Question

. MAX and Chris Company sign a lease agreement dated January 1, 2017. The lease agreement calls for MAX to lease a bulldozer to CHRIS Company beginning January 1, 2017. The terms of the lease agreement and other important data are as follows.

1. The lease term is 5 years. The lease agreement is non-cancellable, requiring equal rental payments of $20,711 at the beginning of each year. The bulldozer has a fair value at the commencement of the lease of $100,000, an estimated economic life of five years, and a guaranteed residual value of $5,000.
2. The lease contains no renewal options. The equipment reverts to Caterpillar at the termination of the lease.
3. CHRIS’s incremental borrowing rate is 5 percent per year. Sterling uses straight-line method for similar equipment that it owns.
4. MAX sets the annual rental rate to earn a rate of return of 4 percent per year.

REQUIRED:

a. What type of lease does CHRIS Co. engaged into (3 points). Justify your answer.

b. How much will MAX recover from the lease? (3 points).

c. Show the journal entries required by CHRIS Co. on January 1, 2017 (3 points)

d. Perform the 4-lease amortization by Sterling Corporation (5 points).

e. Show the journal entry of accrued interest expense as of December 31, 2017 (3 points).

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 5 Years

Lease term is 5 Years

It is 100% of asset's life

ii.)

Fair value of asset is $100,000

NPV is 94.15% of asset's fair value

iii)

No such clause

iv)

No such clause

In our case lease is Financing lease as it has 2 conditions in it

b)
Recovery from Lease =	20711 for 5 Years
PV of Recovery from Lease =	$                    94,151.18
c)
01-Jan-17	Asset right to use A/c	Debit	$                        94,151
	Lease Liability A/c	Credit	$                        94,151
01-Jan-17	Lease Liability A/c	Debit	$                        20,711
	Cash A/c	Credit	$                        20,711
d)
Date	Opening balance	Interest	Installment	Principal repayment	Closing balance
01-01-2017	$                    94,151.18	$                            -	$                        20,711	$                                           20,711	$                 73,440.18
01-01-2018	$                    73,440.18	$                3,672.01	$                        20,711	$                                           17,039	$                 56,401.19
01-01-2019	$                    56,401.19	$                2,820.06	$                        20,711	$                                           17,891	$                 38,510.25
01-01-2020	$                    38,510.25	$                1,925.51	$                        20,711	$                                           18,785	$                 19,724.76
01-01-2021	$                    19,724.76	$                   986.24	$                        20,711	$                                           19,725	$                         -0.00
e)
Interest expense A/c	Debit	$                3,672.01
Lease Liability A/c	Credit	$                3,672.01

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