated over the term of the lease).

Accrued interest on the obligation for the period from November 1, toDecember 31, 2014, will appear in the current liabilities section of thestatement of financial position along with the principal portion of the firstlease payment due October 30, 2015.






WA 20-4 (Continued)

(d) (Continued)

The remaining portion of the principal to be repaid beyond 2015 will be

reported as a non-current liability. The cash flow statement for the yearended December 31, 2014, will show proceeds from the sale of theequipment as a source of cash in the investing section of the cash flowstatement. For the operating activities section, prepared using the indirectformat, the gain on the sale of the equipment and the depreciation expensewill be added back to income as well as the increase in the interest payable(for the accrual recorded for the lease at the end of the year).

Finally the capital lease and the related obligation under capital lease fromthe leaseback transaction are a non-cash financing and investingtransaction that will not appear on the face of the cash flow statement but

will be reported in the notes to the financial statements.

Capital lease treatment under IFRS: Truttman should account for the saleportion of the sale-leaseback transaction at October 31, 2014, byincreasing cash for the sale price for $13 million, decreasing building (andrelated accumulated depreciation) by the carrying amount of $10 million,and recognizing a deferred gain on sale of $3 million for the excess of theequipment’s carrying amount over its sale price. The deferred gain will berecognized over the term of the lease (which differs from ASPE). At thesame time, a capital leased asset and an offsetting capital lease obligationwill be recognized and equal to the present value of the lease payments.

At the end of the year, December 31, 2014, Truttman would recognizeinterest expense on the obligation at the effective interest rate, principalreduction in the obligation, and depreciation expense on the building(depreciated over the term of the lease).

Accrued interest on the obligation for the period from November 1, toDecember 31, 2014, will appear in the current liabilities section of thestatement of financial position along with the principal portion of the firstlease payment due October 30, 2015.

The remaining portion of the principal to be repaid beyond 2015 will bereported as a non-current liability. The cash flow statement for the yearended December 31, 2014, will show proceeds from the sale of theequipment as a source of cash in the investing section of the cash flowstatement. For the operating activities section, if prepared using the indirectformat, the gain on the sale of the equipment and the depreciation expensewill be added back to income as well as the increase in the interest payablefor the accrual recorded on the lease at the end of the year.






WA 20-4 (Continued)

(d) (Continued)

Finally the capital lease and the related obligation under capital lease fromthe leaseback transaction are a non-cash financing and investingtransaction that will not appear on the face of the cash flow statement butwill be reported in the notes to the financial statements.






WA 20-5

There are many differences between IFRS and ASPE and the contractbased approach with respect to measurement and reporting for leases.Primarily, ASPE has been written to follow historical Canadian practice.

ASPE has also been designed with the primary user in mind of being thecreditor, rather than outside shareholders and creditors. Given thatgenerally creditors have access to management; the disclosure has alsobeen simplified. The contract based approach has been designed toeliminate the requirement to arbitrarily classify a lease into operating orcapital. Under this approach, all leases are treated the same and will impactthe statement of financial position and the statement of comprehensiveincome in the same manner. Any perceived manipulation to keep leases offthe balance sheet is eliminated.

In most areas of lease accounting at the time of writing of this book, IFRS

and ASPE are converged. There are some subtle differences that arehighlighted below:

a) ASPE and IFRS use the classification approach for leases – eitheroperating or capital. ASPE refers to capital leases and operatingleases for lessees, and operating, sales-type or direct financing leasesfor lessors. IFRS uses the term “finance leases” or operating leasesfor lessees or lessors. In contrast, the contract based approach doesnot require classification of leases, since they are all treated the same.

b) ASPE has three criteria to assess for determining lease treatment and

numerical thresholds are provided to assist with this. IFRS requiresthat the criteria be applied more judgmentally, with no “bright lines” ofnumerical thresholds provided. In addition, IFRS has one more criteriato assess which looks at the uniqueness of the asset specificallydesigned for use by only the lessee. The only aspect that the contractbased approach would assess is to determine if the lease is insubstance a purchase or sale, and if so, would not be recognizedunder the lease recognition and measurement standards.

c)For an operating lease, both ASPE and IFRS would recognize the leasepayments as they are made, either to income or expense for the lessor

and lessee, respectively.

d)For the contract based approach for the lessee, the rights to use theasset are recognized as an intangible asset and contractual leaseobligations are recognized as a liability. Both of these amounts aredetermined using the present value of the lease payments.

