Professor Authored Problems Intermediate Accounting 3 Acct 343/543. Leases

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1 Professor Authored Problems Intermediate Accounting 3 Acct 343/543 Leases Problem 1 Lessor s computation of lease payments. Calculate the lease payments for each case below: Cost of equipment to lessor 235,000 62, ,300 85,000 Fair value of equipment 235,000 52, ,300 90,000 Lease term 5 years 8 years 4 years 5 years Payments at now or later later now now later Payments annual, semi-annual or quarter annual annual semi quarter Guaranteed residual value 25,000 8, Unguaranteed residual value 0 12,000 15,000 5,000 Initial direct costs 5, ,500 2,000 Lessor s rate of return 5% 6% 7% 8% Lessee s normal cost to borrow 5% 5% 7% 9% Problem 2 Compute lease payment, where a seven (7) year lease is signed on March 26, 2012 and is to be repaid in equal annual installment payments starting on March 26, The lessee s weighted average cost of capital is 6%, and the lessee pays $4,000 to a lawyer to review the language of the lease. The lessor desires a 7% rate of return, and pays a lawyer $5,000 to create the lease. The lessor s rate is not known by the lessee. The asset has a total economic life of twelve (12) years. The asset has a $500,000 historical cost (and $600,000 market value) to the lessor on March 26, The lessor expects the asset to have a total residual value of $50,000 on March 26, 2019 (end of lease), with a guaranteed residual value of $30,000. The lessor expects the asset to have a total residual value of $10,000 (unguaranteed) on March 26, 2026 (end of asset life). Problem 3 Compute lease payment. Compute the amount of a lease payment, where a seven year lease is signed on April 1, 2009 and is to be repaid in equal annual installment payments starting on April 1, The asset has a total economic life of 12 years. The asset has a $516,000 historical cost (and $480,000 market value) to the lessor on April 1, The lessor expects the asset to have a total residual value of $10,000 on April 1, 2021 (end of asset life), and a total residual value of $23,000 on April 1, 2016 (end of lease). The lessor requires a guaranteed residual value of $13,000. The lessee s weighted average cost of capital is 10%, and pays $3,500 to a lawyer to review the language of the lease. The lessor desires a 8.5% rate of return, and pays a lawyer $3,000 to create the lease. The lessor s rate is known by the lessee. 118

2 Problem 4 Operating lease accounting for lessee. On 1/3/2012, the ABC Company (lessor) leases a piece of equipment to the XYZ Company (lessee) for a four (4) year period (at this date, the equipment has a total expected remaining useful life of ten (10) years). The equipment has a fair market value of $650,000 on 1/3/2012, and is carried on ABC's books (lessor) at a cost and book value of $650,000 (purchased 1/2/2012 with a debit to Leased Assets). ABC (lessor) expects the equipment to have a residual value of $300,000 when it is returned on 12/31/2015. Only $10,000 of this value is to be guaranteed by XYZ (lessee). ABC incurs initial direct costs of $0 in drawing up the lease. XYZ has no initial direct costs. ABC expects the equipment to have a residual value of 20,000 at the end of ten years, but there is no guarantee of this. ABC (lessor) structures the annual rental payments of 116,196, due on 1/3/2012 & 1/3/2013 & 1/3/2014 & 1/3/2015, to earn an 7% rate of return (the rate of interest implicit in the lease). XYZ (lessee) is not aware of ABC s rate. XYZ's cost of capital is 9%. This lease is to be accounted for as an operating lease for XYZ (LESSEE). Should it be necessary, both ABC and XYZ use straight-line depreciation, with a full year taken in the year of acquisition. Both ABC and XYZ have a fiscal year that extends from January 1 to December 31 of each year. 1. Prepare all necessary journal entries for 2012 and 2013 for XYZ (LESSEE) to account for the lease. Assume all payments made as scheduled. No explanations are necessary, but provide dates for all entries. 2. Complete this table for the lessee s reported amounts on the financial statements Ppd/ Total Current Long-term Operating Non-op Operating Investing Financing PPE Liability Liability Liability Income Income Activities Activities Activities 119

