Rauch Inc. leases a piece of equipment to Donahue Corp. on Jan 1 2017. The lease

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. 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?

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

3. 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.

Explanation / Answer

PART-1)

Fair value of leased asset to lessor

25,000

Minus: PV of unguaranteed residual value $8,250 X .82270

6,787

Amount to be recovered through lease payments

18,213

Four periodic lease payments ($18,213 /3.72325)

4,892

PART-2)

Debit

Credit

01/01/2017

Cash

4,892

Unearned Lease Revenue

4,892

12/31/2017

Unearned Lease Revenue

4,892

Lease Revenue

4,892

Depreciation Expense

3,333

Accumulated Depreciation – EquipmenT

3,333

PART-3)

Although the expected residual value decreased, however Donahue has guaranteed a residual value of $8,250 resulted Rauch to compute rental payments based on the same amount as if a residual value of $8,250 were unguaranteed. Moreover Rauch will recover by the way the lease payments whatever portion of the fair value of the asset it does not recover through the receipt of a residual value at the end of the lease term. Hence, all else being constant, Rauch demand would be for the similar amount in lease payments from Donahue as would under the original facts of the question

Fair value of leased asset to lessor

25,000

Minus: PV of unguaranteed residual value $8,250 X .82270

6,787

Amount to be recovered through lease payments

18,213

Four periodic lease payments ($18,213 /3.72325)

4,892

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