Application of Classification Criteria

1 Does the agreement specify that ownership of the asset transfers to the lessee? NO 2 Does the agreement contain a bargain purchase option? NO 3 Is the lease term equal to 75% or more of the expected YES economic life of the asset? {8 yrs>75% of 8 yrs} 4 Is the present value of the minimum lease payments equal to or greater than 90% of the YES fair value of the asset? {$645,526^a>90% of $645,526}^a See calculation below.

The lessee’s incremental borrowing rate (11%) is more than the lessor’s implicit rate (10%). So, both parties’ calculations should be made using a 10% discount rate:

Present value of minimum lease payments ($110,000 x 5.86842^**) $645,526

^** present value of an annuity due of $1: n=8, i=10%

Problem 15-18 (continued)

(a) Since at least one (two in this case) classification criterion and both additional lessor conditions are met, this is a capital lease to the lessor (Bidwell Leasing). Since the fair value is the lessor’s cost, there is no dealer’s profit, making this a direct financing lease:

(b) Since at least one (two in this case) criterion is met, this is a capital lease to the lessee. Red Baron records the present value of minimum lease payments as a leased asset and a lease liability.

Requirement 2

January 1, 2011

Red Baron Flying Club (Lessee) Leased equipment (calculated above) 645,526 Lease payable (calculated above) 645,526 Lease payable 110,000 Cash(lease payment) 110,000 Bidwell Leasing (Lessor) Lease receivable (calculated above) 645,526

Inventory of equipment (lessor’s cost) 645,526 Lease receivable 18,099 Cash (initial direct costs) 18,099 Cash(lease payment) 110,000 Lease receivable 110,000

Problem 15-18 (continued)

Requirement 3

Lease Amortization Schedule

Effective Decrease Outstanding Payments Interest in Balance Balance 10% x Outstanding Balance

645,526

1/1/11 110,000 110,000 535,526

12/31/11 110,000 .10 (535,526) = 53,553 56,447 479,079

12/31/12 110,000 .10 (479,079) = 47,908 62,092 416,987

12/31/13 110,000 .10 (416,987) = 41,699 68,301 348,686

12/31/14 110,000 .10 (348,686) = 34,869 75,131 273,555

12/31/15 110,000 .10 (273,555 = 27,356 82,644 190,911

12/31/16 110,000 .10 (190,911) = 19,089* 90,911 100,000

12/31/17 110,000 .10 (100,000) = 10,000 100,000 0

880,000 234,474 645,526

* adjusted for rounding of other numbers in the schedule

Requirement 4

With the initial direct costs, the lease payments are the same, but the net investment is higher: $645,526 + 18,099 = $663,625. The new effective rate is the discount rate that equates the net investment and the future lease payments:

$663,625 ÷ ?^** = $110,000

lessor’s lease investment payments

^** present value of an annuity due of $1: n=8, i=?

Rearranging algebraically we find that the present value table value is $663,625 ÷ $110,000 = 6.03295. When you consult the present value table, you search row 8 (n=8) for this value and find it in the 9% column. So the effective interest rate has declined from 10% to 9%.

The net investment is amortized at the 9% rate.

Problem 15-18 (continued)

Requirement 5