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Chapter15: Leases

Problems

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An alternate exercise and problem set is available on the text website: www.mhhe.com/spiceland6e

P 15-1 Operating lease; scheduled rent increases 
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On January 1, 2011, Sweetwater Furniture Company leased office space under a 21-year operating lease agreement. The contract calls for annual rent payments on December 31 of each year. The payments are $10,000 the first year and increase by $500 per year. Benefits expected from using the office space are expected to remain constant over the lease term.

Required:

Record Sweetwater's rent payment at December 31, 2015 (the fifth rent payment) and December 31, 2025 (the 15th rent payment).

P 15-2 Lease amortization schedule 
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On January 1, 2011, National Insulation Corporation (NIC) leased office space under a capital lease. Lease payments are made annually. Title does not transfer to the lessee and there is no bargain purchase option. Portions of the lessee's lease amortization schedule appear below:

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p. 860

Required:

1.

 

What is NIC's lease liability at the inception of the lease (after the first payment)?

2.

 

What amount would NIC record as a leased asset?

3.

 

What is the lease term in years?

4.

 

What is the asset's residual value expected at the end of the lease term?

5.

 

How much of the residual value is guaranteed by the lessee?

6.

 

What is the effective annual interest rate?

7.

 

What is the total amount of minimum lease payments?

8.

 

What is the total effective interest expense recorded over the term of the lease?

P 15-3 Direct financing and sales-type lease; lessee and lessor 
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Rand Medical manufactures lithotripters. Lithotripsy uses shock waves instead of surgery to eliminate kidney stones. Physicians' Leasing purchased a lithotripter from Rand for $2,000,000 and leased it to Mid-South Urologists Group, Inc., on January 1, 2011.

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Collectibility of the lease payments is reasonably assured, and there are no lessor costs yet to be incurred.

Required:

1.

 

How should this lease be classified by Mid-South Urologists Group and by Physicians' Leasing?

2.

 

Prepare appropriate entries for both Mid-South Urologists Group and Physicians' Leasing from the inception of the lease through the second rental payment on April 1, 2011. Depreciation is recorded at the end of each fiscal year (December 31).

3.

 

Assume Mid-South Urologists Group leased the lithotripter directly from the manufacturer, Rand Medical, which produced the machine at a cost of $1.7 million. Prepare appropriate entries for Rand Medical from the inception of the lease through the second lease payment on April 1, 2011.

P 15-4 Capital lease 
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At the beginning of 2011, VHF Industries acquired a machine with a fair value of $6,074,700 by signing a four-year lease. The lease is payable in four annual payments of $2 million at the end of each year.

Required:

1.

 

What is the effective rate of interest implicit in the agreement?

2.

 

Prepare the lessee's journal entry at the inception of the lease.

3.

 

Prepare the journal entry to record the first lease payment at December 31, 2011.

4.

 

Prepare the journal entry to record the second lease payment at December 31, 2012.

5.

 

Suppose the fair value of the machine and the lessor's implicit rate were unknown at the time of the lease, but that the lessee's incremental borrowing rate of interest for notes of similar risk was 11%. Prepare the lessee's entry at the inception of the lease.

(Note: You may wish to compare your solution to Problem 15-4 with that of Problem 14-12, which deals with a parallel situation in which the machine was acquired with an installment note.)

P 15-5 Capital lease; lessee; financial statement effects 
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(Note: Problems 5, 6, and 7 are three variations of the same basic situation.)

Werner Chemical, Inc., leased a protein analyzer on September 30, 2011. The five-year lease agreement calls for Werner to make quarterly lease payments of $391,548, payable each September 30, December 31, March 31, June 30, with the first payment at September 30, 2011. Werner's incremental borrowing rate is 12%. Depreciation is recorded on a straight-line basis at the end of each fiscal year. The useful life of the equipment is five years.

Required:

1.

 

Determine the present value of the lease payments at September 30, 2011 (to the nearest $000).

2.

 

What pretax amounts related to the lease would Werner report in its balance sheet at December 31, 2011?

3.

 

What pretax amounts related to the lease would Werner report in its income statement for the year ended December 31, 2011?

4.

 

What pretax amounts related to the lease would Werner report in its statement of cash flows for the year ended December 31, 2011?

