Chapter 21 Exercises Day 1

E 21-3

1-1-08, Kimberly-Clark Corp. signs 10-year, non-cancelable lease agreement to lease a storage building from Sheffield Storage Co. KC is LESSEE. Equal rent payments of $72,000 starting 1/1/08 FMV of building 1-1-08 is $440,000. Blding has economic life of 12 years, with Unguaranteed R.V. of $10,000. ST-LINE depreciation. NON-renewable lease. Building reverts to lessor at termination of lease (THUS NO BPO). KC (LESSEE’S) incremental borrowing rate 12% annual. LESSOR’S rate is unknown. Yearly rent payment includes $2,470.51 of executory costs related to taxes on property. Instructions: Prepare journal entries on LESSEE’s BOOKS to reflect signing lease and payments/expenses for 08 and 09. Year end 12/31.

EXECUTORY COSTS? Expenses of ownership and use (e.g., insurance, tax, maintenance). How are they accounted for in an OPERATING LEASE? Paid by lessor and recovered in periodic rent payments.

EXECUTORY COSTS? How are they accounted for in a capital lease? LESSOR LESSEE If lessor retains responsibility for payment If paid directly by lessee to the third party DON’T capitalize into PV of minimum lease payments; executory costs subtracted from lease payment before PV min lease payments calculated No need to adjust the rent payment because it doesn’t include the executory costs.

How much then are the yearly rent payments? Capitalized amount of the lease: Yearly payment $ 72,000.00 Executory costs 2,470.51 Minimum annual lease payment $69,529.49 What is the PRESENT VALUE of the minimum lease payments? Present value of minimum lease payments $69,529.49 X 6.32825 = $440,000.00 10 years at 12%

1/1/08 Leased Asset 440,000.00 Lease Liability 440,000.00 What entry records the lease obligation for the LESSEE? 1/1/08 Leased Asset 440,000.00     Lease Liability 440,000.00 What entry records the first lease payment? 1/1/08 Executory Costs—Property Taxes 2,470.51 Lease Liability 69,529.49 Cash 72,000.00

What other entries are needed for the LESSEE? DEPRECIATION 12/31/05 Depreciation Expense 44,000.00    Accumulated Depreciation— Capital Leases 44,000.00 ($440,000 ÷ 10) * Don’t subtract salvage because its unguaranteed and no transfer of ownership. INTEREST table next slide.

Schedule 1 Kimberly-Clark Paper Co. Lease Amortization Schedule (Lessee) Annual Payment Reduction Balance Less of Lease of Lease Date Executory Costs Interest (12%) Obligation Obligation 1/1/08 $440,000.00 1/1/08 $69,529.49 -0-     $69,529.49 370,470.51 1/1/09 69,529.49 $44,456.46 25,073.03 345,397.48 1/1/10 69,529.49 41,447.70 28,081.79 317,315.69 INTEREST for 2008 12/31/08 Interest Expense …………….. 44,456.46 accrued      Lease Liability (int/p) 44,456.46 * payment made in cash on 1/1/09

Payment on 1/1/09 1/1/09 Executory Costs—Property Taxes 2,470.51 Interest Payable (lease liab) 44,456.46 Lease Liability 25,073.03 Cash 72,000.00 Other entries 12/31/09 Depreciation Expense 44,000.00    Accumulated Depreciation— Capital Leases 44,000.00 12/31/09 Interest Expense 41,447.70      Lease Liability (int/p)….. 41,447.70

Exercise 21-4

a. Prepare entries for CASTLE (LESSOR) for 2008 and 2009 Castle Leasing Co. signs lease on 1-1-08 to lease electronic equipment to Jan Way Co. 2 year lease Payments at END of year. BPO for $16,000 at termination of lease. Cost/FMV of equipment is $160,000 to Castle. Economic life is 2 years. Residual value is $16,000 Executory costs of $5,000/yr paid by Jan Way (LESSEE) Castle leasing desires 10% return. Collectibility of payments reasonably predictable and no important uncertainties surround costs yet to be incurred.

