equip-ment), estimated economic life is 10 years, fair market value of the leased asset is $105,000, and the interest rate implied in the lease is 10 percent.
Asset 2: Lease payment of $15,000 per year for 8 years, $35,000 fair market value purchase option at the end of Year 8 (guaranteed by the lessee to be the minimum value of the equip-ment), estimated economic life is 12 years, fair market value of the leased asset is $105,000, and the interest rate implied in the lease is 10 percent. The company’s incremental borrowing rate is 11 percent.
Options:
a. No entry
b. $89,354 increase in assets and liabilities c. $192,703 increase in assets and liabilities d. None of the above
EXPLANATION
Issue 1: Determine whether the leases are finance or operating.
Issue 2: Determine the accounting entries needed.
164 Chapter 14 Leases (IAS 17)
Asset 1
The lease term is for a major part of the asset’s life, 80 percent (8 out of 10 years). No further work is needed with respect to the criteria, because only one criterion (or a combination of criteria) has to be met to result in the lease being recorded as a finance lease (see IAS 17, paragraph 10). The amount to record is the present value of the 8 years of $15,000 lease pay-ments, plus the present value of the $20,000 purchase option. The discount rate to use is 10 percent, which is the lower of the incremental borrowing rate and the lease’s implicit rate.
The present value is $89,354. This amount will be recorded as an asset and as a liability on the Statement of Financial Position.
Choice b. is correct. The entry required is to record an asset and liability in the amount of
$89,354.
Asset 2
The lease term is less than a major part of the asset’s life, defined as 67 percent (8 out of 12 years). There is no indication of a bargain purchase option, and the property does not go the lessee at the end of the lease (unless the lessee opts to pay $35,000). The present value of the lease payments, including the purchase option, is $96,351. The present value of the minimum lease payments does not approximate the fair market value of $105,000. Asset 2 does not meet any of the finance lease conditions and is accounted for using the operating lease method.
Choice d. is correct. No entries are required under the operating lease method when the lease is entered into.
EXAMPLE 14.3
Which of the following assets would have a higher cash flow from operations in the first year of the lease? (Assume straight-line depreciation, if applicable.)
Asset 1: Lease payment of $15,000 per year for 8 years, $20,000 fair market value purchase option at the end of Year 8 (guaranteed by the lessee to be the minimum value of the equip-ment), estimated economic life is 10 years, fair market value of the leased asset is $105,000, and the interest rate implied in the lease is 10 percent.
Asset 2: Lease payment of $15,000 per year for 8 years, $35,000 fair market value purchase option at the end of Year 8 (guaranteed by the lessee to be the minimum value of the equip-ment), estimated economic life is 12 years, fair market value of the leased asset is $105,000, and the interest rate implied in the lease is 10 percent. The company’s incremental borrowing rate is 11 percent.
Options a. Asset 1.
b. Asset 2.
c. Both assets would have the same total cash flow from operations.
d. Insufficient information given.
Chapter 14 Leases (IAS 17) 165
EXPLANATION Asset 1
The lease term is for a major part of the asset’s life, 80 percent (8 out of 10 years). No further work is needed with respect to the criteria, because only one criterion (or a combination of criteria has to be met to result in the lease being recorded as a finance lease (see IAS 17, para-graph 10). The amount to record is present value of the 8 years of $15,000 lease payments, plus the present value of the $20,000 purchase option. The discount rate to use is 10 percent, which is the lower of the incremental borrowing rate and the lease’s implicit rate. The present value is $89,354. This amount will be recorded as an asset and as a liability on the Statement of Financial Position. The cash flows in the first year will consist of the $15,000 payment, which is allocated between operating cash flow (an outflow for the interest portion of the payment) and financing cash flow (an outflow for the principal portion of the payment):
Total payment = $15,000
Interest portion = 10 percent x $89,354 = $8,935
Principal portion = $6,065
Asset 2
The lease term at 67 percent (8 out of 12 years) is less than a major part of the asset’s life.
There is no indication of a bargain purchase option, and the property does not go to the lessee at the end of the lease (unless the lessee opts to pay $35,000). The present value of the lease payments is $96,351. Therefore, the present value of the minimum lease payments does not approximate the fair market value of $105,000. Asset 2 does not meet any of the finance lease conditions and is accounted for using the operating lease method. The annual lease payment of $15,000 is an operating cash outflow.
