Question

Lewis Corporation entered into a lease agreement on January 1, 2017 to provide Dawkins company with a piece of machinery. The terms of the lease agreement were as follows. The lease is to be for 3 years with rental payments of $10,521 to be made at the beginning of each year. The machinery has a fair value of $55,000, a book value of $40,000, and an econnomic life of 8 years. At the end of the lease term, both parties expect the machinery to have a residual vale of $30,000, none of which is guaranteed. The lease does not transfer ownership at the end of the lease term, does not have a bargain purchase option, and the asset is not of a specialized nature. The implict rate is 6%, which is known by Dawkins Collectibility of the payments is probable

a. Evaluate the criteria for classification of the lease, and describe the nature of the lease.

b. Prepare the amortization schedules Dawkins will use over the lease term.

c. Prepare the 2017 journal entries for Dawkins

d. Prepare the 2017 journal entries for Lewis

e. Suppose the lease were only for one year instead of 3 years, with just one lease payment at the beginning of the lease term. Prepare any journal entries Dawkins would need, assuming it elects to use the short-term lease option.

Answer 1

1)  A lease is normally classified as a finance lease if any of the following conditions apply:

• The asset transfers to the lessee at the end of the lease term
• The lessee has an option to purchase the asset from the lessor at below fair value
• The lease term is for a significant part of the asset’s useful economic life
• The present value of future lease payments amounts to substantially all of the asset’s fair value
• The leased asset is specialised in nature, and may only suit the needs of the lessee without major modification

If any of these circumstances arise, it can normally be said that the lease transfers substantially all the risks and rewards of ownership to the lessee.

Fair value of the machinery is $55,000

calculation of present value of lease payments

year	lease amount in $	present value factor 6%	present value of lease amount in $
0	10521	1.000	10521
1	10521	0.943	9921
2	10521	0.890	9364
	31563		29806

in this case present value of future lease payments does not amounts to substantially all of the asset’s fair value.

so , this lease does not meet any of the conditions specified above and in that way it is not a financial lease.

it is Operating lease.

B)

Amortization schedule of dawkins

Year	lease amount ($)	principal amount ($)	interest ($)
0	10521	10521	0
1	10521	9925.47	595.53
2	10521	9925.47	595.53

C)

Journal entries in the books of Dawkins for the year 2017

Date	Particulars	Debit ($)	Credit ($)
jan 1	lease payment a/c Dr To Lewis corporation a/c	10521	10521
jan 1	Lewis corporation a/c Dr To Cash/Bank a/c	10521	10521
dec 31	Depreciation a/c Dr To Machinery a/c	5000	5000

Amount of Depreciation = book value/ life of the asset = $40000/8 = $5000

D)

Journal entries in the books of Lewis corporation for the year 2017

Date	Particulars	Debit ($)	Credit ($)
Jan 1	Dawkins a/c Dr To Lease rental a/c	10521	10521
jan i	Cash/Bank a/c Dr To Dawkins a/c	10521	10521

E)

Journal entries in the books of Dawkins for the year 2017

Date	Particulars	Debit ($)	Credit ($)
Jan 1	lease payment a/c Dr To Lewis corporation a/c	10521	10521
jan 1	Lewis corporation a/c Dr To Cash/Bank a/c	10521	10521

Depreciation will be provided in the books of lewis as the machinery will handed over to him at the end of the year and depreciation will be provided based on "Substance over Form".