3 Problem 5 Operating lease accounting for lessor. On 1/3/2009, the ABC Company leases a piece of equipment to the XYZ Company for a seven (7) year period (at this date, the equipment has a total expected remaining useful life of fourteen (14) years). The equipment has a fair market value of $900,000 on 1/3/2009, and is carried on ABC's books at a cost and book value of $800,000 (purchased 1/2/2009 with a debit to Leased Assets). ABC expects the equipment to have a residual value of $350,000 when it is returned on 1/3/2016. Only $30,000 of this value is to be guaranteed by XYZ. ABC incurs initial direct costs of $0 in drawing up the lease. ABC expects the equipment to have a residual value of 15,000 at the end of fourteen years, but there is no guarantee of this. ABC structures the annual rental payments of 118,275, due on 1/3/2009 & 1/3/2010 & 1/3/2011 & 1/3/2012 & 1/3/2013 & 1/3/2014 & 1/3/2015, to earn a 7% rate of return (the rate of interest implicit in the lease). XYZ is not aware of ABC s rate. XYZ's cost of capital is 8.2%. This loan is to be accounted for as an operating lease for ABC (LESSOR). Should it be necessary, both ABC and XYZ use straight-line depreciation, with a full year taken in the year of acquisition. Both ABC and XYZ have a fiscal year that extends from January 1 to December 31 of each year. 1. Prepare all necessary journal entries for 2009 and 2010 for ABC (LESSOR) to account for the lease. Assume all payments made as scheduled. No explanations are necessary, but provide dates for all entries. 1/2/09 Leased Assets 800,000 Cash 800, What values does ABC (LESSOR) report on its balance sheets for 12/31/2009 and 12/31/2010? Be sure to identify where on the balance sheet the values are placed. 3. What values does ABC (LESSOR) report on its income statements for 2009 and 2010? Be sure to identify where on the income statements (operating income or non-operating income) the values are placed. 4 What values does ABC (LESSOR) report on its cash flows statements for 2009 and 2010? Be sure to identify where on the statement of cash flows the values are placed. 120

4 Problem 6 Operating Lease. Geddes Company leases some equipment for the period of time from January 1, 2006 through December 31, The equipment is to be used evenly over the fiveyear period. Geddes classifies the lease as an operating lease. The lease payments for this equipment are scheduled for: January 1, $30,000 January 1, $25,000 January 1, $25,000 January 1, $20,000 January 1, $20,000 Required: 1. Prepare journal entries related to this lease over the complete lease term. 2. Geddes s fiscal year is the calendar year. What amounts related to this lease will appear on the balance sheet, income statement and statement of cash flows for this lease? Problem 7 Operating Lease. Geddes Company leases some equipment for the period of time from January 1, 2006 through December 31, The equipment is to be used evenly over the fiveyear period. Geddes classifies the lease as an operating lease. The lease payments for this equipment are scheduled for: January 1, $40,000 January 1, $45,000 January 1, $50,000 January 1, $55,000 January 1, $60,000 Required: Prepare journal entries related to this lease over the total lease term. 121

5 Problem 8 Lease classification for lessee. Stark Finance, the lessor, and Johnson Company, the lessee, sign a lease agreement on April 9, 2009 that provides for Johnson to lease equipment worth $690,000 from Stark Finance. The lease terms, provisions, and other related events are as follows. The lease is noncancellable and has a term of 10 years (the total estimated useful life of the equipment is expected to be 14 years). The annual rental payments of 82,592 are payable every April 9, starting on April 9, Both Stark and Johnson estimate that the equipment will have a total residual value of $80,000 at the end of 10 years, with $55,000 of it guaranteed. Stark expects the property to have a $15,000 residual value at the end of the 14 th year, but this is not guaranteed. Johnson Company can purchase the equipment at the end of the lease for its market value at that time. If not, the equipment is to be returned to Stark Finance. The interest rate implicit in the lease is 5.8%, which is known by Johnson. Johnson Company's incremental borrowing rate is 7.2%. Both companies use the straight-line method to record depreciation on similar equipment, with one-half year taken in the year of acquisition. The cost of the equipment to Stark Finance is $680,000. The lessor incurs initial direct costs of $4,800. The collectibility of the rentals is reasonably assured. There are uncertainties surrounding the amount of unreimbursable costs yet to be incurred by the lessor. Identify the type of lease involved for Johnson (LESSEE), and give reasons for your classification. You should consider all possible classification criteria. Your answer should include your analysis, conclusion and justification for that conclusion. If it isn t written down, I ll assume that you didn t consider it or you don t know it. 122

