Question

Novak Corporation agrees on January 1, 2017, to lease equipment from Alpha, Inc. for 4 years. The lease calls for annual lease payments of $43,000 at the beginning of each year. The lease does not transfer ownership, contain a bargain-purchase option, and is not a specialized asset. In addition, the useful life of the equipment is 12 years, and the present value of the lease payments is less than 90% of the fair value of the equipment.

Prepare Novak’s journal entries on January 1, 2017 (commencement of the operating lease), and on December 31, 2017. Assume the implicit rate used by the lessor is unknown, and Novak’s incremental borrowing rate is 7%.

JUST DO THE 5 TEST FOR CLASSIFICATION OF A FINANCING LEASE!!!!

Answer 1

5 test for Classification of a Financing Lease

The various criteria that differentiated between a financial and operating lease are

1. The lease term makes major portion of the useful life of the asset i.e. 75% or more. This criteria is not fulfilled as the lease term is 4 years against the useful life of 12 years of the asset.
2. The present value of the lease rents rentals is substantively equal to the fair value of the asset i.e. minimum 90% of the face value. This condition is also not fulfilled in the current lease agreement as specified by the question.
3. The lessor has the option to purchase the asset at the end of the lease agreement in the case of financial lease. It is specifically stated that lease does not transfer ownership.
4. To qualify as financial lease, the asset has to be of such a specialized nature that it cannot be used by anyone except lessor without making substantial changes. In the present scenario, it has been specifically stated that the asset is not of specialized nature.
5. To qualify as financial lease, the lease contains a bargain option to purchase the asset at a price less than the market value. The lease agreement between Novak Corporation and Alpha, Inc does not contain Bargain-purchase option.

After analyzing all the aspects, we can conclude that the lease agreement between Novak Corporation and Alpha, Inc is Operating Lease.

Journal Entries in the Books of Novak on January 1,2017

1. At the Inception of lease agreement : No entry

2. On making first payment of the lease rentals

Dr.  Lease rental Expense $43,000

Cr. Cash $43,000

Journal Entries in the Books of Novak on December 31, 2017

No Entry