Question

Problem 21-03

Sandhill Steel Company, as lessee, signed a lease agreement for equipment for 5 years, beginning December 31, 2020. Annual rental payments of $50,025 are to be made at the beginning of each lease year (December 31). The interest rate used by the lessor in setting the payment schedule is 3%; Sandhill’s incremental borrowing rate is 5%. Sandhill is unaware of the rate being used by the lessor. At the end of the lease, Sandhill has the option to buy the equipment for $5,000, considerably below its estimated fair value at that time. The equipment has an estimated useful life of 7 years, with no salvage value. Sandhill uses the straight-line method of depreciation on similar owned equipment.

1. Prepare the journal entries, that Sandhill should record on December 31, 2020.

2. Prepare the journal entries, that Sandhill should record on December 31, 2021.

3. Prepare the journal entries, that Sandhill should record on December 31, 2022.

4. What amounts would appear on Sandhill’s December 31, 2022, balance sheet relative to the lease arrangement?

Answer 1

Ans:

To calculate value of assets recorded in the books of Sandhill, Present value of annual rent to be calculated:

Year	Rent Amount	Present Value Factor @ 5%
0	$50,025	1
1	$50,025	1/1.05
2	$50,025	1/1.05^2
3	$50,025	1/1.05^3
4	$50,025	1/1.05^4
Total	$250,125	4.5459

Present value of all installments: $50,025*4.5459= $227,408.6

At the end of 4 years sandhill has option to buy asset at $5,000

Present value of $5,000 after 4 years at 5%= $5,000*.8227 (1/1.05^4) = $4,113.5

Value of asset on lease: $227,408.6+$4,113.5= $231,522.1

Journal Entries for question : 1, 2 and 3.

Date	Particulars	Amount Dr.	Amount Cr
31/12/2020	Equipment on Lease Account	$227,408.6
	To lessor Account (Being total amount due to lessor for lease)		$227,408.6
31/12/2020	Lessor Account	$50,025
	To Bank (being first installment paid)		$50,025
31/12/2021	Interest on lease expense	$8,869.2
	To Lessor Account (Being interest expense booked on lease at 5% on unpaid amount $177,383.6)		$8,869.2
31/12/2021	Depriciation Account	$33,074.58
	To Equipment on Lease (being depriciation charged at SLM method for 7 year on value of asset calculated)		$33,074.58
31/12/2021	Lessor Account	$50,025
	To Bank (being Second installment paid)		$50,025
31/12/2022	Interest on lease expense	$6,881.4
	To Lessor Account (Being interest expense booked on lease at 5% on unpaid amount $136,227.8)		$6,881.4
31/12/2022	Depriciation Account	$33,074.58
	To Equipment on Lease (being depriciation charged at SLM method for 7 year on value of asset calculated)		$33,074.58
31/12/2022	Lessor Account	$50,025
	To Bank (being Third installment paid)		$50,025

4.

Balance of Lease appearing in the books as on 31/12/2022 is:

Lessor Balance + Interests - Installments paid:

$227,408.6+$8,869.2+$6,881.4-$50,025-$50,025-$50,025 = $93,084.2