Question

Pronghorn Incorporated leases a piece of equipment to Larkspur Corporation on January 1, 2017. The lease agreement called for annual rental payments 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 $26,600, a book value of $21,600, and both parties expect a residual value of $8,200 at the end of the lease term, though this amount is not guaranteed. Pronghorn set the lease payments with the intent of earning a 7% return, and Larkspur is unaware of this rate. Larkspur’s incremental borrowing rate is 9%. Larkspur incurs an initial direct cost of $800. 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.

Required:

1.Calculate the amount of the annual rental payment required by Pronghorn Incorporated (round to nearest dollar).

2.Determine the nature of the lease to both Pronghorn and Larkspur (fill in blank).

It is a/an lease to Pronghorn and a/an lease to Larkspur.

3.Prepare the journal entries for Larkspur in 2017 and 2018 (round to nearest dollar).

4.Prepare the journal entries for Pronghorn in 2017, assuming Pronghorn uses straight-line method for depreciation and the asset has a salvage value of $800 (round to nearest dollar).

Answer 1

1) The annual rental payments required by Pronghorn Incorporated will be equal to a periodic payment that would result in present value equal to the cost of equipment to Pronghorn. We would use below given formula to calculate the annual payment.

Payment per period = A*[r/ (1-(1+r)^-n)] * [1/(1+r)]

Where, A is amount, r is required rate and n is number of periods.

Cost of machine to determine annual payments = $26,600 - $8,200 = $18,400

A = $18,400
r = 7%
n = 4

Annual Payment = $18,400*[0.07 / 1-(1+0.07)^-4] * [1/(1+0.07)]
=> $18,400*(0.07/0.237104788)*(0.934579439)
= $5,076.82

So, Pronghorn will demand annual rental of $5,076.82

2) The lease qualifies as an operating lease for both the parties, since the ownership does not transfer and there is no bargain purchase option.

3)

Date	Account	Debit	Credit
01-Jan-17	Lease Expense	$5,076.82
	Initial Cost	$800.00
	Cash		$5,876.82
01-Jan-18	Lease Expense	$5,076.82
	Cash		$5,076.82

4)

Date	Account	Debit	Credit
01-Jan-17	Cash	$5,076.82
	Lease Rental Revenue		$5,076.82
01-Jan-17	Depreciation Expense	$3,466.67
	Accumulated Depreciation		$3,466.67

Depreciation expense to be recorded = (Book value of asset - Salvage value) / Useful life
=> ($21,600 - $800) / 6 = $3,466.67