Question

Rauch Inc. leases a piece of equipment to Donahue Corp. on Jan 1 2017. The lease agreement called for annual rental payments of $4892 at the beginning of each year of the 4 year lease. The equipment has an economic useful life of 6years, 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 guaranteed. 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.

1. explain how Rauch arrived at the amount of the rental payments used in the lease agreement.

2. Prepare the entries for Rauch for 2017

3. Suppose the 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 eqaul, how would Rauch change the amount of the annual rental payments, if at all?

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

5. 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

1. Calculation of how Rauch arrived at the amount of the rental payments used in the lease agreement

Year	Particular	Amount	PV Factor @ 5%	Present Value
0	Fair Value of lease equiptment	-25000	1	-25000
0	Annual rental payment	4892	1	4892
1	Annual rental payment	4892	0.9524	4659
2	Annual rental payment	4892	0.907	4437
3	Annual rental payment	4892	0.8638	4226
4	Residual Value	8250	0.8227	6787
	NET PRESENT VALUE			1

From above working it is seems that net present value is 1 or nill. Rauch workout the lease rent payment as above

2. Entries for Rauch for 2017

a. Increase valuation of equiptment to fair value

Equiptment a/c debit 25,000

To Equiptment a/c credit 20,000

To Revaluation reserve a/c credit 5,000

(Being the equiptment revalued up to its fair value)

b. Tranfer of equiptment on lease

Donahue Corp a/c debit 25,000

To Equiptment on lease a/c credit 25,000

(Being the equiptment tranfer on lease to party for 4 years)

c. Lease rental received

Bank a/c debit 4,892

To Lease rent received a/c credit 4,892

(Being lease rent received for 2017)

3. If the residual value of equiptment is 5,000 then Rauch should revised the annual lease rental up to 5,610

Year	Particular	Amount	PV Factor @ 5%	Present Value
0	Fair Value of lease equiptment	-25000	1	-25000
0	Annual rental payment	5610	1	5610
1	Annual rental payment	5610	0.9524	5343
2	Annual rental payment	5610	0.907	5088
3	Annual rental payment	5610	0.8638	4846
4	Residual Value	5000	0.8227	4114
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