Question
In: Accounting
Royals Incorporated leases a piece of equipment to Polar Corporation on January 1, 2020. The lease...
Royals Incorporated leases a piece of equipment to Polar Corporation on January 1, 2020. The lease agreement called for annual rental payments of $8,648 at the beginning of each year of the 3-year lease. The equipment has a fair value of $35,000, a book value of $20,000, and an economic useful life of 5 years after which the residual value will be zero. Both parties expect a residual value of $12,500 at the end of the lease term, though this amount is not guaranteed. Royals set the lease payments with the intent of earning a 6% return, and Polar is aware of this rate. There is no bargain purchase option, ownership of the lease does not transfer at the end of the lease term, and the asset is not of a specialized nature.
Instructions:
(Round all numbers to the nearest dollar.)
(a) Describe the nature of the lease to both Royals and Polar.
(b) Prepare the lease amortization schedule(s) for Polar for all 3 years of the lease.
(c) Prepare the journal entries for Polar for 2020 and 2021.
Solutions
Expert Solution
| a |
In the given case: It is Sale type lease for the Lessor(Royals)
& Finance Lease for the Leasee(Polar) due to the following
reasons: Present value of annual lease payment & residual value is $34,998 which is almost equal to the fair value ($35,000)of the asset. |
|||
| Year | Payments (Cash flows) | Present Value Factor @6%p.a | Discounted Cash flows/ Present value | |
| 1 | $ 8,648.00 | 1.00000 | $ 8,648 | |
| 2 | $ 8,648.00 | 0.94340 | $ 8,158 | |
| 3 | $ 8,648.00 | 0.89000 | $ 7,697 | |
| 4 | $ 12,500.00 | 0.83962 | $ 10,495 | |
| Total | $ 25,944.00 | $ 34,998 | ||
| b |
The leasee should use a single accounting model for all type of lease unless it is of less than 1 year or nominal value. Therefore, the leasee shall record the lease liability & right in use asset in the given case. |
|||
| The lease liability and the ROU asset are measured on the commencement date using the Implicit rate of interest(i.e., 6% p.a. in this case) or incremental borrowing rate(if implicit rate is not known) at lease commencement date . The lease liability is accounted for by the interest method subsequently and the ROU asset is subject depreciation on the straight-line basis over the lease term of 3 year. | ||||
| 1)Calculation of lease liability | ||||
| Year | Payments (Cash flows) | Present Value Factor @6%p.a | Discounted Cash flows/ Present value | |
| 1 | $ 8,648.00 | 1.00000 | $ 8,648 | |
| 2 | $ 8,648.00 | 0.94340 | $ 8,158 | |
| 3 | $ 8,648.00 | 0.89000 | $ 7,697 | |
| Total | $ 25,944.00 | $ 24,503 | ||
| 2) Lease Amortisation Schedule: | ||||
| Year | Opening lease liabilty | Annual Payments | Interest Liability @ 6%p.a | Closing lease liability |
| a | b | c=(a-b)*6% | d=a-b+c | |
| 1 | $ 24,503 | $ 8,648 | $ 951 | $ 16,806 |
| 2 | $ 16,806 | $ 8,648 | $ 490 | $ 8,648 |
| 3 | $ 8,648 | $ 8,648 | $ (0) | $ - |
| Note: As the lease payment is To record made at the begining of the year, interest will be calculated on Opening lease liability less annual lease payment . | ||||
| c | In the books of Leasee | |||
| Journal Entries | ||||
| Year | Particulars | Debit | Credit | |
| 01-01-20 | Right of Use Asset | $ 24,503 | ||
| Lease liabilty | $ 24,503 | |||
| (To record initially recognise the lease-related asset and liability .) | ||||
| 01-01-20 | Lease liabilty | $ 8,648 | ||
| Cash | $ 8,648 | |||
| (To record lease payment) | ||||
| 31-12-20 | Interest expense | $ 951 | ||
| Lease liabilty | $ 951 | |||
| (To record interest expense) | ||||
| 31-12-20 | Depreciation expense | $ 8,168 | ||
| Right of Use Asset | $ 8,168 | |||
| ( To record depreciation expense on the ROU asset) | ||||
| ($24,503/3 year) | ||||
| 01-01-21 | Lease liabilty | $ 8,648 | ||
| Cash | $ 8,648 | |||
| (To record lease payment) | ||||
| 31-12-21 | Interest expense | $ 490 | ||
| Lease liabilty | $ 490 | |||
| (To record interest expense) | ||||
| 31-12-21 | Depreciation expense | $ 8,168 | ||
| Right of Use Asset | $ 8,168 | |||
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