Question

On January 1, 2012, Cubs, Inc. engaged in a lease agreement with Dodgers Manufacturing for the use of equipment with an estimated economic life of five years. The term of the lease is four years and requires four annual payments of $100,000 beginning January 1, 2012 and continuing on December 31 of every year from 2012 to 2014. The equipment is not specialized. Dodgers Manufacturing incurred $5,000 in costs related to obtaining credit reports on Cubs and closing the lease arrangement. Cubs incurred no initial direct costs. The equipment cost Dodgers $350,000 to manufacture and the fair value of the equipment is $379,760. The lease terms follow:

- Cubs guarantees that the equipment returned to Dodgers on December 31, 2015 will be worth $30,000.

- There is no transfer of the asset at the end of the lease term and no purchase option.

- The rate implicit in the lease is 8%, and is known to Cubs.

Required:

A. What type of lease has each party signed? Explain in terms of the new US GAAP standard. (3 pts)

B. Prepare all of the 2012 journal entries for both the lessor and lessee. (12 pts)

C. Prepare all of the 2015 journal entries for both the lessor and lessee, assuming that the fair value of the equipment at the end of the lease (12/31/15) is $30,000. How would your answer differ if the equipment’s fair value is $27,000 at the end of the lease? (4 pts)

D. Now assume that the $30,000 residual value is estimated by Dodgers and is not guaranteed. Answer parts a., b., and c. above under this for Dodgers (Lessor) only. (8 pts)

Answer 1

A) This lease should be classified as Finance (Capital ) Lease-

1)The lease term covers more than 75%of the assets economic life. 80% (4years/5) in the above case

2)The present value of the lease payments covers 90% of the cost of the asset.

3)The Lease contains a bargain purchase option.

b) In the books of leasee

1)Asset A/C- Dr 379760

To cash A/C -Cr 100000

To lease liabilitiesA/C - Cr 279760

(being asset purchased on lease with first instalment paid)

2) Interest A/C - Dr 22381

To Lease Liabilities A/C - CR 22381

(being interest expense incurred on lease liability)

3) Lease liability A/C - Dr 100000

To cash A/C - Cr 100000

(being lease liability paid )

IN the books of lessor

1)Cash A/C - Dr 100000

Lease receivables A/C - Dr279760

To Asset A/C - Cr 350000

To profit and loss A/C -Cr 29760

(being Asset given on lease )

2) Lease receivables A/C - Dr 22381

To interest Income A/C - Cr 22381

3) Cash A/C - Dr 100000

To lease receivables A/C - 100000

Present value of future lease payments
Year	Lease payments	8%
0	100000	1.000	100000
1	100000	0.930	93000
2	100000	0.861	86111.11
3	100000	0.797	79732.51
3	30000	0.797	20916.38
TOTAL			379760

C) Present Value of lease payments would change . Refer the working note

Present value of future lease payments
Year	Lease payments	8%
0	100000	1.000	100000
1	100000	0.930	93000
2	100000	0.861	86111.11
3	100000	0.797	79732.51
3	27000	0.797	18525.38
TOTAL			377369

D) In that case the 30000 would not be considered while calculating the present value of future lease payments

Present value of future lease payments
Year	Lease payments	8%
0	100000	1.000	100000
1	100000	0.930	93000
2	100000	0.861	86111.11
3	100000	0.797	79732.51
TOTAL			358843.6

a) it would still be a finance lease

The journal entries in the books of dodgers would be as follows-

1) CAsh A/C -Dr 100000

Lease Receivables A/C -Dr 258843.6

To Asset A/C -Cr 350000

To Profit and loss A/C -8843.6

(being Asset given on lease)

2) Lease receivables A/C - Dr 20707

To Interest income A/C - Cr 20707

3) Cash A/C - Dr 100000

to Lease receivables A/C - Cr 100000

( being down payment received for lease)