Amortization of the intangible right and interest expense on theobligation is recognized over the term of the lease. The concept






WA 20-5 (Continued)

(d) (Continued)

behind the contract based approach is that a contractual obligation has

been entered into on the signing of the lease, and this obligationshould be reported on the statement of financial position. As the rightto the asset is used, amortization is reported; and as the obligation ispaid, the obligation is reduced. In this way, it does not matter whattype of lease is entered into, and judgment is no longer required todetermine if the lease should be treated as operating or a financelease. The contract based approach uses the lessee’s incrementalborrowing rate. For the contract based approach for the lessor, thetreatment is similar as described above except a lease receivable andoffsetting performance obligation is reported.

e)For capital (finance) leases, both IFRS and ASPE recognize the presentvalue of the lease payments as a lease obligation and leased asset forthe lessee. As the lease term progresses, the asset is amortized andinterest expense is recognized on the lease obligation. Paymentsreduce the lease obligation. IFRS uses the interest rate implied in thelease when it can be reasonably determined, or the lessee’sincremental borrowing rate. ASPE uses the lower of the implied leaserate or the lessee’s incremental borrowing rate. Under the contractbased approach, the treatment is the same as described above sinceno differentiation is made between operating and finance leases.However, when the IASB issues its new Exposure Draft (expected in

2013) this may change. In particular, IFRS is considering allowingsome leases to qualify as straight-line leases (with accounting similarto operating leases).

f)For the lessor, ASPE has two other recognition criteria which IFRS doesnot specifically require under the lease standards, but does by defaultunder revenue recognition. Accounting treatment is the same underboth standards.

g)There are differences in what would be included in the lease payments.IFRS and ASPE have similar standards, but the contract approach

would also require that contingent payments under the leaseagreements be estimated.

h)Disclosure is minimized for ASPE. For IFRS, more extensive disclosureis required including reconciliations and additional information aboutterms of the leases.






RESEARCH AND FINANCIAL ANALYSIS

RA20-1 SHOPPERS DRUG MART.

(a) As indicated in note 3 (o) of Shoppers’ financial statements, the Companyleases most of its store locations and office space. Leases that transfersubstantially all the risks and benefits of ownership are recorded as financingleases, and are included with property and equipment, accounts payable andaccrued liabilities and other long-term liabilities as applicable. All other leases areconsidered operating leases and the related rent is expensed on a straight-linebasis over the term of the lease, any rent-free periods are also amortized on astraight-line basis. Landlord inducements are also deferred and amortized on astraight-line basis and reduce rent expense.

The Company has sale-leaseback arrangements for some of its stores. Theleases are accounted for as financing or operating based on their nature. Anygains realized on disposal of sale-leasebacks that are financing in nature, aredeferred and amortized on a straight-line basis over the shorter of the estimateduseful life of the leased asset and the lease term. Executory costs, such aspayments for real estate taxes, maintenance and insurance are expensed in theperiod to which they relate.

(b) As discussed in part (a) above, leases that transfer substantially all therisks and benefits of ownership are recorded as financing leases, and areincluded with property and equipment, accounts payable and accruedliabilities and other long-term liabilities as applicable. Per note 3 (o) ofShoppers’ financial statements, other accounts affected by leases includethose related gains realized on the disposal of the real estate propertiesrelated to (financing) sale-leaseback transactions. Gains realized on thedisposal of real estate properties done at fair value and that are operatingin nature, are recognized within operating and administrative expenses inthe consolidated statements of earnings. Executory costs such as realestate taxes, maintenance and insurance. These amounts are expensed inthe period to which they relate (presumably in the related statement ofearnings accounts). There are no dollar amounts reported separately forthe year ended Dec. 31, 2011 on the consolidated statement of financialposition and the consolidated statement of earnings.






RA20-1 (Continued)

(c) Lease payments for finance leases are included in two types of activitieson the statement of cash flows: operating activities and financing activities.

The portion that represents interest expense is reported in “financeexpenses” of $64,038 thousand of which $6,859 thousand relates tofinancing leases (per note 12, prior to the amount that may have beennetted off as part of “finance expense capitalized”.) Also included inoperating activities (via Net earnings) would be the operating lease costsand executory costs paid. Under financing activities, the repayment offinancing lease obligations representing the reduction of principle of$2,173 thousand is shown.

