Chapter 17

Solutions

Exercise 17.1

a. Lessee analysis (ASPE):

• Does ownership title pass? No, title remains with the lessor.
• Is there a BPO or a bargain renewal option? Yes
• Is the lease term 75% or more of the asset’s estimated economic or useful life? No

6 years/10 years = 60%, which does not meet the 75% threshold

• Does the present value of the minimum lease payments exceed 90% of the leased asset’s fair value? Yes, as calculated below.Present value of minimum lease payments: PV = (25,100 PMT/AD, 7 I/Y, 6 N, 3,000 FV) = $130,014 (rounded) ASPE interest rate used must be the lower of the two rates, since both are known. The present value compared to the fair value of$130,000 exceeds the 90% numeric threshold. Note that the leased asset and obligation cannot exceed fair value, so $130,000 will be the amount used as the valuation in the journal entries below. Any one of the criteria met will result in a classification of a capital lease. In this case, the lease agreement has met two criteria: a bargain purchase option, and a present value of the minimum lease payments that exceeds 90% of the fair value of the asset. Lessor Analysis (ASPE) The lease agreement meets the capitalization criteria for the lessee above. Additionally, there are no uncertainties regarding the collectability of the lease payments and the costs yet to be incurred by the lessor (both must be met). This would, therefore, be classified as a capital lease for the lessor. The initial amount of net investment (fair value) of$130,000 exceeds the lessor’s cost of $90,000, making the lease a sales-type lease to the lessor. b. Gross investment (lease receivable) for the lessor:The minimum lease payments regarding this lease are:  Calculation: =$150,600 BPO + 3,000 Gross investment at inception $153,600 Net investment for the lessor: The$130,000 fair value in this case (or the present value if it does not exceed the fair value).

c.

Lessee and Lessor
Lease Amortization Schedule
Date Annual Lease Payment Plus BPO Interest @ 7% Reduction of Lease Obligation Balance Lease Obligation
Jul 1, 2021 $25,100$130,000
Jul 1, 2021 25,100 $25,100 104,900 Jul 1, 2022 25,100$7,343 17,757 87,143
Jul 1, 2023 25,100 6,100 19,000 68,143
Jul 1, 2024 25,100 4,770 20,330 47,813
Jul 1, 2025 25,100 3,347 21,753 26,060
Jul 1, 2026 25,100 1,824 23,276 2,784
Jun 30, 2027 3,000 216* 2,784 0
$153,600$23,600 $130,000 * Note: The lease valuation is limited to its fair value of$130,000 instead of the present value of $130,014. The difference ($14) is insignificant, thus a new interest rate is not required for the amortization schedule above. Had the present value been significantly higher than the fair value, a new effective interest rate would be required and calculated using the following methodology.

I/Y = (+/- 130,000 PV, 25,100 PMT/AD, 6 N, 3,000 FV) = 7.004876% or 7%

As can be seen, the 7% rate for the lessor has not significantly changed, so 7% will be the rate used in the amortization schedule above.

d. Lessee journal entries:
Year-end adjusting entries:
* Note: Because there is a bargain purchase option, the leased asset is depreciated over its economic life rather than over the lease term. This is because the BPO, much less than the market price at that time, will be exercised by the lessee and the asset will be used beyond the lease term.

e. Lessor entries
Year-end adjusting entry:
2022 payment:
Year-end adjusting entry:
Note: The lessor could record six months of interest income in July, and six months of interest income on December 31 to match the lessee interest entries. However, the minimum reporting requirement would be to recognize interest income each reporting date (December 31). If the lessor also had interim reporting every six months within the fiscal year, interest income would be accrued every six months to ensure that both the interim and year-end financial statements were complete.

f. For the lessee: Rather than using quantitative factors, such as the 75% and the 90% hurdles, the IFRS (IAS 17) criteria use qualitative factors to establish whether the risks and rewards of ownership have transferred to the lessee, which supports the classification as a capitalized lease:

• There is reasonable assurance that the lessee will obtain ownership of the leased property by the end of the lease term. If there is a bargain purchase option in the lease, it is assumed that the lessee will exercise it and obtain ownership of the asset (same as with ASPE).
• The lease term is long enough that the lessee will receive substantially all of the economic benefits that are expected to be derived from using the leased property over its life (equivalent to the 75% numeric threshold for ASPE).
• The lease allows the lessor to recover substantially all of its investment in the leased property and to earn a return on the investment. Evidence of this is provided if the present value of the minimum lease payments is close to the fair value of the leased asset (equivalent to the 90% numeric threshold for ASPE).
• The leased assets are so specialized that, without major modification, they are of use only to the lessee (IFRS (IAS 17) only).

