Question

Culver Leasing Company agrees to lease equipment to Larkspur Corporation on January 1, 2020. The following information relates to the lease agreement. 1. The term of the lease is 7 years with no renewal option, and the machinery has an estimated economic life of 9 years. 2. The cost of the machinery is $575,000, and the fair value of the asset on January 1, 2020, is $755,000. 3. At the end of the lease term, the asset reverts to the lessor and has a guaranteed residual value of $50,000. Larkspur estimates that the expected residual value at the end of the lease term will be 50,000. Larkspur amortizes all of its leased equipment on a straight-line basis. 4. The lease agreement requires equal annual rental payments, beginning on January 1, 2020. 5. The collectibility of the lease payments is probable. 6. Culver desires a 9% rate of return on its investments. Larkspur’s incremental borrowing rate is 10%, and the lessor’s implicit rate is unknown. Discuss the nature of this lease for both the lessee and the lessor. Calculate the amount of the annual rental payment required. Compute the value of the lease liability to the lessee. Prepare the journal entries Larkspur would make in 2020 and 2021 related to the lease arrangement. Prepare the journal entries Culver would make in 2020 and 2021 related to the lease arrangement. Suppose Larkspur expects the residual value at the end of the lease term to be $40,000 but still guarantees a residual of $50,000. Compute the value of the lease liability at lease commencement.

Answer 1

Solution:

This is a capital lease to Larkspur since the lease term is 75% (7 ÷ 9) of the asset’s economic life. In addition, the present value of the minimum lease payments is more than 90% of the fair value of the asset.

This is a capital lease to Culver since collectibility of the lease payments is reasonably predictable, there are no important uncertainties surrounding the costs yet to be incurred by the lessor, and the lease term is 75% of the asset’s economic life. Because the fair value of the equipment ($755000) exceeds the lessor’s cost ($575000), the lease is a sales-type lease.

Calculate the amount of the annual rental payment required : $132639

Fair Value of the asset	755000
Less: PV of the residual value ($50000*.54703)	27352
Amount to be recovered Through periodic lease payments	727648
Lease Payments at the beginning of each of the next seven years @ 9% ($728776÷ 5.48592)	132639

Journal Entries - IN the Books of Culver - Sales Type Lease
01-Jan-20	Lease Receivable	727648
	Cost of Goods Sold	575000
	Sales Revenue		727648
	Inventory of Equipment		575000
	Cash	132639
	Lease receivable		132639
	(To record receipts for first lease rental)
1-Jan.-21	Cash	132639
	Lease receivable ($78838-28235)		79088
	Interest revenue {9% * ($727648 - $132639)}		53551
	(To record receipts of second lease rental)

Compute the value of the lease liability to the lessee: $735975.64

Lease Liability
PV of Lease Payments
Lease Payment	132639.25
No of periods	7
Interest rate per period	10%
PV annuity due Factor @ 10% for 7 years	5.35526
PV of Lease Payments	710317.74
PV of Residual Value of $50,000	₹ 25,657.91
PV of Minimum Lease Payments	735976

Lease Amortisation Schedule (lessee)
Date	Lease Payment	Interest Expense	Reduction in Liability	Lease Liability
01-01-2020				735975.64
01-01-2020	132639.25		132639.25	603336.40
01-01-2021	132639.25	60333.64	72305.61	531030.79
01-01-2022	132639.25	53103.08	79536.17	451494.63
01-01-2023	132639.25	45149.46	87489.78	364004.84

	Journal Entries - In Lessee Books (Larkspur)
Jan 01 2020	Right to use Asset	735975.64
	Lease Liability		735975.64
	(To record Liability)
Jan 01, 2020	Lease Liability	132639.25
	Cash		132639.25
	(To record lease payments)
31-Dec-20	Interest Expense	60333.64
	Interest Payable		60333.64
	( To record accrued interest)
	Depreciation Expense	97996.52
	Accumulated Depreciation - Right-to- Use Asset		97996.52
	(To record Depreciation Expense = (735975.64-50000)/3
Jan 01 2021	Interest Payable	60334
	Interest Expense		60334
	(Reversing the entry)
	Interest Expense	60334
	Lease Liability	72306
	Cash		132639
	To record lease payment
31-Dec-21	Interest Expense	53103
	Interest Payable		53103
	( To record accrued interest)
	Depreciation Expense	97997
	Accumulated Depreciation - Right-to- Use Asset		97997
	(To record Depreciation Expense)