Chapter 20, Problem 5P

Sales-Type Lease with Guaranteed Residual Value Calder Company, the lessor, enters into a lease with Darwin Company, the lessee, to provide heavy equipment beginning January 1, 2017. The lease is appropriately classified as a sales-type lease. The lease terms, provisions, and related events are as follows:

• The lease is noncancelable, has a term of 8 years, and has no renewal or bargain purchase option.
• The annual rentals are $65,000, payable at the end of each year.
• The interest rate implicit in the lease is 15%.
• Darwin agrees to pay all executory costs directly to a third party.
• The cost of the equipment is $280,000. The fair value of the equipment to Calder is $308,021.03.
• Calder incurs no material initial direct costs.
• Calder expects that it will be able to collect all lease payments.
• Calder estimates that the fair value at the end of the lease term will be $50,000 and that the economic life the equipment is 9 years. This residual value is guaranteed by Darwin.

The following present value factors are relevant:

• PV of an ordinary annuity _{n = 8, i = 15%} = 4.487322
• PV _{n = 8, i = 15%} = 0.326902
• PV _{n = 1, i = 15%} = 0.869565

Required:

1. 1. Determine the proper classification of the lease.
2. 2. Prepare a table summarizing the lease receipts and interest income earned by Calder for this lease.
3. 3. Prepare journal entries for Calder for the years 2019, 2020, and 2021.
4. 4. Next Level Prepare partial balance sheets for December 31, 2019, and December 31, 2020, showing how the accounts should be reported. Use the present value of next year’s payment approach to classify the lease receivable as current and noncurrent.
5. 5. Next Level Prepare partial balance sheets for December 31, 2019, and December 31, 2020, showing how the accounts should be reported. Use the change in present value approach to classify the lease receivable as current and noncurrent.

To determine

Identify the proper classification of the lease.

Explanation of Solution

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.

The reasons for classifying the lease as direct financing lease from the criteria table as presented below:

Capitalization Criteria	Met or not	Remarks
1.Transfer of ownership at the end of lease	No
2.Bargain purchase option	No
3.Lease term is for major part of its economic life	Yes	89% $\left(\text{8years/9years}\right)$
4.Present value of lease payments is substantially all of the fair value	Yes	PV is 100% of the fair value of the equipment
5. Specializes nature of the asset
Additional criteria (For lessor)
1. Present value of lease payments and any guaranteed residual value equals or exceeds substantially all of the fair value	Yes
2. Probable that the lessor will collect the lease payments	Yes

Table (2)

From the above table, it is noted that the lease is a sales type lease for Company C as more than one capitalization criteria is met and both of the recognition criteria also met according to the terms of the lease agreement.

Working Note 1: Compute the present value of minimum lease payment:

$\begin{array}{c}\begin{array}{c}\text{PV}\text{}\text{of the minimum}\\ \text{ lease payments}\end{array}\}\text{=}\left(\begin{array}{l}\text{\$65,000}\times \text{PV}\text{}\text{factor of }\\ \text{8 payments at 15\%}\end{array}\right)+\left(\begin{array}{l}\text{PV of single amount of \$50,000,}\\ \text{Guaranteed residual value at 15\%}\end{array}\right)\\ =\left(\$65,000\times 4.487322\right)+\left(\$50,000\times 0.0326902\right)\\ =\$291,675.93+\$16,345.10\\ =\$308,021.03\end{array}$

To determine

Prepare a table summarizing the lease receipts and interest revenue earned by the lessor for the direct financing lease.

Explanation of Solution

Prepare a table summarizing the lease receipts and interest revenue earned by the lessor for the direct financing lease:

Date	Lease payment received	Interest revenue at 15%	Decrease in lease receivable	Lease receivable
(1)	(2)	(3)	(4)	(5)
January 1,2019				$ 308,021.03
December31,2019	$65,000.00	$ 46,203.15	$ 18,796.85	$ 289,224.18
December31,2020	$65,000.00	$ 43,383.63	$ 21,616.37	$ 267,607.82
December31,2021	$65,000.00	$ 40,141.17	$ 24,858.83	$ 242,748.99
December31,2022	$65,000.00	$ 36,412.35	$ 28,587.65	$ 214,161.34
December31,2023	$65,000.00	$ 32,124.20	$ 32,875.80	$ 181,285.54
December31,2024	$65,000.00	$ 27,192.83	$ 37,807.17	$ 143,478.37
December31,2025	$65,000.00	$ 21,521.75	$ 43,478.25	$ 100,000.13
December31,2026	$65,000.00	$ 14,999.87	$ 50,000.13	$ 50,000.00

Table (1)