If the lease is deemed as a lease subject to capitalization, the accounting treatment of the lease by the lessee would be the same as ASPE, although it would be referred to as a finance lease, rather than a capital, direct financing lease.

The treatment of the lease by the lessor would be the same as the lessee above, using qualitative criteria rather than numeric thresholds used for ASPE. (The criteria will not include the two-revenue recognition-based tests for uncertainty regarding collectability of lease payments and estimated un-reimbursable costs for the lessor.) The lease would be referred to as a finance lease, manufacturer or dealer rather than a sales-type lease.

g. If the lease agreement included an unguaranteed residual, the leased asset would be physically returned to the lessor at the end of the lease term. The depreciation charge would, therefore, be over the lease term and not the asset’s economic life, which is the case when a bargain purchase is involved. As well, the depreciation calculation would not include a residual value.

Exericse 17.2

1. Lessee analysis (IFRS, IAS 17)
• Does ownership title pass? No, title remains with the lessor.
• Is there a BPO or a bargain renewal option? No
• Is the lease term covering the majority of the asset’s estimated economic or useful life? Consider that the lease term is eight years and the economic life is ten years, so this constitutes a major part of the economic life of the asset. Yes, capitalize leased asset.
• The leased asset is a specialized piece of landscaping machinery, so it will only benefit the lessee without major modifications. Yes, capitalize leased asset.
• Does the present value of the minimum lease payments allow the lessor to recover substantially all of the leased asset’s fair value as well as realizing a return on the investment? Consider that the present value of the minimum lease payments shown below is nearly equal to the fair value of $270,000, so it appears that the lessor will be reimbursed for all of the leased investment, including a return on investment. Yes, capitalize leased asset. Present value calculation:  Yearly payment$46,754 Less: Executory costs 2,000 Minimum annual lease payment $44,754 Present value of minimum lease payments: PV = (44,754 PMT/AD, 9 I/Y, 8 N, 0 FV) =$269,999 (which is virtually 100% of the fair value of $270,000) Under IFRS (IAS 17), the lessee will classify this lease as a finance lease since the lease term covers substantially all of the asset’s useful life, the present value of the minimum lease payments allows the lessor to recover almost all of the leased asset’s fair value (as well as realizing a return on the investment), and the machinery is highly specialized. Three of the criteria considered were met so it is reasonable to assume that the lessee will capitalize the lease. The treatment of the lease by the lessor would be the same as the lessee above, using the qualitative criteria rather than numeric thresholds used for ASPE. Except the lessor classification criteria will not include the two-revenue recognition-based tests for uncertainty regarding collectability of lease payments and estimated un-reimbursable costs for the lessor. Again, since three criteria were met, it is reasonable to assume that the lease would be classified as a finance lease. 2. IFRS (IAS 17) states that the rate implicit in the lease is to be used wherever it is reasonably determinable. Using the fair value of$270,000, the implicit rate can be calculated: I/Y = (+/- 270,000 PV, 44,754 PMT/AD, 8 N) = 9% (rounded) which is the same rate as the lessee’s
Mercy Ltd.
Lease Amortization Schedule
(Lessee)
Date Annual Lease Payment Excluding Executory Costs) Interest @ 9% Reduction of Lease Obligation Balance Lease Obligation
$270,000 Jan 1, 2021$44,754 $44,754 225,246 Jan 1, 2022 44,754$20,272 24,482 200,764
Jan 1, 2023 44,754 18,069 26,685 174,079
Jan 1, 2024 44,754 15,667 29,087 144,992
Jan 1, 2025 44,754 13,049 31,705 113,287
Jan 1, 2026 44,754 10,196 34,558 78,729
Jan 1, 2027 44,754 7,086 37,668 41,061
Jan 1, 2028 44,754 3,693* 41,061 0
$358,032$88,032 $270,000 * rounded Mercy Ltd. Statement of Financial Position December 31, 2022 Non-current assets Equipment under lease$270,000

