Question & Answer

Use the information for Rick Kleckner Corporation from IFRS21-7. Assume that at December 31, 2014, Kleckner made an adjusting entry to accrue interest expense of $29,530 on the lease. Prepare Kleckner’s January 1, 2015, journal entry to record the second lease payment of $53,920.

Rick Kleckner Corporation recorded a finance lease at $300,000 on January 1, 2014. The interest rate is 12%. Kleckner Corporation made the first lease payment of $53,920 on January 1, 2014. The lease requires eight annual payments. The equipment has a useful life of 8 years with no residual value. Prepare Kleckner Corporation’s December 31, 2014, adjusting entries.

Identify the lease classifications for lessors and the criteria that must be met for each classification.

Outline the accounting procedures involved in applying the finance lease method by a lessee.

Outline the accounting procedures involved in applying the operating lease method by a lessee.

Briefly discuss the IASB and FASB efforts to converge their accounting guidelines for leases.

Briefly describe some of the similarities and differences between GAAP and IFRS with respect to the accounting for leases.

Where can authoritative IFRS related to the accounting for leases be found?

Daniel Hardware Co. is considering alternative financing arrangements for equipment used in its warehouses. Besides purchasing the equipment outright, Daniel is also considering a lease. Accounting for the outright purchase is fairly straightforward, but because Daniel has not used equipment leases in the past, the accounting staff is less informed about the specific accounting rules for leases. The staff is aware of some lease rules related to a “90 percent of fair value,” “75 percent of useful life,” and “residual value deficiencies,” but they are unsure about the meanings of these terms in lease accounting. Daniel has asked you to conduct some research on these items related to lease capitalization criteria.

Instructions

If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses.

(a) What is the objective of lease classification criteria?

(b) An important element of evaluating leases is determining whether substantially all of the risks and rewards of ownership are transferred in the lease. How is “substantially all” defined in the authoritative literature?

(c) Besides the noncancelable term of the lease, name at least three other considerations in determining the “lease term.”

(d) A common issue in the accounting for leases concerns lease requirements that the lessee make up a residual value deficiency that is attributable to damage, extraordinary wear and tear, or excessive usage (e.g., excessive mileage on a leased vehicle). Do these features constitute a lessee guarantee of the residual value such that the estimated residual value of the leased property at the end of the lease term should be included in minimum lease payments? Explain.

The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report, including the notes to the financial statements, can be accessed at the book’s companion website, www.

wiley.com/college/kieso.

Instructions

Refer to P&G’s financial statements, accompanying notes, and management’s discussion and analysis to answer the following questions.

(a) What types of leases are used by P&G?

(b) What amount of capital leases was reported by P&G in total and for less than one year?

(c) What minimum annual rental commitments under all noncancelable leases at June 30, 2011, did P&G disclose?

On January 1, 2014, Perriman Company sold equipment for cash and leased it back. As seller-lessee, Perriman retained the right to substantially all of the remaining use of the equipment. The term of the lease is 8 years. There is a gain on the sale portion of the transaction. The lease portion of the transaction is classified appropriately as a capital lease.

Instructions

(a) What is the theoretical basis for requiring lessees to capitalize certain long-term leases? Do not

discuss the specific criteria for classifying a lease as a capital lease.

(b) (1) How should Perriman account for the sale portion of the sale-leaseback transaction at January 1, 2014?

(2) How should Perriman account for the leaseback portion of the sale-leaseback transaction at

January 1, 2014?

(c) How should Perriman account for the gain on the sale portion of the sale-leaseback transaction during the first year of the lease? Why?

Baden Corporation entered into a lease agreement for 10 photocopy machines for its corporate headquarters. The lease agreement qualifies as an operating lease in all terms except there is a bargain-purchase option. After the 5-year lease term, the corporation can purchase each copier for $1,000, when the anticipated fair value is $2,500. Jerry Suffolk, the financial vice president, thinks the financial statements must recognize the lease agreement as a capital lease because of the bargain-purchase option. The controller, Diane Buchanan, disagrees: “Although I don’t know much about the copiers themselves, there is a way to avoid recording the lease liability.” She argues that the corporation might claim that copier technology advances rapidly and that by the end of the lease term the machines will most likely not be worth the $1,000 bargain price.