(d) (in thousands)Dec. 31, 2011

Net earnings $ 613,934______ Average total assets ($7,300,310 + $7,044,197) ÷ 2Return on total assets 8.6%

Total liabilities $3,032,480Shareholders’ equity 4,267,830Total debt-to-equity ratio 0.71

(e) Under the contract based approach, the asset that is acquired by a lesseeis not the physical property that is leased; rather, it is an intangible assetthat represents the right to use the asset that is conveyed under the lease

agreement. The liability is the contractual obligation to make leasepayments. The asset and the obligation are initially recorded at the presentvalue of the lease payments. For the lessee, the intangible asset is thenamortized over the term of the lease on some systematic basis to earnings,and obligation is reduced by payments less the interest charge.

In the case of Shoppers, we will look at each of the leases individually:1. Finance leases – for leases that are equivalent to in-substance

acquisitions, accounting would be similar to present-day finance leases.2. Other operating leases as lessee - Some leases that are currently

operating leases may end up being capitalized, with the related leased

assets representing a right under intangible assets, rather than asproperty, plant and equipment. However, leases of property (land or abuilding or both) would typically be accounted for using the straight-lineapproach, which is similar to current operating leases. This would occurunless the related lease term is for the major portion of the economic lifeof the underlying building, or where the value of the lease accounts forsubstantially all of the building’s fair value.






RA20-2 CANADIAN NATIONAL RAILWAY COMPANY ANDCANADIAN PACIFIC RAILWAY LIMITED

(a) Canadian National Railway (CNR) discloses the cost, accumulateddepreciation, and net book value of properties held under capital leases in

Note 5, ”Properties” totalling a net carrying value of $1,376 million. Thisnote also indicates that such properties consist primarily of track androadway, rolling stock, buildings, and other. As footnote to this schedule,CNR also indicates that included in track and roadway is the cost of landof which $108 million is a right of way and has been recorded as a capitallease.CNR discloses in Note 9 an amount of “capital lease obligations andother” in its long-term debt note of $957 million. In Note 17, CNR disclosesthe amount of future minimum lease payments for its operating leases,capital leases and in total in its major commitments and contingenciesnote. The note also identifies that the company has operating and capitalleases, mainly for locomotives, freight cars, and intermodal equipment. It

also discloses the amount of imputed interest on its capital leases rangingfrom 0.7% to 11.8% and the present value of the minimum lease paymentsat current rate included in debt of $955 million. Also in this note, CNRindicates that under some of its capital leases, it has the option to purchasethe asset at a fixed amount. We are also told that automotive equipment isleased under operating leases with one year, non-cancellable terms andthat the estimated rental payment is $30 million. Finally, rent expense forall operating leases was $143 million for the 2011 fiscal year.

Canadian Pacific Railway (CPR) discloses in Note 15 the net amount ofassets under capital lease and the amount of related accumulated

depreciation in its net properties note totalling a net carrying value of $351million. CPR discloses in Note 20, the amount of obligations under capitalleases of $288 million, the amount of minimum payments for its capitalleases, the amount of related imputed interest and present value of thesepayments, and the related current portion of the obligations in its long-termdebt note. Interest rates used for the capital lease obligations range from4.90% to 7.63% In note 29, the amount of minimum payments for itsoperating leases is included in its commitments and contingencies note.

Detailed accounts and amounts for both companies are presented below.






RA20-2 (Continued)

CNR ( $ in millions)

Capital Lease Arrangements

Capital leases included in properties, cost $ 1,772 Accumulated depreciation 396

Net book value of assets under capital lease 1,376Capital lease obligations and other 957

Minimum lease payments - capital 1,254Imputed interest on capital leases 299

Present value of minimum lease payments atcurrent rate included in debt 955

Operating Lease ArrangementsMinimum lease payments - operating $ 665

CPR in millions of $'s

Capital Lease ArrangementsNet properties under capital lease $ 518Related accumulated depreciation 167Net book value 351

Obligations under capital leases 288

Total minimum lease payments (capital) 427Imputed interest 139Present value of minimum lease payments –capital 288Current portion 8Long-term portion 280

Operating Lease Arrangements

Minimum payments under operating leases $ 813






RA20-2 (Continued)

(a) Yes, they appear to have provided all the lease disclosures required bythe accounting standards.

