Question

Problem 21-1 Windsor Leasing Company agrees to lease machinery to Sheridan 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 $523,000, and the fair value of the asset on January 1, 2017, is $758,000.

3. At the end of the lease term, the asset reverts to the lessor and has a guaranteed residual value of $108,000. Sheridan 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. Windsor desires a 10% rate of return on its investments. Sheridan’s incremental borrowing rate is 11%, and the lessor’s implicit rate is unknown. (Assume the accounting period ends on December 31

Calculate the amount of the annual rental payment required

Annual rental payment

Compute the present value of the minimum lease payments.

Present value of minimum lease payments

$

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

Prepare the journal entries Windsor would make in 2017 and 2018.

Answer 1

Since the lease period covers 77.78%(=7/9) of the economic life of the assets, the lease is considered as capital lease.

1. Annual rental payments:

Fair value of asset	758,000.00
Less: PV of guaranteed residual value =108000*PVF(10%,7 years) = 108000*0.5132	55,425.60
Amount to be recovered by lessor through lease payments	702,574.40
Beginning of period annual payments for 7 years to yield 10% return to investor =702574.40/5.3553	131,192.28

2. Present value of minimum lease payments:

Present value of minimum rental payments (n=7, r=11%) = 131192.28*5.2305	686,201.22
Add: Present value of guaranteed residual value (108000*0.4817)	52,023.60
PV of minimum lease payments	738,224.82

3.

In books of Sheraton - Lessee
Date	Journal	Dr.	Cr.
01-Jan-17	Leased Equipment	738,224.82
	Lease Liability		738,224.82
	(being capital lease recorded)
01-Jan-17	Lease Liability	131,193.31
	Cash		131,193.31
	(being first lease rental paid)
31-Dec-17	Interest Expense	66,773.47
	Interest Payable		66,773.47
	(being interest on lease liability accrued)
31-Dec-17	Depreciation	105,460.69
	Accumulated Depreciation		105,460.69
	(being depreciation (738224.82/7) on SLM basis recorded)
01-Jan-18	Lease Liability	131,193.31
	Interest Payable	66,773.47
	Cash		197,966.78
	(being lease rental and interest paid)
31-Dec-18	Interest Expense	59,687.28
	Interest Payable		59,687.28
	(being interest on lease liability accrued)
31-Dec-18	Depreciation	105,460.69
	Accumulated Depreciation		105,460.69
	(being depreciation (738224.82/7) on SLM basis recorded)

Interest in year 1: (738224.82-131193.31)*0.11 = 66,773.47

Interest in year 2: (738224.82-131193.31-131193.31+66,773.47)*0.11 = 59,687.28

4.

In books of Windsor - Lessor
01-Jan-17	Lease receivables	702,574.40
	Asset		523,000.00
	Unearned interest revenue		179,574.40
	(being capital lease recorded)
01-Jan-17	Cash	131,193.31
	Lease receivables		131,193.31
	(being lease rental received)
31-Dec-17	Unearned interest revenue	57,138.11
	Interest Income		57,138.11
	(being interest income earned on lease)
01-Jan-18	Cash	131,193.31
	Lease receivables		131,193.31
	(being lease rental received)
31-Dec-17	Unearned interest revenue	49,732.59
	Interest Income		49,732.59
	(being interest income earned on lease)

Interest Income in year 1 = (702574.4-131193.31)*0.1 = 57138.11

Interest income in year 2 = (702574.4-131193.31-131193.31+57138.11)*0.1 = 49,732.59