Financial Accounting: Liabilities & Equities (FA3) Exam Review

FA3 Exam Review notes Barbara Wyntjes, CGA, MBA, B.Sc.
Question 4 (13 marks)
Fred’s Fabricating Ltd., which has a December 31 year end, offers lease financing to
customers who want to buy its prefabricated buildings. Fred’s Fabricating has just
completed a building at a cost of $3,000,000 and will lease it on July 1, 2003, to Bill’s
Building Corp., a manufacturing company. Fred’s Fabricating’s mark up on the building
is 30% of cost.
• The lease term is 15 years; the building’s estimated useful life is 22 years.
• The building’s residual value at the end of the lease term is estimated to be $500,000.
This value is not guaranteed. The salvage value is estimated to be $100,000. Terms of
the lease allow Bill’s Building the option of purchasing the building at the end of the
lease term for $200,000.
• Bill’s Building’s incremental borrowing rate is 9%.
• Bill’s Building knows that the interest rate implicit in the lease is 8%.
• The first annual lease payment is due July 1, 2003.
Required
2 a. Calculate the required annual lease payments.
8 b. Prepare all required journal entries for the lessee, Bill’s Building Corp., for the year
2003.
3 c. Accounting standards sets out the classification criteria that the lessee must use to
determine if a lease qualifies as a capital lease for financial reporting purposes.
Essentially, the 4 criteria are
• a transfer of ownership at the end of the lease term or a bargain purchase
option;
• the lease term major/ ≥ 75% of economic life; or
• the present value of the minimum lease payments substantially all/ ≥ 90% of
fair market value.
• IFRS: specialized nature of asset
In addition to the foregoing, the lessor is required to use supplemental criteria. Identify
the supplemental criteria used by the lessor and explain briefly (in one or two sentences)
why these additional requirements are necessary.
Solution: There is a bargain purchase option (option to purchase at $200,000 versus an
estimated value at the end of the lease term of $500,000). Accordingly, this is a
capital/financing lease as there is reasonable assurance that the lessee will obtain
ownership of the leased property by the end of the lease.
a. Selling price ($3,000,000 × 1.30) $3,900,000
BGN, PV = 3,900,000, n = 15, i = 8, FV = 200,000, PMT = ? = 415,064 (tables 415,067)
b. July 1, 2003
(1) Asset under capital/financing lease ................................3,900,000
(1) Lease liability ............................................................ 3,900,000
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