Question

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Flounder Corporation leased equipment to Shamrock, Inc. on January 1, 2020. The lease agreement called for annual rental payments of $1,276 at the beginning of each year of the 3-year lease. The equipment has an economic useful life of 7 years, a fair value of $7,600, a book value of $5,600, and Flounder expects a residual value of $5,100 at the end of the lease term. Flounder set the lease payments with the intent of earning a 8% return, though Shamrock is unaware of the rate implicit in the lease and has an incremental borrowing rate of 10%. There is no bargain purchase option, ownership of the lease does not transfer at the end of the lease term, and the asset is not of a specialized nature.

What is the amount of the rental payments used in the lease agreement?

Prepare the entries for Flounder for 2020.

How would Flounder’s accounting in part a change if it incurred legal fees of $900 to execute the lease documents and $600 in advertising expenses for the year in connection with the lease?

Answer 1

Part A

Fair value of leased asset to lessor	7600
Less: Present value of unguaranteed residual value (5100*0.79383)	4049
Amount to be recovered through lease payments	3551
Periodic lease payments (3551/2.78326)	$1276
present value of 1 at 8% for 3 periods = 0.79383
Present value of annuity due of 1 for 3 periods at 8% = 2.78326

Part B

Date	General journal	Debit	Credit
January 1, 2020	Cash	1276
	Unearned Lease Revenue		1276
December 31, 2020	Unearned Lease Revenue	1276
	Lease Revenue		1276
	(to record the recognition of the revenue)
December 31, 2020	Depreciation Expense (5600/7)	800
	Accumulated depreciation – equipment		800

Part C

Date	General journal	Debit	Credit
January 1, 2020	Prepaid Legal Fees	900
	Cash		900
January 1, 2020	Advertising Expense	600
	Cash		600
	(to record the recognition of the revenue)
December 31, 2020	Legal Expense (900/3)	300
	Prepaid Legal Fees		300