ISB FADM 2021

Practice Set 8: Liabilities – Part 1

QUESTION 1

SOLUTION

To comply with the sinking fund provision, Ozona must have $125 million in the sinking fund
in 10 years. The annual sinking fund payment required is $9,938,072. Excel formula: =
PMT(5%,10,0,125000000,0).
QUESTION 2

SOLUTION

a. The annual mortgage payment is $530,671. Excel formula: = PMT(5.5%,10,4000000,0)

b.
Interest Annual Principal Balance
Year at 5.5% Payment Reduction Owing

0 4,000,000
1 220,000 530,671 310,671 3,689,329
2 202,913 530,671 327,758 3,361,571
3 184,886 530,671 345,785 3,015,787
4 165,868 530,671 364,803 2,650,984
5 145,804 530,671 384,867 2,266,117
6 124,636 530,671 406,035 1,860,082
7 102,305 530,671 428,366 1,431,716
8 78,744 530,671 451,927 979,789
9 53,888 530,671 476,783 503,007
10 27,665 530,671 503,006 0

c. At the end of year 1, the balance sheet will show $ 327,758 as the current portion of long-
term debt, which is the amount of the principal reduction in year 2 (from the amortization
table).
 QUESTION 3

SOLUTION

a. The annual mortgage payment is $1,415,894. Excel formula: = PMT(7%,20,15000000,0)

b.
Balance Sheet Income Statement

Cash Noncash Liabil- Contrib. Earned Rev- Expen- Net

Transaction + = + + – =
Asset Assets ities Capital Capital enues ses Income
Cash 15,000,000
LTD 15,000,000

Cash
15,000,000
Record 15,000,000
mortgage 15,000,000 = Long-term – =
proceeds debt
LTD
15,000,000

c.
IE 1,050,000
LTD 365,894
Cash 1,415,894

IE
1,050,000
Pay 1st year -365,894 -1,050,000 +1,050,000
LTD mortgage -1,415,894 = Long-term Retained – Interest = -1,050,000
365,894 payment debt Earnings expense

Cash
1,415,894

IE 1,024,387
LTD 391,507
Cash 1,415,894

IE
1,024,387
Pay 2nd year -391,507 -1,024,387 +1,024,387
LTD mortgage -1,415,894 = Long-term Retained – Interest = -1,024,387
391,507 payment debt Earnings expense

Cash
1,415,894
QUESTION 4

SOLUTION

a. The leased asset is office space and with a lease term of 5 years, the value of the leased
asset is not being conveyed to CCH. Therefore this is an operating lease (consistent with
most leases for office, retail, or production space).

b. We can use Excel and the PV function to determine that the present value of the future
lease payments as follows: =PV(5%,5,115,487,0,0) = $500,000.

c. CCH Corporation will add $510,000 to the balance sheet as a right-of-use asset. This
includes the $500,000 present value of future lease payments along with the $10,000 up
front fees paid at the lease inception.

d. The lease amortization schedule follows:

e.
Implicit Interest Lease Amortization Lease Liability, End
Lease Liability, (Lease Liability, (Lease payment – (Lease Liability, Start –
Year Start Start x 5%) Implicit interest) Lease Amortization)
1 500,000 25,000 90,487 409,513
2 409,513 20,476 95,012 314,501
3 314,501 15,725 99,762 214,738
4 214,738 10,737 104,750 109,988
5 109,988 5,499 109,988 ―
 f. The financial statement effects template shows the transactions for the first two years.

Balance Sheet Income Statement

Cash Noncash Liabil- Contrib. Earned Rev- Expen- Net

Transaction + = + + – =
Asset Assets ities Capital Capital enues ses Income
ROU 510,000
510,000 500,000
LL 500,000 Record lease - 10,000 Right-of- = Lease
Cash 10,000 at inception Cash use asset Liability

RE 117,487
Year 1 lease
LL 90,487 -92,487 -90,487 -117,487 117,487
payment and - 115,487
Cash 115,487 Right-of- = Lease Retained Rent -117,487
lease Cash
ROU 92,487 use asset Liability Earnings Expense
amortization
RE 117,487
Year 2 lease
LL 95,012 -97,012 -95,012 -117,487 117,487
payment and - 115,487
Cash 115,487 Right-of- = Lease Retained Rent -117,487
lease Cash
ROU 97,012 use asset Liability Earnings Expense
amortization

g. The table below presents future lease payments.