P 15-6 Direct financing lease; lessor; financial statement effects 
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p. 861

Abbott Equipment leased a protein analyzer to Werner Chemical, Inc., on September 30, 2011. Abbott purchased the machine from NutraLabs, Inc., at a cost of $6 million. The five-year lease agreement calls for Werner to make quarterly lease payments of $391,548, payable each September 30, December 31, March 31, June 30, with the first payment at September 30, 2011. Abbot's implicit interest rate is 12%.

Required:

1.

 

What pretax amounts related to the lease would Abbott report in its balance sheet at December 31, 2011?

2.

 

What pretax amounts related to the lease would Abbott report in its income statement for the year ended December 31, 2011?

3.

 

What pretax amounts related to the lease would Abbott report in its statement of cash flows for the year ended December 31, 2011?

P 15-7 Sales-type lease; lessor; financial statement effects 
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NutraLabs, Inc., leased a protein analyzer to Werner Chemical, Inc., on September 30, 2011. NutraLabs manufactured the machine at a cost of $5 million. The five-year lease agreement calls for Werner to make quarterly lease payments of $391,548, payable each September 30, December 31, March 31, June 30, with the first payment at September 30, 2011. NutraLabs' implicit interest rate is 12%.

Required:

1.

 

Determine the price at which NutraLabs is “selling” the equipment (present value of the lease payments) at September 30, 2011 (to the nearest $000).

2.

 

What pretax amounts related to the lease would NutraLabs report in its balance sheet at December 31, 2011?

3.

 

What pretax amounts related to the lease would NutraLabs report in its income statement for the year ended December 31, 2011?

4.

 

What pretax amounts related to the lease would NutraLabs report in its statement of cash flows for the year ended December 31, 2011?

P 15-8 Guaranteed residual value; direct financing lease 
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(Note: Problems 8, 9, and 10 are three variations of the same basic situation.)

On December 31, 2011, Rhone-Metro Industries leased equipment to Western Soya Co. for a four-year period ending December 31, 2015, at which time possession of the leased asset will revert back to Rhone-Metro. The equipment cost Rhone-Metro $365,760 and has an expected useful life of six years. Its normal sales price is $365,760. The lessee-guaranteed residual value at December 31, 2015, is $25,000. Equal payments under the lease are $100,000 and are due on December 31 of each year. The first payment was made on December 31, 2011. Collectibility of the remaining lease payments is reasonably assured, and Rhone-Metro has no material cost uncertainties. Western Soya's incremental borrowing rate is 12%. Western Soya knows the interest rate implicit in the lease payments is 10%. Both companies use straight-line depreciation.

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Required:

1.

 

Show how Rhone-Metro calculated the $100,000 annual lease payments.

2.

 

How should this lease be classified (a) by Western Soya Co. (the lessee) and (b) by Rhone-Metro Industries (the lessor)? Why?

3.

 

Prepare the appropriate entries for both Western Soya Co. and Rhone-Metro on December 31, 2011.

4.

 

Prepare an amortization schedule(s) describing the pattern of interest over the lease term for the lessee and the lessor.

5.

 

Prepare all appropriate entries for both Western Soya and Rhone-Metro on December 31, 2012 (the second lease payment and depreciation).

6.

 

Prepare the appropriate entries for both Western Soya and Rhone-Metro on December 31, 2015 assuming the equipment is returned to Rhone-Metro and the actual residual value on that date is $1,500.

P 15-9 Unguaranteed residual value; executory costs; sales-type lease 
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Rhone-Metro Industries manufactures equipment that is sold or leased. On December 31, 2011, Rhone-Metro leased equipment to Western Soya Co. for a four-year period ending December 31, 2015, at which time possession of the leased asset will revert back to Rhone-Metro. The equipment cost $300,000 to manufacture and has an expected useful life of six years. Its normal sales price is $365,760. The expected residual value of $25,000 at December 31, 2015, is not guaranteed. Equal payments under the lease are $104,000 (including $4,000 executory costs) and are due on December 31 of each year. The first payment was made on December 31, 2011. Collectibility of the remaining lease payments is reasonably assured, and Rhone-Metro has no material cost uncertainties. Western Soya's incremental borrowing rate is 12%. Western Soya knows the interest rate implicit in the lease payments is 10%. Both companies use straight-line depreciation.

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Required:

1.

