Question

Sylvan Inc. entered into a non-cancelable lease arrangement with Breton Leasing Corporation for a certain machine. Breton's primary business is leasing;it is not a manufacturer or dealer. Sylvan will lease the machine for a period of 3 years, which is 50% of the machine's economic life. Breton will take possession of the machine at the end of the initial 3-year lease and lease it to another, smaller company that does not need the most current version of the machine. Sylvan does not guarantee any residual value for the machine and will not purchase the machine at the end of the lease term.

Sylvan's incremental borrowing rate is 10%, and the implicit rate in the lease is 9%. Sylvan has no way of knowing the implicit rate used by Breton. Using either rate, the present value of the minimum lease payments is between 90% and 100% of the fair value of the machine at the date of the lease agreement.

Sylvan has agreed to pay all executory costs directly, and no allowance for these costs is included in the lease payments.

Breton is reasonably certain that Sylvan will pay all lease payments. Because Sylvan has agreed to pay all executory costs, there are no important uncertainties regarding costs to be incurred by Breton. Assume that no indirect costs are involved.

Instructions

(a)  With respect to Sylvan (the lessee), answer the following.

How should Sylvan compute the appropriate amount to be recorded for the lease or asset acquired?

What accounts will be created or affected by this transaction, and how will the lease or asset and other costs related to the transaction be recorded in earnings?

What disclosures must Sylvan make regarding this leased asset?

(b)  With respect to Breton (the lessor), answer the following.  

How should this lease be recorded by Breton, and how are the appropriate amounts determined?

How should Breton determine the appropriate amount of revenue to be recognized from each lease payment?

What disclosures must Breton make regarding this lease?

Answer 1

Given information,

Lessor - Breton Leasing Corporation

Lessee - Sylvan Inc.

Lease period - 3 years

Life of the asset - 6 years

Answer to a) Accounts of Lessee

As the present value of minimum lease payments is minimum 90%, the lease is classified as capital lease.

As it is the capital lease, asset can be recorded at present vale of lease payments discounted at implicit rate of 9% .

The accounts needed to be created:

For recording purposes the following accounts needs to be created.

i, Initial recognition

Machine account Dr.

To Capital lease liability account

(Being leased asset recorded in books)

ii, Lease payments

Capital lease liability account Dr.

Interest expense account Dr.

To Accounts payable account.

(Being lease payment recognized)

iii, Depreciation

Depreciation account Dr.

To accumulated depreciation account .

(Being depreciation charged)

iv, On the date of returning the asset, if there is any difference between a net carrying cost of asset and accumulated depreciation accounts, then the difference must be recognized as loss or gain.

Disclosures required to be made by Sylvan Inc.:

* General description of leasing agreement,

* Segregate lease assets from owned assets,

* Net carrying amount at the balance sheet date,

* Provide reconciliation between minimum lease payment at balance sheet date and their present value.

Answer to b) Accounts of Lessor:

As the present value of minimum lease payments is minimum 90%, Lessor must recognize the lease as Direct Finance lease.

Lessor must recognize the asset at net investment in the lease.

Breton can determine appropriate amount of revenue by dividing each lease payment as finance income and rental income.

Disclosures required to be made by Breton Leasing Corporation:

* General description of leasing agreement,

* Accounting policy adopted,

* Contingent rent received,

* Unearned financial income,

* Accumulated minimum lease payments

* Reconciliation of brought forward gross investment and minimum lease payments at the balance sheet date,