Chapter 15, Problem 15.18P

Lessee-guaranteed residual value; unguaranteed residual value; nonlease costs; different interest rates for lessor and lessee

• LO15–3, LO15–6, LO15–7

On December 31, 2018, Yard Art Landscaping leased a delivery truck from Branch Motors. Branch paid $40,000 for the truck. Its retail value is $45,114.

The lease agreement specified annual payments of $11,000 beginning December 31, 2018, the beginning of the lease, and at each December 31 through 2021. Branch Motors’ interest rate for determining payments was 10%. At the end of the four-year lease term (December 31, 2022) the truck was expected to be worth $15,000. The estimated useful life of the truck is five years with no salvage value. Both companies use straight-line amortization or depreciation.

Yard Art guaranteed a residual value of $6,000. Yard Art’s incremental borrowing rate is 9% and is unaware of Branch’s implicit rate.

A $1,000 per year maintenance agreement was arranged for the truck with an outside service firm. As an expedient, Branch Motors agreed to pay this fee. It is, however, reflected in the $11,000 lease payments.

Required:

1. 1. How should this lease be classified by Yard Art Landscaping (the lessee)? Why?
2. 2. Calculate the amount Yard Art Landscaping would record as a right-of-use asset and a lease liability.
3. 3. How should this lease be classified by Branch Motors (the lessor)? Why?
4. 4. Show how Branch Motors calculated the $11,000 annual lease payments.
5. 5. Calculate the amount Branch Motors would record as sales revenue.
6. 6. Prepare the appropriate entries for both Yard Art and Branch Motors on December 31, 2018.
7. 7. Prepare an amortization schedule that describes the pattern of interest expense over the lease term for Yard Art.
8. 8. Prepare an amortization schedule that describes the pattern of interest revenue over the lease term for Branch Motors.
9. 9. Prepare the appropriate entries for both Yard Art and Branch Motors on December 31, 2019.
10. 10. Prepare the appropriate entries for both Yard Art and Branch Motors on December 31, 2021 (the final lease payment).
11. 11. Prepare the appropriate entries for both Yard Art and Branch Motors on December 31, 2022 (the end of the lease term), assuming the truck is returned to the lessor and the actual residual value of the truck was $4,000 on that date.

To determine

Lease

Lease is a contractual agreement whereby the right to use an asset for a particular period of time is provided by the owner of the asset to the user of the asset. The owner, who possesses the asset, is termed as ‘Lessor’ and user, to whom the right is transferred to, is termed as ‘Lessee’.

The criteria for defining the lease as finance lease or operating lease

As per the notes issued by Financial Accounting Standard Board (FASB), the following are four criteria to determine is a lease is a capital lease or an operating lease:

1. Transfer of title: The asset is transferred to lessee at the end of the lease period concerned.

2. Purchase option: The purchase option is exercisable when the purchase price is sufficiently lower than expected fair value.

3. Economic life: The economic life of the lease period is 75% or more than the useful life of the asset.

4. Value recovery: Present value of lease payments is greater or equal to 90% of the fair value.

If a particular lease fulfils any one of the above four criteria, then it is considered as finance lease. If a lease does not fulfil any of the above four criteria, it would be considered as operating lease.

Sales-type lease/Finance lease

Sales type/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.

Lessee guaranteed residual value

The lessee guaranteed residual value of leased asset is an estimation of the commercial value of the asset at the end of lease term. The present value is considered when determining the lease classification criteria (Criteria 4). Lessee guaranteed residual value is added to lease receivable and also added to sales revenue.

the appropriate classification of lease by lessee and state the reason.

Answer to Problem 15.18P

The lease is a finance lease to the lessee.

Explanation of Solution

The classification criteria for lessee are as follows:

S.No	Classification criteria	Does it satisfy?
1	Does the lease agreement specify about ownership transfer?	No
2	Does the lease agreement state about bargain purchase option?	No
3	Does the term of lease constitute major part of the expected economic life of the asset?	Yes	Lease term = 4 years Useful life = 5 years
4	Is the present value of lease payments greater than or equal to substantially all of the market/fair value of the asset?	No	Present value (1) = $39,564 Fair value = $45,114
5	Is the asset is of such a specialized nature which is expected to have an alternative use to lessor at the end of the term of lease?	No

Table (1)

Working note:

The present value of lease payments is calculated as below:

