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 A?

2.         What are the required entries for the first year of the lease?

Answer 1

Solution:

A.

The Lease is an Operating Lease for Company A
It is an Operating lease, as the lease did not satisfy even one of the following criteria
Transfer of Ownership	No
Bargain purchase option	No
Is the lease term equal to 75% or more than the estimated economic life of the property	No, its only 70%
Is present value of the minimum lease payments (excluding executory costs) equals or exceeds 90% of the fair value of the property,	No, its only 88%

B.

Calculation of PV of Lease Payments
Lease Payment	100000
No of periods	7
Interest rate per period	6.00%
PV annuity due Factor @ 6% for 7years	5.58238
PV of Lease Paymenst (100000* PV factor)	558238

Lease Amortization Schedule
Date	Lease Payment (A)	Interest Expense (B) = (D) *Interest Rate	Reduction in Liability (C) = (A) - (B)	Lease Liability (D) = (D) - (C)
1				558238
1	100000	33494	66506	491732
2	100000	29504	70496	421236
3	100000	25274	74726	346511
4	100000	20791	79209	267301
5	100000	16038	83962	183339
6	100000	11000	89000	94340
7	100000	5660	94340	0
Total	700000	141762	558238

Journal Entries - IN the Books of Lessee - Company A
Date	Particulars	Debit	Credit
1	Right of use asset	558238
	Lease Payable		558238
Dec-31	Lease Payable	66506
	Right to use Asset	33494
	Cash		100000

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