Question

P21-8 (L02,4) (Lessee Computations and Entries, Finance Lease with Guaranteed Residual Value)
data as in P21-7 and that Chambers Medical Center has an incremental borrowing rate of 5% and an expected residual value at the end of the lease of $10,000

21-7 information was as follows:

Amirante Inc. manufactures an X-ray machine with an estimated life of 12 years and leases it to Chambers Medical Center for a period of 10 years. The normal selling price of the machine is $495,678, and its guaranteed residual value at the end of the non-cancelable lease term is estimated to be $15,000. The hospital will pay rents of $60,000 at the beginning of each year. Amirante incurred costs of $300,000 in manufacturing the machine and $14,000 in legal fees directly related to the signing of the lease. Amirante has determined that the collectibility of the lease payments is probable and that the implicit interest rate is 5%.

Instructions

1. (a) Discuss the nature of this lease in relation to the lessee, and compute the amount of the initial lease liability.

2. (b) Prepare a 10-year lease amortization schedule.

3. (c) Prepare all of the lessee’s journal entries for the first year.

4. (d) Suppose Chambers Medical Center incurred $7,000 of document preparation costs after the execution of the lease. How would the initial measurement of the lease liability and right-of-use asset be affected?

Answer 1

Nature of the Lease in Relation to Lessee: Captal or Financial Lease

A Lease is classified as Capital or Financial Lease if it satifies any of the below mentioned conditions:

1. There is Tranfer of Leased Asset from Lessor to Lessee at the end of Lease Term.

2. The Lesse has an option to Purchased the Leased Asset from the Lessor at below Fair Market Value.

3. The Lease Term is entered for a Significant Part of Asset's Economic Life (Generally More than or Equal to 75%)

4. The Present Value of Future Lease Payment is substantially Equal to Leased Asset's Fair Value.(Generally More than or Equal to 90%)

5. The Leased Asset is of a Specialized nature and will only fulfill the need of Lessee without ay Major Maodification.

Consideration of Facts of the Question:

The Lease Term is entered for a Significant Part of Asset's Economic Life (Generally More than or Equal to 75%)

Asset's Economic Life	12 Years
Lease Period	10 Years
% of Lease Period	83.33

Computation of Initial Lease Liability:

(a) Calculation of Present Value of Minimum Lease Payments:

Year	Discount Factor @5%	Minimum Lease Payments(MLP)	Present Value of MLP
Annual Lease Rentals:	Beginning of Each Year
0	1.0000	60000	60000.00
1	0.9524	60000	57142.86
2	0.9070	60000	54421.77
3	0.8638	60000	51830.26
4	0.8227	60000	49362.15
5	0.7835	60000	47011.57
6	0.7462	60000	44772.92
7	0.7107	60000	42640.88
8	0.6768	60000	40610.36
9	0.6446	60000	38676.53
Guaranteed Residual Value
10	0.6139	15000	9208.70
Total	495678.00

To bring Clarity Understand Following:

1. Why Year 0 ? : Because First Lease Payment was made Upfront at the time Lease Contract was signed.

2. Why not Year 1 ? Becuase Generally Year 1 is used when Lease Payment are made at the End of the Year.

3. How Discount Factor has been calculated ? : Lease Payments are made at the beginning of Each Year (Or You can consider at the End of Each Year for more clarity in Making Calculation)

Therefore for First Lease Payment Discount Factor is 1.(Power for Discount Factor Calculation is 0) (1/(1.05)0)
For Second Lease Payment made at the beginning of 2nd Year (Or can be Considered as Payment made at the end of First Year for More Clarity) So Discount factor has been calculated by taking Power as 1.(1/(1.05)1)

and So On Further Calculation are Made.

4. How PV of Guaranteed Residual Value is Calculated ?
Guaranteed Residual Value is Paid at the End of Lease Term i.e at the End of 10 Years
So PV is Calulated (1/(1.05)10)

(b) Fair Value of Leased Asset : $ 495,678

At inception of Lease , the Lessee will recognise the Leased Asset at Lower of :

(a) Present Value of Minimum Lease Payments $ 495,678
(b) Fair Value of Leased Asset $ 495,678

Therefore Lessee will Record the Follwing:

Description	Debit	Credit
Leasehold Asset	495678
Lease Liability		495678
(Being Initial Lease Liability Recognized)

(b) Prepare a 10-year lease amortization schedule:

Year	Opening Lease Liability	Lease Payments	Finance Cost @ 5%	Reduction in Liability	Closing Liability
0	495678.00	60000	-	60000	435678.00
1	435678.00	60000	21,783.90	38,216.10	397461.90
2	397461.90	60000	19,873.10	40,126.91	357335.00
3	357335.00	60000	17,866.75	42,133.25	315201.74
4	315201.74	60000	15,760.09	44,239.91	270961.83
5	270961.83	60000	13,548.09	46,451.91	224509.92
6	224509.92	60000	11,225.50	48,774.50	175735.42
7	175735.42	60000	8,786.77	51,213.23	124522.19
8	124522.19	60000	6,226.11	53,773.89	70748.30
9	70748.30	60000	3,537.42	56,462.58	14285.72
10	14285.72	15000	714.29	14,285.71	0.00

(c) Prepare all of the lessee’s journal entries for the first year

Description	Debit	Credit
Leasehold Asset	495678
Lease Liability		495678
(Being Initial Lease Liability Recognized)
Lease Liability	60000
Finance Cost	-
Cash/Bank		60000
(Being Payment of Lease Rental)
Depreciation	49567.80
Leasehold Asset		49567.80
(Being Depreciation on Leased Asset Recorded)

Depreciation would be charged on Leased Asset upto Lower of:

1. Expected Useful Life : 12 Years
2. Lease Period : 10 Years

Therefore Depreciation will be Calculated for 10 Years.

(d) Suppose Chambers Medical Center incurred $7,000 of document preparation costs after the execution of the lease. How would the initial measurement of the lease liability and right-of-use asset be affected?

There would be no difference if Chambers Medical Center incurred $7,000 of document preparation costs after the execution of the lease.

Description	Debit	Credit
Document Preparation Expense (Legal Expense)	7000
Cash/Bank	-	7000
(Being Legal Cost Incurred)