$\begin{array}{c}\begin{array}{l}\text{Present value of }\\ \text{lease payments}\end{array}\}\text{ =}\left(\begin{array}{l}\text{Amount recorded as right-of-use asset }\\ \text{+ Present value of lessee guaranteed }\\ \text{residual value}\end{array}\right)\\ =\left[\begin{array}{c}\left(\left[\begin{array}{l}\text{Annual lease payments}\\ -\text{Maintainenance agreement}\end{array}\right]\times \text{PVIFA }\left(\text{9\%,4yrs}\right)\right)\\ +\left(\begin{array}{l}\text{Guaranteed residual value}\\ \times \text{PVIF }\left(\text{9\%,4yrs}\right)\end{array}\right)\end{array}\right]\\ =\left(\left[\$11,000-\$1,000\right]\times 3.53129\right)+\left(\$6,000\times 0.70843\right)\\ =\$39,564\end{array}$ (1)

To determine

To Calculate: the amount YA Company (lessee) would record as right-of-use asset and lease liability.

Explanation of Solution

The present value of lease payments that would be recorded as right-of-use asset is calculated as below:

$\begin{array}{c}\begin{array}{l}\text{Present value of }\\ \text{lease payments}\end{array}\}\text{ =}\left[\begin{array}{l}\text{Annual lease payments}\\ -\text{Maintainenance agreement}\end{array}\right]\times \text{PVIFA }\left(\text{9\%,4yrs}\right)\\ =\left[\$11,000-\$1,000\right]\times 3.53129\\ =\$35,313\end{array}$

When calculating the amount for recording right-of-use asset, the residual value is not included in the lessee’s periodic payments.

Conclusion

Therefore, the present value of lessee’s periodic payments is $35,313

To determine

the appropriate classification of lease by lessor and state the reason.

Answer to Problem 15.18P

The lease is a sales type lease to the lessee.

Explanation of Solution

The classification criteria for lessor are as follows:

S.No	Classification criteria	Does it satisfy?
1	Does the lease agreement specify about ownership transfer?	No
2	Does the lease agreement state about bargain purchase option?	No
3	Does the term of lease constitute major part of the expected economic life of the asset?	Yes	Lease term = 4 years Useful life = 5 years
4	Is the present value of lease payments greater than or equal to substantially all of the market/fair value of the asset?	No	Present value (2) = $38,967 Fair value = $45,114
5	Is the asset is of such a specialized nature which is expected to have an alternative use to lessor at the end of the term of lease?	No

Table (2)

The present value of lease payments is calculated as below:

$\begin{array}{c}\begin{array}{l}\text{Present value of }\\ \text{lease payments}\end{array}\}\text{ =}\left[\begin{array}{c}\left(\left[\begin{array}{l}\text{Annual lease payments}\\ -\text{Maintainenance agreement}\end{array}\right]\times \text{PVIFA }\left(\text{10\%,4yrs}\right)\right)\\ +\left(\begin{array}{l}\text{Guaranteed residual value}\\ \times \text{PVIF }\left(\text{10\%,4yrs}\right)\end{array}\right)\end{array}\right]\\ =\left(\left[\$11,000-\$1,000\right]\times 3.48685\right)+\left(\$6,000\times 0.68301\right)\\ =\$39,564\end{array}$ (2)

To determine

To Show: how the annual lease payments of $11,000 is being calculated.

Explanation of Solution

	Amount ($)
Lease payments at the beginning of each of the next 4 years (5)	10,000
Add: Maintenance cost	1,000
Lease payments including maintenance costs	11,000

Table (3)

Working notes:

Calculate present value of residual amount:

$\begin{array}{c}\text{Present value of residual value = Residual value after 4 years}\times \text{PVIF}\left(10\%,4\right)\\ =\$15,000\times 0.68301\\ =\$10,245\end{array}$ (3)

Calculate the amount to be recovered by periodic lease payments:

	Amount ($)
Amount to be recovered (Fair value of truck)	45,114
Less: Present value of residual value (3)	10,245
Amount to be recovered by periodic lease payments	34,869

(4)

Calculate lease payments at the beginning of each of the next 4 years:

$\begin{array}{c}\begin{array}{l}Leasepayments\\ atthebeginning\\ ofeachofthenext4years\end{array}\}\text{ = }\left[\frac{\begin{array}{l}Amounttoberecovered\\ byperiodicleasepayments\end{array}}{PVIFA\left(10\%,4\right)}\right]\\ =\frac{\$34,869\left(4\right)}{3.48685}\\ =\$10,000\end{array}$ (5)

To determine

To Calculate: the amount the company BM (Lessor) would record as sales revenue.

