In: Accounting
Company A (the lessee) enters into a 5-year, noncancelable lease with Company B for non-specialized manufacturing equipment to be used in its operations. Information related to the lease are as follows:
Fair value of equipment $800,000
Company A’s incremental borrowing rate 5%
Company B’s implicit rate (known) 4.5%
Residual of equipment at end of lease
(guaranteed by Company A) $100,000
Economic life of equipment 8 years
Lease payment schedule
At inception $ 40,000
At end of year 1 $ 65,000
At end of year 2 $ 80,000
At end of year 3 – 5 $100,000
Present value of lease payments @ 4.5% $507,611
Present value of lease payments @ 5% $499,827
1. What type of lease is this to Company B? (assume there are no collectability issues)
2. What journal entries would Company B make for this lease?
Part 1
Finance lease is also known as capital lease.
The charecteristics of Financial lease is as below:
A Finance lease is a long-term and non cancelable lease.
A financial lease allows the lessee to have a purchase option at less than the fair market value of the asset.
Risk and Reawrds related to asset are with the lessee.
In the given question Company A entered into a lease which is noncancelable with Company B so it is a Finance lease.
Answer to part 2
If lessor's implicit interest rate is available, we have to consider the implicit interest rate.
In the given question Company B's interest rate is 4.5%.
Present value of lease payments @4.5% is $507,611
The right of use asset and lease liability of the Company A is $507,611
Note : For referance purpose i have attached below calculation how $507,611 arrived.Table of lease liability repayment it as below
Entries in the books of Company A
Year 1
Capitalising the asset
Debit Right of use Asset $507,611
Credit Lease Libility $507,611
Being Asset and liability recognised in the books of Company A
Lease Payment
Debit Lesae Liablity $65,000
Credit Cash $65,000
Being amount of Lease payment paid for First year.
Interest Expenses
Debit Interest Expenses $21,035
Credit Lease Liability $21,035.
Being interest expenses recognised in income statement.
Amortization expenses
Debit Amortization expenses $63,451 ($507,611/8)
Credit Right of use Asset $63,451.
Being asset is amortized over a period of 8 years and recognised for first year.
Year 2
Lease Payment
Debit Lesae Liablity $80,000
Credit Cash $80,000
Being amount of Lease payment paid for First year.
Interest Expenses
Debit Interest Expenses $19,056
Credit Lease Liability $19,056
Being interest expenses recognised in income statement.
Amortization expenses
Debit Amortization expenses $63,451 ($507,611/8)
Credit Right of use Asset $63,451.
Being asset is amortized over a period of 8 years and recognised for second year.