1. Each of the first 6 months, the entry is: Rent expense 1,800 Deferred rent liability 1,800

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1 Buad 273 Chapter 17 Example Solutions Page 1 of 13 Example 1 Operating Lease with Inducement The matching principle requires that we record rent expense as the benefit of using the building is used to earn revenue. We spread the total cost evenly over the life of the lease as follows: Total number of months: 5*12 = 60 Total number of payments: = 54 Total amount paid $2,000*54 = $108,000 Monthly expense: 108,000/60 = $1, Each of the first 6 months, the entry is: Rent expense 1,800 Deferred rent liability 1,800 At the end of 6 months, the deferred rent liability balance is 6*1,800 = $10,800. This is amortized over the remaining 54 months, at 10,800/54=$200 per month 2. Remaining 54 entries will be: Rent expense 1,800 Deferred rent liability 200 Cash 2,000 At the end of 54 months, the balance in the deferred rent liability account will be zero.

2 Buad 273 Chapter 17 Example Solutions Page 2 of 13 Example 2: A17-5 Requirement 1 #1 #2 #3 a. Lease term 7 years (1) 5 years 1 year b. Bargain purchase option $1 n/a n/a c. Unguaranteed residual n/a n/a? d. Guaranteed residual n/a $75,000 n/a e. Bargain renewal terms n/a n/a n/a f. Minimum net lease payments $150,001 (2) $596,500 (3) $9,200 g. Contingent lease payments n/a n/a $7.40/hour h. Interest rate to be used to discount 8% 10% 10% (1) Renewal term preceeds BPO (2) (($28,600 $2,600) x 5) + (($11,500 $1,500) 2) + $1 (3) ($104,300 5) + $75,000. The full amount of the guaranteed residual is included. Requirement 2 Lease 1: 1. Title passes (BPO). YES 2. PV of the MLP: (Optional: we could also calculate this in one step using the CF function (see the financial calculator tutorial): CF0 = 0 C01 26,000 F01 5 C02 10,000 F02 1 C03 10,001 F03 1 NPV I=8 CPT gives 115,948 ($1 difference due to rounding in multi-step calculation) 115,947/116,000 = 99.95% > 90%, YES 3. Lease term is 7/10 = 70% of life, less than 75%. NO Conclusion: Capital Lease. Copyright 2008 by McGraw-Hill Ryerson Limited. All rights reserved.

3 Buad 273 Chapter 17 Example Solutions Page 3 of 13 Example 2: A17-5 Lease 2: 1. Title passes/bpo? NO 2. PV of minimum lease payments (include GRV): BGN, 104,300PMT, 5N, 10I, 75,000FV CPT PV gives $481, ,486/550,000 = 87% <90%, NO 3. Lease term 5/6 = 83%>75%, YES Conclusion: Capital Lease. Lease 3: 1. Title passes/bpo? NO 2. PV of minimum lease payments: 10,600/55,000 = 19%<90% NO 3. Lease term 1/5 = 20%<75% NO Conclusion: Operating Lease. Requirement 3 #1 Asset under capital lease ,947 Lease liability ,947 #2 Asset under capital lease ,486 Lease liability ,486 Lease liability ,300 Cash ,300 #3 Maintenance and insurance expense... 1,400 Rental expense, machinery... 9,200 Cash... 10,600 [The expense could all be recorded in rental expense] Copyright 2008 by McGraw-Hill Ryerson Limited. All rights reserved.