Accumulated depreciation

(67,500)
202,500
Current liabilities

Interest payable

18,069

Current portion of long-term lease obligation*

26,685
Non-current liabilities

Long-term lease obligation ()

$174,079 * The principal portion of the lease payment over the next 12 months after the reporting date of December 31, 2022. Refer to the amortization schedule above. Required disclosure in the notes: The following is a schedule of future minimum lease payments under the finance lease, expiring December 31, 2028, together with the balance of the obligation under finance lease.  Year ending December 31 2023$46,754 2024 46,754 2025 46,754 2026 46,754 2027 46,754 2028 46,754 280,524 Less amount representing executory costs 12,000 Total minimum lease payments 268,524 Less amount representing interest at 9%* 67,760 Balance of the obligation, December 31, 2022 $200,764 * Note: Additional disclosures would also be required about material lease arrangements, including contingent rents, sub-lease payments, and lease-imposed restrictions. These do not apply in this case. Exercise 17.3 Lessee Analysis (IFRS, IAS 17) • Does the ownership title pass? No, title remains with the lessor. • Is there a BPO or a bargain renewal option? No • Does the lease term cover the majority of the asset’s estimated economic or useful life? Consider that the lease term is eight years, and the economic life is twelve years, the lease covers a major part of the economic life of the asset. Yes, capitalize leased asset. • As the leased asset is a specialized piece of landscaping machinery, it will only benefit the lessee without major modifications. Yes, capitalize leased asset. • Does the present value of the minimum lease payments allow the lessor to recover substantially all of the leased asset’s fair value, as well as realizing a return on the investment? Consider that the present value of the minimum lease payments is$288,960, compared to the fair value of $300,000, making the minimum lease payments nearly equal to the fair value at that date. As such, the lessor will recover substantially all of the leased asset’s fair value, as well as a return of 9% on the investment. Yes, as calculated below. Present value calculation:  Yearly payment$50,397 Less: Executory costs 2,500 Minimum annual lease payment $47,897 Present value of minimum lease payments: PV = (47,897 PMT/AD, 9 I/Y, 8 N, 0 FV) = 288,960 (which is substantially most of the fair value of$300,000)

Consider the following criteria: The lease term covers substantially all of the asset’s useful life, the present value of the minimum lease payments recovers substantially most of the leased asset’s fair value (as well as realizing a return on the investment), and the machinery is highly specialized for the lessee. As these three factors have been met, it is reasonable to assume that the lease will be classified as a finance lease for the lessee under IFRS (IAS 17).

Exercise 17.4

1. This is a finance lease to Oberton Ltd. The IFRS (IAS 17) criteria use qualitative factors to establish whether the risks and rewards of ownership are transferred to the lessee, and supports classification as a finance lease:
1. There is reasonable assurance that the lessee will obtain ownership of the leased property by the end of the lease term. If there is a bargain purchase option in the lease, it is assumed that the lessee will exercise it and obtain ownership of the asset. No
2. The lease term is long enough that the lessee will receive substantially all of the economic benefits that are expected to be derived from using the leased property over its life (as evidenced by a four-year lease compared to a six-year estimated economic life). Yes, this represents a major part of the economic life of the asset.
3. The lease allows the lessor to recover substantially all of its investment in the leased property and to earn a return on the investment. Evidence of this is provided if the present value of the minimum lease payments is close to the fair value of the leased asset. Yes PV = (4,313 PMT/AD excl. executory costs, 8 I/Y, 4 N, 3,500 guaranteed residual) = 18,000Compared to a fair value of $18,000 = 100% recovery of investment + an 8% return on investment. 4. The leased assets are so specialized that, without major modification and/or significant cost to the lessor, they are of use only to the lessee. No The standard also states that these indicators are not always conclusive. The decision has to be made on the substance of each specific transaction. If the lessee determines that the risks and benefits of ownership have not been transferred to it, the lease is classified as an operating lease. In this case, two factors have been met so it would be reasonable to classify this lease as a finance lease for the lessee. For Black Ltd. (the lessor) under IFRS (IAS 17), the lease would receive the same treatment as for the lessee using the qualitative factors. Black Ltd. reasonably meets the factors, and is not a manufacturer or dealer, and so this is a finance lease. 2. Calculation of annual rental payment: PMT = +/- 18,000 PV, 8 I/Y, 4 N, 3,500 FV = =$4,333 lease payment, including executory costs of $20.This confirms that the interest rate used to calculate the lease payment was 8% per annum. 3. Lease Amortization Schedule Date Lease Payment Excluding Lease Executive Costs) Interest @ 8% Reduction of Lease Obligation Balance Lease Obligation$18,000
Jan. 1, 2021 $4,313$4,313 13,687
Jan. 1, 2022 4,313 $1,095 3,218 10,469 Jan. 1, 2023 4,313 838 3,475 6,994 Jan. 1, 2024 4,313 560 3,753 3,241 Jan. 1, 2025 3,500 259 3,241 0$20,752 $2,752$18,000
4. Oberton Ltd.
Statement of Income
For the Year Ended December 31, 2021
Non-current assets
Property, plant, and equipment

