Lease Liability Balance Question

CFA Level I
#1

Kachelmeyer, Inc., signs an agreement on 1 January 2005, to lease equipment from Henderson Company. The term of the lease is five years, and the estimated economic life of the asset is also five years. The agreement requires equal annual payments of $36,285.90, with the first payment on 1 January 2005. Kachelmeyer’s incremental borrowing rate is 12 percent. Henderson’s implicit rate is 10 percent and is known to Kachelmeyer. The prime rate is 8 percent. The balance in the capital lease (liability) account that will appear on the balance sheet of Kachelmeyer on 1 January 2005, after making the first lease payment will be: A) $137,552. B) $115,021. C) $151,307. D) $36,286. Your answer: A was incorrect. The correct answer was B) $115,021. As of 1 January 2005, after making the first lease payment, the balance in the liability account will be $151, 307 – $36,285 = $115,021 (difference due to rounding). ---------- Could someone help explain this? I though the liability was at inception the PV of the MLP just like the asset. However the asset diminishes as it is depreciated, and I thought that the liability diminishes with the part of the annual lease payment that is principal repayment not the entire annual lease payment. So in this case: 151307 x 0,10 = 15130,7 => interest so principal repayment is 36285 - 15130,7 = 21154,3 so balance in lease account would be = 151307 -21154,3 = 130152,7 I looked it up to be sure in the CFA books (volume 3 p 565) and I can’t see what I’m doing wrong. Also if the liabilities diminish with the full annual lease amounts won’t they zero out a lot earlier than the asset amount? If I’m not mistaken both are unequal during the life time but equal out at maturity. Any help would be appreciated

#2

i used 10% as the I/Y to compute the PV of the capital lease. that yields 115k as the balance after 1 payment. gotta rush to a meeting, will post full calculation once i’m back / if someone else posts one before me. could someone tell why they used 10% and not 8% as the lower of the borrowing rates? i know 12% is not supposed to be used.

#3
  1. 10% is being used (in answer to Niraj’s question) because that is the rate implied in the Lease. 2. ZXL, this lease is being paid in the beginning of period. So on Jan 1,2005 – you signed the lease for 151307 Made an immediate lease payment of 36,285.90 So lease balance is : 151307 - 36285.90 = 115021.1 Then over the year the 10% interest kicks in --> 11502.11
#4

Thanks cpk, stupid oversight. Hope I don’t get tricked too much by overlooking items in the question.

#5

I got 115k also. Here’s an amortization table if it helps clarify. Yr_____Open Balance_____Interest (10%)_____Prin_____Payment_____Close Bal 0_____137552__________13755____________22531___36286_______115021 1_____115021__________11502____________24784___36286_______90238 2_____90238___________9024_____________27262___36286_______62976 3_____62976___________6298_____________29988___36286_______32987 4_____32987___________3299_____________32987___36286_______0

#6

thanks cpk i understand now.

#7

You’ve got to love the AMORT function…

#8

AMORT? Bah, I don’t use that. It’s actually one of my little study tricks … any worksheets or examples I want to create, I do manually. Only in the last month did I stop doing bond calcs manually and start relying on my calc (since that’s what I’ll have). I’m not the sharpest knife in the drawer, so the looooooong way is helpful.

#9

What is incremental borrowing rate and implicit rate? In this case Kachelmeyer: Lesse Henderson Company: Lessor They gave implicit rate for Henderson Company and incremental borrowing rate for Kachelmeyer. Since lesse is calculating MLP of Lease, I would have used Kachelmeyer rate. Appreciate for any clarification

#10

It is always Lessee’s incremental borrowing rate or Implicit rate in the lease. In a Capital Lease – first lessee has to go Capital or Operating --> only after that the Lessor can decide which way to go. Lessee **** Lessor Capital Capital/Operating Operating Operating Lessor can go capital if a. Lessee is capital b. No uncertain payments c. Lease payments are reasonably guarenteed. So start is from Lessee ONLY!!!

#11

CPK, If Lessee goes capital and lessor goes operating, does it mean both will depreciate the same asset?

#12

smeet Wrote: ------------------------------------------------------- > CPK, > > If Lessee goes capital and lessor goes operating, > does it mean both will depreciate the same asset? Only Lessee depreciates since he is Capital.

#13

But since the lessor is recognizing something as an operating lease, shouldnt he be the one depreciating it .

#14

It states in the book When Lessor uses the Operating Lease method for accounting for the lease - the Periodic payments from the lease are simply reported as Rental Revenue on the Income statement. The lessor continues to account for the Leased asset as a fixed asset in the balance sheet (and his regular depreciation schedule would apply over there).

#15

Right, so it means that both the lessor and lessee will depreciate the asset, although he wont have a new class called Investment in Lease in Assets side.