Cleveland Inc. leased a new crane to Abriendo Construction under a 5-year noncancelable contract starting January 1, 2014. Terms of the lease require payments of $33,000 each January 1, starting January 1, 2014. Cleveland will pay insurance, taxes, and maintenance charges on the crane, which has an estimated life of 12 years, a fair value of $240,000, and a cost to Cleveland of $240,000. The estimated fair value of the 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 and Abriendo adjust and close books annually at December 31. Collectibility of the lease payments is reasonably certain, and no uncertainties exist relative to unreimbursable lessor 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 the lessee and the lessor.

(b) Prepare all the entries related to the lease contract and leased asset for the year 2014 for the 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.

(c) Discuss what should be presented in the balance sheet, the income statement, and the related notes of both the lessee and the lessor at December 31, 2014.

Answer:

A) 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).

B) 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

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.

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

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

          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.