December 2020
2021 $ 115,487
2022 115,487
2023 115,487
2024 115,487
2025 -
Thereafter -
Total undiscounted lease payments 461,948
Imputed interest (52,437)
Total operating lease liability $409,511

Weighted average remaining lease life 4 years

Weighted average discount rate 5%

h. To enhance comparability we could reclassify the rent expense of $117,487 as interest

expense (from the amounts in the lease amortization table, in part d, above) and
amortization of the ROU asset (the principal portion from the lease amortization table
above PLUS the upfront fee of $10,000 divided by the lease term of 5 years.) These are
the amounts shown for the first two years, in part e, above.
QUESTION 5

SOLUTION

a. The first leased asset is land that the company will convert to an RV park. The lease term
is 15 years, the value of the leased asset is not being conveyed to Alexander Mack
because land lasts longer than 15 years. Therefore, this is an operating lease (consistent
with most leases for office, retail, or production space).

The second lease is computer equipment and two facts indicate that this is a finance
lease: 1) the lease term of 4 years will cover the bulk of the computer equipment’s life
and 2) the bargain purchase option at the end of the lease term.

b. We can use Excel and the PV function to determine that the present value of the future
lease payments for both leases. This will represent the amount of lease liability that
Alexander Mack will add to its balance sheet. The formulas are as follows:

Operating lease =PV(9%,15,-500,000,0,0) = $4,030,344

Finance lease = PV(9%,4,-24,694,0,0) = $80,000

c. Operating lease: Alexander Mack will add $4,480,344 to the balance sheet as a right-of-
use asset. This includes the $4,030,344 present value of future lease payments (above)
along with the $450,000 up front fees paid at the lease inception.

Finance lease: the company will add $85,000 to the balance sheet as PPE. This includes
the $80,000 present value of future lease payments and the $5,000 upfront fees at the
inception of the lease.
d. The operating lease amortization schedule follows:

Implicit Interest Lease Amortization Lease Liability, End

Lease Liability, (Lease Liability, (Lease payment – (Lease Liability, Start –
Year Start Start x 9%) Implicit interest) Lease Amortization)
1 4,030,344 362,731 137,269 3,893,075
2 3,893,075 350,377 149,623 3,743,452
3 3,743,452 336,911 163,089 3,580,363
4 3,580,363 322,233 177,767 3,402,595
5 3,402,595 306,234 193,766 3,208,829
6 3,208,829 288,795 211,205 2,997,623
7 2,997,623 269,786 230,214 2,767,410
8 2,767,410 249,067 250,933 2,516,476
9 2,516,476 226,483 273,517 2,242,959
10 2,242,959 201,866 298,134 1,944,826
11 1,944,826 175,034 324,966 1,619,860
12 1,619,860 145,787 354,213 1,265,647
13 1,265,647 113,908 386,092 879,556
14 879,556 79,160 420,840 458,716
15 458,716 41,284 458,716 0

The finance lease amortization schedule follows:

Implicit Interest Lease Amortization Lease Liability, End

Lease Liability, (Lease Liability, (Lease payment – (Lease Liability, Start –
Year Start Start x 9%) Implicit interest) Lease Amortization)
1 80,000 7,200 17,493 62,507
2 62,507 5,626 19,068 43,439
3 43,439 3,909 20,784 22,655
4 22,655 2,039 22,655 ―

e. The operating lease for land will create a rent expense for the lease payment of $500,000
plus $30,000 per year (the upfront cost of $450,000 divided by the lease term of 15 years).
The total rent expense each period will be $530.000.

f. The finance lease for the equipment will create interest expense of $7,200 (from the
amortization table above) and straight-line depreciation of $21,250 (= $85,000/4) on the
PPE asset, for a total expense of $28,450. The expense will decrease over time because
the interest declines each year.
g. At the end of 2020, the company would make the following disclosure:

At the end of the fiscal year, remaining operating lease payments were as following:

December 2020
2021 $ 500,000
2022 500,000
2023 500,000
2024 500,000
2025 500,000
Thereafter 4,500,000
Total undiscounted lease payments 7,000,000
Imputed interest (3,106,925)
Total operating lease liability $3,893,075

Weighted average remaining lease life 14 years

Weighted average discount rate 9%

h. The ROU asset and lease liability would have the following balances at the end of 2021:

Operating lease:
Asset = $4,133,452 calculated as $4,480,344 less two years of principal
payments ($137,269 and $149,623 from the table in part d., above) and less two
years of amortization of the up-front costs ($450,000 × 2/15).
Liability = $3,743,452 per the table in part d.

Finance lease:
Asset = $85,000 – 2 × $21,250 = $42,500.
Liability = $43,439 per the table in part d.

i. To enhance comparability, we could convert the operating leases to be equivalent on the

income statement to the finance lease. We would replace the rent expense of $530,000
with interest expense (from the amounts in the lease amortization table, in part d, above)
and SL amortization of the ROU asset ($4,480,344/15).