Question

Sage Dairy leases its milking equipment from Pronghorn Finance Company under the following lease terms.

1.		The lease term is 10 years, noncancelable, and requires equal rental payments of $28,200 due at the beginning of each year starting January 1, 2017.
2.		The equipment has a fair value and cost at the inception of the lease (January 1, 2017) of $205,207, an estimated economic life of 10 years, and a residual value (which is guaranteed by Sage Dairy) of $18,800.
3.		The lease contains no renewable options, and the equipment reverts to Pronghorn Finance Company upon termination of the lease.
4.		Sage Dairy’s incremental borrowing rate is 9% per year. The implicit rate is also 9%.
5.		Sage Dairy depreciates similar equipment that it owns on a straight-line basis.
6.		Collectibility of the payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor.

Prepare the journal entries for the lessee and lessor at January 1, 2017, and December 31, 2017 (the lessee’s and lessor’s year-end). Assume no reversing entries.

Lessee:

Jan. 1 2017: To record the lease and to record lease payment.

Lessor:

Jan. 1 2017: To record the lease and to record lease payment.

Lessee:

Dec. 31 2017: To record interest and to record depreciation.

Lessor:

Dec. 31 2017.

What would have been the amount capitalized by the lessee upon the inception of the lease if:

(1)		The residual value of $18,800 had been guaranteed by a third party, not the lessee?
(2)		The residual value of $18,800 had not been guaranteed at all?

On the lessor’s books, what would be the amount recorded as the Net Investment (Lease Receivable) at the inception of the lease, assuming:

(1)		The residual value of $18,800 had been guaranteed by a third party?
(2)		The residual value of $18,800 had not been guaranteed at all? Suppose the useful life of the milking equipment is 20 years. How large would the residual value have to be at the end of 10 years in order for the lessee to qualify for the operating method? (Assume that the residual value would be guaranteed by a third party.) (Hint: The lessee’s annual payments will be appropriately reduced as the residual value increases.) Residual value is greater than/ less than what?

Answer 1

Part 1)

The journal entries in the books of the lessor and lessee are provided as below:

Jan. 1 2017: To record the lease and to record lease payment

Lessee:

Account Titles	Debit	Credit
Leased Equipment (28,200*6.99525 + 18,800*.42241)	$205,207
Lease Liability		$205,207
(To record lease)
Lease Liability	$28,200
Cash		$28,200
(To record lease payment)

_____

Lessor:

Account Titles	Debit	Credit
Lease Receivable	$205,207
Equipment		$205,207
(To record the lease)
Cash	$28,200
Lease Receivable		$28,200
(To record lease payment)

_____

Dec. 31 2017: To record interest and to record depreciation.

Lessee:

Account Titles	Debit	Credit
Interest Expense [(205,207 - 28,200)*9%]	$15,931
Interest Payable		$15,931
(To record interest payment)
Depreciation Expense [(205,207 - 18,800)/10]	$18,641
Accumulated Depreciation - Capital Leases		$18,641
(To record depreciation expense)

_____

Lessor:

Account Titles	Debit	Credit
Interest Receivable [(205,207 - 28,200)*9%]	$15,931
Interest Revenue		$15,931

_____

Part 2)

1) The residual value of $18,800 had been guaranteed by a third party, not the lessee?

The amount capitalized by the lessee upon the inception of the lease would be $197,266 (28,200*6.99525) as the lessee has no obligation to pay the residual value.

_____

2) The residual value of $18,800 had not been guaranteed at all?

The amount capitalized by the lessee upon the inception of the lease would be $197,266 (28,200*6.99525) as the lessee has no obligation to pay the residual value.

_____

Part 3)

1) The residual value of $18,800 had been guaranteed by a third party?

The amount recorded as the net investment (lease receivable) at the inception of the lease by the lessor would be $205,207 as there is a residual value (of the equipment) irrespective of the fact that it is guaranteed by a third party.

_____

2) The residual value of $18,800 had not been guaranteed at all?

The amount recorded as the net investment (lease receivable) at the inception of the lease by the lessor would be $205,207 as there is a residual value (of the equipment) irrespective of the fact that it is guaranteed or not.

_____

Part 4)

The residual value would be have to be greater than 10%*205,207*2.36736 (where 2.36736 represents future interest factor for an annuity for 10 years at 9%) = $48,580