Question

Problem 21-06 (Part Level Submission)

Novak Leasing Company agrees to lease equipment to Splish Corporation on January 1, 2020. The following information relates to the lease agreement.
1. The term of the lease is 7 years with no renewal option, and the machinery has an estimated economic life of 9 years.

2.The cost of the machinery is $517,000, and the fair value of the asset on January 1, 2020, is $657,000

3.At the end of the lease term, the asset reverts to the lessor and has a guaranteed residual value of $55,000. Splish estimates that the expected residual value at the end of the lease term will be 55,000. Splish amortizes all of its leased equipment on a straight-line basis

4. The lease agreement requires equal annual rental payments, beginning on January 1, 2020

5.The collectibility of the lease payments is probable.

6.Novak desires a 10% rate of return on its investments. Splish’s incremental borrowing rate is 11%, and the lessor’s implicit rate is unknown.
(Assume the accounting period ends on December 31.)

A. Discuss the nature of this lease for both the lessee and the lessor.

-This is a finance lease for Splish

-This is a sales type lease for Novack

B. Calculate the amount of the annual rental payment required.

- Annual rental payment $117413

C. Compute the value of the lease liability to the lessee.

- Present value of minimum lease payments ????

D. Prepare the journal entries Splish would make in 2020 and 2021 related to the lease arrangement

E. Prepare the journal entries Novak would make in 2020 and 2021 related to the lease arrangement.

Answer 1

Answer-A: Classification of Lease

i) Economic Life Test: Lease term of the equipment cover 78% (7/9 * 100) of the economic life of equipment. So, the lease term cover major part of asset’s economic life.

ii) Recovery of Investment Test: Fair Value of the Equipment ($657,000) is greater than the cost of equipment ($517,000), and the present value annual lease rentals to be paid by Splish Corporation will cover fair value of the assets. So the Novack Corporation would get fair value of the asset.

iii) Furthet, The collectibility of the lease payments is probable.

Therefore, this lease agreement is finance lease for the Splish Corporation and Sale type lease for Novack Corporation.

Answer-B: Calculation of Annual Lease Rentals

Fair Value of the Equipment	657000
Less: Present Value of Guaranteed Residual Value           (55,000 * PVF @10% for 7 years) = ($55,000 * 0.51316)	28224
Total Value to Paid	628776
PVF of annuity due @ 10% for 7 years	5.35526
Annual Lease Payments ($628,776 / 5.35526)	$1,17,412.78

Answer-C: PV of Minimum Lease Rentals

Present Value of Annual Lease Rentals (Annual Rental * PVF of Annuity Due @11% for 7 years) = ($117,413 * 5.23054)	6,14,133.39
Present Value of Guaranteed Residual Value (Residual value * PVF @ 11% for 7 years) = ($55,000 * 0.48166)	2649.13
PV of minimum lease payments	$6,16,782.52

Answer-D: Journal Entries in the Book of Splish Corporation

Date	Accounts Title	Debit	Credit
2020
Jan 01, 2020	Leased Equipment	616783
	Leased Liability- Equipment		616783
	(To record the asset acquired on lease)
Jan 01, 2020	Lease Liability- Equipment	117413
	Cash		117413
	(To record payment of annual lease rentals)
Dec 31, 2020	Depreciation Expense	80255
	Accumulated Depreciation- Capital Lease (Note- 1)		80255
	(To record annual depreciation expense)
Dec 31, 2020	Interest Expense ($616,783 - $117,413)*11%	54931
	Interest Payable		54931
	(To record accrued interest on lease liability)
2021
jan 01, 2021	Lease Liability	62482
	Interest Payable	54931
	Cash		117413
	(To record payment annual lease rentals)
Dec 31, 2021	Depreciation Expense	80255
	Accumulated Depreciation- Capital Lease (Note- 1)		80255
	(To record annual depreciation expense)
Dec 31, 2021	Interest Expense ($616,783 - $117,413 -$62482) * 11%	48058
	Interest Payable		48058
	(To record accrued interest on lease liability)

Note-1 Depreciation = ($616,783 – 55000)/7 = $80,255