Interstate Automobiles Corporation leased 40 vans to VIP Transport under a four-year noncancelable lease on January 1, 2011. Information concerning the lease and the vans follows:
a. Equal annual lease payments of $300,000 are due on January 1, 2011, and thereafter on December 31 each year. The first payment was made January 1, 2011. Interstate's implicit interest rate is 10% and known by VIP.
b. VIP has the option to purchase all of the vans at the end of the lease for a total of $290,000. The vans' estimated residual value is $300,000 at the end of the lease term and $50,000 at the end of 7 years, the estimated life of each van.
c. VIP estimates the fair value of the vans to be $1,240,000. Interstate's cost was $1,050,000.
d. VIP's incremental borrowing rate is 11%.
e. VIP will pay the executory costs (maintenance, insurance, and other fees not included in the annual lease payments) of $1,000 per year. The depreciation method is straight-line.
f. The collectibility of the lease payments is reasonably predictable, and there are no important cost uncertainties.
Your instructor will divide the class into two to six groups depending on the size of the class. The mission of your group is to assess the proper recording and reporting of the lease described.
Required:
1. Each group member should deliberate the situation independently and draft a tentative argument prior to the class session for which the case is assigned.
2. In class, each group will meet for 10 to 15 minutes in different areas of the classroom. During that meeting, group members will take turns sharing their suggestions for the purpose of arriving at a single group treatment.
3. After the allotted time, a spokesperson for each group (selected during the group meetings) will share the group's solution with the class. The goal of the class is to incorporate the views of each group into a consensus approach to the situation.
Specifically, you should address:
a. Identify potential advantages to VIP of leasing the vans rather than purchasing them.
b. How should the lease be classified by VIP? by Interstate?
c. Regardless of your response to previous requirements, suppose VIP recorded the lease on January 1, 2011, as a capital lease in the amount of $1,100,000. What would be the appropriate journal entries related to the capital lease for the second lease payment on December 31, 2011?