Instructions

Answer the following questions.

(a) What ethical issue is at stake?

(b) Should the controller’s argument be accepted if she does not really know much about copier technology?

Would it make a difference if the controller were knowledgeable about the pace of change in copier technology?

(c) What should Suffolk do?

Albertsen Corporation is considering proposals for either leasing or purchasing aircraft. The proposed lease agreement involves a twin-engine turboprop Viking that has a fair value of $1,000,000. This plane would be leased for a period of 10 years beginning January 1, 2014. The lease agreement is cancelable only upon accidental destruction of the plane. An annual lease payment of $141,780 is due on January 1 of each year; the first payment is to be made on January 1, 2014. Maintenance operations are strictly scheduled by the lessor, and Albertsen Corporation will pay for these services as they are performed. Estimated annual maintenance costs are $6,900. The lessor will pay all insurance premiums and local property taxes, which amount to a combined total of $4,000 annually and are included in the annual lease payment of $141,780. Upon expiration of the 10-year lease, Albertsen Corporation can purchase the Viking for $44,440. The estimated useful life of the plane is 15 years, and its salvage value in the used plane market is estimated to be $100,000 after 10 years. The salvage value probably will never be less than $75,000 if the engines are overhauled and maintained as prescribed by the manufacturer. If the purchase option is not exercised, possession of the plane will revert to the lessor, and there is no provision for renewing the lease agreement beyond its termination on

December 31, 2023.

Albertsen Corporation can borrow $1,000,000 under a 10-year term loan agreement at an annual interest rate of 12%. The lessor’s implicit interest rate is not expressly stated in the lease agreement, but this rate appears to be approximately 8% based on 10 net rental payments of $137,780 per year and the initial fair value of $1,000,000 for the plane. On January 1, 2014, the present value of all net rental payments and the purchase option of $44,440 is $888,890 using the 12% interest rate. The present value of all net rental payments and the $44,440 purchase option on January 1, 2014, is $1,022,226 using the 8% interest rate implicit in the lease agreement. The financial vice president of Albertsen Corporation has established that this lease agreement is a capital lease as defined in GAAP.

Instructions

(a) What is the appropriate amount that Albertsen Corporation should recognize for the leased aircraft on its balance sheet after the lease is signed?

(b) Without prejudice to your answer in part (a), assume that the annual lease payment is $141,780 as stated in the question, that the appropriate capitalized amount for the leased aircraft is $1,000,000 on January 1, 2014, and that the interest rate is 9%. How will the lease be reported in the December 31, 2014, balance sheet and related income statement? (Ignore any income tax implications.)

Part 1: Capital leases and operating leases are the two classifications of leases described in FASB pronouncements from the standpoint of the lessee.

Instructions

(a) Describe how a capital lease would be accounted for by the lessee both at the inception of the lease and during the first year of the lease, assuming the lease transfers ownership of the property to the lessee by the end of the lease.

(b) Describe how an operating lease would be accounted for by the lessee both at the inception of the lease and during the first year of the lease, assuming equal monthly payments are made by the lessee at the beginning of each month of the lease. Describe the change in accounting, if any, when rental payments are not made on a straight-line basis.

Do not discuss the criteria for distinguishing between capital leases and operating leases.

Part 2: Sales-type leases and direct-financing leases are two of the classifications of leases described in FASB pronouncements from the standpoint of the lessor.

Instructions

Compare and contrast a sales-type lease with a direct-financing lease as follows.

(a) Lease receivable.

(b) Recognition of interest revenue.

(c) Manufacturer’s or dealer’s profit.

Do not discuss the criteria for distinguishing between the leases described above and operating leases.

On January 1, Santiago Company, a lessee, entered into three noncancelable leases for brand-new equipment, Lease L, Lease M, and Lease N. None of the three leases transfers ownership of the equipment to Santiago at the end of the lease term. For each of the three leases, the present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the

lessor, is 75% of the fair value of the equipment. The following information is peculiar to each lease.

