Question

(Accounting for an Operating Lease)

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 guaran-

teed. 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

Instructions

(a)

Explain (and show calculations) how Rauch arrived at the amount of the rental payments used in the lease agreement.

(b)

Prepare the entries for Rauch for 2017.

(c)

Suppose that instead of $8,250, Rauch expects the residual value at the end of the lease to be $5,000, but Donahue agrees

to guarantee a residual value of $8,250. All other facts being equal, how would Rauch change the amount of the annual

rental payments, if at all?

(d)

Explain how a fully guaranteed residual value by Donahue would change the accounting for Rauch, the lessor.

(e)

Explain how a bargain renewal option for one extra year at the end of the lease term would change the accounting of

the lease for Rauch, the lessor.

Answer 1

a. Rauch would have calculated the lease payments taking into consideration the current fair value and the rate of return. The sum total of the present value of the lease payments and the salvage value should be equal or close to the current fair value.

Since the present value of the lease payments is close to the fair value of the asset, the lease payments have been fixed at 4,892 per year. This is by trial and error method.

Another way to arrive at the lease rental per year, is by dividing the current fair value by the sum of the present value factors over the lease period. The current fair value is to be taken after deducting the present value of the expected salvage value. Therefore, net current fair value = 25,000 - (8,250*0.86) = 17,873. This should now be divided by 3.72(sum of Pv factors of 4 years). This will given the lease rental amount per year. (17,873/3.72)

b. Cash A/c Dr. 4,892

To Lease rental revenue 4,892

c. Since the amount guaranteed by the lessee is more than the actual salvage value,at the end of the lease period, the lessee will pay the difference amount to the lessor. The lessor will not change the lease rentals in such a scenario.

d. There would not be any change in accounting as this is an operating lease and not a capital lease.