(b) The leases of both companies are long term. CNR’s operating andcapital leases extend at least seven years from the balance sheet date,since the note refers to “2017 and thereafter”. CPR’s operating leasesextend to at least 2016 and the capital leases extend to 2026 and 2031.

(c) The future minimum annual rental commitments under each type oflease for each company are presented below. Even though thecompanies are in the same industry, there is a difference with respect tohow they provide for capacity as evidenced by the fact that they havedifferent proportions of operating versus capital leases measured interms of minimum lease payments. CNR has a higher proportion of

capital leases than CPR, and CPR has a higher proportion of operatingleases than does CNR.

In millions of C$CNR % CPR %

Minimum lease payments -operating $665 34.7% $813 65.6%Minimum lease payments -capital 1,254 65.3% 427 34.4%

(d) The debt-to-total assets ratios for each company at December 31, 2011,are presented below.






RA20-2 (Continued)

(e) CNR presents as part of its Management Discussion & Analysis anestimate of the present value of its operating lease commitments as$542 million. CPR does not provide a similar estimate, but by using a

6% discount rate, the capitalized value of the off-balance-sheetoperating leases can be estimated. (Note: the schedule below assumesthat all of the “thereafter payments” would be made in year 2017, whichis likely not correct.)

year period CPR CPR PV of payments@6%Payments

2012 1.0 $145 136.82013 2.0 131 116.62014 3.0 96 80.6

2015 4.0 83 65.72016 5.0 65 48.6Thereafter 6.0 293 206.6

Total payments $813 $654.9

(f) These operating leases would be recorded as: Increase to intangibleassets for the right of use and an increase to contractual lease obligations.To make an accurate adjustment for the contract-based approach, wewould have needed details of the payments for each year after 2017.

Some of these leases may be due much later than 2017, which wouldchange the calculation of the present values. We have also had to makeassumptions about the effective interest rates that might not be correct.

Also, the contract based approach would include any renewal terms thatwere likely to be used and any contingent rents. And, if the revised IASBExposure Draft allows for straight-line leases in some circumstances, wewould need to assess whether any companies’ leases would qualify asstraight-line leases. Finally, we were unable to make adjustments on thestatement of earnings. In this case, the annual lease expense would beeliminated, and its place would be amortization of the intangible asset on astraight-line basis over the term of the lease and the interest charge on the

lease obligation for the year.






RA20-2 (Continued)

(g) The debt-to-total assets ratios, recalculated to include the capitalized valueof the operating leases, are presented below. By including the capitalizedamount of the operating leases in the liabilities calculation, the debt-to-total

assets ratios of both companies are somewhat higher. For CNR, the ratiohas increased from 59.0% to 61.0%, which is only a 3.4% increase.However, for CPR, that uses predominantly more operating lease thanCNR, the ratio has increased from 67.1% to 71.7%, which represents a6.9% increase.

CNR CPRLiabilities as reported $15,346 $9,461.0Capitalized value of operating leases 542 654.9Revised Liabilities (including capitalizedvalue of operating leases) 15,888 10,115.9

Total Assets 26,026 14,110.0Debt/Total Assets ratio 61.0% 71.7%

(h) In the case of CNR and CPR above, the companies use differentpercentages of owned versus leased assets. In order to properly comparethe companies with respect to debt ratios and asset turnover ratios, it isimportant to reflect all the assets being used along with the obligationsincurred to use those assets. Consequently, the contract based approachwould ensure that the assets and related obligations are recognized andmeasured appropriately on the statement of financial position. In trying to

make the adjustments from the current notes for CNR and CPR, someassumptions were made as to the lease terms and the interest rates whichmight not be correct. And as noted above, we are also missing informationto make all of the adjustments required. If the companies adopted contractbased approaches, these adjustments would no longer be required.






RA20-3 INDIGO BOOKS & MUSIC INC.

(a) As disclosed in Note 4, Summary of Significant Accounting Policies, thecompany explains that it “conducts all of its business from leasedpremises”. These leases have renewal terms, over which the company

depreciates the leasehold improvements when renewal is “reasonablyassured”. All of its leases of premises are considered operating. In thisnote, we also see that the leasehold improvements are depreciated over amaximum term of 10 years. Finally, any lease inducements are amortizedover the lease term.

