Question

Direct financing and sales-type lease; lessee and lessor

Rand Medical manufactures lithotripters. Lithotripsy uses shock waves instead of surgery to eliminate kidney stones. Physicians’ Leasing purchased a lithotripter from Rand for $2,000,000 and leased it to Mid-South Urologists Group, Inc., on January 1, 2016.

Lease Description:
Quarterly lease payments	$130,516—beginning of each period
Lease term	5 years (20 quarters)
No residual value; no BPO
Economic life of lithotripter	5 years
Implicit interest rate and lessee’s incremental borrowing rate	12%
Fair value of asset	$2,000,000

Collectibility of the lease payments is reasonably assured, and there are no lessor costs yet to be incurred.

Required:

1.  How should this lease be classified by Mid-South Urologists Group and by Physicians’ Leasing?

2.  Prepare appropriate entries for both Mid-South Urologists Group and Physicians’ Leasing from the inception of the lease through the second rental payment on April 1, 2016. Depreciation is recorded at the end of each fiscal year (December 31).

3.  Assume Mid-South Urologists Group leased the lithotripter directly from the manufacturer, Rand Medical, which produced the machine at a cost of $1.7 million. Prepare appropriate entries for Rand Medical from the inception of the lease through the second lease payment on April 1, 2016.

Answer 1

Mid-South Urologists Group = Capital lease to lessee Physicians' Leasing = Direct financing lease to lessor.

Since the present value of minimum lease payments (same for both the lessor and the lessee) is greater than 90% of the fair value of the asset, the 90% recovery criterion is met.

Calculation of the Present Value of Minimum Lease Payments Present value of periodic lease payments $130,516 x 15.32380** = $2,000,000 (rounded) ** present value of an annuity due of $1: n=20, i=3%

The 75% of useful life criterion is met also. Both additional lessor conditions are met for a capital lease. There is no dealer's profit because the fair value equals the lessor's cost. Mid-South Urologists Group (Lessee) January 1, 2016 Leased equipment (calculated above) 2,000,000 Lease payable (calculated above)                               2,000,000

Lease payable 130,516 Cash (lease payment) 130,516 April 1, 2016 Interest expense (3% x [$2 million - 130,516]) 56,085 Lease payable (difference)                                      74,431 Cash (lease payment)                                                                130,516