Chapter 20, Problem 8E

Lessor Accounting with Receipts at Beginning of Year Edom Company, the lessor, enters into a lease with Davis Company to lease equipment to Davis beginning January 1, 2016. The lease terms, provisions, and related events are as follows:

1. 1. The lease term is 5 years. The lease is noncancelable and requires annual rental receipts of $100,000 to be made in advance at the beginning of each year.
2. 2. The equipment costs $313,000. The equipment has an estimated life of 6 years and, at the end of the lease term, has an unguaranteed residual value of $20,000 accruing to the benefit of Edom.
3. 3. Davis agrees to pay all executory costs.
4. 4. The interest rate implicit in the lease is 14%.
5. 5. The initial direct costs are insignificant and assumed to be zero.
6. 6. The collectibility of the rentals is reasonably assured, and there are no important uncertainties surrounding the amount of unreimbursable costs yet to be incurred by the lessor.

Required:

1. 1. Next Level Determine if the lease is a sales-type or direct financing lease from Edom’s point of view (calculate the selling price and assume that this is also the fair value).
2. 2. Prepare a table summarizing the lease receipts and interest revenue earned by the lessor.
3. 3. Prepare journal entries for Edom, the lessor, for the years 2016 and 2017.

To determine

Identify that the lease is a sale type lease or direct financing lease from Company E’s point of view.

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’.

Sale type Lease: In a Sales-Type lease, the lessor sells the asset to the lessee and records a receivable. In this type of lease, the lessor records a dealer’s or manufacturer’s profit or loss depending upon the difference between the fair value of the asset and the carrying value of the asset.

Direct financing lease: Under this, 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.

For Company E, the lease is a sales-type lease as the selling price/fair value of the leased equipment is greater than the cost of the equipment ($313,000).

Compute the selling or the fair value of the net investment as below:

$\begin{array}{c}\text{Selling price = Lease payment}\times \text{PV factor for 4 payment at 14\%}\\ \text{= \$100,000}\times \text{3}\text{.913712}\\ \text{= \$391,371}\text{.20}\end{array}$

To determine

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

Explanation of Solution

Calculate the gross investment, unearned interest revenue and the gross profit:

$\begin{array}{c}\text{Gross Investment = }\left(\begin{array}{l}\text{Annual lease payment received}\times \text{Number of payments}\\ \text{+Unguranteed residual value}\end{array}\right)\\ \text{= }\left(\text{\$100,000}\times 5\right)+\$20,000\\ \text{= \$520,000}\end{array}$

$\begin{array}{c}\text{Initial Present Value of teh Investment = }\left(\begin{array}{l}\text{PV of lease payments}\left(\text{selling price}\right)\\ +\text{PV}\text{}\text{of unguranteed residual value}\end{array}\right)\\ \text{= \$391,371}\text{.20+}\left(\$20,000\times \left(\begin{array}{l}\text{PV}\text{}\text{of a single sum }\\ \text{for 5 years at 14\%}\end{array}\right)\right)\\ =\text{ \$391,371}\text{.20+\$10,387}\text{.38}\\ \text{= \$401,758}\text{.58}\end{array}$

$\begin{array}{l}\text{Unearned Interest: Leases = Gross Investment}-\text{Initial PV of Investment}\\ \text{= \$520,000}\text{.00}-\text{\$401,758}\text{.58}\\ \text{= \$118,241}\text{.42}\end{array}$

$\begin{array}{c}\text{Cost of asset leased = Cost of asset}-\text{PV}\text{}\text{of the unguranteed residual value}\\ \text{= \$313,000}\text{.00}-\text{\$10,387}\text{.38}\\ \text{= \$302,612}\text{.62}\end{array}$

$\begin{array}{c}\text{Gross profit = Selling price of net investment}-\text{Cost of leased asset}\\ \text{= \$391,371}\text{.20}-\text{\$302,612}\text{.62}\\ \text{= \$88,758}\text{.58}\end{array}$

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

Date (1)	Lease payment received (2)	Interest revenue at 12% (3)	Lease receivable (4)	Unearned interest (5)	Net investment (6)
January 1,2016			$520,000.00	$118,241.42	$401,758.58
January 1,2016	$100,000.00		420,000.00		301,758.58
December 31,2016		42,246.20		75,995.22	344,004.78
January 1,2017	100,000.00		320,000.00		244,004.78
December 31,2017		34,160.67		41,834.55	278,165.45
January 1,2018	100,000.00		220,000.00		178,165.45
December 31,2018		24,943.16		16,891.39	203,108.61
January 1,2019	100,000.00		120,000.00		103,108.61
December 31,2019		14,435.21		2,456.18	117,543.82
January 1,2020	100,000.00		20,000.00		17,543.82
December 31,2020		2,456.18		0	20,000.00

Table (1)

Notes:

$\begin{array}{l}\text{Lease Receivable}\left(\text{January1,2016}\right)=\left(\$100,000\times 5\right)+\$20,000\\ \text{Unearned Interest: Leases}\left(\text{January1,2016}\right)=\text{ \$520,000}-\text{\$401,758}\text{.58}\end{array}$

$\text{Interest Revenue on Net Investment}\left(\text{Dec}\text{.31,2016}\right)=\text{ \$301,758}\text{.58}\times \text{14\%}$

$\text{Net Investment}\left(\text{Dec}\text{.31,2016}\right)=\$301,758.58+\$42,246.20\text{ Or,\$420,000-\$75,995}\text{.22}$

To determine

Prepare journal entries for Company E, the lessor, for the years 2019 and 2020.

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 for Company E, the lessor, for the years 2019 and 2020:

Date	Accounts title and explanation	Post Ref.	Debit($)	Credit($)
January    1,2016	Lease Receivable		520,000.00
	Cost of Asset Leased		302,612.62
	Sales			391,371.20
	Equipment			313,000.00
	Unearned Interest: Leases			118,241.42
	(To record the sales-type lease at inception)
January    1, 2016	Cash		100,000.00
	Lease Receivable			100,000.00
	(To record the receipt of lease payment)
December 31,2016	Unearned Interest: Leases		42,246.20
	Interest Revenue: Leases			42,246.20
	(To recognize the interest revenue)
January   1,2017	Cash		100,000.00
	Lease Receivable			100,000.00
	(To record the receipt of lease payment)
December 31,2017	Unearned Interest: Leases		34,160.67
	Interest Revenue: Leases			34,160.67
	(To recognize the interest revenue )

Table (2)