Question

Alt Corporation enters into an agreement with Yates Rentals Co. on January 1, 2011 for the purpose of leasing a machine to be used in its manufacturing operations. The following data pertain to the agreement:
(a) The term of the noncancelable lease is 3 years with no renewal option. Payments of $155,213 are due on December 31 of each year.
(b) The fair value of the machine on January 1, 2011, is $400,000. The machine has a remaining economic life of 10 years, with no salvage value. The machine reverts to the lessor upon the termination of the lease.
(c) Alt depreciates all machinery it owns on a straight-line basis.
(d) Alt's incremental borrowing rate is 10% per year. Alt does not have knowledge of the 8% implicit rate used by Yates.
(e) Immediately after signing the lease, Yates finds out that Alt Corp. is the defendant in a suit which is sufficiently material to make collectibility of future lease payments doubtful.

Question: 1.what is the amount of the reduction in the lease liability for Alt Corp in the second full year of the lease if Alt Corp accounts for the lease as a finance lease.

2.If the leased machine has a $350,000 cost to Yates, the profit Yates get from the lease should be ?

Answer 1

1. The second-year lease liability reduction is $126,734. Calculations are given below.

The initial entry passed by Alt Corp. is..

Leased Asset $400,000

Lease Liability $400,000

As the payment due end of the year, first-year interest expense will be $40,000($400,000*10%) and the lease liability reduction will be $115,213 ($155,213-$40,000).

First-year lease liability balance will be $284,787($400,000-$115,213)

Second-year interest will be calculated on the first year lease liability balance.

Year 2 interest is $28,478($284,787*10%) and the lease liability reduction is $126,734($155,213-$28,478)

2. Profit from the lease should be $50,000.

If the cost and FV are different then the lease accounted as Sales-type lease and the profit recognized initially. Initial entries passed by Yates are given below.

Lease receivable $465,639 ($155,213*3)

Unearned Revenue $65,639

Sales $400,000

Cost of goods sold $350,000

Asset $350,000

The above entry recognizes the profit at inception.