How much is the lease payment? LESSOR figures this out. The formula: PV of min lease = (Rent x factor) + (BPO x factor) $160,000 = (Rent x What Rate?) FMV usually same thing RULE ON WHAT RATE TO USE FOR DISCOUNTING LESSEE LESSOR Uses the lower of his/her rate or the lessors; To find leased asset. Uses his/her own rate.

How much is the lease payment? LESSOR figures this out. The formula: PV of min lease = (Rent x factor) + (BPO x factor) $160,000 = (Rent x What Rate?) FMV usually same thing Lessor wants to earn 10%

How much is the lease payment? The formula: PV of min lease = (Rent x factor) + (BPO x factor) $160,000 = (Rent x 1.73554) + ($16,000 X .82645) Table 6-4 (2 years @ 10%; ordinary annuity) Table 6-2 (2 years @ 10%; lump sum)

RENT = $84,571.26 How much is the lease payment? The formula: PV of min lease = (Rent x factor) + (BPO x factor) $160,000 = (Rent x 1.73554) + ($16,000 X .82645) RENT = $84,571.26 Table 6-4 (2 years @ 10%; ordinary annuity) Table 6-3 (2 years @ 10%; lump sum)

How much is the balance of lease receivable? $160,000 (same as PV of lease)

What does the interest table look like? Castle Leasing Company (Lessor) Lease Amortization Schedule Annual Payment Interest Net Lease On Net Investment Net Date Investment Recovery Investment 1/1/08 $160,000.00 12/31/08 $84,571.26 $16,000.00 $68,571.26 91,428.74 12/31/09 84,571.26 009,142.52* 75,428.74 16,000.00 $25,142.52 *Difference of $.35 due to rounding.

Entry on 1/1/08 to initiate lease LESSOR (a) 1/1/08 Lease Payments Receivable 160,000 Equipment 160,000.00 Entries on 12/31/08 To record lease receipt. Cash ($84,571.26 + $5,000) 89,571.26 Executory Costs Payable 5,000.00 Lease Receivable 68,571.26 Interest Revenue 16,000.00

Executory Costs Payable 5,000.00 Lease Payments Receivable 75,428.74 12/31/09 Cash 89,571.26 Executory Costs Payable 5,000.00 Lease Payments Receivable 75,428.74 Interest Revenue................ 9,142.52 B. If Jan Way uses BPO, what journal entry reflects the sale? Cash…………….. $16,000 Lease Payments Receivable…. $16,000 T-account analysis of Lease Receivable next slide.

Lease Receivable Life Lease Receivable $160,000 $68,571.26 $75,428.74 $16,000 This is the BPO

E 21-6

Crosley Company, a machinery dealer, leased a machine to Dexter Corporation on January 1, 2007. The lease is for an 8-year period and requires equal annual payments of $35,013 at the beginning of each year. The first payment is received on January 1, 2007. Crosley had purchased the machine during 2006 for $160,000. Collectibility of lease payments is reasonably predictable, and no important uncertainties surround the amount of costs yet to be incurred by Crosley. Crosley set the annual rental to ensure an 11% rate of return. The machine has an economic life of 10 years with no residual value and reverts to Crosley at the termination of the lease. (a) Compute the amount of the LEASE RECEIVABLE. $35,013 X 5.7122 = $200,001

(b) Prepare all necessary journal entries for Crosley for 2007. Entry to record the lease at its inception for Crosley Lease payments receivable..... $200,001 Cost of goods sold.................... 160,000 Sales............................................ $200,001 (FMV) Inventory (equipment)................ $160,000 (book)

Entry to record the first lease payment (receipt) Cash.......... $35,013 Lease payments receivable........ $35,013 Entry to record interest revenue adjustment. ($200,001 - $35,013) = $164,987 x .11= $18,148 Interest Receivable............. $18,148 Interest revenue......................$18,148

E 21-8 LESSEE: BPO

Noncancellable lease between Mike Mooney Leasing (OR) and Denise Rode (EE). Inception (May 1, 2007) Annual rent (Due at beginning of year starting 5/1/07); $21,227.65 BPO at EOL… $4,000. Lease term 5 years Economic life- 10 years Lessor’s cost.. $65,000 FMV on 5/1/07… $91,000 Lessors ROR… 10% Lessee’s ROR… 10% Lessee assumes all executory costs. collectibility reasonably predictable. no important uncertainties surrounding costs yet to be incurred by lessor. lessee assumes responsibility for all executory costs A. Discuss the NATURE of this lease to RODE (LESSEE).

