On January 2, 2006, Grant Corporation leases an asset to Pippin Corporation under the following conditions:
1. Annual lease payments of $10,000 for twenty years.
2. At the end of the lease term the asset is expected to have a value of $2,750.
3. The fair market value of the asset at the inception of the lease is $92,625.
4. The estimated economic life of the lease is thirty years.
5. Grant’s implicit interest rate is 12 percent; Pippin’s incremental borrowing rate is 10 percent.
6. The asset is recorded in Grant’s inventory at $75,000 just prior to the lease transaction.
Required:
a. What type of lease is this for Pippin? Why?
b. Assume Grant capitalizes the lease. What financial statement accounts are affected by this lease, and what is the amount of each effect?
c. Assume Grant uses straight-line depreciation. What are the income statement, balance sheet, and statement of cash flow effects for 2006?
d. How should Grant record this lease? Why? Would any additional information be helpful in making this decision?
e. Assume that Grant treats the lease as a sales-type lease and the residual value is not guaranteed by Pippin. What financial statement accounts are affected on January 2, 2006?
a. To determine the type of lease for Pippin, we need to compare the terms of the lease agreement with the criteria specified by accounting standards. There are two main types of leases: operating leases and finance leases (also known as capital leases).
In this case, the lease payments of $10,000 per year for twenty years are equal to the fair market value of the asset, which implies that Pippin is effectively paying for the entire cost of the asset. Additionally, the lease term of twenty years is substantially longer than the estimated economic life of the asset (thirty years).
Based on these criteria, it can be concluded that this lease is a finance lease for Pippin. In finance leases, the lessee effectively assumes the risks and rewards of ownership, as they are responsible for the entire cost of the asset and the lease term is similar to or longer than the asset's economic life.
b. If Grant capitalizes the lease, it means that the lease is treated as a financed purchase of the asset, and the relevant financial statement accounts affected would be:
1. Balance Sheet:
- An increase in the asset account for the value of the leased asset (e.g., Lease Receivable or Equipment) - $92,625
- A corresponding increase in the liability account for the present value of the lease payments (e.g., Lease Liability) - Present value of $10,000 annual payments for twenty years at the incremental borrowing rate of 10%.
2. Income Statement:
- No direct effect on the income statement because the lease payments are not considered as an expense when the lease is capitalized.
c. Assuming Grant uses straight-line depreciation, the effects on the financial statements for 2006 would be:
Income Statement:
- Depreciation expense for the leased asset - ($92,625 - $2,750) / 20 years = $4,937.50
Balance Sheet:
- Reduction in the asset account for accumulated depreciation - $4,937.50
- Reduction in the liability account for the portion of the lease liability paid - $10,000
Statement of Cash Flow:
- Cash outflow from the operating activities for the lease payments - $10,000
d. Grant should record this lease as a finance lease because Pippin effectively assumes the risks and rewards of ownership. Under finance leases, the asset and liability related to the leased asset are recorded on the balance sheet.
To make this decision, no additional information is necessary as the terms of the lease agreement and the accounting criteria have already been considered.
e. Assuming Grant treats the lease as a sales-type lease and the residual value is not guaranteed by Pippin, the financial statement accounts affected on January 2, 2006, would be:
Balance Sheet:
- An increase in the asset account for the gross investment in the lease (e.g., Lease Receivable) - Present value of $10,000 annual payments for twenty years at Grant's implicit interest rate of 12%.
- A decrease in the asset account for the net investment in the lease (e.g., Sales-type Lease Receivable)
- An increase in the sales revenue account for the present value of the lease payments ($10,000 annual payments for twenty years) - Present value of $10,000 annual payments for twenty years at Grant's implicit interest rate of 12%.
Income Statement:
- Recognition of interest income over the lease term.
Cash Flow Statement:
- Cash inflow from the sales of the lease.