Question

Rauch Incorporated leases a piece of equipment to Donahue Corporation on January 1, 2017. The lease agreement called for annual rental payments of $4,892 at the beginning of each year of the 4-year lease. The equipment has an economic useful life of 6 years, a fair value of $25,000, a book value of $20,000, and both parties expect a residual value of $8,250 at the end of the lease term, though this amount is not guaranteed. Rauch set the lease payments with the intent of earning a 5% return, and Donahue is aware of this rate. There is no bargain purchase option, ownership of the lease does not transfer at the end of the lease term, and the asset is not of a specialized nature.

1. Determine the nature of the lease to both Rauch and Donahue

2. Prepare the lease amortization schedule(s) for Donahue for all 4 years of the lease.

3. Prepare the journal entries for Donahue for 2017 and 2018

4.Suppose Donahue incurs initial direct costs of $750 related to the lease. Prepare the journal entries for 2017

Answer 1

1)It is an operating lease because ownership of the lease does not transfer at the end of the lease term, and also the asset is not of a specialized nature.The lease is an operating lease for both Rauch and Donahue, as none of the classification tests are met. The lease term is only 67% (4 ÷ 6) of the economic life of the asset, there is no bargain purchase, ownership does not transfer, and the asset is not specialized. The calculation for the 90% test shows the present value of lease payments is below 90% ($18,214 ÷ $25,000 = 73%):

$4,892 Annual rental payment

× 3.72325 PV of annuity due of 1 for n = 4, i = 5%

$18,214 PV of periodic rental payments

2)3)

Date	Account	Debit	Credit
1/1/17	Right to Use Assets	$ 18,214
	Lease Liability		$ 18,214
	(4892*3.723248 pv5%, 4 year)
1/1/17	Lease Liability	$    4,892
	Cash		$    4,892
12/31/17	Interest Expense	$       666		(18214-4892)*5%
	Interest Payable		$       666
1/1/18	Interest Payable	$       666
	Lease Liability	$    4,226
	Cash		$    4,892
12/31/18	Interest Expense	$       455		(18214-4892-4226)*5%
	Interest Payable		$       455

4)PLEASE LET ME KNOW IF THE SOLUTION IS INCORRECT.IN CASE OF ANY DOUBTS FEEL FREE TO COMMENT BELOW.

THANK YOU!!!