Chapter 20, Problem 2P

1.

To determine

Identify the type of the lease between Company A and Company S and give the reasons for such classification.

Explanation of Solution

Lease: Lease is a contractual agreement whereby the right to use an asset for a particular period of time is provided by the owner of the asset to the user of the asset. The owner, who possesses the asset, is termed as ‘Lessor’ and user, to whom the right is transferred to, is termed as ‘Lessee’.

Identify the type of the lease between Company A and Company S:

Criteria	Met or not	Remarks
1. Transfer of ownership at the end of lease	No
2. Bargain purchase option	No
3. Lease term is 75% or more	No	50%(5 years/10 years)
4. Present value of lease payment is 90% or more of the fair value	No	PV 88% of fair value

Table (1)

In the given case, the lease is a operating lease for both companies A and S.

Reason: none of the criteria are met by the lease agreement.

Working note 1: Compute the present value of the lease payments:

$\begin{array}{c}\text{PV= }\left(\begin{array}{l}\text{Yearly lease payments}\\ -\text{Executory costs }\end{array}\right)\times \text{PV}\text{}\text{ factor of 5 payments in advance at 12\%}\\ \text{= }\left(\$70,000-\$3,450\right)\times 4.037349\\ =\text{ \$268,685}\text{.58}\end{array}$

Present value of the lease payment is $268,685.58 which is 88% of the fair value.

2.

To determine

Prepare the appropriate journal entries in the books of the lessor and lessee companies for the year 2016.

Explanation of Solution

Journal: Journal is the method of recording monetary business transactions in chronological order. It records the debit and credit aspects of each transaction to abide by the double-entry system.

Rules of Debit and Credit: Following rules are followed for debiting and crediting different accounts while they occur in business transactions:

• Debit, all increase in assets, expenses and dividends, all decrease in liabilities, revenues and stockholders’ equities.
• Credit, all increase in liabilities, revenues, and stockholders’ equities, all decrease in assets, expenses.

Prepare the appropriate journal entries in the books of the lessor company for the year 2016:

Company A (Lessee):

Date	Accounts title and explanation	Post Ref.	Debit($)	Credit($)
January 2016	Rent Expense		70,000
	Cash			70,000
	(To record the payment of operating lease payment)

Table (1)

Company S (lessor):

Prepare the appropriate journal entries in the books of the lessee company for the year 2016:

Date	Accounts title and explanation	Post Ref.	Debit($)	Credit($)
January 2016	Cash		70,000
	Rental Revenue			70,000
	(To record the receipt of operating lease payment)
During the year	Property Tax Expense		650
	Maintenance Expense		1,600
	Insurance Expense		1,200
	Cash			3,450
	(To record the payment of executory costs)
December 31,2016	Depreciation Expense: Equipment		30,000
	Accumulated Depreciation: Equipment $\left[\left(\$305,000-\$5,000\right)/10\right]$			30,000
	(To record the depreciation expense)

Table (2)

3.

To determine

Identify the type of lease in the event of the residual value at the end of 5 years lease period is guaranteed by the Company A, the lessee and. Prepare journal entry for the lessee and the lessor for 2016, 2017, and when the lessee pays the guaranteed residual value.

Explanation of Solution

Identify the type of lease in the event of the residual value at the end of 5 years lease period is guaranteed by the Company A, the lessee:

Criteria	Met or not	Remarks
1. Transfer of ownership at the end of lease	No
2. Bargain purchase option	No
3. Lease term is 75% or more	No	50%(5 years/10 years)
4. Present value of lease payment is 90% or more of the fair value	Yes	PV of $305,000 is 100% of the  fair value

Table (3)

The lease is classified as capital lease because of the following reasons:

• The lessee company would classify the lease as capital lease as at least one of the capitalization criteria is met.
• On the other hand the lessor company would classify this as direct financing lease since, (1) one of the capitalization criteria is met,(2) both the recognition criteria are met, and (3) there is no dealer’s profit involved(fair value/cost of the asset is equal to present value of the minimum lease payments).

