Question

wildhorse company on january 21 2021 enters into a 9 year noncancelable lease for equipment having an estimated useful life of 10 years and a fair value to the leasor, daly corp., at the inception of the lease of $3,590,000. wildhorses incremental borrowing rate is 8%. wildhorse uses the straight line method to depreciate its assets. the lease contains the following provisions:

1. rental payments of $292,000 are payable at the beginning of each six month period.

2. an option allowing the leasor to extend the lease one year beyond the lease term

3. a guarantee by wildhorse that daly corp will realize $220,000 from selling the asset at the expiration of the lease. however the actual residual value is expected to be $116,000

Answer the following:

a) what kind of lease is this wildhorse company?

b) what should be considered the lease term?

c) what is the present value of the lease payments for (1) classification of the lease and (2) for measurement of the lease liability?

d) what journal entries would wildhorse record during the first year of the lease?

Answer 1

Lease: Lease can be defined as contractual agreement between two parties namely lessor and lesse where the agreement calling for the lessee to pay certain amount to the lessor for the use of an assets.

Any lease can be classified as finance lease when any of the following criteria is met

1. Ownership of the underlying assets is transferred to the lesse at the end of the lease term

2.The lesse has a purchase option to buy the leased assets ,and is reasonably certain to use it.

3.The lease term covers major part of the underlying assets remaining economic life.This is considered to be 75% or more of the remaining economic life of underlying assets.

4.The present value of sum of all the lease payments and any lesse guaranteed residual value matches or exceeds the fair value of the underlying assets

5.The assets is so specialized that it is has no alternative use for the lessor after the term of the lease.

On the basis of above condition or criteria the above lease is considered as finance lease as the economic life of assets is 10 years and 75% of 10years means 7.5 years but the lease term is for 10 years which covers more than 75% of assets economic life.

a) In above the question the lease is classified as finance lease(Capital lease) because the term of lease covers more than 75% (i.e. more than 7.5 years) of economic life of the assets.

b) The toal lease term would be 10 years( 9 years non- cancellable lease plus one year at the option allowing the lessor to extend the lease)