Question

Renter’s Dilemma

Hucks, Inc. (Hucks), a publicly traded corporation, plans to lease equipment from Jackson Co. (Jackson) on January 1, 2020, for a period of three years. Lease payments of $100,000 are due to Jackson each year. Other expenses (e.g., insurance, taxes, and maintenance) are also to be paid by Hucks and amount to $2,000 per year. Jackson will not incur any initial direct costs. The lease contains no purchase or renewal options and the equipment reverts back to Jackson on the expiration of the lease. The remaining useful life of the equipment is four years. The fair value of the equipment at lease inception is $265,000. Hucks has guaranteed $20,000 as the residual value at the end of the lease term. The $20,000 represents the expected value of the leased equipment to Hucks at the end of the lease term. The salvage value of the equipment is expected to be $2,000 after the end of its economic life. Hucks’s incremental borrowing rate is 11 percent (Jackson’s implicit rate is 10 percent and is calculable by Hucks from the lease agreement).

The junior accountant of Hucks analyzed the assets under lease, determined whether the lease was an operating lease or finance lease, and prepared the applicable journal entries. The senior accountant of Hucks reviewed the junior accountant’s analysis and prepared a separate analysis. As the finance controller, you were given both analyses to determine the correct accounting treatment. Calculations and journal entries performed by your junior and senior accountant follow:

Present Value of the Lease Obligation

Using the rate implicit in the lease (10 percent), the present value of the guaranteed residual value would be $15,026 ($20,000 x 0.7513), and the present value of the annual payments would be $248,685 ($100,000 x 2.4869).

Using the incremental borrowing rate (11 percent), the present value of the guaranteed residual value would be $14,624 ($20,000 x 0.7312), and the present value of the annual payments would be $244,371 ($100,000 x 2.4437).

Junior accountant analysis:

Since the equipment reverts back to Jackson, it is an operating lease. 840

Entry to be posted in years 1, 2, and 3:

Dr. Rent expense                        $100,000

Dr. Insurance expense                   $2,000

              Cr. Cash                                                        $102,000

        (Operating lease rental paid to Jackson)

1. Was the assistant controller’s analysis correct? Why or why not?

2. Show the correct analysis including all year one entry(ies)?

3. Use FASB codification to support the answer?

Answer 1

Hucks, Inc.
Implied rate of interest = 11% i.e. incremental borrowing rate
Year	Particulars	PVF@11%	CF	PVCF
1-3	Lease Rentals	2.4437	100,000.00	244,371.50
3	Guaranteed Residual Value	0.7312	20,000.00	14,623.83
	Total guaranteed payment			258,995.33
	1) Fair value of the asset at the beginning of the lease period = $ 265000 2) Useful life of the asset at the inception of lease period = 4 years 3) Guranteed lease rentals and residual value as a % of fair value = 258995.33/265000 = 97.73% 4) Lease period as a % of remaining useful life = 3 / 4 years = 75% 5) Residual value as % of fair value at the inception = 2000 / 265000 = .75%
1	Recommendation/Conclusion: Based on above it can be seen that lease rental almost covers the fair value of the asset at the inception of lease period. There is very little residual value in comparison to fair value of the asset at the inception. Therefore lease shall be classified as a finance lease and not operating lease.
2	Based on above discussions, Junior accountant's recommendation to treat this as operating lease is wrong.
3	Assistant controller's treatment can not be commented upon since there is no specific treatment suggested by assitant controller appearing in question.
	Correct Journal Entries shall be as follows:
Sr.No/ Date	Account Titles	Debit	Credit
01.01.2020	Lease Equipment A/c	258,995.33
	Lease Vendor Payable		258,995.33
	To record initial purchase of equipment in a finance lease transaction.
31.12.2020	Lease Vendor Payable (bal.fig.)	71,510.51
	Interest Expenses @ 11%	28,489.49
	Bank A/c		100,000.00
	To record annual lease payment to finance lease vendor
31.12.2020	Depreciation A/c	-----
	Lease Equipment A/c		-----
	Since rate of depreciation is not specified amounts are entered as zero.
	Finance Lease amortisation schedule
Year	Particulars	Opening Bal.	Interest @ 11%	Installment paid	Closing Balance
(1)	(2)	(3)	(4)	(5)	(6) = (3+4-5)
0	Initial Cost	-	-	-	258,995.33
1	Interest and installment	258,995.33	28,489.49	100,000.00	187,484.81
2	Interest and installment	187,484.81	20,623.33	100,000.00	108,108.14
3	Interest and installment	108,108.14	11,891.90	120,000.00	-