Question

On January 1, 2018, the lease commencement date, Curran Manufacturing Corporation (CMC) agreed to lease a piece of nonspecialized, heavy equipment to Oates Products, Inc. CMC paid $900,000 to manufacture the machine and carries it at this amount in its inventory. The fair value (current selling price) of the machine is $995,000. The relevant lease terms follow.  

-Annual rental payments of $240,000 are due on January 1 of each year, with the first payment made at the commencenment of thelease. THe lease payments do not include any other lease componennts such as insurance or property taxes.

-The lease term is 4 years.

-There is no purchase option

-The lessee guarantees a residual value of $60,000 at the termination of the lease. This amount is equal to the expected residual value and there is no unguaranteed residual value frot the assest.

-The economic life of the asset is 7 years.

-The lessor's 7% implicit rate is known to Oates Products, Inc.

-The lessee's incremental borrowing rate is 9%.

- Annual maintenance is $10,000 and annual training is $7,700. The lessee pays both at the end of the year to an independent third-party vendor. The lessee classifies these costs as general and adminstrative expenses.

-CMC indicates that collectibility of all lease payments is reasonably assured, and it is probable that the residual value will be fully recovered.

-Oates depreciates (amortizes) similar equipment using the straight-line method.

REQUIRED:

a)Prepare the lessor's journal entries required for the first three years of the lease term (Date, Account titles and descriptions, Debit, Credit)

b) Prepare the December 31, 2021, journal entry for the lessor assuming that the equipment is returned with a fair value of $45,000. (Date, Account titles and descriptions, Debit, Credit)

Answer 1

For preparing journal entries one should know the type of lease.

there are two types of lease accountings

1. Financial lease.

2. operating lease.

Financial lease:

Lease should satisfy following criteria to call it as finance lease

1. In case of a finance lease the lease term (i.e. the duration of the lease) makes major portion of the useful life of the asset (i.e. in US GAAP, ratio of lease term to useful life is equal to or greater than 75%). If the criterion is not met, the lease is an operating lease.
2. Another criterion for finance lease (i.e. capital lease) is that the present value of lease rentals make substantively all of the fair value of the leased asset. (US GAAP guidance: present value of minimum lease payments is equal to or greater than 90% of the fair value of the lease). A lease not meeting this criterion is classified as an operating lease.
3. If the leased asset is a tailor-made asset made for the lessee, it is a finance lease. If the asset is of general nature, i.e. it can be leased out to another party by the lessor, the lease is an operating lease if other criteria are met.
4. A finance lease may involve transfer of asset to the lessee at the end of the lease term while operating lease does not have any such provision.

For the given problem

1. life term = 4/7* 100 = 57.14% < 75 - Not satisfied

2. Present value of lease payments= 240,000x(1+0.9346+0.8734+0.8163)=869836 < 895,500 (which is 90% of 995,000).

3. It is not a tailor made equipment as it was clearly stated as "a piece of nonspecialized, heavy equipment".

4. There is no such provision as transfer of rights or sale option at the end of lease term is stated in the question.

In the given problem not even a single criteria is met. Hence the lease in the given problem is operating lease.

Journal entries in the books of leesor:

a) 1. 01-jan 2018 cash a/c Dr 240,000

To lease rentals a/c Cr 2,40,000

(Being first term lease payment received)

2. 31st Dec 2018 Depreciation expense a/c Dr 210,000

To Accumulated Depreciation a/c Cr 210,000

(Being straight line depreciation is recoreded for at the year end. (900000-60000)/4=210,000).

3. 01-jan 2019 cash a/c Dr 240,000

To lease rentals a/c Cr 2,40,000

(Being second term lease payment received)

4. 31st Dec 2019 Depreciation expense a/c Dr 210,000

To Accumulated Depreciation a/c Cr 210,000

(Being straight line depreciation is recoreded for at the year end. (900000-60000)/4=210,000).

5. 01st jan 2020 cash a/c Dr 240,000

To lease rentals a/c Cr 2,40,000

(Being Third term lease payment received)

6. 31st Dec 2020 Depreciation expense a/c Dr 210,000

To Accumulated Depreciation a/c Cr 210,000

(Being straight line depreciation is recoreded for at the year end. (900000-60000)/4=210,000).

b) 1. 01-jan 2018 cash a/c Dr 240,000

To lease rentals a/c Cr 2,40,000

(Being fourth term lease payment received)

2. 31st Dec 2021 Depreciation expense a/c Dr 210,000

To Accumulated Depreciation a/c Cr 210,000

(Being straight line depreciation is recoreded for at the year end. (900000-60000)/4=210,000).

3. 31st Dec 2021 Loss on impairment a/c Dr 15,000

To Asset a/c Cr 15,000

( Being impairment on asset recorded (60,000-45,000=15,000))

The remaining 45,000 value of the asset is to be depreciated over the remaining 3 years life of the asset.