Problem 1 On January 1, 2016, Breshing Company enters into a noncancelable lease
ID: 2565932 • Letter: P
Question
Problem 1
On January 1, 2016, Breshing Company enters into a noncancelable lease, with no renewal option, to lease a new piece of equipment from Edwards Leasing Company. The lease term is for three years and the lease payments are made on December 31 of each year.
The equipment cost Edwards $250,000, it has a fair value of $300,000 and a useful life of four years with no residual value. The equipment reverts to Edwards upon termination of the lease. Breshing guarantees a $100,000 residual value at the end of the lease term.
Both Breshing Company and Edwards Company depreciate all machinery that they own on a straight-line basis. Breshing’s incremental borrowing rate is 8 percent per year and Breshing Company does not have knowledge of the 5 percent implicit rate used by Edwards.
Collectability of the future lease payments is reasonably predictable, and no additional costs related to the lease are expected.
Required:
1. Determine the annual lease payments, as set by the lessor.
2. Determine the amount of the minimum lease payments that will be capitalized by the lessee.
3. What type of lease is this to Breshing Company? Be specific in justifying your answer.
4. What type of lease is this to Edwards Company? Be specific in justifying your answer.
5. Prepare any necessary journal entries on January 1, 2016, for both parties.
6. Prepare any necessary journal entries on December 31, 2106 for both parties.
7. Which party will depreciate the asset? What is the amount of depreciation expense that will be recognized by that party? Be sure to show all calculations.
8. How would your answer change if the residual value were unguaranteed? (You just need to provide a narrative explanation of its impact on both parties. I am not looking for calculations with the new assumptions).
Problem 2
On January 1, 2016, Charloff Company entered into an agreement to lease a piece of machinery from Pierre Corporation for four years. The machinery had a cost and fair value of $800,000 and a useful life of seven years. The lease called for annual rental payments on December 31 of each year, starting on December 31, 2016. At the end of the lease term, Charloff has the option to purchase the equipment for $30,000, which is significantly less than what the fair market value of the equipment will be at that time.
Charloff’s incremental borrowing rate is 10% and Pierre’s implicit borrowing rate is 8%. Charloff is unaware of Pierre’s implicit rate.
Collectability of the future lease payments is reasonably predictable, and no additional costs related to the lease are expected.
Required:
1. What type of lease is this for Pierre? (Be specific and provide justification)
2. What type of lease is this for Charloff?
3. Determine the annual lease payments, as set by Pierre Corporation.
4. Determine the minimum lease payments, as calculated by Charloff.
5. Prepare the entry on the date of the lease inception for both the lessee and lessor.
6. Prepare the lessee’s amortization schedule for the term of the lease.
7. Prepare the entry for the first interest payment for both the lessee and lessor.
8. Prepare the entry to record depreciation expense for the asset for the year 2017, assuming that Charloff uses the straight-line method.
9. Complete parts 3-6, assuming that the lease payments are made each January 1, starting on January 1, 2016 instead of on December 31st of each year.
