Chapter 20, Problem 12P

Comprehensive Landlord Company and Tenant Company enter into a noncancelable, direct financing lease on January 1, 2019, for nonspecialized equipment that cost the Landlord $280,000 (useful life is 6 years with no residual value). The fair value of the equipment is $300,000. The interest rate implicit in the lease is 14%. The 6-year lease requires 6 equal annual amounts payable each January 1, beginning with January 1, 2019. Tenant pays all executory costs directly to a third party on December 1 of each year. The equipment reverts to the lessor at the termination of the lease. Assume that there are no initial direct costs. Landlord expects to collect all rental payments.

Required:

1. 1. Next Level (a) Show how landlord should compute the annual rental amounts, (b) Discuss how the Tenant Company should compute the present value of the lease payments. What additional information would be required to make this computation?
2. 2. Next Level Prepare a table summarizing the lease and interest receipts that would be suitable for Landlord. Under what conditions would this table be suitable for Tenant?
3. 3. Assuming that the table prepared in Requirement 2 is suitable for both the lessee and the lessor, prepare the journal entries for both firms for the years 2019 and 2020. Use the straight-line depreciation method for the leased equipment. The executory costs paid by the lessee are in 2019: insurance, $700 and property taxes, $800; in 2020: insurance, $600 and property taxes, $750.
4. 4. Next Level Show the items and amounts that would be reported on the comparative 2019 and 2020 income statements and ending balance sheets for both the lessor and the lessee, using the change in present value approach.

To determine

Calculate the annual rental amounts.

Explanation of Solution

Compute the annual rental amount of Company L, as follows:

$\begin{array}{c}\text{Annul Rental Amount = }\frac{\text{Cost of Equipment}}{\text{PV}\text{}\text{ factor for 6 receipts in advance at 14\%}}\\ \text{= }\frac{\$300,000}{4.433081}\\ \text{ = \$}67,673.02\end{array}$

Therefore, annual rental amount is $67,673.02.

To determine

Explain the way Company T should compute the present value of the lease rights and additional information required to make such calculation.

Explanation of Solution

To determine the present value of the lease rights, Company T should multiply the annual rental payment of $67,673.02 by the PV factor for 6 periods in advance at x%. That x% would be lesser than 14% or incremental borrowing rate of the Company T. Thus the incremental borrowing rate for Company T is the required additional information to compute the PV of lease rights.

To determine

Prepare the table summarizing the lease and interest receipts that would be suitable for Company L.

Explanation of Solution

Prepare the table summarizing the lease and interest receipts that would be suitable for Company L:

Date (1)	Lease payment received (2)	Interest revenue at 14% (3)	Net investment (4)
January 1,2019			$300,000.00
January 1,2019	$67,673.02		232,326.98
December31,2019		$32,525.78	264,852.76
January 1,2020	$67,673.02		197,179.74
December31,2020		27,605.16	224,784.90
January 1,2021	$67,673.02		157,111.88
December31,2021		21,995.66	179,107.54
January 1,2022	$67,673.02		111,434.52
December31,2022		15,600.83	127,035.35
January 1,2023	$67,673.02		59,362.33
December31,2023		8,310.69	67,673.02
January 1,2024	$67,673.02		0.00

Table (1)

Notes for the above table:

$\text{Interest Revenue on Net Investment}\left(\text{December 31,2016}\right)\text{ = \$232,326}\text{.98}\times \text{14\%}$

$\begin{array}{l}\text{Net Investment}\left(\text{Decemnber 31,2016}\right)\text{ = \$232,326}\text{.98+\$32,525}\text{.78}\\ \text{Interest Revenue on Net Investment}\left(\text{December 31,2020}\right)\text{ is adjusted for \$0}\text{.04 rounding error}\text{.}\end{array}$

The aforesaid table would also be suitable for Company T, if the incremental borrowing rate is $\ge$ 14% rate of return in the lease.