Vehicles under lease

$18,000 Less accumulated depreciation 3,625 14,375 Current liabilities Interest payable 1,095 Obligations under lease (Note 1) 3,218 Non-current liabilities Obligations under lease (Note 1)$10,469

Note 1: The following is a schedule of future minimum payments under finance lease expiring January 1, 2025, together with the present balance of the obligation under the lease.

 Year ending December 31, 2021 2022 $4,333 2023 4,333 2024 4,333 2025 3,500 16,499 Amount representing executory costs (60) Amount representing interest (2,752) Balance of obligation December 31, 2021$13,687
Oberton Ltd.
Statement of Income
For the Year Ended December 31, 2021
Administrative expense

Depreciation expense

$3,625 Insurance expense 20 Other expenses Interest expense 1,095 * from lease amortization schedule part (c) 5. Entries for Black Ltd.: 6. Black Ltd. Income Statement For the Year Ended December 31, 2021 Revenue Interest income (leases)*$1,095

* from lease amortization schedule part (c)

Note: The insurance recovery of $20 per year would offset the original insurance expense incurred by Black Ltd. Exercise 17.5 a. Lessor Analysis (ASPE)The lease is a capital lease for the following reasons: the lease term exceeds 75% of the asset’s estimated economic life (10 ÷ 12 years = 83%), the collectability of payments is reasonably assured, and there are no further costs to be incurred. Furthermore, it is a sales-type lease because Helmac Ltd. will realize a gross profit of$199,122 ($283,774 –$84,652) in addition to the financing charge of $75,878 to be amortized over the lease term using the effective interest method. b. * Note: The unguaranteed residual value is included in the lessor’s gross investment even though the lessee does not guarantee it. From the lessor’s perspective, it anticipates receiving$25,000 from a third party at the end of the lease term and it does not matter who they receive it from.

** The residual value is unguaranteed, so its present value must be removed from the sale price to the lessee.Present value of the minimum lease payments = (35,000 PMT/AD, 5 I/Y, 10 N, 25,000 FV) = $299,122 Sales price OR remove the$25,000 residual value from the present value calculation above. PV = (35,000 PMT/AD, 5 I/Y, 10 N) = $283,774 *** The unearned interest income of$75,878 is calculated as the lease receivable (gross investment) less the present value of the minimum lease payments ().

c. Assuming the $25,000 residual value was guaranteed by the lessee, this would change the initial entry for the sale as follows: The sales revenue and cost of goods sold would not need to be reduced by the present value of the estimated residual value ($15,348) calculated in part (b). The sales revenue would, therefore, be the amount equaling the present value of the minimum lease payments.