4 Buad 273 Chapter 17 Example Solutions Page 4 of 13 Example 3: Assignment 17-1 Requirement 1 Minimum lease payments: [($104,000 $9,600) 5] + $26,500 = ($94,400 5) + $26,500 = $498,500. Only the guaranteed residual is included despite higher expectations of resale value. Requirement 2 The asset will be recorded at the present value of the minimum lease payments (including the guaranteed residual value), discounted at 10%: BGN, 94,400PMT, 5N, 10I, 26,500FV, CPT PV gives $410,090 Requirement 3 If the residual value is unguaranteed, it won t be included in the minimum lease payments. Therefore, the asset will be recorded at the NPV of the lease payments: BGN, 94,400PMT, 5N, 10I, CPT PV gives $393,635 Requirement 4 A leased asset cannot be recorded at more than its fair value. The asset must be recorded at $375,000. Subsequent accounting for the lease must be at the implicit interest rate that discounts the stream of $498,500 lease payments to a present value of $375,000. Assuming the GRV, BGN, -375,000PV, 94,400PMT, 5N, 26,500FV, CPT I gives 15.35%. Copyright 2008 by McGraw-Hill Ryerson Limited. All rights reserved.

5 Buad 273 Chapter 17 Example Solutions Page 5 of 13 Example 4: Assignment 17-2 Requirement 1 The lease term is eight years. Guaranteed residual value, none. Unguaranteed residual value exists as the value of the asset to the lessor at the end of the lease term. There is no way to calculate this amount. BPO, none. Minimum net lease payments, ($24,000 $4,000) 8 years = $160,000. Incremental borrowing rate, 8%. Requirement 2 To be a capital lease, the lease would have to meet one of the following three criteria, applied judgmentally: 1. Transfer of title No 2. Economic life vs lease term No; 8/12 < 75% 3. PV of MLP vs fair value PV of MLP: BGN, (24,000 4,000)Pmt, 8n, 8i, Cpt PV gives $124,127. $124,127 $133,000 = 93%>90% Yes Since criterion 3 is met, this is a capital lease. Copyright 2008 by McGraw-Hill Ryerson Limited. All rights reserved.

6 Buad 273 Chapter 17 Example Solutions Page 6 of 13 Example 4: Assignment 17-2 Requirement 3 Date Opening balance Interest Payment Closing balance 1-Jan-X1 124,127 20, ,127 1-Jan-X2 104,127 8,330 20,000 92,457 1-Jan-X3 92,457 7,397 20,000 79,854 1-Jan-X4 79,854 6,388 20,000 66,242 1-Jan-X5 66,242 5,299 20,000 51,541 1-Jan-X6 51,541 4,123 20,000 35,664 1-Jan-X7 35,664 2,853 20,000 18,517 1-Jan-X8 18,517 1,483 20,000 - Beginning of fiscal year and lease term: Asset under capital lease ,127 Lease liability ,127 Lease liability... 20,000 Prepaid maintenance expense... 4,000 Cash... 24,000 End of the fiscal year: Maintenance expense... 4,000 Prepaid maintenance expense... 4,000 Interest expense... 8,330 Lease liability... 8,330 Amortization expense ($124,127 8)... 15,516 Accumulated amortization... 15,516 Requirement 4 If the lease were cancellable, the lease term would be (effectively) one year, and the minimum lease payments, $20,000 net; $24,000 gross. The lease would not qualify for capitalization, and would be recorded annually as an operating lease: Rent expense... 24,000 Cash... 24,000 The annual payment could be split between rental and maintenance if Burrill wished. Copyright 2008 by McGraw-Hill Ryerson Limited. All rights reserved.

7 Buad 273 Chapter 17 Example Solutions Page 7 of 13 Example 5: Capital Lease, with Bargain Purchase Option In calculating the present value of the lease payments when there is a Bargain Purchase Option, we include the bargain purchase amount in the calculation. In the amortization schedule, the last payment is the bargain purchase amount. Note that the last payment is on January 1 20X5, but the lease term ends on December 31, 20X5. 1 Jan. X3 Date Opening balanceinterestpaymentclosing balance 1-Jan-03 15,756-5,000 10,756 1-Jan-04 10,756 1,183 5,000 6,939 1-Jan-05 6, ,000 2, Dec-05 2, ,000 - Inception of the lease record the asset and liability, and the first payment: 31 Dec. X3 Asset under capital lease 15,756 Lease liability 15,756 Lease liability 5,000 Cash 5,000 At year-end we record the expenses for the year interest and amortization: Interest expense 1,183 Lease liability 1,183 Amortization expense 15,756/5 1 3,151 Accumulated amortization 3,151 1 We include the full PV including BPO, and divide by the life of the asset rather than the lease life. Because of the BPO the lessee is sure to buy the asset, and we assume they will use it for its full useful life. If there is no BPO, we divide by the lease term, even if it is less than the life of the asset.