To determine

Prepare journal entries suitable for Company L and Company T 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 journal entries suitable for Company L and Company T for the years 2016 and 2017:

In the books of lessee Company T:

Date	Accounts title and explanation	Post Ref.	Debit ($)	Credit ($)
January 1,2019	Right of use asset		300,000.00
	Lease liability			300,000.00
	(To record the capital lease at inception)
January 1,2019	Lease liability		67,673.02
	Cash			67,673.02
	(To record the capital lease payment)
December 01, 2019	Insurance Expense		700.00
	Property Tax Expense		800.00
	Cash			1,500.00
	(To record the payment for executory costs)
December 31, 2019	Amortization expense $\left(\$30,000/6\right)$		50,000.00
	Right of use asset			50,000.00
	(To record the depreciation expense)
December 31, 2019	Interest Expense		32,525.78
	Lease liability			32,525.78
	(To record the interest expense)
January 1,2020	Lease liability		67,673.02
	Cash			67,673.02
	(To record the payment of accrued interest and lease payment)
December 01, 2020	Insurance Expense		600.00
	Property Tax Expense		750.00
	Cash			1,350.00
	(To record the payment for executory costs)
December 31, 2020	Amortization expense		50,000.00
	Right of use asset			50,000.00
	(To record the depreciation expense)
December 31, 2020	Interest Expense		27,605.16
	Lease liability			27,605.16
	(To record the interest expense)

Table (2)

In the books of Lessor (Company L):

Date	Accounts title and explanation	Post Ref.	Debit($)	Credit($)
January 01, 2019	Lease receivable		300,000.00
	Sales revenue			300,000.00
	(To record the lease at inception)
January 01, 2019	Cost of goods sold		$280,000
	Equipment Leased to Others			$280,000
	(To record the lease receivable in a capital lease)
January 01, 2019	Cash		67,673.02
	Lease Receivable			67,673.02
	(To record the receipt lease payment)
December31, 2019	Lease receivable		32,525.78
	Interest Revenue: Leases			32,525.78
	(To recognize the interest revenue for the year)
January 1,2020	Cash		67,673.02
	Lease Receivable			67,673.02
	(To record the receipt lease payment)
December 31, 2020	Lease Receivable		27,605.16
	Interest Income			27,605.16
	(To recognize the interest revenue for the year)

Table (3)

To determine

Prepare income statements and ending balance sheets for both Company L and Company T for the year 2016 and 2017 with appropriate notes.

Explanation of Solution

Income statement: The financial statement which reports revenues and expenses from business operations and the result of those operations as net income or net loss for a particular time period is referred to as income statement.

Balance Sheet:  Balance Sheet is one of the financial statements which summarize the assets, the liabilities, and the Shareholder’s equity of a company at a given date. It is also known as the statement of financial status of the business.

Income statements and ending balance sheets for Company T:

Company T
Comparative Income statement(Partial)
For the year ended December 31
	2020	2019
Interest Expense	$27,605.16	$32,525.78
Insurance Expense	600.00	700.00
Property Tax Expense	750.00	800.00
Depreciation Expense	50,000.00	50,000.00
Comparative Balance Sheet(Partial)
As on December 31
	2020	2019
Assets
Right of use asset
(Notes 1 and 2)	$200,000.00	$250,000.00
Liabilities and Shareholders’ equity
Current:
Capital Lease Obligation	$67,673.02	$67,673.02
Non-Current:
Capital Lease Obligation(Notes 1 and 2)	$157,111.88	$197,179.74

Table (4)

Note 1: Description of Right of use asset:

Company T is leasing heavy equipment from Company L. The lease term is 6 years and 4 years are still remaining. There are no restrictions and no purchase option too in the lease. The heavy equipment reverts to Company L once the lease period is over.

Note 2: financial Leases:

The leased property details are as follows:

	31.12.2020	31.12.2019
Leased Equipment	$300,000.00	$300,000.00
Less: Accumulated amortization	$100,000.00	$50,000.00
Balance	$200,000.00	$250,000.00

Table (5)

Income statements and ending balance sheets for Company L:

Company L
Comparative Income statement(Partial)
For the year ended December 31
	2020	2019
Revenue:
Interest Revenue: Leases	27,605.16	32,525.78
Comparative Balance Sheet (Partial)
As on December 31st
	2020	2019
Current Assets
Net investment in direct financing leases
(Notes 3 and 4)	$67,673.02	$67,673.02
Non-Current Assets:
Net Investment in direct financing leases
(Notes3 and 4)	$157,111.88	$197,179.74

Table (7)

Note 3: Description of leasing arrangements:

Company L has leased the heavy equipment to Company T. The lease term is 6 years and 4 years are remaining. The heavy equipment reverts to Company L after the expiry of the lease.

Note 4: Net Investment in direct financing leases:

Following are the components of net investments in direct financing leases as on December 31 of the years as depicted in the schedule below:

	2020	2019
Total lease payment receivable	$270,692.08	$338,365.10
Less: Unearned interest: leases	45,907.18	73,512.34
Total lease payment receivable(net)	$224,784.90	$264,852.76

Table (8)