E21-3 (L02,4) (Lessee Computations and Entries; Finance Lease with Guaranteed Re

Question

E21-3 (L02,4) (Lessee Computations and Entries; Finance Lease with Guaranteed Residual Value) Delaney Company leases an automobile with a fair value of $10,000 from Simon Motors, Inc, on the following terms. Non-cancelable term of 50 months. 1. 2. 3. 4. 5. Rental of $200 per month (at the beginning of each month). (The present value at 0.5% per month is $8,873.) Delaney guarantees a residual value of $1,180 the present value at 0.5% per month is 5920 Delaney expects the probable residual value to be $1,180 at the end of the lease term. Estimated economic life of the automobile is 60 months. Delaney's incremental borrowing rate is 6% a year (0.5% a month . Simon's implicit rate is unknown. Exercises 21-60 Instructions (a) What is the nature of this lease to Delaney? (b) What is the present value of the lease payments to determine the lease liability? (c) Based on the original fact pattern, record the lease on Delaney's books at the date of co (d) Record the first month's lease payment (at commencement of the lease) (e) Record the second month's lease payment. (f) Record the first month's amortization on Delaney's books (assume straight-line). g) Suppose that instead of $1,180, Delaney expects the residual value to be only $500 (the guaranteed amount is still $1,180). How does the calculation of the present value of the lease payments change from part (b)?

Explanation / Answer

a) The nature of this lease to Delaney is capital lease because the lease terms satisfy the following criteria:-

i) The lease term (50 months) is greater than 75% of the economic life of the asset (60 months) that is the lease term is 83.33% of the economic life of asset (50 months/60 months = 83.33%).

ii) The present value of the minimum lease payments ($8,873+$920 = $9,793) is greater than 90% of the fair value of the leased asset ($10,000), that is the present value of $9,793 is 97.93% of the fair value of the leased asset ($9,793/$10,000 = 97.93%).

Therefore the nature of this lease to Delaney is capital lease.

b) The present value of lease payments is calculated as follows:-

PV of lease payments = PV of monthly payment+PV of guaranteed residual value

= $8,873+$920 = $9,793

c, d, e & f) Right of use asset will be recorded at the present value of lease payments and correspondingly lease payable account will be credited with the same amount. All the required Journal Entries to record the lease on Delaney’s books is shown as follows:-   

Journal Entry (Amount in $)

No. Account Titles Debit Credit c) Right of use asset 9,793 Lease Payable 9,793 (To record the lease at commencement) d) Interest Expense ($9,793*0.5%) 48.96 Lease Payable (200-48.96) 151.04 Cash 200 (To record the first lease payment) e) Interest Expense [(9,793-151.04)*0.5%] 48.21 Lease Payable (200-48.21) 151.79 Cash 200 (To record the second lease payment) f) Amortization expense (9,793/50 months) 195.86 Right of use asset 195.86 (To record the first month’s amortization)

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