Types of Leases and Related Issues

Circuit Village Company entered into a lease arrangement with Thomas Leasing Company for a certain machine. Thomas’s primary business is leasing, and it is not a manufacturer or dealer. Circuit Village will lease the machine for a period of 4 years, which is 50% of the machine’s economic life. Thomas will take possession of the machine at the end of the initial 4-year lease and lease it to another smaller company that does not need the most current version of the machine. Circuit Village does not guarantee any residual value for the machine and will not purchase the machine at the end of the lease term. Circuit Village’s incremental borrowing rate is 16%, and the implicit rate on the lease is 14%. Circuit Village has no way of knowing or estimating the implicit rate used by Thomas. Using either rate, the present value of the minimum lease payments is between 90% and 100% of the fair value of the machine at the time of the lease agreement. Circuit Village has agreed to pay all executor costs directly, and no allowance for these costs is included in the lease payments. Thomas is reasonably certain that Circuit Village will pay all lease payments, and because it has agreed to pay all executory costs, there are no important uncertainties regarding costs to be incurred by Thomas.

Required:

1. With respect to Circuit Village (the lessee), answer the following:

1. a. What type of lease has been entered into? Explain the reason for your answer.
2. b. How should Circuit Village compute the appropriate amount to record for the lease or asset acquired?
3. c. What accounts will be created or affected by this transaction, and how will the lease or asset or other cost be matched with earnings?

2. With respect to Thomas (the lessor), answer the following:

1. a. What type of leasing arrangement has been entered into? Explain the reason for your answer.
2. b. How should this lease be recorded by Thomas, and how are the appropriate amounts determined?
3. c. How should Thomas determine the appropriate amount of earnings to be recognized from each lease payment?