Working note 2: Compute the present value of the lease payments:

$\begin{array}{c}\text{PV }=\left(\begin{array}{c}\left(\text{Yearly lease payments}-\text{Executory costs}\right)\\ \times \text{PV}\text{}\text{factor of 5 payments in advance at 12\%}\\ \text{+ PV of guranteed residual value}\end{array}\right)\\ =\left(\$70,000-\$3,450\right)\times 4.037349+\left(\$64,000\times 0.567427\right)\\ =\$268,685.57+\$36,315.33\\ =\text{ \$305,000}\left(\text{rounded}\right)\end{array}$

Present value of the lease payment is $305,000 or 100% of the fair value.

Prepare journal entry for the lessee and the lessor for 2016, 2017, and when the lessee pays the guaranteed residual value:

Company A (Lessee):

Date	Accounts title and explanation	Post Ref.	Debit($)	Credit($)
January 01, 2016	Leased Equipment		305,000.00
	Capital Lease Obligation			305,000.00
	(To record the capital lease at inception)
January 01, 2016	Executory Expense		3,450.00
	Capital Lease Obligation		66,550.00
	Cash			70,000.00
	(To record the payment of the executory costs and the lease obligation)
December 31,2016	Depreciation Expense: Leased Equipment		48,200.00
	Accumulated Depreciation: Equipment $\left[\left(\$305,000-\$64,000\right)/5\right]$			48,200.00
	(To record the depreciation expense)
December 31,2016	Interest Expense $\left(\left[\$305,000-\$66,550\right]\times 12\%\right)$		28,614.00
	Accrued Interest on Capital Lease Obligation			28,614.00
	(To record the interest expense)
January 01, 2017	Executory Costs Expense		3,450.00
	Accrued Interest on Capital Lease Obligation		28,614.00
	Capital Lease Obligation		37,936.00
	Cash			70,000.00
	(To record the payment of the executory costs and the lease obligation)
December 31,2017	Depreciation Expense: Leased Equipment		48,200.00
	Accumulated Depreciation: Equipment			48,200.00
	(To record the depreciation expense)
December 31,2016	Interest Expense $\left(\left[\$305,000-\$66,550-\$37,936\right]\times 12\%\right)$		24,061.68
	Accrued Interest on Capital Lease Obligation			24,061.68
	(To record the interest expense)
December 31,2020	Capital Lease Obligation		64,000.00
	Cash			64,000.00
	(To record the payment of final lease obligation)

Table (4)

Company S (Lessor):

Date	Accounts title and explanation	Post Ref.	Debit($)	Credit($)
January 01,2016	Equipment Leased to Others		305,000.00
	Cash			305,000.00
	(To record the payment of capital lease at inception)
January 01, 2016	Lease Receivable $\left[\left(\$66,500\times 5\right)+\$64,000\right]$		396,750.00
	Equipment Leased to Others			305,000.00
	Unearned Interest: Leases			91,750.00
	(To record the lease receivable in a capital lease)
January 01, 2016	Cash		70,000.00
	Property Tax Payable			650.00
	Maintenance Expense Payable			1,600.00
	Insurance Expense Payable			1,200.00
	Lease Receivable			66,550.00
	(To record the receipt for executory costs)
During 2016	Property Tax Payable		650.00
	Maintenance Expense Payable		1,600.00
	Insurance Expense Payable		1,200.00
	Cash			3,450.00
	(To record the payment of executory costs)
December 31,2016	Unearned Interest: Leases		28,614.00
	Interest Revenue: Leases			28,614.00
	(To recognize the interest revenue of the year)
January 01, 2017	Cash		70,000.00
	Property Tax Payable			650.00
	Maintenance Expense Payable			1,600.00
	Insurance Expense Payable			1,200.00
	Lease Receivable			66,550.00
	(To record the receipt for executory costs)
During 2017	Property Tax Payable		650.00
	Maintenance Expense Payable		1,600.00
	Insurance Expense Payable		1,200.00
	Cash			3,450.00
	(To record the payment of executory costs)
December 31,2017	Unearned Interest: Leases		24,061.68
	Interest Revenue: Leases			24,061.68
	(To recognize the interest revenue of the year)
January 01, 2020	Cash		64,000.00
	Lease Receivable			64,000.00
	(To record the receipt of final lease payment )

Table (5)