Date

Cash

Interest
Expense

Amortization

Carrying Value

1/1/Y2 $359,495 1/1/Y2 56,808 - 56,808 302,687 12/31/Y2 56,808 36,322 20,486 282,202 12/31/Y3 56,808 33,864 22,944 259,258 12/31/Y4 56,808 31,111 25,697 233,561 12/31/Y5 56,808 28,027 28,781 204,780 12/31/Y6 56,808 24,574 32,234 172,546 12/31/Y7 56,808 20,705 36,103 136,443 12/31/Y8 56,808 16,373 40,435 96,008 12/31/Y9 56,808 11,521 45,287 50,721 12/31/Y10 56,808 6,087 50,721 0 2. Type of lease This is a capital lease. • does not qualify for the short term exemption: length of term is 10 years. • does not qualify for the low dollar exemption: present value of the lease is a significant portion of the fair value. 3. Journal entries for Hamilton  1/1/Y2 Right-of-use asset 359,495 Lease Liability 359,495 setup leased asset and record liability 1/1/Y2 Lease Liability 56,808 Cash 56,808 record first payment 12/31/Y2 Depreciation Expense 35,950 Accumulated Depreciation 35,950 (359,495 / 10 years) 12/31/Y2 Interest Expense 36,322 Interest Payable 36,322 to accrue for interest on lease (could use Lease Liability) 1/1/Y3 Interest Payable 36,322 Lease Liability 20,486 Cash 56,808 record lease payment (if lease liability is used @12/31/Y2, only lease liability would be debited) 12/31/Y3 Depreciation Expense 35,950 Accumulated Depreciation 35,950 (359,495 / 10 years) 12/31/Y3 Interest Expense 33,864 Interest Payable 33,864 to accrue for interest on lease 4. Note Presentation Note ##. The following is a schedule of future lease payments under a contract-based lease liability expiring December 31, Y10.  Year Ending December 31 Y4$56,808 Y5 56,808 Y6 56,808 Y7 56,808 Y8 56,808 Y9 and beyond 113,616 Total lease payments 397,656 Less: Interest @12% 138,398 Balance of lease liability $259,258 Exercise 17.8 1. Type of lease This is a capital lease because it does not qualify for the short term exemption and it does not qualify for the low-dollar value exemption. For the lessor (Kitchener), this is a sales type lease because the collectability of the lease payments is reasonably predictable and there are no uncertainties surround unreimburseable costs. 2. Present value and amortization schedule  PV$117,451 Rate 10% Nper 6 Pmt -24,516 FV 0 Type 1

Date

Cash

Interest
Expense

Amortization

Carrying
Value

1/1/Y4 117,451
1/1/Y4 24,516 - 24,516 92,935
12/31/Y4 24,516 9,293 15,223 77,712
12/31/Y5 24,516 7,771 16,745 60,968
12/31/Y6 24,516 6,097 18,419 42,548
12/31/Y7 24,516 4,255 20,261 22,287
12/31/Y8 24,516 2,229 22,287 0
147,096 29,645 117,451

3. Journal Entries

Waterloo (lessee)
 1/1/Y4 Right-of-Use Asset 117,451 Lease Liability 117,451 to set up leased asset and liability 1/1/Y4 Lease Liability 24,516 Cash 24,516 to record first lease payment 12/31/Y4 Depreciation Expense 19,575 Accumulated Depreciation 19,575 ($117,451 / 6 years) 12/31/Y4 Interest Expense 9,293 Interest Payable 9,293 to record interest incurred in Y4 1/1/Y5 Interest Payable 9,293 Lease Liability 15,223 Cash 24,516 record lease payment 12/31/Y5 Depreciation Expense 19,575 Accumulated Depreciation 19,575 ($117,451 / 6 years) 12/31/Y5 Interest Expense 7,771 Interest Payable 7,771 to record interest incurred in Y5
Kitchener (lessor)
 1/1/Y4 Lease Receivable 147,096 Cost of Goods Sold 86,325 Sales Revenue 117,451 Inventory 86,325 Unearned Interest Revenue 29,645 to record lease receivable and sales revenue earned 1/1/Y4 Cash 24,516 Lease Receivable 24,516 to record lease payment received 12/31/Y4 Unearned Interest Revenue 9,293 Interest Revenue 9,293 to record interest revenue earned 1/1/Y5 Cash 24,516 Lease Receivable 24,516 to record lease payment received 12/31/Y5 Unearned Interest Revenue 7,771 Interest Revenue 7,771 to record interest revenue earned

Exercise 17.9

1. Type of lease

 Lease term 5 years = 83.33% Since 83% > 75% of lease term, it's a capital lease Life of asset 6 years

2. Present value and amortization schedule

Min (lessor)
 1/1/Y5 Lease Receivable 162,760 Equipment acquired for lessee 147,980 Unearned Interest Revenue 14,780 to setup lease receivable 1/1/Y5 Cash 32,552 Lease Receivable 32,552 to record receipt of lease payment 12/31/Y5 Unearned Interest Revenue 5,771 Interest Revenue 5,771 to record interest revenue earned 1/1/Y6 Cash 32,552 Lease Receivable 32,552 to record receipt of lease payment 12/31/Y6 Unearned Interest Revenue 4,432 Interest Revenue 4,432 to record interest revenue earned

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