Question

At the beginning of 2018, Advanced Industries acquired a large, custom-made machine with a fair value of $7,331,130 by signing a three-year lease agreement. The lease is payable in three annual payments of $3.0 million at the end of each year.

Required:

a. What is the effective annual interest rate implicit in the agreement?

b. Prepare the lessee's journal entries required at the inception of the lease, the first lease payment which is due and paid December 31, 2018, and the second lease payment which is due and paid December 31, 2019.

Date Account Debit Credit

January 1, 2018:

December 31, 2018:

December 31, 2019:

c. Suppose the fair value of the machine and the lessor's implicit interest rate were unknown at the time of the lease, but you are able to determine that the lessee's incremental borrowing rate of interest for notes of similar "risk was 10%. Prepare the lessee's entry at the inception of the lease.

HINT: Use the Time Value of Money tables provided in previous tabs" Account Debit Credit

Answer 1

Solution:
A.	The implicit interest rate	11%
Working Notes:
	Computation of Implicit interest rate
	Ordinary annuity present value = Machine fair value/Annual lease payment
	Ordinary annuity present value =$7,331,130/$3,000,000
	Ordinary annuity present value =2.44371
	See in table no 4. of PVA of $1,
	n=3 as the lease agreement is for 3 years so see row no. 3 and column of 11% we have value of 2.44371.
Hence,	Our Implicit interest rate is 11%
B.
Date	General Journal	Debit	Credit
January 1, 2018	Leased asset	7,331,130
	Lease payable		7,331,130
Notes:	Recorded at fair value of machine
Date	General Journal	Debit	Credit
December 31, 2018	Interest expense	806,424
	Lease payable	2,193,576
	Cash		3,000,000
Working Notes:
	Interest expense	806,424
	[fair value x implicit rate]
	[7,331,130 x 11% = 806,424.30
	Lease payable	2,193,576
	[annual lease payment -interest expense]
	[$3,000,000 -$806,424=$2,193,576
	Cash		3,000,000
	[annual lease payment]
Date	General Journal	Debit	Credit
December 31, 2019	Interest expense	565,131
	Lease payable	2,434,869
	Cash		3,000,000
Working Notes:
	Interest expense	565,131
	[(fair value- principal amount paid in 2018) x implicit rate]
	[(7,331,130 -2,193,576) x 11% = 565,130.94
	Lease payable	2,434,869
	[annual lease payment -interest expense]
	[$3,000,000 -$565,131=$2,434,869
	Cash		3,000,000
	[annual lease payment]
C.
Date	General Journal	Debit	Credit
January 1, 2018	Leased asset	7,460,550
	Lease payable		7,460,550
Notes:	Recorded at fair value of machine
	Fair value of machine is calculated at 10%
	See in table no 4. of PVA of $1,
	n=3 as the lease agreement is for 3 years so see row no. 3 and column of 10% we have value of 2.48685.
	Fair value machine = Annual lease payment x ordinary annuity present value of 10% for n=3
	Fair value machine = $3,000,000 x 2.48685
	Fair value machine = $7,460,550
Please feel free to ask if anything about above solution in comment section of the question.