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Q2CA_a(1).

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Intermediate Accounting (Kieso)
Found in: Page 1251

Short Answer

(Lessor and Lessee Accounting and Disclosure) Sylvan Inc. entered into a noncancelable lease arrangement with Breton Leasing Corporation for a certain machine. Breton’s primary business is leasing; it is not a manufacturer or dealer. Sylvan will lease the machine for a period of 3 years, which is 50% of the machine’s economic life. Breton will take possession of the machine at the end of the initial 3-year lease and lease it to another, smaller company that does not need the most current version of the machine. Sylvan does not guarantee any residual value for the machine and will not purchase the machine at the end of the lease term.

Sylvan’s incremental borrowing rate is 10%, and the implicit rate in the lease is 9%. Sylvan has no way of knowing the implicit rate used by Breton. Using either rate, the present value of the minimum lease payments is between 90% and 100% of the fair value of the machine at the date of the lease agreement.

Sylvan has agreed to pay all executory costs directly, and no allowance for these costs is included in the lease payments. Breton is reasonably certain that Sylvan will pay all lease payments. Because Sylvan has agreed to pay all executory costs, there are no important uncertainties regarding costs to be incurred by Breton. Assume that no indirect costs are involved.

Instructions

(a) With respect to Sylvan (the lessee), answer the following.

  1. What type of lease has been entered into? Explain the reason for your answer.

The lease is a capital lease.

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Step by Step Solution

Meaning of Capital lease

The transfer of ownership rights from one party to another at the completion of the lease period is term as a capital lease. A lessee might benefit from capital leasing by purchasing an asset at a lower cost than the market value.

Explaining the type of lease and the reason behind it.

Sylvan should record this as a capital lease since the present value of the minimum lease payments is higher than 90% of the asset's fair value at the start of the lease.

Most popular questions for Business-studies Textbooks

Question: (Balance Sheet and Income Statement Disclosure—Lessee) 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

–0–

Lessor’s implicit rate

10%

Lessee’s 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.

(b) Assuming the lessee’s accounting period ends on December 31, answer the following questions with respect to this lease agreement.

(1) What items and amounts will appear on the lessee’s income statement for the year ending December 31, 2017?

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