1. Lease L does not contain a bargain-purchase option. The lease term is equal to 80% of the estimated economic life of the equipment.

2. Lease M contains a bargain-purchase option. The lease term is equal to 50% of the estimated economic life of the equipment.

3. Lease N does not contain a bargain-purchase option. The lease term is equal to 50% of the estimated economic life of the equipment.

Instructions

(a) How should Santiago Company classify each of the three leases above, and why? Discuss the rationale for your answer.

(b) What amount, if any, should Santiago record as a liability at the inception of the lease for each of the three leases above?

(c) Assuming that the minimum lease payments are made on a straight-line basis, how should Santiago record each minimum lease payment for each of the three leases above?

Sylvan Inc. entered into a noncancelable lease arrangement with Breton Leasing Corporation for a certain machine. Breton’s primary business is leasing; it is not a manufacturer or dealer. Sylvan will lease the machine for a period of 3 years, which is 50% of the machine’s economic life. Breton will take possession of the machine at the end of the initial 3-year lease and lease it to another, smaller company that does not need the most current version of the machine. Sylvan does not guarantee any residual value for the machine and will not purchase the machine at the end of the lease term.

Sylvan’s incremental borrowing rate is 10%, and the implicit rate in the lease is 9%. Sylvan has no way of knowing the implicit rate used by Breton. Using either rate, the present value of the minimum lease payments is between 90% and 100% of the fair value of the machine at the date of the lease agreement.

Sylvan has agreed to pay all executory costs directly, and no allowance for these costs is included in the lease payments. Breton is reasonably certain that Sylvan will pay all lease payments. Because Sylvan has agreed to pay all executory costs, there are no important uncertainties regarding costs to be incurred by Breton. Assume that no indirect costs are involved.

Instructions

(a) With respect to Sylvan (the lessee), answer the following.

(1) What type of lease has been entered into? Explain the reason for your answer.

(2) How should Sylvan compute the appropriate amount to be recorded for the lease or asset acquired?

(3) What accounts will be created or affected by this transaction, and how will the lease or asset and other costs related to the transaction be matched with earnings?

(4) What disclosures must Sylvan make regarding this leased asset?

(b) With respect to Breton (the lessor), answer the following.

(1) What type of leasing arrangement has been entered into? Explain the reason for your answer.

(2) How should this lease be recorded by Breton, and how are the appropriate amounts determined?

(3) How should Breton determine the appropriate amount of earnings to be recognized from each lease payment?

(4) What disclosures must Breton make regarding this lease?

On January 1, 2014, Evans Company entered into a noncancelable lease for a machine to be used in its manufacturing operations. The lease transfers ownership of the machine to Evans by the end of the lease term. The term of the lease is 8 years. The minimum lease payment made by Evans on January 1, 2014, was one of eight equal annual payments. At the inception of the lease, the criteria established for classification as a capital lease by the lessee were met.

Instructions

(a) What is the theoretical basis for the accounting standard that requires certain long-term leases to be capitalized by the lessee? Do not discuss the specific criteria for classifying a specific lease as a capital lease.

(b) How should Evans account for this lease at its inception and determine the amount to be recorded?

(c) What expenses related to this lease will Evans incur during the first year of the lease, and how will they be determined?

(d) How should Evans report the lease transaction on its December 31, 2014, balance sheet?

Goring Dairy leases its milking equipment from King Finance Company under the following lease terms.

1. The lease term is 10 years, noncancelable, and requires equal rental payments of $30,300 due at the beginning of each year starting January 1, 2014.

2. The equipment has a fair value and cost at the inception of the lease (January 1, 2014) of $220,404, an estimated economic life of 10 years, and a residual value (which is guaranteed by Goring Dairy) of $20,000.

3. The lease contains no renewable options, and the equipment reverts to King Finance Company upon termination of the lease.

4. Goring Dairy’s incremental borrowing rate is 9% per year. The implicit rate is also 9%.

5. Goring Dairy depreciates similar equipment that it owns on a straight-line basis.

6. Collectibility of the payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor.

Instructions

(a) Evaluate the criteria for classification of the lease, and describe the nature of the lease. In general, discuss how the lessee and lessor should account for the lease transaction.