The lease agreement has a BPO and, thus meets the criteria to be classified as a capital lease from the viewpoint of the lessee. The present value of the minimum lease payments exceeds 90% of the FMV of the assets. B. Discuss the nature of the lease to MOONEY Company (LESSOR). The lease agreement has a BPO. 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 lease, therefore, qualifies as a capital type lease from the viewpoint of the lessor. Due to the fact that the initial amount of net investment (which in this case equal the present value of the minimum lease payments, $91,000) exceeds the lessor’s cost of $65,000, the lease is a SALES TYPE LEASE.

C. Prepare Lease Amortization schedule for RODE (LESEE). Need the PV of the minimum lease payments. Should be $91,000 (FMV of asset). ($21,227.65 x 4.16986) + ($4,000 x .62092) = $91,000 rent 10%, 5 yrs T 6-5 10%, 5 yrs T 6-2 BPO

Denise Rode Company (LESSEE) Lease Amortization Schedule Annual Lease Reduction Balance Payment Interest (10%) on unpaid of lease Date Plus BPO Obligation Obligation Obligation 5/1/07 $91,000 5/1/07 $21,227.65 $21,227.65 69,772.35 5/1/08 $21,227.65 $6,977.24 14,250.41 55,521.94 5/1/09 21,227.65 5,552.19 15,675.46 39,846.48 5/1/10 21,227.65 3,984.65 17,243.00 22,603.48 5/1/11 21,227.65 2,260.35 18,967.30 3,636.18 4/30/12 4,000.00 363.82 3,636.18 -0- -------------- ------------ ------------- $110,138.25 $19,138.25 $91,000

Prepare journal entries on the LESSEE’s books. Reversing entries ARE USED by RODES. Entries needed on 5/1/07 Leased asset……….. $91,000 Lease liability………$91,000 Lease liability…. $21,227.65 Cash……………$21,227.65

Entries needed on 12/31/07 To record interest 6977.24 x 8/12 = 4651.49 Interest expense… $4,651.49 Interest payable… $4,651.49 To record depreciation Depreciation expense… $6,066.67 Accumulated depreciation……. $6,066.67 $91,000 / 10 = $9,100.00 LIFE of asset because of BPO (no salvage is mentioned) $9,100 x 8/12 = $6,066.67

Entries on 1/1/08 Interest payable……. $4,651.49 Interest expense……. $4,651.49 REVERSING Entries for 5/1/08 Interest expense… $6977.24 Lease Liability…. $14,250.41 Cash…………….$21,227.65 Entries for 12/31/08 Interest expense…….. $3701.46 (5552 x 8/12) Interest payable……..$3701.46 Depreciation Expense….. $9100 Accumulated depreciation….$9100

Exercise 21-9 Lessor with BPO Continuation of E 21-8

A. Compute the amount of Lease Receivable at the start of the lease. ($21,227.65 x 4.16986) + ($4,000 x .62092) = $91,000

B. Prepare the lease amortization schedule for MOONEY Annual Lease Interest Net Net Payment (10%) on Investment Investment Date Plus BPO Investment Recovery 5/1/07 $91,000 5/1/07 $21,227.65 $21,227.65 69,772.35 5/1/08 21,227.65 6,977.24 14,250.41 55,521.94 5/1/09 21,227.65 5,552.19 15,675.46 39,846.48 5/1/10 21,227.65 3,984.65 17,243.00 22,603.48 5/1/11 21,227.65 2,260.35 18,967.30 3,636.18 4/30/12 4,000.00 363.82 3,636.18 -0- -------------- ----------- --------------- $110,138.25 $19,138.25 $91,000.00