Explanation of Solution

Calculate the sales revenue for lessor as follows:

	Amount ($)
Present value of periodic lease payments (4)	34,869
Add: Present value of lessee guaranteed residual value (6)	4,908
Sales revenue	38,967

Table (4)

Working notes:

Calculate the present value of lessee guaranteed residual value

$\begin{array}{c}\begin{array}{l}\text{Present value of leasee}\\ \text{ guaranteed residual value}\end{array}\}\text{ = Lessee Guaranteed residual value}\times \text{PVIF}\left(10\%,4\right)\\ =\$6,000\times 0.68301\\ =\$4,908\end{array}$ (6)

Conclusion

Hence, the sales revenue for lessor is $38,967

To determine

To Prepare: appropriatejournal entries for YA Company (Lessee) and Company BM (Lessor) on December 31, 2018.

Explanation of Solution

Prepare journal entry for YA Company (Lessee) in the month of December 31, 2018

Date		Accounts title and explanation	Post Ref.	Debit ($)	Credit ($)
		Right-of-use asset (7)		35,313
		Lease Payable			35,313
		(To record the lease payable)

Table (5)

• Right-of-use asset is an asset. There is an increase in asset. Therefore, debit right-of-use asset account by $35,313.
• Lease payable is a liability. There is an increase in liability. Therefore, credit lease liability by $35,313.

Working notes:

The present value of lease payments that would be recorded as right-of-use asset is calculated as below:

$\begin{array}{c}\begin{array}{l}\text{Present value of }\\ \text{lease payments}\end{array}\}\text{ =}\left[\begin{array}{l}\text{Annual lease payments}\\ -\text{Maintainenance agreement}\end{array}\right]\times \text{PVIFA }\left(\text{9\%,4yrs}\right)\\ =\left[\$11,000-\$1,000\right]\times 3.53129\\ =\$35,313\end{array}$ (7)

Transaction on December 31, 2018: Record the lease payments and prepaid maintenance expense.

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
	Prepaid maintenance expenses		1,000
	Lease payable (Difference)		10,000
	Cash			11,000
	(To record annual lease payment and maintenance expenses.)

Table (6)

• Prepaid maintenance expense is an asset and increases. Therefore, debit prepaid maintenance expense by $1,000.
• Lease payable is a liability. There is a decrease in liability. Therefore, debit lease liability by $10,000.
• Cash is an asset. There is a decrease in asset. Therefore, credit cash account by $11,000.

Prepare journal entry for BM Company (Lessor) in the month of December 31, 2018

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
		Lease Receivable		45,114
		Cost of Goods Sold (7)		33,853
		Sales Revenue Table (4)			38,967
		Equipment			40,000
		(To record lease inception)

Table (7)

• Lease receivable is an asset. There is an increase in asset. Therefore, debit lease receivable by $45,114.
• Equipment is an asset. There is a decrease in asset. Therefore, credit inventory of equipment by $40,000.
• Cost of goods sold decreases stockholders’ equity. Therefore, debit cost of goods sold by $33,853.
• Sales revenue increases stockholders’ equity. Therefore, credit sales revenue by $38,967.

Working notes:

Calculate the cost of goods sold as follows:

$\begin{array}{c}\text{Cost of goods sold = Equipment value}-\left[\text{Unguaranteed residual value}\times PVIF\left(10\%,4\right)\right]\\ =\$40,000-\left[\left(\$15,000-\$6,000\right)\times 0.68301\right]\\ =\$40,000-\$6,147\\ =\$33,853\end{array}$ (7)

Journalize the lease receivable: December 31, 2018

Date		Accounts Title and Explanation	Post Ref.	Debit ($)	Credit ($)
		Cash		11,000
		Lease Receivable			10,000
		Maintenance fee payable			1,000
		(To record the lease received)

Table (8)

• Cash is an asset. There is an increase in asset. Therefore, debit Cash Account by $11,000.
• Lease receivable is an asset. There is a decrease in asset. Therefore, credit Lease Receivable Account by $10,000.
• Maintenance fees payable is a liability and is increased. Therefore, credit maintenance fees payable by $1,000.

To determine

To prepare: an amortization schedule that describes the pattern of interest expense over the lease term for YA Company.

Explanation of Solution

Prepare an amortization schedule for the Lessee – YA Company.

Lease Amortization Schedule
A	B	C	D	E
Year (Dec 31)	Lease Payment ($)	Effective Interest (9% × Outstanding balance) ($)	Payment Reduction ($) (B – C)	Outstanding Balance ($) (E – D)
				35,313
2018	10,000		10,000	25,313
2019	10,000	2,278	7,722	17,591
2020	10,000	1,583	8,417	9,174
2021	10,000	826	9,174	0
	40,000	4,687	35,313

Table (9)

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 4 term period of lease using effective interest rate of 9%. 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.