Notes to the above table:

$\begin{array}{l}\text{Lease Receivable}\left(\text{January 01,2019}\right)\text{ is the undiscounted value of the lease payments along with }\\ \text{the unguranteed residual value}\text{.}\\ \text{Present value of the unguranteed residual value}\text{.}\\ \text{Interest income at 15\% on lease receivable}\left(\text{December 31,2019}\right)\text{ = \$308,021}\text{.03}\times \text{15\%}\\ \text{Decrease of lease receivable}\left(\text{December 31,2019}\right)\text{ = \$65,000}\text{.00}-\text{\$46,203}\text{.15}\end{array}$$\begin{array}{l}\text{Lease receivable}\left(\text{December 31,2019}\right)\text{ = \$308,021}\text{.03}-\text{\$18,796}\text{.85}\\ \text{Interest income at 15\% on lease receivable}\left(\text{December 31,2026}\right)\text{ is }\\ \text{adjusted for \$0}\text{.13 rounding error}\text{.}\end{array}$

To determine

Prepare the journal entries for Company C for the years 2019, 2020, and 2021.

Explanation of Solution

Prepare the journal entries for Company C for the years 2019, 2020, and 2021:

Date	Accounts title and explanation	Post Ref.	Debit($)	Credit($)
January 1,2019	Equipment Leased to Others		308,021.03
	Cash			308,021.03
	(To record the payment of capital lease at inception)
January 1,2019	Cost of goods sold		$280,000
	Equipment leased to others			$280,000
	(To record the cost of the leased equipment)
December 31,2019	Cash		$65,000.00
	Lease Receivable			$18,796.85
	Interest Revenue: Leases			$46,203.15
	(To recognize the interest revenue of the year)
December 31,2020	Cash		$65,000.00
	Lease Receivable			$21,616.37
	Interest Revenue: Leases			$43,383.63
	(To recognize the interest revenue of the year)
December 31,2021	Cash		$65,000
	Lease Receivable			$24,858.83
	Interest Revenue: Leases			$40,141.17
	(To recognize the interest revenue of the year)

Table (3)

To determine

Prepare a partial balance sheet for December 31, 2019 and December 31, 2020 showing the reported accounts in it.

Explanation of Solution

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.

Here using the present value of next year’s payment approach to classify the lease receivable as current and non-current.

Prepare a partial balance sheet for December 31, 2019 and December 31, 2020 showing the reported accounts in it:

Company C
Balance Sheet(Partial)
As on December 31
Particulars	2019	2020
Assets
Current Assets:
Net Investment in Direct Financing Leases	$56,521.73	$56,521.73
Non-Current Assets:
Net Investment in Direct Financing Leases	$211,086.08	$232,702.45
Liabilities
Current liabilities:
Non-Current liabilities:

Table (4)

Notes for the above table:

$\begin{array}{c}\begin{array}{l}\text{Net Investment in Direct}\\ \text{Financing Leases: Current}\left(2019\text{ and 2020}\right)\end{array}\}\text{= \$65,000}\times \text{0}\text{.869565}\\ \begin{array}{l}\text{Net Investment in Direct }\\ \text{Financing: Leases: Non-current}\left(2019\right)\end{array}\}\text{= \$289,224}\text{.18}-\text{\$56,521}\text{.73}\\ \begin{array}{l}\text{Net Investment in Direct }\\ \text{Financing: Leases: Non-current}\left(2020\right)\end{array}\}=\text{ \$267,607}\text{.81}-\text{\$56,521}\text{.73}\end{array}$

To determine

Prepare a partial balance sheet for December 31, 2016 and December 31, 2017 showing the reported accounts in it.

Explanation of Solution

Here using the present value approach to classify the lease receivable as current and non-current.

Prepare a partial balance sheet for December 31, 2016 and December 31, 2017 showing the reported accounts in it:

Company C
Balance Sheet(Partial)
As on December 31
Particulars	2016	2017
Assets
Current Assets:
Net Investment in Direct Financing Leases	$24,858.83	$21,616.37
Non-Current Assets:
Net Investment in Direct Financing Leases	$242,748.99	$267,607.82
Liabilities
Current liabilities:
Non-Current liabilities:

Table (4)

Notes for the above table:

$\begin{array}{l}\text{For 2019, the amounts are calculated by the "change in present value approach" }\\ \text{which are \$21,616}\text{.37 ans \$267,607}\text{.82 respectively}\text{.}\\ \\ \text{For 2020, the amounts are calculated by the "change in present value approach" }\\ \text{which are \$24,858}\text{.83 ans \$242,748}\text{.99 respectively}\text{.}\end{array}$