Question

Winston Industries and Ewing Inc. enter into an agreement that requires Ewing Inc. 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 noncancelable, becomes effective on January 1, 2017, and requires annual rental payments of \(413,971 each January 1, starting January 1, 2017.

Winston’s incremental borrowing rate is 10%. The implicit interest rate used by Ewing Inc. and known to Winston is 8%. The total cost of building the three engines is \)2,600,000. The economic life of the engines is estimated to be 10 years, with 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. Collectibility of the lease payments is reasonably certain; no uncertainties exist relative to unreimbursable lessor costs.

Instructions

(a) Discuss the nature of this lease transaction from the viewpoints of both lessee and lessor.

Short answer

Present value of lease payments is $3,000,000

Dealers’ Profit is $400,000

Step-by-step solution

Meaning of Lease

A lease is a legally binding contract between a lessor and a lessee. The lessee has been given the right to use certain property owned by the lessee for the period specified under this agreement. The lessee pays the lessee rent payments over the term of the lease in exchange for the use of the asset.

Explaining the nature of this lease transaction from the viewpoints of both lessee and lessor

Winston Industries should approach leasing as a capital lease, requiring the lessee to capitalize the leased asset. Since

1. The ownership of the engine is transferred to the lessee,
2. The term of the lease is equal to the expected life of the asset, and
3. 3) The present value of the minimum lease payment exceeds 90% of the fair value of the lease and is eligible for capital lease accounting by the lessee. The transaction signifies a paid purchase at establishments over a ten-year period.

Since a manufacturer’s profit accrues to Ewing Inc., this arrangement is a sale-type lease. This leasing agreement also indicates the financing of the producer of the transaction over a period of 10 years.

Calculation of Present Value of Lease Payments

$\begin{array}{rcl}\mathrm{Present}\mathrm{value}\mathrm{of}\mathrm{lease}\mathrm{payments}& =& \mathrm{Annual}\mathrm{rental}\times \mathrm{Present}\mathrm{value}\mathrm{of}\mathrm{annuity}\\ & =& \$413,917\times 7.24689\\ & =& \$3,000,000\end{array}$

Note: Present value of an annuity due at 8% for 10 years, rounded by $2.

Calculation of Dealer’s Profit:

Sales (present value of lease payments)	$3,000,000
Less cost of engines	2,600,000
Profit on sale	$ 400,000