Question

In: Accounting

Edom Company, the lessor, enters into a lease with Davis Company to lease equipment to Davis...

Edom Company, the lessor, enters into a lease with Davis Company to lease equipment to Davis beginning January 1, 2016. The lease terms, provisions, and related events are as follows:

1. The lease term is 5 years. The lease is noncancelable and requires annual rental receipts of $100,000 to be made in advance at the beginning of each year.

2. The equipment costs $313,000. The equipment has an estimated life of 6 years and, at the end of the lease term, has an unguaranteed residual value of $20,000 accruing to the benefit of Edom.

3. Davis agrees to pay all executory costs.

4. The interest rate implicit in the lease is 14%.

5. The initial direct costs are insignificant and assumed to be zero.

6. The collectibility of the rentals is reasonably assured, and there are no important uncertainties surrounding the amount of unreimbursable costs yet to be incurred by the lessor.

Solve: 1. Determine if the lease is a sales-type or direct financing lease from Edom’s point of view (calculate the selling price and assume that this is also the fair value).

2. Prepare a table summarizing the lease receipts and interest revenue earned by the lessor.

3. Prepare journal entries for Edom, the lessor, for the years 2016 and 2017.

I have part 1, the Selling price at fair value is 520,000 and is a sales type contract, its the rest I am having trouble with

Solutions

Expert Solution

Part 2)

Step 1: Calculate Present Value of Annual Lease Payments

The present value of annual lease payments can be calculated with the use of PV (Present Value) function/formula of EXCEL/Financial Calculator. The function/formula for PV is PV(Rate,Nper,PMT,FV,1) where Rate = Interest Rate, Nper = Period, PMT = Payment, FV = Future Value and 1 indicates Annuity Due.

Here, Rate = 14%, Nper = 5, PMT = $100,000 and FV = 0

Using these values in the above function/formula for PV, we get,

Present Value of Annual Lease Payments = PV(14%,5,100000,0,1) = $391,371.23

_____

Step 2: Calculate Present Value of Unguaranteed Residual Value

The present value of annual lease payments can be calculated with the use of PV (Present Value) function/formula of EXCEL/Financial Calculator. The function/formula for PV is PV(Rate,Nper,PMT,FV) where Rate = Interest Rate, Nper = Period, PMT = Payment, FV = Future Value.

Here, Rate = 14%, Nper = 5, PMT = 0 and FV = $20,000

Using these values in the above function/formula for PV, we get,

Present Value of Unguaranteed Residual Value = PV(14%,5,0,20000) = $10,387.37

_____

Step 3: Calculate Amount of Unearned Interest

The amount of unearned interest is determined as below:

Fair Value of Equipment (from Step 1) 520,000
Less Present Value of Annual Lease Payments 391,371.23
Present Value of Unguaranteed Residual Value 10,387.37
Unearned Interest $118,241.40

_____

Step 4: Prepare the Table Summarizing Lease Receipts and Interest Revenue Earned by Lessor:

The table summarizing the lease receipts and interest revenue earned by the lessor is given as below:

Date Payment Received Interest Revenue Lease Receivable Unearned Interest Net Investment
01-01-2016 520,000 118,241.40 401,758.60
01-01-2016 100,000 420,000 301,758.60
31-12-2016 42,246.20 (301,758.60*14%) 75,995.20 (118,241.40 - 42,246.20) 344,004.80 (301,758.60 + 42,246.20)
01-01-2017 100,000 320,000 (420,000 - 100,000) 244,004.80 (344,004.80 - 100,000)
31-12-2017 34,160.67 (244,004.80*14%) 41,834.52 (75,995.20 - 34,160.67) 278,165.48 (244,004.80 + 34,160.67)
01-01-2018 100,000 220,000 (320,000 - 100,000) 178,165.48 (278,165.48 - 100,000)
31-12-2018 24,943.17 (178,165.48*14%) 16,891.36 (41,834.52 - 24,943.17) 203,108.64 (178,165.48 + 24,943.17)
01-01-2019 100,000 120,000 (220,000 - 100,000) 103,108.64 (203,108.64 - 100,000)
31-12-2019 14,435.21 (103,108.64*14%) 2,456.15 (16,891.36 - 14,435.21) 117,543.85 (103,108.64 + 14,435.21)
01-01-2020 100,000 20,000 (120,000 - 100,000) 17,543.85 (117,543.85 - 100,000)
31-12-2020 2,456.14 (17,543.85*14%) 0.01 (2,456.15 - 2,456.14) 19,999.99 (17,543.85 + 2,456.14)

_____

Part 3)

The journal entries are prepared as below:

Date Account Titles Debit Credit
01-01-2016 Lease Receivable $520,000.00
Sales Revenue $401,758.60
Unearned Interest - Leases $118,241.40
01-01-2016 Cost of Lease Asset $313,000.00
Inventory $313,000.00
01-01-2016 Cash $100,000.00
Lease Receivable $100,000.00
31-12-2016 Unearned Interest - Leases $42,246.20
Interest Revenue - Leases $42,246.20
01-01-2017 Cash $100,000.00
Lease Receivable $100,000.00
31-12-2017 Unearned Interest - Leases $34,160.67
Interest Revenue - Leases $34,160.67

_____

Notes:

There can be a slight difference in values on account of methodology used for calculation of present values.


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