Chapter 15, Problem 15.19P

Initial direct costs; sales-type lease

• LO15–2, LO15–7

Bidwell Leasing purchased a single-engine plane for its fair value of $645,526 and leased it to Red Baron Flying Club on January 1, 2018.

Terms of the lease agreement and related facts were:

1. a. Eight annual payments of $110,000 beginning January 1, 2018, the beginning of the lease, and at each December 31 through 2024. Bidwell Leasing’s implicit interest rate was 10%. The estimated useful life of the plane is eight years. Payments were calculated as follows:

1. b. Red Baron’s incremental borrowing rate is 11%.
2. c. Incremental costs of negotiating and consummating the completed lease transaction incurred by Bidwell Leasing were $18,099.

Required:

1. 1. How should this lease be classified (a) by Bidwell Leasing (the lessor) and (b) by Red Baron (the lessee)?
2. 2. Prepare the appropriate entries for both Red Baron Flying Club and Bidwell Leasing on January 1, 2018.
3. 3. Prepare an amortization schedule that describes the pattern of interest expense over the lease term for Red Baron Flying Club.
4. 4. Determine the effective rate of interest for Bidwell Leasing for the purpose of recognizing interest revenue over the lease term.
5. 5. Prepare an amortization schedule that describes the pattern of interest revenue over the lease term for Bidwell Leasing.
6. 6. Prepare the appropriate entries for both Red Baron and Bidwell Leasing on December 31, 2018 (the second lease payment). Both companies use straight-line depreciation.
7. 7. Prepare the appropriate entries for both Red Baron and Bidwell Leasing on December 31, 2024 (the final lease payment).

To determine

Sales-type lease

Sales type 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.

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:

• Transfer of title: The asset is transferred to lessee at the end of the lease period concerned.
• Purchase option: The purchase option is exercisable when the purchase price is sufficiently lower than expected fair value.
• Economic life: The economic life of the lease period is 75% or more than the useful life of the asset.
• 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.

Initial direct cost

Initial direct cost refers to the cost that

1. (a) Related directly with the completing a lease agreement
2. (b) Important for acquiring a lease
3. (c) Would not have been incurred had the lease agreement not occurred.

To Classify: the type of lease by BL company (Lessor) and by RB Company (Lessee)

Explanation of Solution

BL Company (Lessor)

Here at least one (Two in this scenario) classification criterion are met, this is a finance lease. As the fair value is the lessor’s cost, also no selling profit, in this sales type lease.

RB Company (Lessee)

Since at least one (Two in this scenario) criteria are met, this is finance lease to the lessee. The lessee records the present value of lease payments as right-of-use asset and lease payable.

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 = 8 years Useful life = 8 years
4	Is the present value of lease payments greater than or equal to substantially (90%) all of the market/fair value of the asset?	Yes	Present value (1) = $645,526 Fair value = $645,526
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:

$\begin{array}{c}\begin{array}{l}\text{Present value of }\\ \text{lease payments}\end{array}\}\text{ =Annual lease payments}\times \text{PVIFA }\left(\text{10\%,8}\right)\\ =\$110,000\times 5.86842\\ =\$645,526\end{array}$ (1)

To determine

To Prepare: the appropriate entries for RB Company (Lessee) and BL Company (Lessor) on January 01, 2018.

Explanation of Solution

Prepare journal entries for RB Company (Lessee)

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
2018
January 01	Right-of-use asset (1)		645,526
	Lease Payable			26,427
	(To record the lease payable)
January 01	Lease payable		110,000
	Cash			110,000
	(To record the quarterly lease payments)

Table (2)

Prepare journal entries for BL Company (Lessor)

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
2018
January 01	Lease Receivable		645,526
	Equipment			645,526
	(To record the lease receivable)
January 01	Lease receivable		18,099
	Cash			18,099
	(To record the initial direct cost)
January 01	Cash		110,000
	Lease receivable			110,000
	(To record the lease payments received)

Table (3)

To determine

To Prepare: amortization schedule for RB Company (Lessee)

Explanation of Solution

Prepare amortization schedule as follows:

Lease Amortization Schedule
A	B	C	D	E
Date	Lease Payment($)	Effective Interest (10% × Outstanding balance) ($)	Payment Reduction ($) (B –C)	Outstanding Balance($) (E –D)
				645,526
1/1/2018	110,000		110,000	535,526
12/31/2018	110,000	53,553	56,447	479,079
12/31/2019	110,000	47,908	62,092	416,986
12/31/2020	110,000	41,699	68,301	348,685
12/31/2021	110,000	34,869	75,131	273,554
12/31/2022	110,000	27,355	82,645	190,909
12/31/2023	110,000	19,091	90,909	100,000
12/31/2024	110,000	10,000	100,000	0
	880,000	234,474	645,526

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- 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

the effective rate of interest for BL Company (Lessor) for the purpose of recognizing interest revenue over the lease term.

Explanation of Solution

First, calculate the net investment.

The net investment is higher: $645,526 + $18,099 = $663,625

$\begin{array}{c}\text{Net investment = Fair value + Initial direct cost}\\ \text{= \$645,526 + \$18,099}\\ \text{= \$663,625}\end{array}$

Then, calculate the present value table amount from the given data:

$\begin{array}{c}\begin{array}{l}\text{Present value }\\ \text{annuity amount}\end{array}\}\text{ = }\frac{\text{Net investment}}{\text{Annual lease payment}}\\ \text{= }\frac{\text{\$663,625}}{\text{\$110,000}}\\ \text{= 6}\text{.03295}\end{array}$

Now, match the present value annuity with the rates of interest in the present value annuity table to ascertain the applied rate of interest.

When matching the present value annuity amount (6.03295) with the annuity table, we could find that the value 6.03295 falls in 8 years column under 9% rate of interest.

Conclusion

Therefore, effective rate of interest is 9%

To determine

To Prepare: amortization schedule for BL Company (Lessor)

Explanation of Solution

Prepare amortization schedule as follows:

Lease Amortization Schedule
A	B	C	D	E
Date	Lease Payment($)	Effective Interest (9% × Outstanding balance) ($)	Payment Reduction ($) (B –C)	Outstanding Balance($) (E –D)
				663,625
1/1/2018	110,000		110,000	553,625
12/31/2018	110,000	49,826	60,174	493,451
12/31/2019	110,000	44,411	65,589	427,862
12/31/2020	110,000	38,508	71,492	356,369
12/31/2021	110,000	32,073	77,927	278,443
12/31/2022	110,000	25,060	84,940	193,503
12/31/2023	110,000	17,415	92,585	100,918
12/31/2024	110,000	9,083	100,917	0
	880,000	216,375	663,625

Table (5)

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- 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: appropriate entries for RB Company (Lessee) and BL Company (Lessor) as on December 31, 2018. (Second lease payments)

Explanation of Solution

Prepare journal entries for RB Company (Lessee)

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
2018
December 31	Amortization expense (2)		80,691
	Right-of-use asset			80,691
	(To record amortization expense.)
December 31	Interest expense (From table 4)		53,553
	Lease payable		56,447
	Cash			110,000
	(To record the lease payments and interest expense)

Table (6)

Working note:

Calculate the amortization expense for the asset

$\begin{array}{c}\text{Amortization expense = }\frac{\text{Present value of lease payments}}{\text{Lease term}}\\ =\frac{\$645,526}{8}\\ =\$80,691\end{array}$ (2)

Prepare journal entries for BL Company (Lessor)

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
2018
December 31	Cash		110,000
	Lease receivable			60,174
	Interest revenue (From table 5)			49,826
	(To record interest revenue.)

Table (7)

To determine

To Prepare: appropriate entries for RB Company (Lessee) and BL Company (Lessor) as on December 31, 2024. (Final lease payments)

Explanation of Solution

Prepare journal entries for RB Company (Lessee)

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
2024
December 31	Amortization expense (2)		80,691
	Right-of-use asset			80,691
	(To record amortization expense.)
December 31	Interest expense (From table 4)		10,000
	Lease payable		100,000
	Cash			110,000
	(To record the lease payments and interest expense)

Table (8)

Prepare journal entries for BL Company (Lessor)

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
2024
December 31	Cash		110,000
	Lease receivable			100,918
	Interest revenue (From table 5)			9,082
	(To record interest revenue.)

Table (9)