Question

Branif Leasing leases mechanical equipment to industrial consumers under sales-type leases that earn Branif a 10% rate of return for providing long-term financing. A lease agreement with Branson Construction specified 20 annual payments beginning December 31, 2021, the beginning of the lease. The estimated useful life of the leased equipment is 20 years with no residual value. Its cost to Branif was $936,492. The lease qualifies as a finance lease to Branson. Maintenance of the equipment was contracted for through a 20-year service agreement with Midway Service Company requiring 20 annual payments of $3,000 beginning December 31, 2021. Progressive Insurance Company charges Branif $3,000 annually for hazard insurance coverage on the equipment. Both companies use straight-line depreciation or amortization. (FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.)

Required:

Prepare the appropriate entries for both the lessee and lessor to record the second lease payment and depreciation on December 31, 2022, under each of three independent assumptions:

1. The lessee pays maintenance costs as incurred. The lessor pays insurance premiums as incurred. The lease agreement requires annual payments of $100,000.
2. The contract specifies that the lessor pays maintenance costs as incurred. The lessee’s lease payments were increased to $103,000 to include an amount sufficient to reimburse these costs.
3. The lessee’s lease payments of $103,000 included $3,000 for hazard insurance on the equipment rather than maintenance.

Answer 1

Requirement 1

Branson Construction (Lessee)
Interest expense (10% x [$936,492* – 100,000])..........................               83,649
Lease payable (difference)............................................................               16,351
     Cash (lease payment)................................................................                                    100,000

* $100,000 x 9.36492
** present value of an annuity due of $1: n=20, i=10%

Maintenance expense.....................................................................                 3,000
     Cash (2022 expenses as incurred).............................................                                        3,000

Amortization expense ($936,492 ÷ 20 years)................................               46,825
     Right-of-use asset.....................................................................                                      46,825

Branif Leasing (Lessor)
Cash (lease payment).....................................................................             100,000
     Lease receivable (difference)....................................................                                      16,351

     Interest revenue (10% x [$936,492* – 100,000]).....................                                      83,649

* $100,000 x 9.36492
** present value of an annuity due of $1: n=20, i=10%

Requirement 2

Branson Construction (Lessee)
Interest expense (10% x [$936,492* – 100,000])..........................               83,649
Lease payable (to balance).............................................................               16,351
Maintenance expense (annual fee)***...........................................                 3,000
     Cash (lease payment)................................................................                                    103,000

* $100,000 x 9.36492
** present value of an annuity due of $1: n=20, i=10%

Amortization expense ($936,492 ÷ 20 years)................................               46,825
     Right-of-use asset.....................................................................                                      46,825

*** This debit to maintenance expense is the net effect of (a) expensing the current year’s costs that were prepaid with the first lease payment the last day of 2021 and (b) prepaying next year’s expense with the 2022 payment:

Maintenance expense (2022 costs)................................................                 3,000
     Prepaid maintenance expense (paid in 2021)............................                                        3,000

Interest expense (10% x [$936,492 – 100,000])............................               83,649
Lease payable (difference)............................................................               16,351
Prepaid maintenance expense (2020 costs)...................................                 3,000
     Cash (lease payment)................................................................                                    103,000

Branif Leasing (Lessor)
Cash (lease payment).....................................................................             103,000
     Lease receivable (to balance)....................................................                                      16,351
     Maintenance fee payable [or cash]............................................                                        3,000

Interest revenue (10% x [$936,492* – 100,000])..........................                                      83,649

* $100,000 x 9.36492
** present value of an annuity due of $1: n=20, i=10%

Requirement 3

Branson Construction (Lessee)
Interest expense (10% x [$964,587* – 103,000])..........................               86,159
Lease payable (to balance).............................................................               16,841

     Cash (lease payment)................................................................                                    103,000

  * $103,000 x 9.36492
** present value of an annuity due of $1: n=20, i=10%

Whether to include costs as separate components of the lease contract (to be expensed by the lessee) or, instead, included in the payments to be capitalized as part of the right-of-use asset depends on whether the charge represents a transfer of a good or service to the lessee.  If so, it qualifies as a “non lease component” of the payment and is separated from the lease payments and expensed. That was the case for maintenance costs, but not for insurance costs. In fact, ASC 842 specifically excludes insurance and taxes from costs that can be expensed.  So, in this case, the entire $103,000 is capitalized.

Amortization expense ($964,587 ÷ 20 years)................................               48,229
     Right-of-use asset.....................................................................                                      48,229

Branif Leasing (Lessor)
Cash (lease payment).....................................................................             103,000

     Lease receivable (to balance)....................................................                                      16,841

Interest revenue (10% x [$964,587* – 103,000])..........................                                      86,159