Question

At the beginning of 2021, VHF Industries acquired a machine with a fair value of $9,978,930 by signing a five-year lease. The lease is payable in five annual payments of $2.7 million at the end of each year. (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: 1. What is the effective rate of interest implicit in the agreement? 2-4. Prepare the lessee’s journal entries at the beginning of the lease, the first lease payment at December 31, 2021 and the second lease payment at December 31, 2022. 5. Suppose the fair value of the machine and the lessor’s implicit rate were unknown at the time of the lease, but that the lessee’s incremental borrowing rate of interest for notes of similar risk was 10%. Prepare the lessee’s entry at the beginning of the lease.

Answer 1

Solution 1:

Let effective interest rate implicit in lease = i

Now at i present value of lease payment = Fair value of machine

Cumulative PV Factor at i for 5 periods = $9,978,930 / $2,700,000 = 3.6959

Refer PV factor table, this factor falls at i = 11%

Therefore implicit interest rate in lease = 11%

Solution 2-4:
Journal Entries - VHF Industries
Date	Particulars	Debit	Credit
1-Jan-21	Machinery Dr	$9,978,930.00
	To Lease Payable		$9,978,930.00
	(To record machiney purchased on lease)
31-Dec-21	Interest expense Dr ($9,978,930*11%)	$1,097,682.00
	Lease Payable Dr	$1,602,318.00
	To Cash		$2,700,000.00
	(To record lease payment)
31-Dec-22	Interest expense Dr [($9,978,930 - $1,602,318)*11%]	$921,427.00
	Lease Payable Dr	$1,778,573.00
	To Cash		$2,700,000.00
	(To record lease payment)

Solution 5:

Fair value of machine = $2,700,000 * Cumulative PV Factor at 10% for 5 periods

= $2,700,000 * 3.79079 = $10,235,133