Crown Inc. (CI) is a private company that manufactures a special type of cap tha

Question

Crown Inc. (CI) is a private company that manufactures a special type of cap that fits on a bottle. At present, it is the only manufacturer of this cap and therefore enjoys market security. The machinery that makes the cap has been in use for 20 years and is due for replacement. CI has the option of buying the machine or leasing it. Currently, CI is leaning toward leasing the machine since it is expensive to buy and funds would have to be borrowed, the debt to equity ratio would surely worsen. CI’s top management is anxious to maintain the ratio at its present level.

The dilemma for CI is that if it leases the machine, it may have to set up a long-term obligation under the lease and this would also affect the debt to equity ratio. Since this is clearly unacceptable, CI decided to see if the leasing company, Anchor Limited, could do anything to help with the situation. After much negotiation, the following terms were agreed upon and written into the lease agreement.

1. Anchor Limited would manufacture and lease to CI a unique machine for making caps.

2. The lease would be for a period of 12 years.

3. The lease payments of $150,000 would be paid at the end of each year.

4. CI would have the option to purchase the machine for $850,000 at the end of the lease term, which is equal to the expected fair market value at that time; otherwise, the machine would be returned to the lessor.

5. CI also has the option to lease the machine for another eight years at $150,000 per year.

6. The rate that is implicit in the lease is 9%.

The new machine is expected to last 20years. Since it is a unique machine, Anchor Limited has no other use for it if CI does not either purchase it at the end of the lease or renew the lease. If CI had purchased the asset, it would have cost $1.9 million. Although it was purposefully omitted from the written lease agreement, there was an understanding that CI would either renew the lease or exercise the purchase option.

Instructions:

Assume the role of CI’s auditors and discuss the nature of the lease, nothing how it should be accounted for. The company controlled has confided in you that the machine will likely be purchased at the end of the lease. Assume that you are aware of top management’s position on adding debt to the balance sheet. Management has also asked you to compare the account under ASPE and IFRS.

Explanation / Answer

Accounting treatment under ASPE for lessee with respect to capital lease   is as follows:

A leased asset is recognized separate from owned assets on the balance sheet at the present value of the

minimum lease payments, excluding any executory costs.

This amount cannot exceed the leased asset;s fair value

The leased asset is amortized over the period of expected use on a basis consistent with the lessee’s depre

ciation policy for similar fixed assets and depending on the terms of the lease.

The related obligation under capital lease is recognised separately fro other long-term obligations on the

The discount rate is the lower of the lessee's rate for incremental and the interest rate implicit in the lease.

Lease payments made are allocated as a reduction of the obligation,interestexpense and any executory costs.

Accounting treatment under ASPE for lessee with respect to Operating lease   is as follows:

.NO balance sheet recognition for either the leased asset or any obligation thereof.

Annual Journal Entry for the term of the lease will be

Debit Lease Rental 150000

Credit Cash.Bank   150000

which also gives reduced tax outflow.

I Present value of 1st option - 12 years lease and Purchase for $ 850,000 @ end of lease PV of an annuity of 150000 fo 12 yrs. @9% + PV of $ 850000 to be paid @ end of 12 th year using the formula,   PV = PMT (1-(1+i)^-n/i)     =150000((1-1.09^-12)/0.09))+ 850000/1.09^12       = 1074108.79 + 302204.52= $ 1376313.31 II 2nd option - 150000 lease rental for 20 years       = 150000({1 -1.09^-20)/0.09)       = $ 1369281.85 III Out -right purchase by CI - $ 1900000 UNDER ASPE Option 1The proposal with purchase option is a Capital lease for the very same reason and also as the PV of lease payments exceeds 90% of the Fair market value of the asset.

Accounting treatment under ASPE for lessee with respect to capital lease   is as follows:

A leased asset is recognized separate from owned assets on the balance sheet at the present value of the

minimum lease payments, excluding any executory costs.

This amount cannot exceed the leased asset;s fair value

The leased asset is amortized over the period of expected use on a basis consistent with the lessee’s depre

ciation policy for similar fixed assets and depending on the terms of the lease.

The related obligation under capital lease is recognised separately fro other long-term obligations on the

balance sheet at the PV of the minimum lease payments,excluding any executory costs.The current portion payable is presented separately in current liabilities.

The discount rate is the lower of the lessee's rate for incremental and the interest rate implicit in the lease.

Lease payments made are allocated as a reduction of the obligation,interestexpense and any executory costs.

Option II This is an Operating lease type.

Accounting treatment under ASPE for lessee with respect to Operating lease   is as follows:

.NO balance sheet recognition for either the leased asset or any obligation thereof.

Lease rentals are recognised in the income statement on a straight line basis , during lease-term

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