The primary lease arrangements indicated in the company’s financialstatements are the operating leases for stores, offices, and equipmentidentified in Note 19, “Commitments and Contingencies”. The operatingleases expire between 2012 and 2021 and are subject to renewal terms insome cases (although the term and amounts are not disclosed). There are

also contingent rents based on sales as part of some of these operatingleases.

As disclosed in Note 13, the company has finance lease obligationsoutstanding of $2.2 million at March 31, 2012 which are included in longterm debt. For the capital leases related to equipment, Note 8, “Property,Plant and Equipment” discloses that the gross carrying amount andaccumulated depreciation to date for this leased equipment is $6,146thousands and $3,932 thousands, respectively for a net balance of $2,214thousands. This equipment is depreciated over 3 to 5 years (see Note 4).

For the operating leases, the only amounts on Indigo’s balance sheet wouldbe prepaid or accrued lease payments, which are not separately identified.On the income statement, the annual lease payments would be included inthe “operating and administrative expenses” line. For the capital leases,equipment under capital leases at an amount of $2,214 thousands isincluded in the property, plant and equipment line of the financialstatements (net of accumulated amortization). There is an offsettingamount of $1.1 million being shown as current portion of long-term debt,and $1.1 million being shown as part of the non-current portion of long-termdebt.

On the consolidated statement of earnings, net earnings disclosed arepresumably after a charge for lease expense for the operating leases, anddepreciation expense and interest expense on the capital leases.






RA20-3 (Continued)

(b) Ratios for Indigo are presented below.

( $ in thousands) Amount

A Property, plant and equipment $ 67,464B Total Assets 592,536C Total Liabilities 236,904D Total Equity 355,632E Revenues 933,990F Net earnings 66,1891 Debt/Equity ratio (C/D) 0.672 Capital asset turnover ratio (E/A) 13.8 X3 Total asset turnover ratio (E/B) 1.58X4 Return on assets (F/B) 11.2%

(c) To adopt the contract based approach, the following adjustments arerequired:

1. Capital leases – Under the contract based approach, one of thedifferences in this analysis would be if there were contingent rents to bepaid. Since the notes make no mention of this with respect to the capitalleases, we can assume that there are none. Leased assets set up underthe existing standard would likely continue to be set up as leased assets(and classified are part of property, plant and equipment (PPE). The only

other adjustment would be that for additional leased assets that were notpreviously required to be capitalized, a right-of-use asset would beincluded as part of intangible assets. There are no adjustments requiredon the income statement provided we assume that the amortization ofthe intangible asset would be consistent with the depreciation of theequipment, which is likely the case.

2. To capitalize the operating lease commitments, one needs the following:a) The amount and timing of the annual payments and the effective interest

rate for capitalization for the opening balance and the closing balance ofthe obligation:






RA20-3 (Continued)

(c) 2. (Continued)

Assuming an interest rate of 6%, and using the minimum operating lease

payment amounts disclosed in Note 13, an estimate of the capitalized value isprovided below for the 2012 fiscal year. Although there are contingent rents,without some information on these amounts, the value of these have not beenincluded in the present value of the obligation. Furthermore, although we knowthat some of the leases have renewal periods, without adequate information, wewere unable to include these in the following calculations. Consequently, wehave assumed no renewal periods and no contingent rents.

We have assumed that the lease term is 6 years (based on the forecasted cashflows) and therefore the intangible right of use will be amortized over theremaining lease term of 6 years.

(millions of $)

yearPost-2012payments

presentvalue

@ 6%

2013 $58.5 $55.22014 46.4 41.32015 31.0 26.02016 22.0 17.42017 15.0 11.2

2018+ 22.8 16.1Total $195.7 $167.2

Based on the above information, the next step is to calculate the implied interestcharge for the year: 167.2 X 6% = 10.0 million.

Amortization of the intangible asset for the 2012 fiscal year -- assuming that thenew leases arose half way through the year, the amortization on the intangibleasset is assumed to be: (167.2/ 6) = 27.9 million. Net book value of intangibleassets at 2012 would be: 167.2 - 27.9 = 139.3

Impact on net earnings will be: Add back lease payment+ 58.5Deduct Amortization on new intangible assets - 27.9Deduct Interest on lease obligation- 10.0Net change+20.6






RA20-3 (Continued)

(c) (Continued)

(Note: this calculation overstates the positive impact on earnings. Since

the leases are relatively short term in nature, new leases would be signedeach year, increasing related interest and amortization charges – whereas asignificant portion of the related rent expense would be in the years 2014and beyond).

