Question

Kingbird Leasing Company agrees to lease machinery to Oriole Corporation on January 1, 2017. 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 $500,000, and the fair value of the asset on January 1, 2017, is $659,000.
3.		At the end of the lease term, the asset reverts to the lessor and has a guaranteed residual value of $103,000. Oriole depreciates all of its equipment on a straight-line basis.
4.		The lease agreement requires equal annual rental payments, beginning on January 1, 2017.
5.		The collectibility of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the amount of costs yet to be incurred by the lessor.
6.		Kingbird desires a 9% rate of return on its investments. Oriole’s incremental borrowing rate is 10%, and the lessor’s implicit rate is unknown.

(Assume the accounting period ends on December 31.)

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

b. Compute the present value of the minimum lease payments.

c. Prepare the journal entries Oriole would make in 2017 and 2018 related to the lease arrangement.

d. Prepare the journal entries Kingbird would make in 2017 and 2018.

Answer 1

Part a:

Year	Present value factor @9% per annum
0	1
1	0.917431
2	0.84168
3	0.772183
4	0.708425
5	0.649931
6	0.596267
7	0.547034
Particulars	Amount ($)
Thus, present value of residual value (103000 x 0.547034)	56344.53
Fair value of the machine as on January 01, 2017	659000
Less: Present value of residual value	56344.53
Amount to be recovered from lease rent	602655.5
Present value factor for year 0 to 6 at the rate of 9% per annum	5.485919
Thus, annual lease rent should be (602655.50 / 5.485919)	($) 109855

Part b:

Particulars	Amount ($)
Present value of minimum lease payment
Present value of annual lease rent (109855 x 5.485919)	602655.5
Add: present value of residual value (103000 x 0.547034)	56344.53
Present value of minimum lease payment	659000

Part c:

Date	Account titles and explanations	`Debit ($)	Credit ($)
01-01-17	Machine	659000
	Kingbird Leasing Company		659000
	(Being the lease recorded at the present value of lease)
01-01-17	Kingbird Leasing Company	109855
	Bank		109855
	(Being the first lease payment made)
31-12-17	Interest on lease (659000-109855) x 9%	49423.05
	Kingbird Leasing Company		49423.05
	(Being the interest on lease charged)
31-12-17	Depreciation (659000 x 1/7)	94142.86
	Machine		94142.86
	(being the depreciation provided)
31-12-17	profit and loss account	143565.9
	Interest on lease (659000-109855) x 9%		49423.05
	Depreciation (659000 x 1/7)		94142.86
	(being the depreciation and interest charged against the profit and loss of the company)
01-01-18	Kingbird Leasing Company	109855
	Bank		109855
	(Being the first lease payment made)
31-12-18	Interest on lease {(659000-109855)+49423} x 9%	53871.13
	Kingbird Leasing Company		53871.13
	(Being the interest on lease charged)
31-12-18	Depreciation (659000 x 1/7)	94142.86
	Machine		94142.86
	(being the depreciation provided)
31-12-18	profit and loss account	148014
	Interest on lease {(659000-109855)+49423} x 9%		53871.13
	Depreciation (659000 x 1/7)		94142.86
	(being the depreciation and interest charged against the profit and loss of the company)

Part d:

Date	Account titles and explanations	`Debit ($)	Credit ($)
01-01-17	Oriole Corporation	659000
	Machine		659000
	(being lease provided)
01-01-17	Bank	109855
	Oriole Corporation		109854.979
	(being the lease rental received)
31-12-17	Oriole Corporation (659000-109855) x 9%	49423.05
	Interest on lease (659000-109855) x 9%		49423.0519
	(Being interest on outstanding amount charged)
31-12-17	Interest on lease (659000-109855) x 9%	49423.05
	profit and loss account		49423.0519
	(being interest credited)
01-01-18	Bank	109855
	Oriole Corporation		109854.979
	(being the lease rental received)
31-12-18	Oriole Corporation {(659000-109855)+49423} x 9%	53871.13
	Interest on lease {(659000-109855)+49423} x 9%		53871.129
	(Being interest on outstanding amount charged)
31-12-18	Interest on lease {(659000-109855)+49423} x 9%	53871.13
	Profit and loss account		53871.129
	(being interest credited)