Choice a. is correct. There is the issue of whether the leases are finance or operating. Once this issue is resolved, then the amount and classification of the cash flows can be deter-mined. As the explanation above shows, the total cash flows are the same—a negative
$15,000. Asset 1, being a finance lease, results in a portion of this outflow being considered a financing cash flow. Thus it shows a lower operating cash outflow, meaning a higher cash flow from operations.
Choice b. is incorrect. Assuming the leases are of similar size, the finance lease will reflect a higher operating cash flow than the operating lease. This is true for every year of the lease term, because a portion of the lease payment is shifted under a finance lease to being a financ-ing cash outflow.
Choice c. is incorrect. The only way for each to have the same operating cash flows in this scenario would be if both were treated as operating leases. But Asset 1 is required to be accounted for as a finance lease.
Choice d. is incorrect. Sufficient information has been provided.
EXAMPLE 14.4
The “capitalization” of a finance lease by a lessee will increase which of the following:
a. Debt-to-equity ratio b. Rate of return on assets c. Current ratio
d. Asset turnover
166 Chapter 14 Leases (IAS 17)
EXPLANATION
Choice a. is correct. Because the capitalization of a finance lease by a lessee increases the debt obligation and lowers net income (equity), the entity will be more leveraged as the debt-to-equity ratio will increase.
Choice b. is incorrect. Given that net income declines and total assets increase under a finance lease, the rate of return on assets would decrease.
Choice c. is incorrect. Because the current obligation of the finance lease increases current liabilities while current assets are unaffected, the current ratio declines.
Choice d. is incorrect. Finance leases increase a company’s asset base, which lowers the asset turnover ratio.
EXAMPLE 14.5
All of the following are true statements regarding the impact of a lease on the statement of cash flows regardless of whether the finance lease or operating lease method is used—except for:
a. The total cash flow impact for the life of the lease is the same under both methods.
b. The interest portion of the payment under a finance lease will affect operating activities, whereas the principal reduction portion of the finance lease payment will affect financing activities.
c. Over time, a cash payment under the finance lease method will cause operating cash flow to decline, whereas financing cash flows will tend to increase.
d. Cash payments made under an operating lease will affect operating activities only.
EXPLANATION
Choice c. is false. When finance leases are used, operating cash flow will increase over time as the level of interest expense declines and more of the payment is allocated to principal repayment, which will result in a decline in financing cash flows over time.
Choice a. is true. Total cash flows over the life of the lease are the same under the operating and finance lease methods.
Choice b. is true. A finance lease payment affects operating cash flows and financing cash flows.
Choice d. is true. The operating lease payment is made up of the rent expense, which affects operating cash flow only.
EXAMPLE 14.6
On January 1, 20X1, ABC Company, lessee, enters into an operating lease for new equipment valued at $1.5 million. Terms of the lease agreement include five annual lease payments of
$125,000 to be made by ABC Company to the leasing company.
Chapter 14 Leases (IAS 17) 167
During the first year of the lease, ABC Company will record which of the following?
a. Initially, an increase (debit) of leased equipment of $625,000 and an increase (credit) in equipment payables of $625,000. At year-end, a decrease (debit) in equipment payable of
$125,000 and a decrease (credit) to cash of $125,000.
b. An increase (debit) in rent expense of $125,000 and a decrease (credit) in cash of
$125,000.
c. No entry is recorded on the financial statements.
d. An increase (debit) in leased equipment of $125,000 and a decrease (credit) in cash of
$125,000; no Statement of Comprehensive Income entry.
EXPLANATION
Choice b. is correct. Because the above transaction is an operating lease, only rent expense is recorded on the Statement of Comprehensive Income, with a corresponding reduction to cash on the Statement of Financial Position to reflect the payment.
Choice a. is incorrect. Operating leases do not include the present value of the asset on the Statement of Financial Position.
Choice c. is incorrect. Rent expense is recorded on the Statement of Comprehensive Income for operating leases.
Choice d. is incorrect. The leased asset is not recorded on the Statement of Financial Position for operating leases.
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