On January 1, 2011, Lavery Corporation leased equipment to Flynn Corporation. Both Lavery and Flynn use private enterprise GAAP and have calendar year ends. The following information pertains to this lease.
1. The term of the non-cancellable lease is six years, with no renewal option. The equipment reverts to the lessor at the termination of the lease, at which time it is expected to have a residual value (not guaranteed) of $6,000. Flynn Corporation depreciates all its equipment on a straight-line basis.
2. Equal rental payments are due on January 1 of each year, beginning in 2011.
3. The equipment’s fair value on January 1, 2011, is $144,000 and its cost to Lavery is $111,000.
4. The equipment has an economic life of seven years.
5. Lavery set the annual rental to ensure a 9% rate of return. Flynn’s incremental borrowing rate is 10% and the lessor’s implicit rate is unknown to the lessee.
6. Collectibility of lease payments is reasonably predictable and there are no important uncertainties about any unreimbursable costs that have not yet been incurred by the lessor.
(a) Explain clearly why this lease is a capital lease to Flynn and a sales-type lease to Lavery.
(b) Using time value of money tables, a financial calculator, or computer spreadsheet functions, calculate the amount of the annual rental payment.
(c) Prepare all necessary journal entries for Flynn for 2011.
(d) Prepare all necessary journal entries for Lavery for 2011.
(e) Discuss the differences, if any, in the classification of the lease to Lavery Corporation (the lessor) or to Flynn Corporation (the lessee) if both were using IFRS in their financial reporting.