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Chapter 21: Q.21-91FRS (page 1263)

Question: Brecker Company leases an automobile with a fair value of \(10,906 from Emporia Motors, Inc., on the following terms:

  1. Non-cancelable term of 50 months.
  2. Rental of \)250 per month (at end of each month). (The present value at 1% per month is \(9,800.)
  3. Estimated residual value after 50 months is \)1,180. (The present value at 1% per month is \(715.) Brecker Company guarantees the residual value of \)1,180.
  4. Estimated economic life of the automobile is 60 months.
  5. Brecker Company鈥檚 incremental borrowing rate is 12% a year (1% a month). It is impracticable to determine Emporia鈥檚 implicit rate.

Instructions

(a)What is the nature of this lease to Brecker Company?

Short Answer

Expert verified

Answer

The lease is a financial lease.

Step by step solution

01

Meaning of Lease 

For lease rentals, a finance lease is one in which the lessor passes nearly all of the risks and rewardsof asset ownership to the lessee. To put it another way, it puts the lessee in the same position as if he or she had bought the asset.

02

Explaining the nature of the lease

This lease is a financing lease to Brecker, the lessee because the terms meet the following criteria:

  1. The lease period is for the majority of the economic life of the leased asset (more than 75 percent); that is, the lease duration is 831/3 percent (50/60) of the economic life.
  2. The present value of the minimum lease payments equals substantially all (more than 90%) of the leased asset's fair value; for example, the present value of $10,515 (see below) equals substantially all (96%) of the leased asset's fair value:

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Most popular questions from this chapter

Lessor Computations and Entries, Sales-Type Lease with Guaranteed Residual Value) 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.

(3) Cost of sales.

What is the nature of a 鈥渟ale-leaseback鈥� transaction?

Metheny Corporation鈥檚 lease arrangements qualify as sales-type leases at the time of entering into the transactions. How should the corporation recognize revenues and costs in these situations?

Question: (Balance Sheet and Income Statement Disclosure鈥擫essee) The following facts pertain to a noncancelable lease agreement between Alschuler Leasing Company and McKee Electronics, a lessee, for a computer system.

Inception date

October 1, 2017

Lease term

6 years

Economic life of leased equipment

6 years

Fair value of asset at October 1, 2017

\(300,383

Residual value at end of lease term

鈥�0鈥�

Lessor鈥檚 implicit rate

10%

Lessee鈥檚 incremental borrowing rate

10%

Annual lease payment due at the beginning of each year, beginning with October 1, 2017

\)62,700

The collectibility of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. The lessee assumes responsibility for all executory costs, which amount to \(5,500 per year and are to be paid each October 1, beginning October 1, 2017. (This \)5,500 is not included in the rental payment of \(62,700.) The asset will revert to the lessor at the end of the lease term. The straight-line depreciation method is used for all equipment.

The following amortization schedule has been prepared correctly for use by both the lessor and the lessee in accounting for this lease. The lease is to be accounted for properly as a capital lease by the lessee and as a direct-financing lease by the lessor.

Date

Annual lease payments/Receipt

Interest (10%)

On Unpaid liability/Receivable

Reduction of Lease Liability?

Receivable

Balance of Lease Liability/Receivable

10/01/17

\)300,383

10/01/17

\(62,700

\)62,700

237,683

10/01/18

\(62,700

\)23,768

38,932

198,751

10/01/19

\(62,700

19,875

42,825

155,926

10/01/20

\)62,700

15,593

47,107

108,819

10/01/21

\(62,700

10,882

51,818

57,001

10/01/22

\)62,700

5,699*

57,001

0

\(376,200

\)75,817

\(300,383

*Rounding error is \)1.

Instructions

(a) Assuming the lessee鈥檚 accounting period ends on September 30, answer the following questions with respect to this lease agreement.

(b) What items and amounts will appear on the lessee鈥檚 income statement for the year ending September 30, 2018?

Winston Industries and Ewing Inc. enter into an agreement that requires Ewing Inc. to build three diesel-electric engines to Winston鈥檚 specifications. Upon completion of the engines, Winston has agreed to lease them for a period of 10 years and to assume all costs and risks of ownership. The lease is noncancelable, becomes effective on January 1, 2017, and requires annual rental payments of \(413,971 each January 1, starting January 1, 2017.

Winston鈥檚 incremental borrowing rate is 10%. The implicit interest rate used by Ewing Inc. and known to Winston is 8%. The total cost of building the three engines is \)2,600,000. The economic life of the engines is estimated to be 10 years, with residual value set at zero. Winston depreciates similar equipment on a straight-line basis. At the end of the lease, Winston assumes title to the engines. Collectibility of the lease payments is reasonably certain; no uncertainties exist relative to unreimbursable lessor costs.

Instructions

(a) Discuss the nature of this lease transaction from the viewpoints of both lessee and lessor.
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