P21-2` Cleveland inc.

leased a new crane to Abriendo construction under 5-year

noncancelable contract staring june1, 2011. Terms of the lease require payments of
$33,000 each June 1, starting June 1, 2011. Cleveland will pay insurants, taxes, and
maintenance charges on the crane, which has an estimate life of 12 years, a fair value of
$240,000, and a cost to Cleveland of $240,000. The estimated fair value of crane is
expected to be $45,000 at the end of the lease term. No bargain-purchase or renewal
options are included in the contract. Both Cleveland Abriendo adjust and close books
annually at December 31. Collectability of lease payments is reasonably certain, and no
uncertainties exist relative to unreimbursable lesson costs. Abriendo’s incremental
borrowing rate is 10%, and Cleveland’s implicit interest rate of 9% is known to Abriendo.
Instructions

(a) Identify the type of lease involved and give reasons for your classification. Discuss
the accounting treatment that should be applied by both lessee and lessor.

The lease is an operating lease to the lessee and lessor because:

1. it does not transfer ownership,

2. it does not contain a bargain purchase option,

3. it does not cover at least 75% of the estimated economic life of the crane,
and

4. the present value of the lease payments is not at least 90% of the fair
value of the leased crane.

$33,000 Annual Lease Payments X PV of annuity due at 9% for 5 years

$33,000 X 4.23972 = $139,910.76, which is less than $216,000.00 (90% X
$240,000.00).

At least one of the four criteria would have had to be satisfied for the lease to
be classified as other than an operating lease.

(b) Prepare all entries related to the lease contract and leased asset for the year 2011 for
lessee and lessor, assuming the following amounts. (1) Insurance $500 (2) Taxes $2,000
(3) Maintenance $650 (4) Straight –line depreciation and salvage value $15,000.

Lessee’s Entries
Rent Expense........................................................................................ 33,000
Cash..............................................................................................
33,000
 Lessor’s Entries
Insurance Expense............................................................................... 500
Tax Expense.......................................................................................... 2,000
Maintenance Expense.......................................................................... 650
Cash or Accounts Payable..........................................................
3,150

Depreciation Expense.......................................................................... 18,750

Accumulated Depreciation—Crane
[($240,000 – $15,000) ÷ 12].....................................................
18,750

Cash ...................................................................................................... 33,000

Rental Revenue............................................................................
33,000

(c) Discuss what should be presented in the balance sheet, the income statement, and
related notes of both the lessee and the lessor at December 31, 2011.

(c) Abriendo as lessee must disclose in the income statement the $33,000 of rent
expense and in the notes the future minimum rental payments required as of
January 1 (in total, $132,000) and for each of the succeeding four years: 2012—
$33,000; 2013—$33,000; 2014—$33,000; 2015— $33,000. Nothing relative to
this lease would appear on the lessee’s balance sheet.

Cleveland as lessor must disclose in the balance sheet or in the notes the cost of the
leased crane ($240,000) and the accumulated depreciation of $18,750 separately
from assets not leased. Additionally, Cleveland must disclose in the notes the
minimum future rentals as a total of $132,000, and for each of the succeeding
four years: 2012—$33,000; 2013—$33,000; 2014—$33,000; 2015—$33,000.

The income statement for the lessor reports rental revenue and expenses for
insurance, taxes, maintenance, and depreciation expense.

P21-3 Winston Industries and Ewing inc. enter into an agreement that requires Ewing inc.
to build three diesel-electric engines to Winston’s specifications. Upon completion of the
engines Winston has agreed to lease them for a period of 10 years and to assume all costs
and risks of ownership. The lease is noncancelable, becomes effective on January 1,
2011, and requires annual rental payments of $413,917 each January 1, starting January
1, 2011. Winston’s incremental borrowing rate is 10%. The implicit interest rate used by
Ewing inc.

(a) The lease should be treated as a capital lease by Winston Industries requiring
the lessee to capitalize the leased asset. The lease qualifies for capital lease
accounting by the lessee because: (1) title to the engines transfers to the lessee,
(2) the lease term is equal to the estimated life of the asset, and (3) the present
value of the minimum lease payments exceeds 90% of the fair value of the
leased engines. The transaction represents a purchase financed by installment
payments over a 10-year period.

For Ewing Inc. the transaction is a sales-type lease because a manu-facturer’s

profit accrues to Ewing. This lease arrangement also represents the
manufacturer’s financing the transaction over a period of 10 years.

Present Value of Lease Payments

$413,971 X 7.24689*...........................................................................
$3,000,000

*Present value of an annuity due at 8% for 10 years, rounded by $2.

Dealer Profit
Sales (present value of lease payments).................................................
$3,000,000
Less cost of engines..................................................................................
2,600,000
Profit on sale............................................................................................. $
400,000

(b) Leased Engines Under Capital Leases................................... 3,000,000

Lease Liability.................................................................
3,000,000

(c) Lease Receivable...................................................................... 3,000,000

Cost of Goods Sold................................................................... 2,600,000
Sales..................................................................................
3,000,000
Inventory..........................................................................
2,600,000
(d) Lessee (January 1, 2011)
Lease Liability.......................................................................... 413,971
Cash..................................................................................
413,971

Lessor (January 1, 2011)

Cash 413,971
Lease Receivable.............................................................
413,971

(e) WINSTON INDUSTRIES

Lease Amortization Schedule

Annual Lease
Receipt/ Interest on Reduction in Lease
Payment Receivable/ Liability Receivable/ Receivable/
Date at 8% Liability Liability
1/1/11 3,000,000
1/1/11 413,971 413,971 2,586,029
1/1/12 413,971 206,882 207,089 2,378,940
1/1/13 413,971 190,315 223,656 2,155,284

Lessee (December 31, 2011)

Interest Expense....................................................................... 206,882
Interest Payable...............................................................
206,882

Lessor (December 31, 2011)

Interest Receivable................................................................... 206,882
Interest Revenue..............................................................
206,882

(f) WINSTON INDUSTRIES

Balance Sheet
December 31, 2011

Property, plant, and equipment: Current liabilities:

Leased property
under capital leases $3,000,000 Interest payable $ 206,882
 Lease liability 207,089**
Less accumulated
depreciation 300,000* Long-term liabilities:
$2,700,000 Lease liability (See 2,378,940***
schedule)

*$3,000,000 ÷ 10 = $300,000
**($413,971 – $206,882)
***No portion of this amount paid within the next year.

Note: The title Obligations under Capital Leases is often used instead of lease
liability.

EWING INC.
Balance Sheet
December 31, 2011

Assets
Current assets:
Interest receivable................................................................................. $
206,882
Lease receivable....................................................................................
207,089

Noncurrent assets:
Lease receivable....................................................................................
$2,378,940*

Note: The title Net Investment in Sales-Type Leases is often shown instead of
lease receivable.

*See balance on amortization schedule at 1/1/12.