 

Show how Rhone-Metro calculated the $104,000 annual lease payments.

2.

 

How should this lease be classified (a) by Western Soya Co. (the lessee) and (b) by Rhone-Metro Industries (the lessor)? Why?

p. 862

3.

 

Prepare the appropriate entries for both Western Soya Co. and Rhone-Metro on December 31, 2011.

4.

 

Prepare an amortization schedule(s) describing the pattern of interest over the lease term for the lessee and the lessor.

5.

 

Prepare the appropriate entries for both Western Soya and Rhone-Metro on December 31, 2012 (the second lease payment and depreciation).

6.

 

Prepare the appropriate entries for both Western Soya and Rhone-Metro on December 31, 2015, assuming the equipment is returned to Rhone-Metro and the actual residual value on that date is $1,500.

P 15-10 Bargain purchase option exercisable before lease term ends; executor costs; sales-type lease 
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Rhone-Metro Industries manufactures equipment that is sold or leased. On December 31, 2011, Rhone-Metro leased equipment to Western Soya Co. for a noncancelable stated lease term of four years ending December 31, 2015, at which time possession of the leased asset will revert back to Rhone-Metro. The equipment cost $300,000 to manufacture and has an expected useful life of six years. Its normal sales price is $365,760. The expected residual value of $25,000 at December 31, 2015, is not guaranteed. Western Soya Co. can exercise a bargain purchase option on December 30, 2014, at an option price of $10,000. Equal payments under the lease are $134,960 (including $4,000 annual executory costs) and are due on December 31 of each year. The first payment was made on December 31, 2011. Collectibility of the remaining lease payments is reasonably assured, and Rhone-Metro has no material cost uncertainties. Western Soya's incremental borrowing rate is 12%. Western Soya knows the interest rate implicit in the lease payments is 10%. Both companies use straight-line depreciation.

   Hint: A lease term ends for accounting purposes when an option becomes exercisable if it's expected to be exercised (i.e., a BPO).

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Required:

1.

 

Show how Rhone-Metro calculated the $134,960 annual lease payments.

2.

 

How should this lease be classified (a) by Western Soya Co. (the lessee) and (b) by Rhone-Metro Industries (the lessor)? Why?

3.

 

Prepare the appropriate entries for both Western Soya Co. and Rhone-Metro on December 31, 2011.

4.

 

Prepare an amortization schedule(s) describing the pattern of interest over the lease term for the lessee and the lessor.

5.

 

Prepare the appropriate entries for both Western Soya and Rhone-Metro on December 31, 2012 (the second rent payment and depreciation).

6.

 

Prepare the appropriate entries for both Western Soya and Rhone-Metro on December 30, 2014, assuming the BPO is exercised on that date.

P 15-11 Operating lease to lessee—capital lease to lessor 
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Allied Industries manufactures high-performance conveyers that often are leased to industrial customers. On December 31, 2011, Allied leased a conveyer to Poole Carrier Corporation for a three-year period ending December 31, 2014, at which time possession of the leased asset will revert back to Allied. Equal payments under the lease are $200,000 and are due on December 31 of each year. The first payment was made on December 31, 2011. Collectibility of the remaining lease payments is reasonably assured, and Allied has no material cost uncertainties. The conveyer cost $450,000 to manufacture and has an expected useful life of six years. Its normal sales price is $659,805. The expected residual value of $150,000 at December 31, 2014, is guaranteed by United Assurance Group. Poole Carrier's incremental borrowing rate and the interest rate implicit in the lease payments are 10%.

Required:

1.

 

Show how Allied Industries calculated the $200,000 annual lease payments.

2.

 

How should this lease be classified (a) by Allied (the lessor) and (b) by Poole (the lessee)? Why?

3.

 

Prepare the appropriate entries for both Poole and Allied on December 31, 2011.

4.

 

Prepare an amortization schedule(s) describing the pattern of interest over the lease term.

5.

 

Prepare the appropriate entries for both Poole and Allied on December 31, 2012, 2013, and 2014, assuming the conveyer is returned to Allied at the end of the lease and the actual residual value on that date is $105,000.

P 15-12 Lease concepts; direct financing leases; guaranteed and unguaranteed residual value 
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Each of the four independent situations below describes a direct financing lease in which annual lease payments of $10,000 are payable at the beginning of each year. Each is a capital lease for the lessee. Determine the following amounts at the inception of the lease:

A. The lessor’s:

  

1.