(b) Prepare the journal entries for the lessee and lessor at January 1, 2014, and December 31, 2014 (the lessee’s and lessor’s year-end). Assume no reversing entries.

(c) What would have been the amount capitalized by the lessee upon the inception of the lease if:

(1) The residual value of $20,000 had been guaranteed by a third party, not the lessee?

(2) The residual value of $20,000 had not been guaranteed at all?

(d) On the lessor’s books, what would be the amount recorded as the Net Investment (Lease Receivable) at the inception of the lease, assuming:

(1) The residual value of $20,000 had been guaranteed by a third party?

(2) The residual value of $20,000 had not been guaranteed at all?

(e) Suppose the useful life of the milking equipment is 20 years. How large would the residual value have to be at the end of 10 years in order for the lessee to qualify for the operating method? (Assume that the residual value would be guaranteed by a third party.) (Hint: The lessee’s annual payments will be appropriately reduced as the residual value increases.)

You are auditing the December 31, 2014, financial statements of Hockney, Inc., manufacturer of novelties and party favors. During your inspection of the company garage, you discovered that a used automobile not listed in the equipment subsidiary ledger is parked there. You ask Stacy Reeder, plant manager, about the vehicle, and she tells you that the company did not list the automobile because the company was only leasing it. The lease agreement was entered into on January 1, 2014, with Crown New and Used Cars.

You decide to review the lease agreement to ensure that the lease should be afforded operating lease treatment, and you discover the following lease terms.

1. Noncancelable term of 4 years.

2. Rental of $3,240 per year (at the end of each year). (The present value at 8% per year is $10,731.)

3. Estimated residual value after 4 years is $1,100. (The present value at 8% per year is $809.) Hockney guarantees the residual value of $1,100.

4. Estimated economic life of the automobile is 5 years.

5. Hockney’s incremental borrowing rate is 8% per year.

Instructions

You are a senior auditor writing a memo to your supervisor, the audit partner in charge of this audit, to discuss the above situation. Be sure to include (a) why you inspected the lease agreement, (b) what you determined about the lease, and (c) how you advised your client to account for this lease. Explain every journal entry that you believe is necessary to record this lease properly on the client’s books. (It is also necessary to include the fact that you communicated this information to your client.)

Assume the same data as in P21-13 and that Chambers Medical Center has an incremental borrowing rate of 10%.

Instructions

(a) Discuss the nature of this lease in relation to the lessee, and compute the amount of the initial lease liability.

(b) Prepare a 10-year lease amortization schedule.

(c) Prepare all of the lessee’s journal entries for the first year.

Amirante Inc. manufactures an X-ray machine with an estimated life of 12 years and leases it to Chambers Medical Center for a period of 10 years. The normal selling price of the machine is $411,324, and its guaranteed residual value at the end of the noncancelable lease term is estimated to be $15,000. The hospital will pay rents of $60,000 at the beginning of each year and all maintenance, insurance, and taxes. Amirante Inc. incurred costs of $250,000 in manufacturing the machine and $14,000 in negotiating and closing the lease. Amirante Inc. has determined that the collectibility of the lease payments is reasonably predictable, that there will be no additional costs incurred, and that the implicit interest rate is 10%.

Instructions

(a) Discuss the nature of this lease in relation to the lessor and compute the amount of each of the following items.

(1) Lease receivable at inception of the lease.

(2) Sales price.

(3) Cost of sales.

(b) Prepare a 10-year lease amortization schedule.

(c) Prepare all of the lessor’s journal entries for the first year.

In 2013, Grishell Trucking Company negotiated and closed a long-term lease contract for newly constructed truck terminals and freight storage facilities. The buildings were erected to the company’s specifications on land owned by the company. On January 1, 2014, Grishell Trucking Company took possession of the lease properties. On January 1, 2014 and 2015, the company made cash payments of $948,000 that were recorded as rental expenses.

Although the terminals have a composite useful life of 40 years, the noncancelable lease runs for 20 years from January 1, 2014, with a bargain-purchase option available upon expiration of the lease.