To determine

To prepare: an amortization schedule that describes the pattern of interest expense over the lease term for BM Company.

Explanation of Solution

Prepare an amortization schedule for the Lessee – BM Company.

Lease Amortization Schedule
A	B	C	D	E
Year (Dec 31)	Lease Payment ($)	Effective Interest (10% × Outstanding balance) ($)	Payment Reduction ($) (B – C)	Outstanding Balance ($) (E – D)
				45,114
2018			10,000	35,114
2019	15,000	3,511	6,489	28,625
2020	15,000	2,863	7,137	21,448
2021	15,000	2,149	7,851	13,637
2022	15,000	1,363	13,637	0
	55,000	9,886	45,114

Table (10)

The amortization table is prepared to present the pattern of interest expenses throughout the period. The schedule shows the lease balance and interest change over the 4 term period of lease using effective interest rate of 10%. 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.

To determine

To Prepare: the appropriate entries for both YA Company and BM Company on December 31, 2019.

Explanation of Solution

Prepare entries in the books of YA Company.

Transaction on December 31, 2019: Record the maintenance expense.

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
	Maintenance expense		1,000
	Prepaid maintenance expenses			1,000
	(To record maintenance expenses.)

Table (11)

• Maintenance expense decreases stockholders’ equity. Therefore, debit maintenance interest expense by $1,000.
• Prepaid maintenance expense is an asset and decreases. Therefore, credit prepaid maintenance expense by $1,000.

Transaction on December 31, 2019: Record the lease payment.  

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
		Interest expense (8)		2,278
		Lease payable		7,722
		Prepaid maintenance expense		1,000
		Cash			11,000
		(To record lease payment)

Table (12)

• Interest expense decreases stockholders’ equity. Therefore, debit maintenance interest expense by $2,278.
• Prepaid maintenance expense is an asset and increases. Therefore, credit prepaid maintenance expense by $1,000.
• Lease payable is a liability. There is a decrease in liability. Therefore, debit lease liability by $10,000.
• Cash is an asset. There is a decrease in asset. Therefore, credit Cash Account by $11,000.

Working note:

Calculate the amount of interest expense for December 31, 2019 as follows:

$\begin{array}{c}\text{Interest expense}=\text{Rate of interest}\times \text{Outstanding Lease liability}\\ =9\text{\%}\times \left(\$35,313-\$10,000\right)\\ =\$2,278\end{array}$ (8)

Transaction on December 31, 2019: Record the amortization expense.

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
	Amortization expense (9)		8,828
	Right-of-use asset			8,828
	(To record amortization expense.)

Table (13)

• Amortization expense decreases stockholders’ equity. Therefore, debit amortization expense by $8,828.
• Right-of-use asset is an asset. There is a decrease in asset. Therefore, credit right-of-use asset by $8,828.

Working note:

Calculate the amortization expense for December 31, 2019 as follows:

$\begin{array}{c}\text{Amortization expenses = }\frac{\text{Present value of lessee periodic lease payment}}{\text{Term of lease}}\\ =\frac{\$35,313}{4}\\ =\$8,828\end{array}$ (9)

Prepare entries in the books of BM Company.

Journalize the lease receivable and interest revenue: December 31, 2019

Date		Accounts Title and Explanation	Post Ref.	Debit ($)	Credit ($)
		Cash		11,000
		Lease Receivable (Difference)			6,489
		Maintenance fee payable			1,000
		Interest revenue (10)			3,511
		(To record the lease received)

Table (14)

• Cash is an asset. There is an increase in asset. Therefore, debit Cash Account by $11,000.
• Lease receivable is an asset. There is a decrease in asset. Therefore, credit Lease Receivable Account by $10,000.
• Maintenance fees payable is a liability and is increased. Therefore, credit maintenance fees payable by $1,000.
• Interest revenue increases stockholders’ equity. Therefore, credit interest revenue by $3,511.

Working note:

Calculate the amount of interest revenue for December 31, 2019 as follows:

$\begin{array}{c}\text{Interest revenue}=\text{Rate of interest}\times \text{Outstanding Lease liability}\\ =10\text{\%}\times \left(\$45,114-\$10,000\right)\\ =\$3,511\end{array}$ (10)

To determine

To Prepare: the appropriate entries for both YA Company and BM Company on December 31, 2021.

Explanation of Solution

Prepare entries in the books of YA Company.

