Question

Company A (a lessee) enters into a contract with Company B (a lessor) to lease equipment for a seven-year period.  Company A will use the equipment in its manufacturing operations.  The lease requires Company A to make annual lease payments of $100,000 on December 31.  At the end of the lease, the asset reverts to Company B.

Additional Information:

Company A’s incremental borrowing rate                                            6%

Company B’s implicit rate in the lease (known to Co. A)                  7%

Fair value of asset at lease commencement                                   $632,342

Residual value of asset at end of lease (unguaranteed)             $150,000

Economic life of asset at commencement of lease                      10 years

Present value factors:                                           6%                  7%     

Ordinary annuity, 7 periods                                5.58238          5.38929

Single sum, 7 periods                                              .66506            .62275          

1.     What type of lease is this to Company B?

2.      Would your answer to question 1 be affected by a third party guaranteeing the $150,000 residual value?

3. What are the required journal entries for the first year of the lease? (Company B’s cost of the equipment is $550,000)

Answer 1