Sax Company signs a lease agreement dated January 1, 2016, that provides for it

Question

Sax Company signs a lease agreement dated January 1, 2016, that provides for it to lease computers from Appleton Company beginning January 1, 2016. The lease terms, provisions, and related events are as follows:

Required:

1. The lease term is 5 years. The lease is noncancelable and requires equal rental payments to be made at the end of each year. 2. The computers have an estimated life of 5 years, a fair value of $300,000, and a zero estimated residual value. 3. Sax agrees to pay all executory costs. 4. The lease contains no renewal or bargain purchase option. 5. The annual payment is set by Appleton at $83,222.92 to earn a rate of return of 12% on its net investment. Sax is aware of this rate, which is equal to its borrowing rate. 6. Sax uses the straight-line method to record depreciation on similar equipment.

Explanation / Answer

1.) Both lease term and estimated life of computers are 5 years and the present value of installments is [$83,222.92*PVAF(12%,5yrs)] approximately $300,000 which is equal to fair value of computers. Thus the nature of the lease is capital lease (or financial lease). Both asset and a liability is recognised at the present value of minimum lease payments in the books of lessee.

2.) The amount of asset and liability at the inception of lease is recognised at the present value of minimum lease payments which is computed as follows:-

Present value of minimum lease payments = Annual Payment*PVAF(12%,5 yrs)

= $83,222.92*3.605 = $300,019 (i.e. $300,000 approx.)

3.) Table summarizing the lease payments and interest expense

Interest Expense [(iii) = (i)*12%]

4.) Journal Entries for the year 2016 in the books of Sax

Journal Entries for the year 2017 in the books of Sax

Year Opening Balance(i) Annual Installment(ii)

Interest Expense [(iii) = (i)*12%]

Lease Payments[(iv) = (ii)- (iii)] Closing Balance [(i)-(iv)] 1 300,000 83,222.92 36,000 47,222.92 252,777.08 2 252,777.08 83,222.92 30,333.25 52,889.67 199,887.41 3 199,887.41 83,222.92 23,986.49 59,236.43 140,650.98 4 140,650.98 83,222.92 16,878.12 66,344.80 74306.18 5 74306.18 83,222.92 8916.74 74306.18 0

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