On January 1, 2016, Ryan Company leased equipment to Brady Corporation. The foll

Question

On January 1, 2016, Ryan Company leased equipment to Brady Corporation. The following information pertains to this lease.

The term of the non cancelable lease is 6 years, with no renewal option. The equipment reverts to the lessor at the termination of the lease.

Equal rental payments of $41,451.82 are due on January 1 of each year, beginning in 2016.

The fair value of the equipment on January 1, 2016, is $200,000, and its cost is $150,000.

The equipment has an economic life of 8 years, with an unguaranteed residual value of $10,000. Brady depreciates all of it equipment on a straight-line basis.

Ryan sets the annual rental to ensure an 11% rate of return. Brady’ incremental borrowing rate is 12%. The implicit rate of the lessor is not known to Brady.

Collection of lease payments is reasonably predictable, and no important uncertainties surround the amount of costs yet to be incurred by the lessor.

   a. Discuss the nature of this lease to Brady.

   b. Prepare all the necessary journal entries for Brady through January 1, 2017.

   c. Discuss the nature of this lease to Ryan.

   d. If the cost of this lease had been $200,000, how with this have changed your answer to Part (c)?

   e. Had the title of the lease transferred at the end of the lease, how with this have changed your depreciation calculation for Brady?

Explanation / Answer

   a.Nature of this lease to Brady. The terms of the lease meets 2 of the capital lease criteria:ie. the term of the lease is 6/8=75% of the economic life of the asset & the PV of the lease payments taking incremental borrowing rate of Brady(lessee) as the discount rate = 41451.82*4.604776= 190876.35 PFOADue F 12%, 6yrs.=4.604776 This PV is more than 90% of the fair value of the asset(200000*90%=180000) So, based on the above, this is a capital lease for Brady Corpn. Lease amortisation schedule for Brady Corpn. Year Annuity Tow.Int. Tow. Prin. Principal 0 190876.35 1 41451.82 0.00 41451.82 149424.53 2 41451.82 17930.94 23520.88 125903.65 3 41451.82 15108.44 26343.38 99560.27 4 41451.82 11947.23 29504.59 70055.68 5 41451.82 8406.68 33045.14 37010.55 6 41451.82 4441.27 37010.55 -0.01 TOTAL 248710.92 57834.56 190876.36 b.   Jan 1,2016 Equipment 190876.35 Capital lease liability 190876.35 Capital lease liability 41451.82 Cash 41451.82 Depreciation-Equipment 31812.73 Accumulated Depreciation-Equipment 31812.73 (190876.35/6 yrs.) Interest expense 17930.94 Interest payable 17930.94 Jan.1, 2017 Interest payable 17930.94 Capital lease liability 23520.88 Cash 41451.82 c. Nature of this lease to Ryan (Lessor) It is a capital lease as both the additional criteria for the same to the lessor are met, namely, collection of lease payments is reasonably predictable and no important uncertainties surround the amount of costs yet to be incurred by the lessor. As the PV of the lease receivable is more than the carrying value, here, cost of the asset 150000, this is a sale type capital lease, in which the difference is the gross profit recognised at the inception of the lease. d. In that case, where the PV is less than the carrying value or cost of the leased asset, it is a direct financing lease, in which case, only interest income is recognised & realised throughout the lease. e. Title trfd. To Brady corpn. Depreciation will be provided for the full economic life of the asset, ie. 8 yrs Depreciation-Equipment 23859.54 Accumulated Depreciation-Equipment 23859.54 (190876.35/8 yrs.)

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