Question

Renter’s Dilemma

Adam's, Inc., a publicly traded corporation, plans to lease equipment from Jackson Co. (Jackson) on January 1, 2020, for a period of three years. Lease payments of $100,000 are due to Jackson each year. Other expenses (e.g., insurance, taxes, and maintenance) are also to be paid by Adams and amount to $2,000 per year. Jackson will not incur any initial direct costs. The lease contains no purchase or renewal options and the equipment reverts back to Jackson on the expiration of the lease. The remaining useful life of the equipment is four years. The fair value of the equipment at lease inception is $265,000. Adams has guaranteed $20,000 as the residual value at the end of the lease term. The $20,000 represents the expected value of the leased equipment to Adams at the end of the lease term. The salvage value of the equipment is expected to be $2,000 after the end of its economic life. Adam’s incremental borrowing rate is 11 percent (Jackson’s implicit rate is 10 percent and is calculable by Adams from the lease agreement).

The junior accountant of Adams analyzed the assets under lease, determined whether the lease was an operating lease or finance lease, and prepared the applicable journal entries. The senior accountant of Adams reviewed the junior accountant’s analysis and prepared a separate analysis. As the finance controller, you were given both analyses to determine the correct accounting treatment. Calculations and journal entries performed by your junior and senior accountant follow:

Present Value of the Lease Obligation

Using the rate implicit in the lease (10 percent), the present value of the guaranteed residual value would be $15,026 ($20,000 x 0.7513), and the present value of the annual payments would be $248,685 ($100,000 x 2.4869).

Using the incremental borrowing rate (11 percent), the present value of the guaranteed residual value would be $14,624 ($20,000 x 0.7312), and the present value of the annual payments would be $244,371 ($100,000 x 2.4437).

Junior accountant analysis:

Since the equipment reverts back to Jackson, it is an operating lease. 840

Entry to be posted in years 1, 2, and 3:

Dr. Rent expense                        $100,000

Dr. Insurance expense                   $2,000

              Cr. Cash                                                        $102,000

        (Operating lease rental paid to Jackson)

Senior accountant analysis:

Step 1 – Lease classification

The lease term is for three years. The useful life of the equipment is four years. Since the lease term is for a major part of the useful life of the equipment, it is a finance lease.

Step 2 – Computation of the lease asset and obligation

Since Adam’s incremental borrowing rate is greater than the implicit rate in the lease, compute the present value of the minimum lease payments using the 11 percent rate.

Present value of the minimum lease payments = $100,000 x 2.4437 = $244,371.

Step 3 – Allocation of payments between interest and lease obligation

Since interest has to be charged on the straight-line method, the following is the allocation of the interest and the reduction in the lease liability.

Year	Cash Payment	Interest Expense (11%)	Reduction in Lease Obligation	Balance of Lease Obligation
0				$244,371
1	$100,000	$26,881	$73,119	$171,252
2	$100,000	$26,881	$73,119	$98,133
3	$100,000	$26,881	$73,119	$25,014

Entry to be posted in year 1 for capitalization of equipment:

Db. Equipment                            $244,371

              Cr. Lease obligation                                 $244,371

Entry to be posted in years 1, 2, and 3 for payment:

Dr. Rent expense                             $2,000

Dr. Interest expense                    $26,881

Dr. Lease obligation                     $73,119

              Cr. Cash                                                        $102,000

        (Finance lease rental paid to Jackson)

Required:

Are either of the above analyses correct? If so, which one? If not, why not and what would need to be changed? Please provide appropriate codification support for your conclusions. ( Use answers according FASB Codifications)

Answer 1

The second one needs to be changed for the discount rate & lease inception amt.

At the outset, ,this is not an operating lease, but a finance lease , & to be accounted as such

as it meets 2 out of the 4 classification criteria ,for capital lease, as per GAAP.

ie.

There is no transfer of ownership of the equipment at the end of the lease term, the equipment reverts back to Jackson on the expiration of the lease.

There is option to purchase the equipment at discounted prices at the end of the term,the lease contains no purchase or renewal options

The term of the lease is equal to 75% , ie. 3 yrs./4 yrs. =75% of the useful life of the equipment

The present value of the lease payments $ 248685 is greater than 90% of the equipment's fair market value 265000--it is 93.84%

As 2 out of the above 4 criteria , are met, this is to be accounted as capital / finance lease by Adam's Inc.

As per FASB codification for leases, ASU 842,

If the lessor's implicit rate is known & determinable to the lessee, then the lease cash flows are to be discounted with that lessor's implicit rate only.

Given that "Jackson’s implicit rate is 10 percent and is calculable by Adams from the lease agreement" here, the discount rate to be used by Adam's is 10%

So,

Calculation of lease amount at inception:

PV of annual lease payments	100000*(1-1.1^-3)/0.1=	248685	93.84%
PV of guaranteed residual value	20000/1.1^3=	15026
		263711

Lease Amortisation Table
Year	Annual pmt.	Tow.Int.	Tow.Lease	Lease bal.
0				263711
1	100000	26371	73629	190082
2	100000	19008	80992	109090
3	100000	10909	89091	19999
	300000	56288	243712	Res. Value

Hence the journal entries will be :
Yr.1,beg.	Equipment	263711
	Lease obligation		263711
Yr.1, end	Lease obligation	73629
	Interest expense	26371
	Other expenses	2000
	Cash		102000
	Depreciation expense	87904
	Acc. Depn.-Leased eqpt.		87904
	(263711/3)
Yr. 2,end	Lease obligation	80992
	Interest expense	19008
	Other expenses	2000
	Cash		102000
	Depreciation expense	87904
	Acc. Depn.-Leased eqpt.		87904
Yr. 3,end	Lease obligation	89091
	Interest expense	10909
	Other expenses	2000
	Cash		102000
	Depreciation expense	87904
	Acc. Depn.-Leased eqpt.		87904
	Acc. Depn.-Leased eqpt.	263712
	Equipment		263712