D. Prepare journal entries for MOONEY. Reversing NOT used. Record the signing of the lease. Lease Receivable…. $91,000 COG………………. $65,000 Sales……. $91,000 Inventory.. $65,000 The first lease payment. Cash……. $21,227.65 Lease Receivable…. $21,227.65

12/31/07 Adjust the interest. Interest Receivable....… $4,651.49 Interest revenue……………..$4,651.49 $6,977.24 x 8/12 = $4,651.49 5/1/08 Receipt of cash payment. Cash…….. $21,227.65 Lease Receivable…… $14,250.41 Interest Receivable.....$ 4,651.49 Interest Revenue....... .$ 2325.72 ($6,977.21 - $4,651.49) Interest Receivable… $3,701.46 Interest revenue………….$3,701.46 Adjustment of interest 12/31/08 $5,552.19 x 8/12 = $3,701.46

Rest of the entries for 2009 5/1/09 Cash…… $21,227.65 Lease receivable…….$15,675.46 Interest Receivable....$ 3,701.46 Interest Revenue........$ 1,850.73 (5,552.19 - $3,701.46) 12/31/09 Interest Receivable.......… $2,656.43 Interest revenue…………$2,656.43 * 8/12 adjustment (3,984.65 x 8/12 ) = $2,656.43

Exercise 21-10

Morgan Marie Leasing Co. signs an agreement on January 1, 2004 to lease equipment to Cole William Company. The following information relates to this agreement. 1. The term of the noncancelable lease is 6 years with no renewal option. The equipment has an estimated economic life of 6 years. 2. The cost of the asset to the lessor is $245,000. The fair value of the asset at January 1, 2004 is $245,000. 3. The asset will revert to the lessor at the end of the lease term at which time the asset is expected to have a residual value of $43,622, none of which is guaranteed. 4. Cole William Company assumes direct responsibility for all executory costs. (LESSEE RESPONSIBLE). 5. The agreement requires equal annual rental payments, beginning on January 1, 2004. 6. Collectibility of the lease payments is reasonably predictable. There are no important uncertainties surrounding the amount of costs yet to be incurred by the lessor.

$46,000 FMV = (Rent x factor) + (Residual value x factor) Instructions: a. Assuming the lessor desires a 10% rate of return on its investment, calculate the amount of the annual rent payment. FMV = (Rent x factor) + (Residual value x factor) $43,622 .56447 4.79079 6 per @ 10% $245,000 $46,000

Morgan Marie Leasing Company (Lessor) Lease Amortization Schedule B. Prepare an amortization schedule that would be suitable for the lessor for the lease term. Morgan Marie Leasing Company (Lessor) Lease Amortization Schedule Annual Lease Interest Net Balance Date Payment (10%) on Invest- of Net Plus URV Net Invest. ment Recovery Investment 1/1/04 $245,000 1/1/04 $46,000 $46,000 199,000 1/1/05 46,000 19,900 26,100 172,900 1/1/06 46,000 17,290 28,710 144,190 1/1/07 46,000 14,419 31,581 112,609 1/1/08 46,000 11,261 34,739 77,870 1/1/09 46,000 7,787 38,213 39,657 12/31/09 43,622 3,965 39,657 0 ------------ ---------- ------------- ------------------- $319,622 $ 74,622 $245,000

C. Prepare all of the journal entries for the LESSOR for 2004 and 2005. To record inception of lease 1/1/04 Lease Receivable…………… $319,622 Equipment……………………$245,000 Unearned interest revenue…. 74,622 To record receipt of first cash payment on 1/1/04 Cash………………. $46,000 Lease Receivable………… $46,000 To record accrual of interest on 12/31/04 Unearned interest revenue………. $19,900 Interest revenue………………….$19,900

Receipt of second payment on 1/1/05 Cash…………….. $46,000 Lease Receivable……….. $46,000 Accrual of interest on 12/31/05 Unearned interest revenue…… $17,290 Interest revenue……………..$17,290