6 Problem 9 Lease accounting for lessee. On 1/1/2009, the ABC Company leases a piece of equipment to the XYZ Company for a six (6) year period. At this date, the equipment has a total expected remaining useful life of eight (8) years. The equipment has a fair market value of $634,000 on 1/1/2009, and is carried on ABC's books at a cost and book value of $570,000. ABC expects the equipment to have a residual value of $58,000 when it is returned on 1/1/2015. Only $14,000 of this value is to be guaranteed by XYZ. Eventually, at the end of the 8 th year the asset will have a residual value of $10,000 but there is no guarantee. ABC incurs initial direct costs of $4,000 in drawing up the lease. ABC structures the annual rental payments of 118,401, due on 1/1/2009 & 1/1/2010 & 1/1/2011 & 1/1/2012 & 1/1/2013 & 1/1/2014, to earn an 7.3% rate of return (the rate of interest implicit in the lease). Please notice that a lease payment is due on the date the lease is signed. XYZ is aware of ABC s rate. XYZ's cost of capital is 6.9%. This loan is to be accounted for as a capital lease for XYZ (LESSEE). Should it be necessary, both ABC and XYZ use straight-line depreciation, with a full year taken in the year of acquisition. Both ABC and XYZ have a fiscal year that extends from January 1 to December 31 of each year. 1. Prepare an amortization table for XYZ (LESSEE) to aid in the accounting for the lease. Please round all amounts to dollars. Your table should contain an adjustment to account for rounding errors. 2. Prepare all necessary journal entries for 2009 and 2010 for XYZ (LESSEE) to account for the lease. Assume all payments made as scheduled. No explanations are necessary, but provide dates for all entries. 3. What values does XYZ (LESSEE) report on its balance sheets for 12/31/2009 and 12/31/2010? Be sure to identify where on the balance sheet the values are placed. 4. What values does XYZ (LESSEE) report on its income statements for 2009 and 2010? Be sure to identify where on the income statements the values are placed (including whether or not it is in operating income). 5 What values does XYZ (LESSEE) report on its cash flows statements for 2009 and 2010? Be sure to identify where on the statement of cash flows the values are placed. 123

7 Problem 10 Accounting for lessor and lessee. (This was a previous exam question.) On 1/1/2005, the Smith Finance Company leases a piece of equipment to the Jones Company for a four (4) year period (at this date, the equipment has a total expected remaining useful life of five (5) years). The equipment has a fair value of $850,000 on 1/1/2005, and is carried on Smith's books at a cost and book value of $850,000. Smith expects the equipment to have a residual value of $50,000 when it is returned, on 1/1/2009. Only $30,000 of this value is to be guaranteed by Jones. Jones may purchase the equipment at the end of the lease period for $60,000. The lessor incurs no material initial direct costs. The collectibility of the rentals is reasonably assured, and there are no important uncertainties surrounding the amount of unreimbursable costs yet to be incurred by the lessor. Smith structures the payments, due on 1/1/2005 & 1/1/2006 & 1/1/2007 & 1/1/2008, to earn a 5% rate of return (the rate of interest implicit in the lease). Jones is not aware of this rate. Jones's cost of capital is 6%. The lease qualifies as a capital lease to Jones, and a direct financing lease to Smith. Required: 1. Compute the annual lease payment amount. 2. What is the present value of minimum lease payments for Smith (lessor). 3. Analyze the terms of the lease to prove that it should be accounted for as a direct financing lease to Smith. You should consider all seven lessor test criteria. 4. Prepare an amortization table for Smith (lessor) to aid in the accounting for the lease. Please round all amounts to dollars. 5. Prepare all journal entries on 1/1/2005 through 12/31/2006 for Smith (lessor) to account for the lease. Please round all amounts to dollars (no cents). 6. What is the present value of minimum lease payments for Jones (lessee). 7. Analyze the terms of the lease to prove that it should be accounted for as a capital lease to Jones. You should consider all four lessee test criteria. 8. Prepare an amortization table for Jones (lessee) to aid in the accounting for the lease. Please round all amounts to dollars. 9. Prepare all journal entries on 1/1/2005 through 12/31/2006 for Jones (lessee) to account for the lease. Please round all amounts to dollars (no cents). 10. Show how this lease will be reported on Jones s balance sheet, income statement and statement of cash flows for 2005, assuming a fiscal year equal to the calendar year. 124

