Question

On January 1, 2019, Amity Company leases a crane to Baltimore Company. The lease contains the following terms and provisions:

•	The lease is noncancelable and has a term of 10 years.
•	The lease does not contain a renewal or bargain purchase option.
•	The annual rentals are $3,960, payable at the beginning of each year.
•	Baltimore agrees to pay all executory costs directly to a third party.
•	The cost of the equipment to the lessor is $24,592.55. The fair value of the equipment is $26,100.
•	Amity incurs initial direct costs of $1,401.04.
•	The interest rate implicit in the lease is 12%.
•	Amity expects to collect all lease payments from Baltimore.
•	Amity estimates that the fair value at the end of the lease term will be $2,900 and that the economic life of the crane is 12 years. This value is not guaranteed by Baltimore.

Required:

1.	Next Level What are initial direct costs? Discuss the accounting treatment of these costs. Are they treated in the same manner for (a) an operating lease, (b) a sales-type lease, and (c) a direct financing lease?
2.	From the lessor’s viewpoint, is the preceding lease a sales-type or direct financing lease? Give reasons to support your conclusion.
3.	Prepare the journal entries for Amity for 2019.

Next Level

Initial direct costs include which of the following items? Check all that apply.

Legal fees

Equipment purchased for lease

Depreciation on equipment purchased for lease

Payments made to a third party to guarantee the leased asset’s residual value

Commissions

Select the lease type that matches the described accounting treatment of initial direct costs.

Lease type	Accounting treatment of initial direct costs
	The initial direct costs are recorded as an asset and allocated as an operating expense in proportion to the rental receipts over the term of the lease.
	The initial direct costs are expensed in the period in which the lease is commenced. These costs may be either (1) added to the expense “Cost of Asset Leased/Cost of Goods Sold” or (2) included as a selling expense entitled “Initial Direct Sales-Type Lease Expense.”
	The initial direct costs are deferred. This accounting procedure requires that the lessor determine a new (lower) implicit rate that will discount the remaining future minimum lease payments to the net investment at the inception of the lease.

Analysis

From the lessor’s viewpoint, is the lease a sales-type or direct financing lease? Give reasons to support your conclusion.

From the lessor’s viewpoint, is the lease a sales-type or direct financing lease? Give reasons to support your conclusion.

Criteria	Met
1. Transfer of ownership at end of lease
2. Bargain purchase option
3. Lease term is for a major part of its economic life
4. Present value of lease payments and any guaranteed residual value equals or exceeds substantially all of the fair value
5. Specialized nature of the asset
Additional Criteria:
1. Present value of the sum of the lease payments and any residual value guaranteed by the lessee and any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of the underlying asset.
2. Probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.

Answer 1

1.2.

Direct Financing Lease
PV of lease payments	$3,960	$6.32825	$ 25,059.87
PV of unguaranteed residual value	$2,900	$0.32197	$      933.72
Less: Initial Costs			$ (1,401.04)
FMV			$ 24,592.55
Since the cost of the asset and FMV are equal it’s a Direct Lease

3.

Date	Account Titles	Debit	Credit
1-Jan-19	Equipment Leased to Others	$ 24,592.55
	Cash		$ 24,592.55
1-Jan-19	Lease Receivable (3960*10+2900)	$42,500
	Equipment Leased to Others		$ 24,592.55
	Unearned Interest		$17,907.45
1-Jan-19	Unearned Interest	$   1,401.04
	Cash		$   1,401.04
1-Jan-19	Cash	$   3,960.00
	Lease Receivable		$   3,960.00
31-Dec-19	Unearned Interest	$2,644
	Interest Revenue: Leases		$2,644.03
	12%*((42500-3960)-(17907.45-1401.04))