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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’s incremental borrowing rate is 12% a year (1% a month). It is impracticable to determine Emporia’s 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

Assume that on January 1, 2017, Elmer’s Restaurants sells a computer system to Liquidity Finance Co. for \(680,000 and immediately leases the computer system back. The relevant information is as follows.

  1. The computer was carried on Elmer’s books at a value of \)600,000.
  2. The term of the noncancelable lease is 10 years; title will transfer to Elmer.
  3. The lease agreement requires equal rental payments of \(110,666.81 at the end of each year.
  4. The incremental borrowing rate for Elmer is 12%. Elmer is aware that Liquidity Finance Co. set the annual rental to ensure a rate of return of 10%.
  5. The computer has a fair value of \)680,000 on January 1, 2017, and an estimated economic life of 10 years.
  6. Elmer pays executory costs of $9,000 per year.

Instructions

Prepare the journal entries for both the lessee and the lessor for 2017 to reflect the sale and leaseback agreement. No uncertainties exist, and collectibility is reasonably certain.

Winston Industries and Ewing Inc. enter into an agreement that requires Ewing Inc. to build three diesel-electric engines to Winston’s 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’s 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

(f) Show the items and amounts that would be reported on the balance sheet (not notes) at December 31, 2017, for both the lessee and the lessor.

(Operating Lease vs. Capital Lease) You are auditing the December 31, 2017, 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, 2017, 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. 2. Rental of \(3,240 per year (at the end of each year). (The present value at 8% per year is \)10,731.)
  3. 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. 4. Estimated economic life of the automobile is 5 years.
  5. 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.)

The residual value is the estimated fair value of the leased property at the end of the lease term.

(b) Of what significance is (1) an unguaranteed and (2) a guaranteed residual value in the lessor’s accounting for a direct-financing lease transaction?

Use the information for Rick Kleckner Corporation from BE21-3. Assume that at December 31, 2017, Kleckner made an adjusting entry to accrue interest expense of \(29,530 on the lease. Prepare Kleckner’s January 1, 2018, journal entry to record the second lease payment of \)53,920.

Rick Kleckner Corporation recorded a capital lease at \(300,000 on January 1, 2017. The interest rate is 12%. Kleckner Corporation made the first lease payment of \)53,920 on January 1, 2017. The lease requires eight annual payments. The equipment has a useful life of 8 years with no salvage value. Prepare Kleckner Corporation’s December 31, 2017, adjusting entries.
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