3. The lease contains no renewal options and the equipment reverts to Green Finance Corporation on termination of the lease

Lanier Dairy Ltd. leases its milk cooling equipment from Green Finance Corporation. Both companies use IFRS 16. The lease has the following terms.

1. The lease is dated May 30, 2017, with a lease term of eight years. It is non-cancellable and requires equal rental payments of $30,000 due each May 30, beginning in 2017.

2. The equipment has a fair value and cost at the inception of the lease of $211,902, an estimated economic life of 10 years, and a residual value (which is guaranteed by Lanier Dairy) of $23,000.

3. The lease contains no renewal options and the equipment reverts to Green Finance Corporation on termination of the lease.

4. Lanier Dairy’s incremental borrowing rate is 6% per year; the implicit rate is also 6%.

5. Lanier Dairy uses straight-line depreciation for similar equipment that it owns.

6. Collectibility of the payments is reasonably predictable, and there are no important uncertainties about costs that have not yet been incurred by the lessor.

Instructions

(a) Describe the nature of the lease and, in general, discuss how the lessee and lessor should account for the lease transaction.

(b) Using tables, a financial calculator, or Excel functions, calculate the present value of the lease payments and guaranteed residual value under the lease.

(c) Prepare the journal entries for the lessee and lessor at May 30, 2017 and at December 31, 2017, which is the lessee’s and lessor’s year ends.

(d) Prepare the journal entries at May 30, 2018 for the lessee and lessor. Assume reversing entries are not used.

(e) What amount would have been capitalized by the lessee upon inception of the lease if:

1. The residual value of $23,000 had been guaranteed by a third party, not the lessee?

2. The residual value of $23,000 had not been guaranteed at all?

(f) On the lessor’s books, what amount would be recorded as the net investment at the inception of the lease, assuming:

1. Green Finance had incurred $1,200 of direct costs in processing the lease?

2. The residual value of $23,000 had been guaranteed by a third party?

3. The residual value of $23,000 had not been guaranteed at all?

(g) Assume that the milk cooling equipment’s useful life is 20 years. How large would the residual value have to be at the end of eight years in order for the lessee to qualify for the operating method? Assume that the residual value would be guaranteed by a third party.

(h) Discuss how Lanier would have determined the classification of the lease if the company were using ASPE for its financial reporting.

SOLUTION

(a) Green Finance Corporation, the lessor, needs to determine that the risks and benefits of ownership of the leased property are transferred. These factors include:

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 purchase option in the lease, Green needs to determine that it is reasonably certain that the purchase option will be exercised by the lessee.

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. This criteria appears to have been met since the lease is for 8 years (vs. an economic life of 10 years).