Edom Company, the lessor, enters into a lease with Davis Company to lease equipm

Question

Edom Company, the lessor, enters into a lease with Davis Company to lease equipment to Davis beginning January 1, 2016. The lease terms, provisions, and related events are as follows:

1. The lease term is 5 years. The lease is noncancelable and requires annual rental receipts of $100,000 to be made in advance at the beginning of each year.

2. The equipment costs $313,000. The equipment has an estimated life of 6 years and, at the end of the lease term, has an unguaranteed residual value of $20,000 accruing to the benefit of Edom.

3. Davis agrees to pay all executory costs.

4. The interest rate implicit in the lease is 14%.

5. The initial direct costs are insignificant and assumed to be zero.

6. The collectibility of the rentals is reasonably assured, and there are no important uncertainties surrounding the amount of unreimbursable costs yet to be incurred by the lessor.

Solve: 1. Determine if the lease is a sales-type or direct financing lease from Edom’s point of view (calculate the selling price and assume that this is also the fair value).

2. Prepare a table summarizing the lease receipts and interest revenue earned by the lessor.

3. Prepare journal entries for Edom, the lessor, for the years 2016 and 2017.

I have part 1, the Selling price at fair value is 520,000 and is a sales type contract, its the rest I am having trouble with

Explanation / Answer

Part 2)

Step 1: Calculate Present Value of Annual Lease Payments

The present value of annual lease payments can be calculated with the use of PV (Present Value) function/formula of EXCEL/Financial Calculator. The function/formula for PV is PV(Rate,Nper,PMT,FV,1) where Rate = Interest Rate, Nper = Period, PMT = Payment, FV = Future Value and 1 indicates Annuity Due.

Here, Rate = 14%, Nper = 5, PMT = $100,000 and FV = 0

Using these values in the above function/formula for PV, we get,

Present Value of Annual Lease Payments = PV(14%,5,100000,0,1) = $391,371.23

_____

Step 2: Calculate Present Value of Unguaranteed Residual Value

The present value of annual lease payments can be calculated with the use of PV (Present Value) function/formula of EXCEL/Financial Calculator. The function/formula for PV is PV(Rate,Nper,PMT,FV) where Rate = Interest Rate, Nper = Period, PMT = Payment, FV = Future Value.

Here, Rate = 14%, Nper = 5, PMT = 0 and FV = $20,000

Using these values in the above function/formula for PV, we get,

Present Value of Unguaranteed Residual Value = PV(14%,5,0,20000) = $10,387.37

_____

Step 3: Calculate Amount of Unearned Interest

The amount of unearned interest is determined as below:

_____

Step 4: Prepare the Table Summarizing Lease Receipts and Interest Revenue Earned by Lessor:

The table summarizing the lease receipts and interest revenue earned by the lessor is given as below:

_____

Part 3)

The journal entries are prepared as below:

_____

Notes:

There can be a slight difference in values on account of methodology used for calculation of present values.

Fair Value of Equipment (from Step 1) 520,000 Less Present Value of Annual Lease Payments 391,371.23 Present Value of Unguaranteed Residual Value 10,387.37 Unearned Interest $118,241.40

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