8 Problem 11 Accounting for lessor and lessee. (This was a previous exam question.) Wynk Equipment, the lessor, and Burkhardt Farms, the lessee, sign a lease agreement on January 1, 2005 that provides for Burkhardt Farms to lease a tomato harvester. The lease terms, provisions, and other related events are as follows. The lease is noncancellable and has a term of 6 years (the total estimated useful life is expected to be 10 years). The annual rentals of $40,000 are due on January 1 of each year, with the first payment due on January 1, Both Wynk & Burkhardt estimate that the harvester will have a residual value of $50,000 at the end of 6 years, but only $20,000 of it is guaranteed. Burkhardt may purchase the harvester for $50,000 at the end of the lease term. The interest rate implicit in the lease is 8%. The cost of the harvester to Wynk Equipment is $150,000. The actual fair value of the tomato harvester is the present value of the lease payments and residual value. The lessor incurs no material initial direct costs. The collectibility of the rentals is not reasonably assured, but there are no important uncertainties surrounding the amount of unreimbursable costs yet to be incurred by the lessor. The interest rate implicit in the lease is not known by Burkhardt. Burkhardt Farms' incremental borrowing rate is 10% and it uses the straight-line method to record depreciation on similar equipment. Required: 1. Identify the type of lease (i.e., operating, capital) involved for Burkhardt Farms (lessee), and give reasons for your classification. You should consider all four possible classification criteria and explicitly note your decision rule, your analysis and your conclusion. If it isn t written down, I ll assume that you didn t consider it. 2. In case it is a capital lease for Burkhardt Farms (lessee), prepare an amortization table for Burkhardt Farms as a possible aid in the accounting for the lease. Please round all amounts to dollars. 3. Prepare all journal entries for 2005 and 2006 for Burkhardt Farms (lessee) to account for the lease. Be sure to date each entry. Please round all amounts to dollars (no cents). 4. Show how this lease will be reported on Burkhardt s balance sheet, income statement and statement of cash flows for 2005, assuming a fiscal year equal to the calendar year. 5. Identify the type of lease (i.e., operating, direct-financing, or sales-type) involved for Wynk Equipment (lessor), and give reasons for your classification. You should consider all seven possible classification criteria and explicitly note your decision rule, your analysis and your conclusion. If it isn t written down, I ll assume that you didn t consider it. 6. Prepare all journal entries for 2005 and 2006 for Wynk Equipment (lessor) to account for the lease. Be sure to date each entry. Please round all amounts to dollars (no cents). If Wynk 125