8 Buad 273 Chapter 17 Example Solutions Page 8 of 13 Example 5: Capital Lease, with Bargain Purchase Option 1 Jan. X4 Record the payment: Lease liability 5,000 Cash 5,000 Note that the liability is now $6,939, as per the schedule 31 Dec. X4 Year-end adjustments: 1 Jan. X5 Interest expense 763 Lease liability 763 Amortization expense 3,151 Accumulated amortization 3,151 Record the payment: Lease liability 5,000 Cash 5,000 Note that the liability is now $2,702, as per the schedule 31 Dec. 05 Year-end adjustments: Interest expense 298 Lease liability 298 Amortization expense 3,151 Accumulated amortization 3,151 This is the end of the lease term, so the lessee would purchase the asset: Lease liability 3,000 Cash 3,000 Note that the liability is now $0, as per the schedule The lessee would also reallocate the asset and its accumulated amortization: Capital assets 15,756 Asset under capital lease 15,756 Accumulated amortization, leased asset 3,151*3 9,453 Accumulated amortization, asset 9,453 (Amortization would continue until the end of year 5)

9 Buad 273 Chapter 17 Example Solutions Page 9 of 13 Example 6: Capital Lease, Different Year-end In Example 5 we calculated the following amortization schedule. Date Opening balanceinterestpaymentclosing balance 1-Jan-03 15,756-5,000 10,756 1-Jan-04 10,756 1,183 5,000 6,939 1-Jan-05 6, ,000 2, Dec-05 2, ,000 - This schedule still applies to the lease. Given a May 31 year-end, we simply have to calculate the portion of interest expense that applies to each fiscal year. 1 Jan. X3 Inception of the lease record the asset and liability and first payment (as before): 31May X3 Asset under capital lease 15,756 Lease liability 15,756 Lease liability 5,000 Cash 5,000 At year-end we record the expenses for the year interest and amortization. Only 5 months have passed since the inception of the lease. 1 Jan. X4 Interest expense 1,183*5/ Lease liability 493 Amortization expense (15,756/5)*5/12 1,313 Accumulated amortization 1,313 Record the payment: 31 May X4 Lease liability 5,000 Cash 5,000 Year-end adjustments: Interest expense 1,183*7/ *5/12 1,008 Lease liability 1,008 Amortization expense (full year) 3,151 Accumulated amortization 3,151

10 Buad 273 Chapter 17 Example Solutions Page 10 of 13 Example 6: Capital Lease, Different Year-end 1 Jan. X5 Record the payment: 31 May X5 Lease liability 5,000 Cash 5,000 Year-end adjustments: 31 Dec. X5 Interest expense 763*7/ *5/ Lease liability 569 Amortization expense (full year) 3,151 Accumulated amortization 3,151 This is the end of the lease term, so the lessee would purchase the asset: Lease liability 3,000 Cash 3,000 Record interest expense: Interest expense 298*7/ Lease liability 174 Record amortization expense to disposal date: Amortization expense 3,151*7/12 1,838 Accumulated amortization 1,838 And reallocate the asset and its accumulated amortization: Capital assets 15,756 Asset under capital lease 15,756 Acc. amortization, leased asset 1,313+3,151+3, ,838 9,453 Accumulated amortization, asset 9,453

