Question

On January 1, 2020, Mays Leasing Company leases equipment to Brick Co. The lease term is five years, with 5 equal annual payments of $160,000 each, beginning on 1/1/2020. The equipment has an estimated economic life of 8 years and the fair value on 1/1/2020 is $800,000. Brick agrees to guarantee $150,000 residual value at the end of the lease term. The expected value of the residual value is $50,000. At the termination of the lease, the equipment reverts to the lessor. Brick’s incremental borrowing rate is 10% and Brick knows that Mays’ implicit interest rate is 8%.

Present value factors:                        Ordinary Annuity         Annuity Due        A Single Sum

5 periods 8%                                3.99271                     4.31213                 0.68058

5 periods 10%                              3.79079                     4.16986                 0.62092

1. Use lease classification tests to determine the type of lease that Brick Co. has entered into.
2. Construct the lease amortization schedule for the first two payments made by Brick Co.
3. Prepare Brick’s journal entries that relate to the lease agreement for the following three dates: January 1, 2020, December 31, 2020, and January 1, 2021.

Answer 1

a.)

Type of tests for identifying type of Lease

Lease is considerd as capital lease if:

i) The lease duration is 75% or more of the asset’s useful life

ii) The net present value (NPV) of lease payments is 90% or more of the asset’s fair value

iii) There is a direct term or clause in the lease stating transfer of title

iv) There is a term in the lease that enables the lessee, at the end of the lease, to purchase the asset at a discounted price

All leases except for capital lease are operating lease

In our instant case:

i.)

Life of asset is 8 Years

Lease term is 5 Years

It is 62.50% of asset's life

ii.)

Fair value of asset is $800,000

PV of Lease payment is $ 689,940 (160,000*4.31213)

NPV is 86.24% of asset's fair value

iii.)

No such clause

iv.)

No such clause

In our case lease is Financing lease

b)
Date	Installment	Interest	Principal repaid	Outstanding balance
				$                        6,89,940.00
01-01-2020	$                  1,60,000.00	$                                                       -	$                             1,60,000.00	$                        5,29,940.00
01-01-2021	$                  1,60,000.00	$                                         42,395.20	$                             1,17,604.80	$                        4,12,335.20
01-01-2022	$                  1,60,000.00	$                                         32,986.82	$                             1,27,013.18	$                        2,85,322.02

c)
01-Jan-20	Leased asset A/c	Debit	$                              6,89,940
	Lease Liability A/c	Credit	$                              6,89,940
01-Jan-20	Lease Liability A/c	Debit	$                              1,60,000
	Cash A/c	Credit	$                              1,60,000
31-Dec-20	Finance charge	Debit	$                                 42,395
	Lease Liability A/c	Credit	$                                 42,395
31-Dec-20	Depreciation A/c	Debit	$                              1,37,988
	Leased asset A/c	Credit	$                              1,37,988
01-Jan-21	Lease Liability A/c	Debit	$                              1,60,000
	Cash A/c	Credit	$                              1,60,000

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