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Chapter 21: Q21-8E-b (page 1242)

Question: (Lessee Entries with Bargain-Purchase Option) The following facts pertain to a noncancelable lease agreement between Mooney Leasing Company and Rode Company, a lessee.

Inception date

May 1, 2017

Annual lease payment due at the beginning

of each year, beginning with May 1, 2017

\(21,227.65

Bargain-purchase option price at end of lease term

\) 4,000.00

Lease term

5 years

Economic life of leased equipment

10 years

Lessor鈥檚 cost

\(65,000.00

Fair value of asset at May 1, 2017

\)91,000.00

Lessor鈥檚 implicit rate

10%

Lessee鈥檚 incremental borrowing rate

10%

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.

Instructions

(Round all numbers to the nearest cent.)

(b) Discuss the nature of this lease to Mooney Leasing Company.

Short Answer

Expert verified

Answer

The lease has a bargain purchase option.

Step by step solution

01

Meaning of Bargain Purchase Option (BPO)

A BPO offers the lessee the option to purchase the leased asset at a price that is much lower than the estimated fair value of the asset and appears relatively certain to exercise the option.

02

 Step 2: Discussing the nature of the lease

The lease agreement includes a bargain-buy option. Lease payments are generally estimated in terms of collectables, and there is no significant uncertainty about the lessor鈥檚 future expenses.

Consequently, from the lessor's point of view, the lease qualifies as a capital-type lease. The lease is classified as a sale-type lease because the initial amount of the lease receivable (net investment) (which equals the present value of the minimum lease payment, in this case, $91,000) exceeds the lessor鈥檚 cost ($65,000).

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Most popular questions from this chapter

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.

(b) Assuming the lessee鈥檚 accounting period ends on December 31, answer the following questions with respect to this lease agreement.

(2) What items and amounts will appear on the lessee鈥檚 balance sheet at December 31, 2017?

Describe the effect of a 鈥渂argain-purchase option鈥� on accounting for a capital lease transaction by a lessee.

Metheny Corporation鈥檚 lease arrangements qualify as sales-type leases at the time of entering into the transactions. How should the corporation recognize revenues and costs in these situations?

(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.)

Question: (Lessee Entries and Balance Sheet Presentation, Capital Lease) On January 1, 2017, Cage Company contracts to lease equipment for 5 years, agreeing to make a payment of \(137,899 (including the executory costs of \)6,000) at the beginning of each year, starting January 1, 2017. The taxes, the insurance, and the maintenance, estimated at \(6,000 a year, are the obligations of the lessee. The leased equipment is to be capitalized at \)550,000. The asset is to be depreciated on a double-declining-balance basis, and the obligation is to be reduced on an effective-interest basis. Cage鈥檚 incremental borrowing rate is 12%, and the implicit rate in the lease is 10%, which is known by Cage. Title to the equipment transfers to Cage when the lease expires. The asset has an estimated useful life of 5 years and no residual value.

Instructions

(c) Prepare the journal entry to record depreciation of the leased asset for the year 2017.
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