Question

On January 1, 2018, Foley Company (as lessor) entered into a noncancelable lease agreement with Pinkley Company for machinery which was carried on the accounting records of Foley at $9,060,000 and had a fair value of $9,600,000. Minimum lease payments under the lease agreement which expires on December 31, 2027, total $14,200,000. Payments of $1,420,000 are due each January 1. The first payment was made on January 1, 2018 when the lease agreement was finalized. The interest rate of 10% which was stipulated in the lease agreement is the implicit rate set by the lessor. The effective interest method of amortization is being used. Pinkley expects the machine to have a ten-year life with no salvage value, and be depreciated on a straight-line basis. Collectibility of the payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. Instructions (a) From the lessee's viewpoint, what kind of lease is the above agreement? From the lessor's viewpoint, what kind of lease is the above agreement? (b) What should be the income before income taxes derived by Foley from the lease for the year ended December 31, 2018? (c) Ignoring income taxes, what should be the expenses incurred by Pinkley from this lease for the year ended December 31, 2018? (d) What journal entries should be recorded by Pinkley Company on January 1, 2018? (e) What journal entries should be recorded by Foley Company on January 1, 2018?

Answer 1

(a)    From the viewpoint of the lessee (Pinkley Company), the lease is a capital lease because the present value of the minimum lease payments ($9,600,000) exceeds 90% of the fair market value of the leased property. The lease term also is in excess of 75% of the property's estimated economic life. For those same reasons and because of the predictable collectibility, absence of uncertainties surrounding costs yet to be incurred by the lessor, and presence of a dealer's profit, the lease is a sales-type lease to the lessor, Foley Company.

(b)     Profit on sale                                                                     $540,000      (9.6M-9.06M)

         Interest on outstanding balance

              ($9,600,000 – $1,420,000) × .10                                    818,000

         Income of lessor in 2018                                                $1,358,000

(c)     Interest on outstanding balance

              ($9,600,000 – $1,420,000) × .10                                  $818,000

         Depreciation ($9,600,000 ÷ 10)                                          960,000

         Expenses incurred by lessee in 2018                              $1,778,000

(d)    Leased Equipment ........................................................................      9,600,000

                     Lease Liability...................................................................                           9,600,000

         Lease Liability...............................................................................      1,420,000

                     Cash...................................................................................                           1,420,000

(e)     Lease Receivable ..........................................................................      9,600,000

         Cost of Goods Sold .....................................................................      9,060,000

                     Sales Revenue ..................................................................                           9,600,000

                     Inventory ..........................................................................                           9,060,000

         Cash ..............................................................................................      1,420,000

                     Lease Receivable...............................................................                           1,420,000