Question

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

Answer 1

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

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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

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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

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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)

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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

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Notes:

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