(d) Adjustments required to the balance sheet, income statement and cash flowstatement are summarized as follows:

(in millions $) As reported Adjustments Revised balance

Total assets $592.5 $139.4 $731.9

Total liabilities 236.9 167.2 404.1Total equity 355.6 20.6 376.2

Net earnings 66.2 +20.6 86.8

($ in thousands)Originalamount Revised

Debt/Equity ratioTotal asset turnover

0.671.58 X

1.071.28

As can be seen from the above table, the debt/equity and total asset turnoverratios will worsen if the operating leases are recognized under the contract basedapproach (Note: the analysis is based on the 2010 Exposure Draft, and thereforeassumes that all operating leases would result in right-of-use assets; if the IASBmodifies their exposure draft to exclude many short term leases of buildings, theportion of operating leases relating to the Company’s premises would likely notbe required to be capitalized).

This example illustrates how significantly the capitalization of all operating leaseswould affect the financial statements, and emphasizes why there is sometimesan incentive for management to keep leases “off the balance sheet”. To compareIndigo’s financial statements with competitors who purchase their buildings andequipment outright, one should use the revised figures presented above toenhance the comparability of the companies. Without doing so, Indigo’s resultsmight appear more favourable than they really are which could be misleading.

As a result, adopting the contract based approach would make all the companiescomparative without the need to make numerous assumptions in order the makethe appropriate adjustments.






RA20-4RESEARCH AN AUTOMOBILE LEASE

(a) The terms and conditions associated with the lease of a vehicle include:1. Lease costs which include

a) leased vehicle price, which include price of accessories,

dealer installed options, freight and pre-delivery inspection,and all applicable taxes such as federal air conditioning tax,provincial gas consumption tax, tire tax, etc., but excludesHST/GST and PST;

b) optional extended warranty;c) optional life insurance;d) optional disability insurance;e) other (specify);f) less cash down payment;g) less trade-in allowance (net of amount owing on trade-in);

and

h) less end value of vehicle, to arrive at the amount to beamortized. (See item 8 below)

2. Total lease charges, representing interest, and annual lease rate,stated as a percentage (the latter being provided in the majority ofcases).

3. The lease term, expressed in the number of months.

4. Amount of monthly payments (annuity due) including:a) number of monthly payments,

b) base monthly payment,c) plus GST or HST,d) plus PST (where applicable), to arrive at the total monthly

payment.

5. Total of monthly payments arrived at by multiplying the monthlypayment by the number of monthly payments.

6. Summary of amounts due on delivery including:a) net cash down payment,b) net trade-in allowance,

c) GST, PST or HSTd) vehicle licence fee,e) registration fee,f) other (specified),g) first monthly payment, andh) refundable security deposit.






RA20-4 (Continued)

7. Specification concerning the kilometre charge for kilometres drivenbeyond a set limit negotiated and specified in the lease to fit thecustomer’s particular needs.

8. Lease end purchase based on the estimated fair market value ofthe vehicle at the end of the term of the lease. This option pricewould have HST (or GST and PST) added as well as licence fee,registration fee, and charges related to certification of the vehicle.

9. Other conditions of the lease include:a) insurance;b) maintenance repairs and operating expenses;c) taxes, registration and other charges;d) excess wear clauses;

e) fines, liens and encumbrances;f) early termination clauses;g) defaults;h) warranties;i) guarantees; and

j) clauses concerning modification or relocation of the vehicle.

(b) The cash flows associated with the lease include the amounts specifiedunder the amounts due on delivery of the vehicle (item 6 of part (a)above); the monthly payments under the lease, as calculated above; andthe “lease end purchase” (described in item 8 above), should the lessee

choose the option price at the end of the term of the lease, to purchasethe vehicle.

(c) The purchase option is often the better choice. In the car lease, all of therisks associated with ownership are passed on to the lessee. The amountprovided as the option price to purchase the vehicle at the end of the termof the lease is a conservative amount arrived at by the lessor to reducethe risk to them from the realization of the value of the vehicle throughresale or through an additional lease transaction, should the option topurchase not be exercised.



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