Chapter 15, Problem 15.15P

1)

To determine

Sales-type lease

Finance lease is a parallel type of direct financing whereby the owner (lessor) purchases the equipment to lease it and received the interest revenue over the period of lease for equipment, apart from the recognition of profit from sale of equipment.

Purchase option reasonably certain to be exercised before lease term

If the purchase option is reasonably certain to be exercised before lease term, the lease term ends for accounting purpose. The lease payments includes only periodic cash payments stated in the lease agreement that occur preceding to the date a BPO becomes exercisable.

To Calculate: the amount of selling profit that MS Company would recognize in this sales type lease.

Explanation of Solution

	Amount ($)
Present value of quarterly lease payments (1)	21,691
Add: Present value of BPO price (2)	4,736
Present value of lease payments	26,427

Table (1)

Working note:

Use the present value factor 7.23028 (Present value annuity factor of $1 for 8 years $\left(2\times 4\right)$ at 3% $\left(\frac{12\%}{4}\right)$ rate for calculating present value of lease payments.

Calculate the present value of quarterly lease payments:

$\begin{array}{c}\begin{array}{l}\text{Present value of }\\ \text{quarterly lease payments}\end{array}\}\text{ = Quarterly lease payments }\times \text{ PVIFA}\left(3\%,8\right)\\ =\$3,000\times 7.23028\\ =\$21,691\end{array}$ (1)

Calculate the present value of Bargain Purchase Option (BPO) price:

$\begin{array}{c}\text{Present value of BPO price = BPO Price }\times \text{ PVIF}\left(3\%,8\right)\\ =\$6,000\times 0.78941\\ =\$4,736\end{array}$ (2)

The exercise of the option present at the beginning of the lease seems to be reasonably certain, payment of option price of $6,000 is expected to occur when the option becomes exercisable at the end of 8^th quarter.

Correspondingly, the lease agreement specifies that the bargain purchase option becomes exercisable before the specified lease term ends. Since bargain purchase option is expected to be exercised, the lease term ends for the accounting purpose when the option becomes exercisable.

(2)

To determine

To Prepare: the appropriate entries for AG Company (Lessee) and MS Company (Lessor) on September 30, 2016.

Explanation of Solution

Prepare journal entries for AG Company (Lessee)

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
2016
September 30	Right-of-use asset Table (1)		26,427
	Lease Payable			26,427
	(To record the lease payable)
September 30	Lease payable		3,000
	Cash			3,000
	(To record the quarterly lease payments)

Table (2)

Prepare journal entries for MS Company (Lessor)

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
2016
September 30	Lease Receivable		26,427
	Cost of goods sold		25,000
	Sales revenue			26,427
	Equipment			25,000
	(To record the lease receivable)
September 30	Cash		3,000
	Lease receivable			3,000
	(To record the quarterly lease payments received)

Table (3)

(3)

To determine

To Prepare: amortization schedule for AG Company (Lessee) and MS Company (Lessor)

Explanation of Solution

Here the lessee and lessor both use same discount rate, therefore the amortization schedule is same for both persons.

Prepare amortization schedule as follows:

Lease Amortization Schedule
A	B	C	D	E
Date	Lease Payment ($)	Effective Interest (3% × Outstanding balance) ($)	Payment Reduction ($) (B –C)	Outstanding Balance ($) (E –D)
9/30/2016				26,427
9/30/2016	3,000		3,000	23,427
12/31/2016	3,000	703	2,297	21,130
3/31/2017	3,000	634	2,366	18,764
6/30/2017	3,000	563	2,437	16,327
9/30/2017	3,000	490	2,510	13,816
12/31/2017	3,000	414	2,586	11,231
3/31/2018	3,000	337	2,663	8,568
6/30/2018	3,000	257	2,743	5,825
9/29/2018	6,000	175	5,825	0
	30,000	3,573	26,427

Table (4)

The amortization table is prepared to present the pattern of interest expenses throughout the period. The schedule shows the lease balance and effective interest change over the 8-quarterly term period of lease using effective interest rate of 3%. Each lease payment after the first payment includes both the interest and amount that represents the reduction of outstanding balance. At the end of the lease period, the outstanding balance becomes zero.

(4)

To determine

To Prepare: appropriate entries for AG Company (Lessee) and MS Company (Lessor) as on December 31, 2016.

Explanation of Solution

Prepare journal entries for AG Company (Lessee)

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
2016
December 31	Amortization expense (3)		1,652
	Right-of-use asset			1,652
	(To record amortization expense.)
December 31	Interest expense		703
	Lease payable		2,297
	Cash			3,000
	(To record the quarterly lease payments and interest expense)

Table (5)

Working note:

Calculate the amortization expense for the asset

$\begin{array}{c}\text{Amortization expense = }\frac{\text{Present value of lease payments}}{\text{Lease term}}\\ =\frac{\$26,427}{4}\times \frac{1}{4}\\ =\$1,652\end{array}$ (3)

Prepare journal entries for MS Company (Lessor)

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
2016
December 31	Cash		3,000
	Lease receivable			2,297
	Interest revenue			703
	(To record interest revenue.)

Table (6)

(5)

To determine

To Prepare: the appropriate entries for AG Company (Lessee) and MS Company (Lessor) as on September 29, 2018 (Assuming purchase option was exercise on that date)

Explanation of Solution

Prepare journal entries for AG Company (Lessee)

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
2016
December 31	Amortization expense (4)		4,955
	Right-of-use asset			4,955
	(To record amortization expense.)
December 31	Interest expense		174
	Lease payable		5,826
	Cash			6,000
	(To record the quarterly lease payments and interest expense)

Table (7)

Working note:

Calculate the amortization expense for the asset

$\begin{array}{c}\text{Amortization expense = }\frac{\text{Present value of lease payments}}{\text{Lease term}}\\ =\frac{\$26,427}{4}\times \frac{3}{4}\\ =\$4,955\end{array}$ (4)

Prepare journal entries for MS Company (Lessor)

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
2016
December 31	Cash		6,000
	Lease receivable			5,826
	Interest revenue			174
	(To record interest revenue.)

Table (8)