Explanation / Answer
Problem 1 1. With a residual value of `100000 lease payments For Edwards--lessor is as follows: Fair Market Value of Equipment = 300000 Less Present Value of Residual Value =100000* 0.79383= 79383 Amount to be recovered by Edwards through the lease payments is= 300000-79383= 220617 So, 3 Year-end Lease Payments =220617/2.57710= 85606.69 2. The guaranteed residual value is included in the minimum lease payments.So,it is required that Breshing Co. ---the lessee capitalize the present value of the amount (ie. 100000 ) guaranteed. So, the capitalized amount for Breshing Co. is as follows: 1. Present value of three Year-end lease-rental payments discounted at 8%=85606.69*2.57710= 220617 ------- (PVOA F 8%,3 Yrs.) Add: 2. Present value of a single sum of 100000 (the guaranteed residual value) discounted at 8% =100000*0.79383= 79383--------------- (1/1.08^3= 0.79383) 3. Total Present value of minimum lease payments = 220617+79383= 300000 3. What type of lease is this to Breshing Company? CAPITAL lease 1. Lease term(3 Years) is equal to 75% of the useful life(4 years) of the equipment 2.Present value of the minimum lease payments is 100% of the fair value ,ie. Both are 300000 4. What type of lease is this to Edwards Company? In addition to the above mentioned criteria, the following are also met, Collectability of the future lease payments is reasonably predictable, and no additional costs related to the lease are expected---- this is a Capital lease for Edwards 5. The initial recording of the capital lease at present value: Jan 1,2016 Breshing Company Leased Equipment 300000 Capital Lease Liability 300000 Edwards Company Lease receivable 300000 Equipment 3000000 Guaranteed residual Value Year Year-end annuity tow.principal Tow int. Principal bal. 1 2 3=2-4 4=Previous 5*8% 5 0 300000 1 85606.69 61606.69 24000 238393 2 85606.69 66535.23 19071.46 171858 3 85606.69 71858.04 13748.65 100000 100000 0 6 31-Dec-16 Breshing Company Capital Lease Liability 61606.69 Interest expense 24000 Cash 85606.69 Depreciation expense 100000 Accumulated depreciation 100000 (300000/3) 31-Dec-16 Edwards Company Cash 85606.69 Lease receivable 85606.69 7 Breshing Company will depreciate the asset--- as the asset is recorded In its books . The PV of the lease(value of the leased equipment) (300000) will be depreciated over the term of the lease(3 Years). So the amount of depreciation will be 300000/3=100000 8 The lessee- Breshing Company does not take into account the unguaranteed residual value while calculating the PV of lease payments . Accordingly, His Present value of three Year-end lease-rental payments discounted at 8%=85606.69*2.57710= 220617 ------- (PVOA F 8%,3 Yrs.) & the lease amortisation schedule will be: Unguaranteed residual Value Year Year-end annuity tow.principal Tow int. Principal bal. 1 2 3=2-4 4=Previous 5*8% 5 0 220617 1 85606.69 67957.33 17649.36 152660 2 85606.69 73393.92 12212.77 79266 3 85606.69 79265.43 6341.26 0 The lessor Edwards adds the ungauaranteed residual value to the PV of lease payments receivable & amortises in interest revenues. Problem-2 1. What type of lease is this for Pierre?--the lessor Capital lease In addition to the option to purchase by the lessee-- Charloff Collectability of the future lease payments is reasonably predictable, and no additional costs related to the lease are expected. Exist. 2. What type of lease is this for Charloff?--- the lessee Capital lease Option to purchase for less than the fair market value. 3.Annual lease payments, as set by Pierre Corporation. 1. With a BPO of `30000 lease payments For Pierre --lessor is as follows: Fair Market Value of Equipment = 800000 Less Present Value of BPO=30000* 0.68301= 20490--------- (1/1.10^4=0.68301) Amount to be recovered by Edwards through the lease payments is=800000-20490= 779510 So,4 Year-end Lease Payments =779510/3.16987= 245912-------- (PVOA F 10%, 4Yrs.) 4.Minimum lease payments, by Charloff. The Bargain Purchase option value is included in the minimum lease payments 1. Present value of 4 Year-end lease-rental payments discounted at 10%=245912*3.16987= 779510 ------- (PVOA F10% ,4 Yrs.) Add: 2. Present value of a single sum of 30000 (the BPO value) discounted at 10% =30000*0.68301= 20490-------------- (1/1.10^4= 0.68301) 3. Total Present value of minimum lease payments = 779510+20490= 800000 5. Journal Entry on the date of the lease inception for both the lessee and lessor. Jan 1,2016 Charloff Company(Lessee) Leased Equipment 800000 Capital Lease Liability 800000 Pierre Company Lease receivable 800000 Equipment 800000
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