  

Minimum lease payments

  

2.

  

Gross investment in the lease

  

3.

  

Net investment in the lease

p. 863

B. The lessee’s:

  

4.

  

Minimum lease payments

  

5.

  

Leased asset

  

6.

  

Lease liability

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P 15-13 Lease concepts 
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Four independent situations are described below. For each, annual lease payments of $100,000 (not including any executory costs paid by lessor) are payable at the beginning of each year. Each is a capital lease for both the lessor and lessee. Determine the following amounts at the inception of the lease:

A. The lessor’s:

  

1.

  

Minimum lease payments

  

2.

  

Gross investment in the lease

  

3.

  

Net investment in the lease

  

4.

  

Sales revenue

  

5.

  

Cost of goods sold

  

6.

  

Dealer’s profit

B. The lessee’s:

  

7.

  

Minimum lease payments

  

8.

  

Leased asset

  

9.

  

Lease liability

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P 15-14 Executory costs; lessor and lessee 
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Branif Leasing leases mechanical equipment to industrial consumers under direct financing leases that earn Branif a 10% rate of return for providing long-term financing. A lease agreement with Branson Construction specified 20 annual payments of $100,000 beginning December 31, 2011, the inception of the lease. The estimated useful life of the leased equipment is 20 years with no residual value. Its cost to Branif was $936,500. The lease qualifies as a capital lease to Branson. Maintenance of the equipment was contracted for through a 20-year service agreement with Midway Service Company requiring 20 annual payments of $3,000 beginning December 31, 2011. Both companies use straight-line depreciation.

Required:

Prepare the appropriate entries for both the lessee and lessor to record the second lease payment and depreciation on December 31, 2012, under each of three independent assumptions:

1.

 

The lessee pays executory costs as incurred.

2.

 

The contract specifies that the lessor pays executory costs as incurred. The lessee's lease payments were increased to $103,000 to include an amount sufficient to reimburse these costs.

3.

 

The contract specifies that the lessor pays executory costs as incurred. The lessee's lease payments were increased to $103,300 to include an amount sufficient to reimburse these costs plus a 10% management fee for Branif.

P 15-15 Sales-type lease; bargain purchase option exercisable before lease term ends; lessor and lessee 
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p. 864

Mid-South Auto Leasing leases vehicles to consumers. The attraction to customers is that the company can offer competitive prices due to volume buying and requires an interest rate implicit in the lease that is one percent below alternate methods of financing. On September 30, 2011, the company leased a delivery truck to a local florist, Anything Grows.

   The lease agreement specified quarterly payments of $3,000 beginning September 30, 2011, the inception of the lease, and each quarter (December 31, March 31, and June 30) through June 30, 2014 (three-year lease term). The florist had the option to purchase the truck on September 29, 2013, for $6,000 when it was expected to have a residual value of $10,000. The estimated useful life of the truck is four years. Mid-South Auto Leasing's quarterly interest rate for determining payments was 3% (approximately 12% annually). Mid-South paid $25,000 for the truck. Both companies use straight-line depreciation. Anything Grows' incremental interest rate is 12%.

   Hint: A lease term ends for accounting purposes when an option becomes exercisable if it's expected to be exercised (i.e., a BPO).

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Required:

1.

 

Calculate the amount of dealer's profit that Mid-South would recognize in this sales-type lease. (Be careful to note that, although payments occur on the last calendar day of each quarter, since the first payment was at the inception of the lease, payments represent an annuity due.)

2.

 

Prepare the appropriate entries for Anything Grows and Mid-South on September 30, 2011.

3.

 

Prepare an amortization schedule(s) describing the pattern of interest expense for Anything Grows and interest revenue for Mid-South Auto Leasing over the lease term.

4.

 

Prepare the appropriate entries for Anything Grows and Mid-South Auto Leasing on December 31, 2011.

5.

 

Prepare the appropriate entries for Anything Grows and Mid-South on September 29, 2013, assuming the bargain purchase option was exercised on that date.

P 15-16 Lessee-guaranteed residual value; third-party-guaranteed residual value; unguaranteed residual value; executory costs; different interest rates for lessor and lessee 
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On December 31, 2011, Yard Art Landscaping leased a delivery truck from Branch Motors. Branch paid $40,000 for the truck. Its retail value is $45,114.