11 Buad 273 Chapter 17 Example Solutions Page 11 of 13 Example 7: Capital Lease with Guaranteed Residual Value Some leases have a Guaranteed Residual Value, which means that if the asset is not worth that specified amount at the end of the lease term, the lessee has to pay the difference to the lessor. When there is a guaranteed residual value, we include it in the calculation of the present value, just like we do for a BPO. Note that if there is an unguaranteed residual value, the lessee ignores it. It is of interest only to the lessor. The calculation of the PV of the lease would be: BGN, 10,000Pmt, 4,000FV, 3N, 9i, Cpt PV, which gives 30,680. Note how the following amortization schedule ends with a liability balance of 4,000 (the guaranteed residual value) at the end of year 4. We will show what happens to that balance when we do the final journal entries. Date Opening balanceinterestpaymentclosing balance 1-Jan-03 30,680-10,000 20,680 1-Jan-04 20,680 1,861 10,000 12,541 1-Jan-05 12,541 1,129 10,000 3, Dec-05 3, ,000 Journal entries: 1 Jan 20X3 Asset under capital lease 30,680 Lease liability 30,680 Lease liability 10,000 Cash 10, Dec. 20X3 Interest expense (schedule) 1,861 Lease liability 1,861 Amortization expense (30,680-4,000)/3 1 8,893 Accumulated amortization 8,893 1 When there is a guaranteed residual value, we subtract the GRV from the PV in calculating the amortization base, and divide by the lease life rather than the life of the asset. The reason for this will become clear when we do the end-of-lease entries at the end of year 3. 1 Jan 20X4 Lease liability 10,000 Cash 10, Dec. 20X4 Interest expense (schedule) 1,129 Lease liability 1,129 Amortization expense 8,893 Accumulated amortization 8,893 1 Jan 20X5 Lease liability 10,000 Cash 10,000

12 Buad 273 Chapter 17 Example Solutions Page 12 of 13 Example 7: Capital Lease with Guaranteed Residual Value 31 Dec. 20X5 Interest expense (schedule) 330 Lease liability (see note below) 330 Amortization expense 8,894 Accumulated amortization 8,894 Amortization expense was increased by $1 to correct a rounding error, which will soon become clear. So what happens now? The lease is over, and here s what is on the books of the lessee. Lease Liability Asset under C.L. Accum. Amort. 10,000 30,680 30,680 8,893 10,000 1,861 8,893 10,000 1,129 8, ,000 30,680 26,680 How do we record the fact that the lease is done? Note that the remaining balances all balance out with equal Dr and Cr, and can be removed with a single journal entry. That s why we removed the guaranteed residual value from the amortization base (and also why we rounded the last amortization amount!) Assumption 1 Lessee does not have to pay Lease liability 4,000 Accumulated amortization 26,680 Asset under capital lease 30,680 Assumption 2 Lessee pays $1,000 Same entry as Assumption 1, plus: Loss on lease contract 1,000 Cash 1,000 Note that under both assumptions, the asset is fully amortized and does not appear on the books any more.

13 Buad 273 Chapter 17 Example Solutions Page 13 of 13 Example 8: Sale and Leaseback Case 1: Capital Lease: We calculate the present value of the lease payments as usual: In BGN mode press 20n, 50,000Pmt, 10i, Cpt PV which gives 468,246 Record disposal of the building: Cash 500,000 Accumulated amortization 550,000 Building 1,000,000 Deferred gain (plug) 50,000 Record leaseback under capital lease, and initial payment: Leased building 468,246 Lease obligation 468,246 Lease obligation 50,000 Cash 50,000 Next payment, at year-end: Lease obligation 50,000 Cash 5,0000 Interest expense (468,246 50,000)*10% 41,825 Lease obligation 41,825 Amortization expense 468,246/20 23,412 Accumulated amortization 23,412 We also amortize the deferred gain on the same basis as the amortization of the asset: Deferred gain 50,000/20 2,500 Amortization expense 2,500 Case 2: Operating Lease: Record disposal of the building: Cash 500,000 Accumulated amortization 550,000 Building 1,000,000 Deferred gain (plug) 50,000 Record initial payment: Prepaid lease expense 50,000 Cash 50,000 Next payment, at year-end: Lease expense 50,000 Prepaid lease expense 50,000 Prepaid lease expense 50,000 Cash 50,000 We also amortize the deferred gain on the same basis as the asset: Deferred gain 50,000/20 2,500 Lease expense 2,500

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