Question

Federated Fabrications leased a tooling machine on January 1, 2018, for a three-year period ending December 31, 2020. The lease agreement specified annual payments of $30,000 beginning with the first payment at the beginning of the lease, and each December 31 through 2019. The company had the option to purchase the machine on December 30, 2020, for $39,000 when its fair value was expected to be $54,000 a sufficient difference that exercise seems reasonably certain. The machine's estimated useful life was six years with no salvage value. Federated was aware that the lessor’s implicit rate of return was 11%. (FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.) Required: 1. Calculate the amount Federated should record as a right-of-use asset and lease liability for this finance lease. 2. Prepare an amortization schedule that describes the pattern of interest expense for Federated over the lease term. 3. Prepare the appropriate entries for Federated from the beginning of the lease through the end of the lease term.

Answer 1

1) As there is a bargain purchase option to the lessee on December 31, 2020 for $39,000, this lease is a finance lease.

Lease Liability = Present Value of Annual Payments+Present Value of purchase price at the end of lease

Present Value of Annual Payments = Lease Payments*PVAF(11%, 3 yrs) (beginning of period)

= $30,000*2.71252 = $81,376

(PVAF denotes present value annuity factor and PVF denotes present value factor)

Present Value of purchase price at the end of lease = Bargain purchase price*PVF(11%, 3 yrs)

= $39,000*0.73119 = 28,516

Lease Liability = $81,376+$28,516 = $109,892

Therefore, Federated should record $109,892 as a right-of-use asset and lease liability for this finance lease.

2) Amortization Table showing Lease payment and interest expense (Amounts in $)

Date	Lease Payment	Interest expense (11%)	Cash paid	Lease Liability Balance
1/1/18				109,892
1/1/18	30,000	-	30,000	79,892
12/31/18	21,212 (30,000-8,788)	8,788 (79,892*11%)	30,000	58,680 (79,892-21,212)
12/31/19	23,545 (30,000-6,455)	6,455 (58,680*11%)	30,000	35,135 (58,680-23,545)
12/31/20	35,135 (39,000-3,865)	3,865 (35,135*11%)	39,000	0

Three payments are for annual lease at the beginning of period and last payment of $39,000 is for bargain purchase option.

3) The required journal entries for the given lease is shown as follows:-

Federated Fabrications

Journal Entries (Amounts in $)

Date	Account Titles and Explanation	Debit	Credit
1/1/18	Right of use Asset	109,892
	Lease Liability		109,892
	(To record the right of use asset and lease liability)
1/1/18	Lease Liability	30,000
	Cash		30,000
	(To record the first lease payment)
12/31/18	Lease Liability	21,212
	Interest Expense	8,788
	Cash		30,000
	(To record the second lease payment)
12/31/18	Depreciation Expense [(109,892-0)/6 yrs]	18,315
	Accumulated Depreciation		18,315
	(To record the depreciation expense)
12/31/19	Lease Liability	23,545
	Interest Expense	6,455
	Cash		30,000
	(To record the third lease payment)
12/31/19	Depreciation Expense	18,315
	Accumulated Depreciation		18,315
	(To record the depreciation expense)
12/31/20	Lease Liability	35,135
	Interest Expense	3,865
	Cash		39,000
	(To record the bargain purchase)
12/31/20	Depreciation Expense	18,315
	Accumulated Depreciation		18,315
	(To record the depreciation expense)

Notes:-

1) Depreciation is charged for useful life of machine by straight line method.