Question

On December 31, 2018, Yard Art Landscaping leased a delivery truck from Branch Motors. Branch paid $40,000 for the truck. Its retail value is $45,114.

The lease agreement specified annual payments of $11,000 beginning December 31, 2018, the beginning of the lease, and at each December 31 through 2021. Branch Motors’ interest rate for determining payments was 10%. At the end of the four-year lease term (December 31, 2022) the truck was expected to be worth $15,000. The estimated useful life of the truck is five years with no salvage value. Both companies use straight-line amortization or depreciation.

Yard Art guaranteed a residual value of $6,000. Yard Art’s incremental borrowing rate is 9% and is unaware of Branch’s implicit rate.

A $1,000 per year maintenance agreement was arranged for the truck with an outside service firm. As an expedient, Branch Motors agreed to pay this fee. It is, however, reflected in the $11,000 lease payments. (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. How should this lease be classified by Yard Art Landscaping (the lessee)?
2. Calculate the amount Yard Art Landscaping would record as a right-of-use asset and a lease liability.
3. How should this lease be classified by Branch Motors (the lessor)?
4. Show how Branch Motors calculated the $11,000 annual lease payments.
5. Calculate the amount Branch Motors would record as sales revenue.
6. Prepare the appropriate entries for both Yard Art and Branch Motors on December 31, 2018.
7. Prepare an amortization schedule that describes the pattern of interest expense over the lease term for Yard Art.
8. Prepare an amortization schedule that describes the pattern of interest revenue over the lease term for Branch Motors.
9. Prepare the appropriate entries for both Yard Art and Branch Motors on December 31, 2019.
10. Prepare the appropriate entries for both Yard Art and Branch Motors on December 31, 2021 (the final lease payment).
11. Prepare the appropriate entries for both Yard Art and Branch Motors on December 31, 2022 (the end of the lease term), assuming the truck is returned to the lessor and the actual residual value of the truck was $4,000 on that date.

Answer 1

Answer

1.

According to the Law, A lease must satisfy any one of the below conditions to qualify as Capital Lease

1. the life of the lease must be 75% or greater of the asset's useful life
2. the lease must contain a bargain purchase option for a price less than the market value of an asset
3. he lessee must gain ownership at the end of the lease period
4. the present value of lease payments must be greater than 90% of the asset's market value

The lease is fulfilling 1^st (As Useful life is 5 years and lease is of 4 years, more than 75%) condition so we need to satisfy only one condition to classify the lease as Capital Lease.

So this is Capital Lease.

2.

We should record the asset at present Value,

So,

Annual Payment = $11,000

Cost of capital = 9%

Lease life = 4 years

Present Value Annuity Factor (PVAF) @9% for 4 Years = 3.53129

Present Value (PV) @9% of 4^th year = 0.70843

Present Value = (Annual Payment * PVAF @9% for 4 years) + (Salvage value * PV @9% of 4^th year)

= ($11,000 * 3.53129) + ($6,000 * 0.70843)

= $43,094.77

We should record the asset at $43,094.77

3.

As we have discussed in 1^st part, this is Capital lease to Lessor too.

4.

We first have to calculate how much amount we have to recover from the Lease, so

Amount to recover = Fair value of Asset – Present Value of Asset from Lessor Point of View

Fair Value = $45,114

Cost of capital = 10%

Lease life = 4 years

Present Value Annuity Factor (PVAF) @10% for 4 Years = 3.4868

Present Value (PV) @10% of 4^th year = 0.68301

Present Value of Salvage Value = $15,000* 0.68301

Present Value of Salvage Value = $10,245.15

Amount to recover = Fair value of Asset – Present Value of Asset from Lessor Point of View

= $45,114 – 10,245.15

Amount to recover = $34,868.85

Now we will divide this amount by PVAF @10% for 4 Years

= $34,868.85 / 3.4868

= $10,000

Annual Lease payment = $10,000 + $1,000 (Lessor cost)

= $11,000