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Chapter 21: Q21-2E-a (page 1241)

Question: (Lessee Computations and Entries; Capital Lease with Guaranteed Residual Value) Pat Delaney Company leases an automobile with a fair value of \(8,725 from John Simon Motors, Inc., on the following terms:

  1. Noncancelable term of 50 months.
  2. Rental of \)200 per month (at end of each month). (The present value at 1% per month is \(7,840.)
  3. Estimated residual value after 50 months is \)1,180. (The present value at 1% per month is \(715.) Delaney Company guarantees the residual value of \)1,180.
  4. Estimated economic life of the automobile is 60 months.
  5. Delaney Company鈥檚 incremental borrowing rate is 12% a year (1% a month). Simon鈥檚 implicit rate is unknown.

Instructions

a. What is the nature of this lease to Delaney Company?

Short Answer

Expert verified

Answer

The present value of the lease exceeds 90% of the fair value

Step by step solution

01

Meaning of Lease

In exchange for one or more payments, a lessor agrees to allow a lessee to have authority over the use of specific property, plant, and equipment for a specified length of time. Depending on whether an entity is a lessee or the lessor, there are different sorts of lease designations. Following that, we'll go over these terms.

02

Explaining the nature of the lease to Delaney Company

This lease is a capital lease to Delaney because the terms meet the following criteria:

  1. The term of the lease exceeds 75% of the economic life of the leased asset, i.e., the term of the lease is 831/3%percent (50/60) of the economic life of the asset.
  2. The present value of the minimum lease payment exceeds 90% of the fair value of the leased asset; For example, the present value of $8,555 is over 90% of the leased property's fair value.

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Most popular questions from this chapter

(Accounting for an Operating Lease) On January 1, 2017, a machine was purchased for \(900,000 by Young Co. The machine is expected to have an 8-year life with no salvage value. It is to be depreciated on a straight-line basis. The machine was leased to St. Leger Inc. on January 1, 2017, at an annual rental of \)210,000. Other relevant information is as follows.

  1. The lease term is for 3 years.
  2. Young Co. incurred maintenance and other executory costs of \(25,000 in 2017 related to this lease.
  3. The machine could have been sold by Young Co. for \)940,000 instead of leasing it.
  4. St. Leger is required to pay a rent security deposit of \(35,000 and to prepay the last month鈥檚 rent of \)17,500.

Instructions

(b) What amount should St. Leger Inc. report for rent expenses for 2017 on this lease?

Question: (Balance Sheet and Income Statement Disclosure鈥擫essee) The following facts pertain to a noncancelable lease agreement between Alschuler Leasing Company and McKee Electronics, a lessee, for a computer system.

Inception date

October 1, 2017

Lease term

6 years

Economic life of leased equipment

6 years

Fair value of asset at October 1, 2017

\(300,383

Residual value at end of lease term

鈥�0鈥�

Lessor鈥檚 implicit rate

10%

Lessee鈥檚 incremental borrowing rate

10%

Annual lease payment due at the beginning of each year, beginning with October 1, 2017

\)62,700

The collectibility of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. The lessee assumes responsibility for all executory costs, which amount to \(5,500 per year and are to be paid each October 1, beginning October 1, 2017. (This \)5,500 is not included in the rental payment of \(62,700.) The asset will revert to the lessor at the end of the lease term. The straight-line depreciation method is used for all equipment.

The following amortization schedule has been prepared correctly for use by both the lessor and the lessee in accounting for this lease. The lease is to be accounted for properly as a capital lease by the lessee and as a direct-financing lease by the lessor.

Date

Annual lease payments/Receipt

Interest (10%)

On Unpaid liability/Receivable

Reduction of Lease Liability?

Receivable

Balance of Lease Liability/Receivable

10/01/17

\)300,383

10/01/17

\(62,700

\)62,700

237,683

10/01/18

\(62,700

\)23,768

38,932

198,751

10/01/19

\(62,700

19,875

42,825

155,926

10/01/20

\)62,700

15,593

47,107

108,819

10/01/21

\(62,700

10,882

51,818

57,001

10/01/22

\)62,700

5,699*

57,001

0

\(376,200

\)75,817

\(300,383

*Rounding error is \)1.

Instructions

(a) Assuming the lessee鈥檚 accounting period ends on September 30, answer the following questions with respect to this lease agreement.


(4) What items and amounts will appear on the lessee鈥檚 balance sheet at September 30, 2019?

(Operating Lease vs. Capital Lease) You are auditing the December 31, 2017, financial statements of Hockney, Inc., manufacturer of novelties and party favors. During your inspection of the company garage, you discovered that a used automobile not listed in the equipment subsidiary ledger is parked there. You ask Stacy Reeder, plant manager, about the vehicle, and she tells you that the company did not list the automobile because the company was only leasing it. The lease agreement was entered into on January 1, 2017, with Crown New and Used Cars.

You decide to review the lease agreement to ensure that the lease should be afforded operating lease treatment, and you discover the following lease terms.

  1. Noncancelable term of 4 years.
  2. 2. Rental of \(3,240 per year (at the end of each year). (The present value at 8% per year is \)10,731.)
  3. 3. Estimated residual value after 4 years is \(1,100. (The present value at 8% per year is \)809.) Hockney guarantees the residual value of $1,100.
  4. 4. Estimated economic life of the automobile is 5 years.
  5. 5. Hockney鈥檚 incremental borrowing rate is 8% per year.

Instructions

You are a senior auditor writing a memo to your supervisor, the audit partner in charge of this audit, to discuss the above situation. Be sure to include (a) why you inspected the lease agreement, (b) what you determined about the lease, and (c) how you advised your client to account for this lease. Explain every journal entry that you believe is necessary to record this lease properly on the client鈥檚 books. (It is also necessary to include the fact that you communicated this information to your client.)

(Type of Lease; Amortization Schedule) Mike Macinski Leasing Company leases a new machine that has a cost and fair value of $95,000 to Sharrer Corporation on a 3-year noncancelable contract. Sharrer Corporation agrees to assume all risks of normal ownership including such costs as insurance, taxes, and maintenance. The machine has a 3-year useful life and no residual value. The lease was signed on January 1, 2017. Mike Macinski Leasing Company expects to earn a 9% return on its investment. The annual rentals are payable on each December 31.

Instructions

(b) Prepare an amortization schedule that would be suitable for both the lessor and the lessee and that covers all the years involved.

The following are four independent situations.

On December 31, 2017, Wasicsko Co. sold a machine to Cross Co. and simultaneously leased it back for one year. The sales price of the machine was \(480,000, the carrying amount is \)420,000, and it had an estimated remaining useful life of 14 years. The present value of the rental payments for the one year is $35,000. At December 31, 2017, how much should Wasicsko report as deferred revenue from the sale of the machine?
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