   The lease agreement specified annual payments of $11,000 beginning December 31, 2011, the inception of the lease, and at each December 31 through 2014. Branch Motors' interest rate for determining payments was 10%. At the end of the four-year lease term (December 31, 2015) the truck was expected to be worth $15,000. The estimated useful life of the truck is five years with no salvage value. Both companies use straight-line depreciation.

   Yard Art guaranteed a residual value of $6,000. Guarantor Assurance Corporation was engaged to guarantee a residual value of $11,000, but with a deductible equal to any amount paid by the lessee ($11,000 reduced by any amount paid by the lessee). Yard Art's incremental borrowing rate is 9%.

   A $1,000 per year maintenance agreement was arranged for the truck with an outside service firm. As an expediency, Branch Motors agreed to pay this fee. It is, however, reflected in the $11,000 lease payments.

   Collectibility of the lease payments by Yard Art is reasonably predictable and there are no costs to the lessor that are yet to be incurred.

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Required:

1.

 

How should this lease be classified by Yard Art Landscaping (the lessee)? Why?

2.

 

Calculate the amount Yard Art Landscaping would record as a leased asset and a lease liability.

3.

 

How should this lease be classified by Branch Motors (the lessor)? Why?

4.

 

Show how Branch Motors calculated the $11,000 annual lease payments.

5.

 

Calculate the amount Branch Motors would record as sales revenue.

6.

 

Prepare the appropriate entries for both Yard Art and Branch Motors on December 31, 2011.

7.

 

Prepare an amortization schedule that describes the pattern of interest expense over the lease term for Yard Art.

8.

 

Prepare an amortization schedule that describes the pattern of interest revenue over the lease term for Branch Motors.

9.

 

Prepare the appropriate entries for both Yard Art and Branch Motors on December 31, 2012.

10.

 

Prepare the appropriate entries for both Yard Art and Branch Motors on December 31, 2014 (the final lease payment).

11.

 

Prepare the appropriate entries for both Yard Art and Branch Motors on December 31, 2015 (the end of the lease term), assuming the truck is returned to the lessor and the actual residual value of the truck was $4,000 on that date.

P 15-17 Integrating problem; bonds; note; lease 
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You are the new controller for Moonlight Bay Resorts. The company CFO has asked you to determine the company's interest expense for the year ended December 31, 2011. Your accounting group provided you the following information on the company's debt:

1.

 

On July 1, 2011, Moonlight Bay issued bonds with a face amount of $2,000,000. The bonds mature in 20 years and interest of 9% is payable semiannually on June 30 and December 31. The bonds were issued at a price to yield investors 10%. Moonlight Bay records interest at the effective rate.

p. 865

2.

 

At December 31, 2010, Moonlight Bay had a 10% installment note payable to Third Mercantile Bank with a balance of $500,000. The annual payment is $60,000, payable each June 30.

3.

 

On January 1, 2011, Moonlight Bay leased a building under a capital lease calling for four annual lease payments of $40,000 beginning January 1, 2011. Moonlight Bay's incremental borrowing rate on the date of the lease was 11% and the lessor's implicit rate, which was known by Moonlight Bay, was 10%.

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Required:

Calculate interest expense for the year ended December 31, 2011.

P 15-18 Initial direct costs; direct financing lease 
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Bidwell Leasing purchased a single-engine plane for its fair value of $645,526 and leased it to Red Baron Flying Club on January 1, 2011.

   Terms of the lease agreement and related facts were:

a.

 

Eight annual payments of $110,000 beginning January 1, 2011, the inception of the lease, and at each December 31 through 2017. Bidwell Leasing's implicit interest rate was 10%. The estimated useful life of the plane is eight years. Payments were calculated as follows:

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b.

 

Red Baron's incremental borrowing rate is 11%.

c.

 

Costs of negotiating and consummating the completed lease transaction incurred by Bidwell Leasing were $18,099.

d.

 

Collectibility of the lease payments by Bidwell Leasing is reasonably predictable and there are no costs to the lessor that are yet to be incurred.

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Required:

1.

 

How should this lease be classified (a) by Bidwell Leasing (the lessor) and (b) by Red Baron (the lessee)?

2.

