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Question: Lessee-Lessor Entries, Sales-Type Lease) Glaus Leasing Company agrees to lease machinery to Jensen Corporation on January 1, 2017. The following information relates to the lease agreement.

1. The term of the lease is 7 years with no renewal option, and the machinery has an estimated economic life of 9 years.
2. The cost of the machinery is \(525,000, and the fair value of the asset on January 1, 2017, is \)700,000.
3. At the end of the lease term, the asset reverts to the lessor and has a guaranteed residual value of $100,000. Jensen depreciates all of its equipment on a straight-line basis.
4. The lease agreement requires equal annual rental payments, beginning on January 1, 2017.
5. The collectibility of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the amount of costs yet to be incurred by the lessor. 6. Glaus desires a 10% rate of return on its investments. Jensen’s incremental borrowing rate is 11%, and the lessor’s implicit rate is unknown.

Instructions

(Assume the accounting period ends on December 31.)

(d) Prepare the journal entries Jensen would make in 2017 and 2018 related to the lease arrangement.

Step by step solution

01

Meaning of Lease arrangements

Lease agreements have a bargaining option. Lease payments are typically estimated as collectibles, and there is no significant uncertainty about the lessor’s future expenses. As a result, from the lessor's perspective, the lease qualifies as a capital lease.

02

Preparing Journal Entries

Date	Particular	Debit ($)	Credit ($)
Jan.1, 2017	Leased Equipment	681,741
	Lease Liability		681,741
Jan.1, 2017	Lease Liability	121,130
	Cash		121,130
Dec.31, 2017	Depreciation Expense	61,667
	Accumulated Depreciation Capital Leases		61,667
Dec.31, 2017	Interest Expense
	Interest Payable
Jan. 1, 2018	Lease Liability	59,463
	Interest Payable	61,667
	Cash		121,130
Dec.31, 2018	Depreciation Expense	83,106
	Accumulated Depreciation Capital Leases		83,106
Dec.31, 2018	Interest Expense	55,126
	Interest Payable		55,126

$$\begin{gathered} WorkingNotes: \\ Calculationofcapitallease \\ capitallease=\frac{Presentvalueofminimumleasepayments-residualvalue}{Termoflease} \\ =\frac{\$681,741-\$100,000}{7} \\ =\frac{\$581,741}{7} \\ =\$83,016 \\ CalculationofInterestPayable \\ Interrestpayable=\left(Presentvalueofminimumlease-leaseliability\right)×incrementalborrowingrate \\ =\left(\$681,741-\$100,000\right)×11\% \\ =\$560,611×\frac{11}{100} \\ =\$61,667 \\ CalculationofInterestpayableonDec.31,2018 \\ Interestpayable=\left(Presentvalueofminimumlease-leaseliability\right)×incrementalborrowingrate \\ =\left(\$681,741-\$121,130-\$59,463\right)×11\% \\ =\$501,148×\frac{11}{100} \\ =\$55,126 \end{gathered}$$

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