The 20-year lease is effective for the period January 1, 2014, through December 31, 2033. Advance rental payments of $800,000 are payable to the lessor on January 1 of each of the first 10 years of the lease term. Advance rental payments of $320,000 are due on January 1 for each of the last 10 years of the lease.

The company has an option to purchase all of these leased facilities for $1 on December 31, 2033. It also must make annual payments to the lessor of $125,000 for property taxes and $23,000 for insurance. The lease was negotiated to assure the lessor a 6% rate of return.

Instructions

(a) Prepare a schedule to compute for Grishell Trucking Company the present value of the terminal facilities and related obligation at January 1, 2014.

(b) Assuming that the present value of terminal facilities and related obligation at January 1, 2014, was

$7,600,000, prepare journal entries for Grishell Trucking Company to record the:

(1) Cash payment to the lessor on January 1, 2016.

(2) Amortization of the cost of the leased properties for 2016 using the straight-line method and assuming a zero salvage value.

(3) Accrual of interest expense at December 31, 2016.

Selected present value factors are as follows.

For an Ordinary

Periods Annuity of $1 at 6% For $1 at 6%

1 .943396 .943396

2 1.833393 .889996

8 6.209794 .627412

9 6.801692 .591898

10 7.360087 .558395

19 11.158117 .330513

20 11.469921 .311805

Assume the same data as in P21-10 with National Airlines Co. having an incremental borrowing rate of 10%.

Instructions

(a) Discuss the nature of this lease in relation to the lessee, and compute the amount of the initial lease liability.

(b) Prepare a 10-year lease amortization schedule.

(c) Prepare all of the lessee’s journal entries for the first year.

George Company manufactures a check-in kiosk with an estimated economic life of 12 years and leases it to National Airlines for a period of 10 years. The normal selling price of the equipment is $278,072, and its unguaranteed residual value at the end of the lease term is estimated to be $20,000. National will pay annual payments of $40,000 at the beginning of each year and all maintenance, insurance, and taxes.

George incurred costs of $180,000 in manufacturing the equipment and $4,000 in negotiating and closing the lease. George has determined that the collectibility of the lease payments is reasonably predictable, that no additional costs will be incurred, and that the implicit interest rate is 10%.

Instructions

(a) Discuss the nature of this lease in relation to the lessor and compute the amount of each of the following items.

(1) Lease receivable.

(2) Sales price.

(3) Cost of sales.

(b) Prepare a 10-year lease amortization schedule.

(c) Prepare all of the lessor’s journal entries for the first year.

Shapiro Inc. was incorporated in 2013 to operate as a computer software service firm with an accounting fiscal year ending August 31. Shapiro’s primary product is a sophisticated online inventory-control system; its customers pay a fixed fee plus a usage charge for using the system. Shapiro has leased a large, Alpha-3 computer system from the manufacturer. The lease calls for a monthly rental of $40,000 for the 144 months (12 years) of the lease term. The estimated useful life of the computer is 15 years.

Each scheduled monthly rental payment includes $3,000 for full-service maintenance on the computer to be performed by the manufacturer. All rentals are payable on the first day of the month beginning with

August 1, 2014, the date the computer was installed and the lease agreement was signed. The lease is noncancelable for its 12-year term, and it is secured only by the manufacturer’s chattel lien on the Alpha-3 system. This lease is to be accounted for as a capital lease by Shapiro, and it will be depreciated by the straightline method with no expected salvage value. Borrowed funds for this type of transaction would cost Shapiro 12% per year (1% per month). Following is a schedule of the present value of $1 for selected periods discounted at 1% per period when payments are made at the beginning of each period.

Periods Present Value of $1 per Period (months) Discounted at 1% per Period

1 1.000

2 1.990

3 2.970

143 76.658

144 76.899

Instructions

Prepare all entries Shapiro should have made in its accounting records during August 2014 relating to this lease. Give full explanations and show supporting computations for each entry. Remember, August 31,

2014, is the end of Shapiro’s fiscal accounting period and it will be preparing financial statements on that date. Do not prepare closing entries.