Question

On January 1, 1996, ParkOne Co. (lessee) signs a 10-year noncancelable lease agreement to lease a storage building from DIY Storage Company (lessor). The following information pertains to this lease agreement:

• The agreement requires equal rental payments of $76,332 beginning on December 31, 1996. The annual payment includes $3,000 as reimbursement of property taxes.

• The fair value of the building on January 1, 1996 is $453,000. On DIY’s book, it has a cost of $400,000.

• The building has an estimated useful life of 15 years. The estimated residual value at the end of the lease term of $60,000 is guaranteed by ParkOne. ParkOne Co. depreciates similar buildings on the straight-line method.

• The lease is nonrenewable. At the termination of the lease term the building reverts back to the lessor. • There is no uncertainty concerning rental and all other payments.

• ParkOne’s incremental borrowing rate is 11% per year. The lessor’s implicit interest rate is 11%, too.

Required: Based on this information answer the following questions. Show all computations and round amounts to the nearest dollar.

1. What kind of lease is it for ParkOne Co.? Why?

2. Prepare the journal entry ParkOne Co. would make with respect to the lease on January 1, 1996.

3. Prepare all entries ParkOne Co. would make with respect to the lease obligation and leased asset on December 31, 1996.

4. What kind of lease is it for DIY Storage Co? 5. Write the journal entry DIY Storage Co. will make on 1/1/96. (Use the Net method.) 6. Write the journal entries DIY Storage Co. will make on 12/31/96 when it receives the first payment.

Answer 1

1. It is an operating lease since it is non renewable. At the end of 10 years the building reverts back to the lessor even though the estimated useful life is 15 years,

2. Journal entries in the books of Park one co (Lessee). on Jan 1,1996

(a) Advance Lease Charges A/c Dr $ 76,332

To DIY Storage Co Cr $ 76,332

(Being lease rent payable to DIY Storage company including property taxes on January 1, 1996).

3. journal entries in the books on 31.12.1996

Lease Charges Dr $ 76,332

To Advance Lease Charges Cr $ 76,332

No further entries are required to be made in the books of Parkone Co since all operating leases are off balance sheet means of financing.

4. For DIY Storage Co also it is an operating lease because of the following reasons ;

(a) Ownership of the property will not be transferred to Parkone Co at the end of the lease period.

(b) The fair value of the property is $ 4,53,000. Estimated life of the asset is 15 yeards, So for the balance useful life of property i.e. 5 years, the depreciated fair value of the assets would be $4,53,000/15 x 5 = $ 1,51,000. But Parkone Co has offered a value of only $ 60,000.

( c ) Lease period also covers only 66 % of the economic value of the asset.

(d) Present value of the minimum lease rentals for 10 years discounted at 11 % amounts to 2,66,679 which is also only around 58 % of the fair market value of the property.

But the most important point is that the lessee will take back the asset after the expiry of lease period and after expiry of only 66 % of the life of the asset.

Entries in the books of DIY Storage Co on 01.01.1996.

Bank A/c Dr $ 76,332

To Parkone Co Cr $ 76,332

(Being the lease rent for the year 1996 recieved in advance from Parkone Co.

Journal entries in the books of DIY Storage Co on 31.12.1996.

Parkone Co Dr $76,332

To Lease Rent A/c Cr $ 73,332

To Property Tax A/c.Cr $ 3,000

(Being adjustment of advance recieved from Parkone Co on lease rentals and property tax recd in January).

Depreciation A/c Dr $22,667

To Storage Building A/c Cr $ 22,667

(Being the depreciation charged on storage buildings at cost less residual value on straight line method.