Chapter 20, Problem 10P

1.

To determine

Identify the type of lease involved for lessee and lessor and provide the reasons for such classification.

Explanation of Solution

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’.

Capital leases: In capital lease all the ownership risks and responsibilities are transferred from the lessor to the lessee.

Direct Financing Lease: Under direct financing lease, the lessor considers the lease as a sale of the asset at fair value equal to the cost of the asset or its carrying value and records an accompanying receivable. Since there is no manufacture’s or dealer’s profit or loss, the lessor records the net amount at which the receivable must be equal to the cost of the asset or carrying value of the property.

Identify the type of lease involved for lessee and lessor:

Criteria	Met or not	Remarks
1. Transfer of ownership at the end of lease	No
2. Bargain purchase option	No
3. Lease term is 75% or more	Not Known
4. Present value of lease payment is 90% or more of the fair value	Yes	100%
Recognition Criteria
1. Collectivity assured	Yes
2. No Uncertainties	Yes

Table (1)

Reason: From the above table, it is noted that, since one or more than one of the capitalization criteria and both the recognition criteria are met, the lease is a direct financing lease (absence of any dealer’s profit) for the Lessor Company and a capital lease for the Lessee Company.

Working note 1: Compute the present value of the lease payment.

$\begin{array}{c}\text{Present Value}\text{}\text{= Annual Lease Amount}\times \text{PV}\text{}\text{ factor for 10 Payments in advance at 12\%}\\ \text{ = \$27,653}\text{.77}\times \text{6}\text{.328250}\\ \text{ = \$175,000}\left(\text{rounded}\right)\end{array}$

2.

To determine

Prepare the journal entries in the books of lessee and lessor for the years 2016 and 2017.

Explanation of Solution

Journal: Journal is the method of recording monetary business transactions in chronological order. It records the debit and credit aspects of each transaction to abide by the double-entry system.

Rules of Debit and Credit: Following rules are followed for debiting and crediting different accounts while they occur in business transactions:

• Debit, all increase in assets, expenses and dividends, all decrease in liabilities, revenues and stockholders’ equities.
• Credit, all increase in liabilities, revenues, and stockholders’ equities, all decrease in assets, expenses.

Prepare the journal entries in the books of lessee and lessor for the years 2016 and 2017:

In the books of lessee:

Date	Accounts title and explanation	Post Ref.	Debit($)	Credit($)
January 01, 2016	Leased Equipment		175,000.00
	Capital Lease Obligation			175,000.00
	(To record the capital lease at inception)
January 01, 2016	Capital Lease Obligation		27,653.77
	Cash			27,653.77
	(To record the capital lease payment)
During year	Insurance Expense: Capital Leases		1,900.00
	Property Tax Expense: Capital Leases		1,300.00
	Maintenance Expense: Capital Lease		600.00
	Cash			3,800.00
	(To record the payment of the executory costs )
December 31,2016	Depreciation Expense: Leased Equipment		17,500.00
	Accumulated Depreciation: Equipment			17,500.00
	(To record the depreciation expense)
December 31,2016	Interest Expense		17,681.55
	Accrued Interest on Capital Lease Obligation			17,681.55
	(To record the interest expense)
January 01,2017	Accrued Interest on Capital Lease Obligation		17,681.55
	Capital Lease Obligation		9,972.22
	Cash			27,653.77
	(To record the payment of accrued interest and capital lease)
During year	Insurance Expense: Capital Leases		1,800.00
	Property Tax Expense: Capital Leases		1,200.00
	Maintenance Expense: Capital Lease		500.00
	Cash			3,500.00
	(To record the payment of the executory costs )
December 31,2017	Depreciation Expense: Leased Equipment		17,500.00
	Accumulated Depreciation: Equipment			17,500.00
	(To record the depreciation expense)
December 31,2017	Interest Expense		16,484.88
	Accrued Interest on CapitalLease Obligation			16,484.88
	(To record the interest expense)

Table (2)

In the books of lessor:

Date	Accounts title and explanation	Post Ref.	Debit($)	Credit($)
January 01,2016	Equipment Leased to Others		175,000.00
	Cash			175,000.00
	(To record the payment of capital lease at inception)
January 01,2016	Lease Receivable		276,537.70
	Equipment Leased to Others			175,000.00
	Unearned Interest: Leases			101,537.70
	(To record the lease receivable in a capital lease)
January 01,2016	Cash		27,653.77
	Lease Receivable			27,653.77
	(To record the receipt lease payment)
December 31,2016	Unearned Interest: Leases		17,681.55
	Interest Revenue: Leases			17,681.55
	(To recognize the interest revenue of the year)
January 01,2017	Cash		27,653.77
	Lease Receivable			27,653.77
	(To record the receipt of lease payment of the year)
December 31,2017	Unearned Interest: Leases		16,484.88
	Interest Revenue: Leases			16,484.88
	(To recognize the interest revenue of the year)

Table (3)

Working note 2: Prepare the table regarding the lease payment received/required, interest revenue/expense and net investment.

Summary Table for 2016 and 2017
Lessee Company
	Lease payment required	Interest Expense	Balance of Lease Obligation
Lessor Company
Date	Lease payment received	Interest Revenue	Net Investment
January 01,2016			$175,000.00
January 01,2016	$27,653.77	0	147,346.23
December 31,2016	$0.00	$17,681.55	165,027.78
January 01,2017	27,653.77	0	137,374.01
December 31,2017	0	16,484.88	153,858.89

Table (4)

Notes to the above table:

$\text{Cost or the fair value for lessor}\left(\text{January 01,2016}\right)\text{ = \$175,000}\text{.00}\left(\begin{array}{l}\text{PV}\text{}\text{of lease }\\ \text{payments for lessee}\end{array}\right)$

$\begin{array}{c}\text{Net Investment }\left(\text{January 01,2016}\right)=\text{ Lease Receivable}-\text{Unearned Interest: Leases}\\ \text{= \$276,537}\text{.70}-\text{\$101,537}\text{.70}\\ \text{= \$175,000}\text{.00}\end{array}$

$\begin{array}{c}\text{Net Investment }\left(\text{December 31,2016}\right)=\text{Lease Receivable}-\text{Unearned Interest: Leases}\\ =\$248,883.93-\$83,856.15\\ =\$165,027.78\end{array}$

$\begin{array}{c}\text{Net Investment }\left(\text{December 31,2017}\right)=\text{ Lease Receivable}-\text{Unearned Interest: Leases}\\ =\$221,230.16-\$67,371.27\\ =\$153,858.89\end{array}$

$\begin{array}{l}\text{Lease Receivable}\left(\text{January 01,2016}\right)=\text{ \$27,653}\text{.77}\times \text{10}\\ \text{Unearned Interest: Leases }=\text{ \$276,537}\text{.70}-\text{\$175,000}\text{.00}\end{array}$

$\begin{array}{l}\text{Net Investment}\left(\text{January 01,2016}\right)=\text{ \$175,000}-\text{\$27,653}\text{.77}\\ \text{Interest Revenue}\left(\text{Decmber 31, 2016}\right)=\text{ \$147,346}\text{.23}\times \text{12\%}\\ \text{Net Investment}\left(\text{December 31,2016}\right)=\$147,346.23+\$17,681.55\end{array}$