9 accounts for the lease as some sort of capital lease, prepare an amortization table to assist in the accounting. 7. Repeat requirements 5 & 6, assuming that the collectibility of the lease payments is reasonably assured. Problem 12 Unguaranteed residual value; implicit rate in lease. From Intermediate Accounting, 6 th Edition, by Chasteen, Flaherty & O Connor (1998). Adapted. Super Shuttle, Inc. (SSI), enters into a lease agreement with Kevin Industrial Complex (KIC) whereby KIC agrees to lease 35 shuttle flights from SSI. The cost and fair value of the shuttle is $48 million. The term of the lease is 10 years. KIC must utilize its 35 flights during this 10-year period and has exclusive use during this period. The estimated useful life of the shuttle is 100 flights, after which its residual value will be zero. At the end of the10-year lease term, the estimated residual value is $25 million, which is not guaranteed by KIC. SSI sets the lease payments, payable at the beginning of each year, to earn a 12 percent rate of return. KIC s incremental borrowing rate is 8 percent, and KIC may purchase the shuttle at the end of the lease term for its fair value at that time. KIC agrees to pay all costs associated with operating the shuttle and does not know the implicit rate in the lease. Required: 1. Calculate the annual lease payments required by SSI. 2. What type of lease is the above to SSI? To KIC? Explain and show calculations. 3. Prepare all necessary entries for SSI and for KIC (a) at the inception of the lease and (b) for the first two years of the lease. KIC made five shuttle flights during the first year and three flights during the second year. Both parties base depreciation on usage. If either company accounts for the lease as some sort of capital lease, prepare the necessary amortization table. 126

10 Problem 13 Guaranteed residual value. From Intermediate Accounting, 6 th Edition, by Chasteen, Flaherty & O Connor (1998). Adapted. On July 1, 1998, Fast Freight Forwarders (FFF) leased a fleet of trucks from Aron Corporation (AC). AC had recently manufactured the trucks at a cost of $3 million. The fleet's normal selling price was $3.5 million. Terms of the lease agreement were as follows: Length of lease years Semiannual lease payments, beginning 7/1/ $474,532 Estimated life of trucks years Estimated residual value of trucks at end of lease term (guaranteed by FFF).... $600,000 Implicit (semiannual) rate in lease (known to FFF) % The lessee agreed to assume full responsibility for periodic maintenance and service on the fleet. The full amount of the lease payments was expected to be collectible, and no other costs were expected to be incurred by the1essor. Both the lessor and the lessee have fiscal years that end on December 31. Required: 1. Determine how AC {the lessor) and FFF (the lessee) should classify the lease. 2. Prepare all necessary journal entries for the1essor and the lessee on July 1, Prepare all necessary journal entries for the lessor and the lessee for the rest of 1998 and for all of Straight-line depreciation is appropriate. Prepare amortization tables if necessary. 127

11 Problem 14 Lease accounting for lessor. The Taves Company frequently purchases equipment from manufacturers. It then leases the equipment to other companies. If Taves is required to depreciate the equipment for financial accounting purposes, straight line depreciation is used with a half year taken in the year of acquisition. Taves has a fiscal year that extends from January 1 to December 31 of each year. Taves purchased a piece of equipment for $640,000 on 4/1/09, and debited the Leased Assets account. Taves expects the equipment to have an eight year life with a residual value (unguaranteed) of $50,000 at the end of the eighth year. On 6/1/2009, the equipment has a fair market value of $670,000. On 6/1/2009, the Taves Company leases the equipment to another company for a six (6) year period. On 6/1/2009, Taves spent $5,000 for lawyer fees (initial direct costs). Taves expects the equipment to have a residual value of $55,000 ($11,000 guaranteed) when it is returned at the end of the six year lease term, on 6/1/2015. Taves structures the annual rental payments of 128,873, due on 6/1/2009 & 6/1/2010 & 6/1/2011 & 6/1/2012 & 6/1/2013 & 6/1/2014, to earn an 8.2% rate of return. Taves knows that the lessee has a weighted average cost of capital of 7.2%. This loan is to be accounted for as a sales-type lease for Taves (LESSOR). (1) Prepare a lease amortization table to assist Taves (LESSOR) in the accounting for this lease. Please round all amounts to dollars. Your table should contain an adjustment to account for rounding errors. (2) Prepare all journal entries that Taves (LESSOR) will need for 2009 and /1/09 Leased Assets 640,000 Cash 640,