Transaction on December 31, 2021: Record the maintenance expense.

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
	Maintenance expense		1,000
	Prepaid maintenance expenses			1,000
	(To record maintenance expenses.)

Table (15)

• Maintenance expense decreases stockholders’ equity. Therefore, debit maintenance interest expense by $1,000.
• Prepaid maintenance expense is an asset and decreases. Therefore, credit prepaid maintenance expense by $1,000.

Transaction on December 31, 2021: Record the final lease payment.  

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
		Interest expense		826
		Lease payable		9,174
		Prepaid maintenance expense		1,000
		Cash			11,000
		(To record lease payment)

Table (16)

• Interest expense decreases stockholders’ equity. Therefore, debit maintenance interest expense by $826.
• Prepaid maintenance expense is an asset and increases. Therefore, credit prepaid maintenance expense by $1,000.
• Lease payable is a liability. There is a decrease in liability. Therefore, debit lease liability by $9,174.
• Cash is an asset. There is a decrease in asset. Therefore, credit Cash Account by $11,000.

Transaction on December 31, 2019: Record the amortization expense.

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
	Amortization expense (9)		8,828
	Right-of-use asset			8,828
	(To record amortization expense.)

Table (17)

• Amortization expense decreases stockholders’ equity. Therefore, debit amortization expense by $8,828.
• Right-of-use asset is an asset. There is a decrease in asset. Therefore, credit right-of-use asset by $8,828.

Prepare entries in the books of BM Company.

Journalize the lease receivable and interest revenue: December 31, 2021

Date		Accounts Title and Explanation	Post Ref.	Debit ($)	Credit ($)
		Cash		11,000
		Lease Receivable (Difference)			7,851
		Maintenance fee payable			1,000
		Interest revenue			2,149
		(To record the lease received)

Table (18)

• Cash is an asset. There is an increase in asset. Therefore, debit Cash Account by $11,000.
• Lease receivable is an asset. There is a decrease in asset. Therefore, credit Lease Receivable Account by $7,851.
• Maintenance fees payable is a liability and is increased. Therefore, credit maintenance fees payable by $1,000.
• Interest revenue increases stockholders’ equity. Therefore, credit interest revenue by $2,149.

To determine

To Prepare: the appropriate entries for both YA Company and BM Company on December 31, 2022.

Explanation of Solution

Prepare entries in the books of YA Company.

Transaction on December 31, 2022: Record the maintenance expense.

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
	Maintenance expense		1,000
	Prepaid maintenance expenses			1,000
	(To record maintenance expenses.)

Table (19)

• Maintenance expense decreases stockholders’ equity. Therefore, debit maintenance interest expense by $1,000.
• Prepaid maintenance expense is an asset and decreases. Therefore, credit prepaid maintenance expense by $1,000.

Transaction on December 31, 2022: Record the amortization expense.

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
	Amortization expense (9)		8,828
	Right-of-use asset			8,828
	(To record amortization expense.)

Table (20)

• Amortization expense decreases stockholders’ equity. Therefore, debit amortization expense by $8,828.
• Right-of-use asset is an asset. There is a decrease in asset. Therefore, credit right-of-use asset by $8,828.

Transaction on December 31, 2022: Record the loss on residual value guarantee.

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
	Loss on residual value guarantee		2,000
	Cash ($6,000 – $4,000)			2,000
	(To record loss on residual value.)

Table (21)

• Loss on residual value guarantee decreases stockholders’ equity. Therefore, debit amortization expense by $2,000.
• Cash is an asset. There is a decrease in asset. Therefore, credit cash account by $2,000.

Prepare entries in the books of BM Company.

Journalize the lease receivable and interest revenue: December 31, 2022

Date		Accounts Title and Explanation	Post Ref.	Debit ($)	Credit ($)
		Cash ($6,000– $4,000)		2,000
		Equipment		4,000
		Loss on leased assets ($15,000 – $4,000)		9,000
		Lease receivable			13,637
		Interest revenue			1,363
		(To record the lease received)

Table (22)

• Cash is an asset. There is an increase in asset. Therefore, debit Cash Account by $2,000.
• Equipment is an asset. There is an increase in asset. Therefore, debit Lease Receivable Account by $4,000.
• Loss on residual value guarantee decreases stockholders’ equity. Therefore, debit amortization expense by $9,000.
• Lease receivable is an asset. There is an increase in asset. Therefore, credit Lease Receivable Account by $13,637.
• Interest revenue increases stockholders’ equity. Therefore, credit interest revenue by $1,363.