Financial Accounting: Liabilities & Equities Class notes Barbara Wyntjes, B.Sc., CGA

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1 Module 5: Leases Part 2: Assignment 17-1 (Chapter 17, page 1080) The lease term is eight years. Guaranteed residual value, none. Unguaranteed residual value, unknown BPO, none. Minimum net lease payment, ($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: 1. Transfer of title No 2. Economic life vs lease term No; 8/12 < 75% 3. PV of MLP vs fair value Yes; $114,933* > 90% of $125,000 *PV of MLP: PMT = ($24,000 $4,000), i = 8%, n = 8, FV = 0, P = $114,933 $114,933 $125,000 = 92%. Since criterion 3 is met, this is a capital lease. Beginning of fiscal year and lease term: Asset under capital lease ,933 Lease liability ,933 End of the fiscal year: Maintenance expense... 4,000 Lease liability... 20,000 Cash... 24,000 Interest expense... 9,195 Lease liability ($114,933.08)... 9,195 Amortization expense ($114,933 8)... 14,367 Accumulated amortization... 14,367 Requirement 4 If the lease were cancellable, the lease term would be (effectively) one year, and the minimum net lease payments, $20,000; $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. 1

2 Part 3: Assignment 17-3 (Chapter 17, pages ) #1 #2 #3 a. Lease term 7 years (1) 1 year 5 years b. Bargain purchase option $1 n/a n/a c. Unguaranteed residual n/a? n/a d. Guaranteed residual n/a n/a $75,000 e. Bargain renewal terms n/a n/a n/a f. Minimum net lease payments $150,001 (2) $9,200 $596,500 (3) g. Contingent lease payments n/a $7.40/hour n/a 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. Guaranteed residual is included. Requirement 2: Classification #1 Capital lease. Title passes (BPO). The PV of the MLP is also high to give the lessor return of principal and interest: a) ($28,600 $2,600) (P/A, 8%, 5) ( ) $103,810 b) ($11,500 $1,500) (P/A, 8%, 2) (P/F, 8%, 5) = $10,000 ( ) (.68058) 12,137 $115,947 (The BPO has a negligible PV). Note that since title passes to the lessee, this would be a capital lease for tax purposes as well. The lessor has no tax savings and all return comes from the lessee. #2 Operating lease. None of the capitalization criteria are met: this is a straightforward rental. #3 Capital lease. The lease term covers substantially all (5/6) of the asset s useful life. However, the PV of the MLP 's is not 90% of fair value, implying significant tax savings for the lessor or a lower interest rate: BGN PMT = $104,300, n = 5, i = 10%, FV = 75,000, PV =? = $481,486 #1 Asset under capital lease ,947 Lease liability ,947 #2 Maintenance and insurance expense... 1,400 Rental expense, machinery... 9,200 Cash... 10,600 The expense could all be recorded in rental expense #3 Asset under capital lease ,486 Lease liability ,486 Lease liability ,300 Cash ,300 2

3 Part 4: Assignment 17-7 (Chapter 17, pages ) This is a capital lease for Roscoe. They pay for the equipment and provide return to the lessor over the life of the lease: PV of MLP = PMT =$7,400, i = 7%, n = 5, PV =? = $30,342. $30,342/$32,500 = 93% The lease could also be classified based on the lease term vs economic life (100%) Requirement 2 Lease Amortization - End of Year Payments Outstanding Interest End of period Inc/(Dec) Ending Year Balance at 7% Cash Flow in Balance Balance 20x1 30,342 2,124 7,400 (5,276) 25,066 20x2 25,066 1,755 7,400 (5,645) 19,421 20x3 19,421 1,360 7,400 (6,040) 13,381 20x4 13, ,400 (6,463) 6,918 20x5 6, ,400 (6,916) (2) rounding 1 January 20x1 Asset under capital lease... 30,342 Lease liability... 30, December 20x1 Interest expense... 2,124 Lease liability... 2,124 Insurance and maintenance expense Lease liability... 7,400 Cash... 7,600 Amortization expense ($30,342/5)... 6,068 Accumulated amortization, asset under lease... 6, December 20x2 Interest expense... 1,755 Lease liability... 1,755 Insurance and maintenance expense Lease liability... 7,400 Cash... 7,600 Amortization expense... 6,068 Accumulated amortization, asset under lease... 6,068 Requirement 4 Interest expense, 20x1 $2,124 x 6/12 = $1,062 Interest expense, 20x2 $1,062 (2,124 x 6/12) (1,755 x 6/12) = $1,940 Requirement 5 FMV is less thus use that value and determine the IRR = Implicit interest rate = 14%; PV = 25,405, FV = 0, PMT = 7,400, n = 5; r = 14%. 1st yr interest: = $3,557; ($25,405 x 14%) 3

4 Part 6: Assignment (Chapter 17, pages ) : Annuity due = beginning of year payments Lease payments: PV = 600,000, r = 12%, n = 5, FV = 50,000, PMT =? = $141,585 Requirement 2: First: Capital or operating lease? Capital FV = 0, n = 5, r = 12%, PMT = 141,585, PV = 571,628 (rounded to 571,629) Income statement: Interest expense: ($571,629 $141,585beg) 12% $ 51,605 Amortization expense: $571,629 5 (straight line assumed) $ 114,326 Balance sheet: Leased computer equipment Accumulated amortization on leased equipment Lease liability (current)* Lease liability (long-term)* $ 571,629 dr. $ 114,326 cr. $ 141,585 cr. $ 340,064 cr. * Calculation of lease liability: Lease liability at inception $ 571,629 First payment (1 January 20X1) 141,585 Balance outstanding through 20X1 430,044 Accrued interest for 20X1 (above) + 51,605 Lease liability balance, 31 December 20X1 481,649 Current portion (lease payment due on the next day 1 January 20X2) 141,585 Long-term portion $ 340,064 4

5 Class Example 1: E Transportation leases most of its trucks. On July 1, 2005, E entered into a 5-year lease for a new truck with a fair value of $60,000. The payments are made at the beginning of each lease year. E has the option of purchasing the truck at the end of the lease for $5,000. The expected value at the end of the lease is $20,000. E s incremental borrowing rate is 10% and the implicit interest rate in the lease is 11%. The expected useful life is 8 years. Required: Calculate the lease payment. BPO because $5,000 significantly < $20,000. Lessor determines the payment thus use their rate of 11%. Calculation of lease payments: Annuity Due PV = fair value = $60,000, n = 5 years, i = 11%, FV = $5,000 (BPO), PMT =? = $13,902 THE END 5

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