Question

Winston Industries and Ewing SA enter into an agreement that requires Ewing 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 non-cancellable, becomes effective on January 1, 2019, and requires equal annual rental payments each January 1, starting January 1, 2019.

Winston’s incremental borrowing rate is 8%. The implicit interest rate used by Ewing is 6% and unknown to Winston. The total cost of building the three engines is $2,600,000. The fair value of the three engines is $3,000,000. The economic life of the engines is estimated to be 12 years, with the residual value set at zero. Winston depreciates similar equipment on a straight-line basis. At the end of the lease, Winston assumes title to the engines. Collectability of the lease payments is probable.

Required: (Round all amounts to the nearest dollar.)

(a) Discuss the nature of this lease agreement to the lessor.

(b) Compute the amount of the annual rental payment required.

(c) Compute the amount of the lease liability to the lessee.

Answer 1

Answer-a:

The lease is a non-cancellable lease and the collectibility of the payment is reasonably certain.

Hence, it is a capital lease to Ewing (lessor).

Additionaly, the fair value of the asset i.e $3,000,000 exceeds the cost to the lessor i.e. $2,600,000, it is a sale-type lease.

Answer-b:

Amount to be recovered (fair value)	$      3,000,000
PV factor of annuity due at 8% for 9 years,
payments beginning at the beginning of the year
(1 + 6.74415)	7.74415
Annual rental payments	$         387,389

Answer-c:

Lease liability = $3,000,000