 

Prepare the appropriate entries for both Red Baron Flying Club and Bidwell Leasing on January 1, 2011.

3.

 

Prepare an amortization schedule that describes the pattern of interest expense over the lease term for Red Baron Flying Club.

4.

 

Determine the effective rate of interest for Bidwell Leasing for the purpose of recognizing interest revenue over the lease term.

5.

 

Prepare an amortization schedule that describes the pattern of interest revenue over the lease term for Bidwell Leasing.

6.

 

Prepare the appropriate entries for both Red Baron and Bidwell Leasing on December 31, 2011 (the second lease payment). Both companies use straight-line depreciation.

7.

 

Prepare the appropriate entries for both Red Baron and Bidwell Leasing on December 31, 2017 (the final lease payment).

P 15-19 Initial direct costs; sales-type lease 
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(Note: This problem is a variation of the preceding problem, modified to cause the lease to be a sales-type lease.)

   Bidwell Leasing purchased a single-engine plane for $400,000 and leased it to Red Baron Flying Club for its fair value of $645,526 on January 1, 2011.

   Terms of the lease agreement and related facts were:

a.

 

Eight annual payments of $110,000 beginning January 1, 2011, the inception of the lease, and at each December 31 through 2017. Bidwell Leasing's implicit interest rate was 10%. The estimated useful life of the plane is eight years. Payments were calculated as follows:

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b.

 

Red Baron's incremental borrowing rate is 11%.

c.

 

Costs of negotiating and consummating the completed lease transaction incurred by Bidwell Leasing were $18,099.

d.

 

Collectibility of the lease payments by Bidwell Leasing is reasonably predictable and there are no costs to the lessor that are yet to be incurred.

p. 866

Required:

1.

 

How should this lease be classified (a) by Bidwell Leasing (the lessor) and (b) by Red Baron (the lessee)?

2.

 

Prepare the appropriate entries for both Red Baron Flying Club and Bidwell Leasing on January 1, 2011.

3.

 

Prepare an amortization schedule that describes the pattern of interest expense over the lease term for Red Baron Flying Club.

4.

 

Prepare the appropriate entries for both Red Baron and Bidwell Leasing on December 31, 2011 (the second lease payment). Both companies use straight-line depreciation.

5.

 

Prepare the appropriate entries for both Red Baron and Bidwell Leasing on December 31, 2017 (the final lease payment).

P 15-20 Sale-leaseback 
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To raise operating funds, North American Courier Corporation sold its building on January 1, 2011, to an insurance company for $500,000 and immediately leased the building back. The lease is for a 10-year period ending December 31, 2020, at which time ownership of the building will revert to North American Courier. The building has a carrying amount of $400,000 (original cost $1,000,000). The lease requires North American to make payments of $88,492 to the insurance company each December 31. The building had a total original useful life of 30 years with no residual value and is being depreciated on a straight-line basis. The lease has an implicit rate of 12%.

Required:

1.

 

Prepare the appropriate entries for North American on (a) January 1, 2011, to record the sale-leaseback and (b) December 31, 2011, to record necessary adjustments.

2.

 

Show how North American's December 31, 2011, balance sheet and income statement would reflect the sale-leaseback.

P 15-21 Real estate lease; land and building 
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On January 1, 2011, Cook Textiles leased a building with two acres of land from Peck Development. The lease is for 10 years. No purchase option exists and the property will revert to Peck at the end of the lease. The building and land combined have a fair market value on January 1, 2011, of $1,450,000 and the building has an estimated life of 20 years with a residual value of $150,000. The lease calls for Cook to assume all costs of ownership and to make annual payments of $200,000 due at the beginning of each year. On January 1, 2011, the estimated value of the land was $400,000. Cook uses the straight-line method of depreciation and pays 10% interest on borrowed money. Peck's implicit rate is unknown.

Required:

1.

 

Prepare journal entries for Cook Textiles for 2011. Assume the land could be leased without the building for $59,000 each year.

2.

 

Assuming the land had a fair value on January 1, 2011, of $200,000 and could be leased alone for $30,000, prepare journal entries for Cook Textiles for 2011.

P 15-22 IFRS; real estate lease; land and building 
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Refer to the situation described in Problem 15-21.

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Required:

How might your solution differ if Cook Textiles prepares its financial statements according to International Financial Reporting Standards?

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