LEASES Leases–Introduction A LEASE involves a rental contract. The LESSOR is the owner of the property being leased. The LESSEE uses the leased asset and in return makes lease payments to the lessor. Companies lease assets because of the advantages, both to the lessee and to the lessor. The advantages of leasing to a lessee include the following (1) Reducing (and sometimes completely eliminating) initial down payments. This is important for companies that do not have sufficient cash or wish to use available cash for other purposes. (2) Avoiding the risks of ownership. This may be important for companies in industries subject to fast technological change, which could render equipment obsolete. The advantages of leasing to a lessor include these (1) Increased sales. Many customers who cannot afford to purchase the asset outright may be able to lease it. (2) Customer relationship. Leasing keeps the customer in touch, which provides opportunities to make additional sales. SFAS No. 13 is the relevant accounting standard for lease accounting. Operating and Capital Leases There are two types of leases: operating and capital. From the perspective of a lessee, the primary difference is the following: (1) If a lease is classified as an OPERATING LEASE, the rental payments are treated as periodic expenses in the income statement.
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LEASES
Leases–Introduction
A LEASE involves a rental contract. The LESSOR is the owner of the property being leased. The LESSEE uses the leased asset and in return makes lease payments to the lessor.
Companies lease assets because of the advantages, both to the lessee and to the lessor.
The advantages of leasing to a lessee include the following(1) Reducing (and sometimes completely eliminating) initial down payments. This is important for companies that do not have sufficient cash or wish to use available cash for other purposes. (2) Avoiding the risks of ownership. This may be important for companies in industries subject to fast technological change, which could render equipment obsolete.
The advantages of leasing to a lessor include these(1) Increased sales. Many customers who cannot afford to purchase the asset outright may be able to lease it.(2) Customer relationship. Leasing keeps the customer in touch, which provides opportunities to make additional sales.
SFAS No. 13 is the relevant accounting standard for lease accounting.
Operating and Capital Leases
There are two types of leases: operating and capital.
From the perspective of a lessee, the primary difference is the following:(1) If a lease is classified as an OPERATING LEASE, the rental payments are treated as periodic expenses in the income statement. (2) If a lease is classified as a CAPITAL LEASE, the value of the asset and the
related liability are both recorded on the balance sheet (in addition to the periodic interest and depreciation expenses, which are reflected in the income statement). The liability is the future obligation (that is, the required future payments to be made) of the lessee to the lessor.
Lessees would prefer to have leases classified as operating leases. This is so because a capital lease requires the company to record both the leased asset and the related liability. Companies do not like to have the “extra” liability on the balance sheet because it adversely affects financial statement-based ratios (for example, leverage ratios such as debt to equity), which may be used by creditors and investors. Companies also may not like the “extra” leased asset on the balance sheet because it adversely affects other financial ratios that measure performance (for example, return on assets).
Therefore, lessees usually prefer all leases to be classified as operating leases. SFAS No. 13 makes this difficult by imposing four conditions.
These are the four questions:(1) Will the lessee become the owner of the asset at the end of the lease?(2) Does the lessee have a bargain purchase option at the end of the lease?(3) Is the lease term equal to or more than 75 percent of the economic life of the asset?(4) Is the present value of the minimum lease payments equal to or greater than 90 percent of the fair market value of the asset?
If the answer to all of these four questions is no, both the lessor and lessee will classify the lease as an operating lease.
If the answer to any one of these four questions is yes, 1. The lessee must classify the lease as a capital lease. 2. The lessor must examine two additional conditions (Is the collection of future
payments reasonably certain? Is there no uncertainty about future costs to lessor?). If both of these additional conditions also are met, then it is a capital lease to the lessor; otherwise, it is an operating lease to the lessor.
To recap, to determine whether a lease is a capital lease, four conditions must be examined for the lessee but six conditions must be considered for the lessor.
Accounting for Leases-Definitions
Minimum lease payments include the periodic rental payments, and also any(a) Guaranteed residual value. (b) Bargain purchase option price.(c) Penalties to be paid by lessee for nonrenewal of the lease. These items are usually specified in the lease contract.
GUARANTEED RESIDUAL VALUE (GUV): Leases sometimes include a guarantee by the lessee that the market value of the asset will not fall below a specified amount, known as the guaranteed residual value. If the market value at the end of the lease term falls below this amount, then the lessee must pay the difference. For example, if the GUV of a leased asset is $10,000 and the actual market value at the end of the lease is only $7,000, the lessee must pay an extra $3,000 at the end of the lease to the lessor.
A BARGAIN PUCHASE OPTION permits the lessee to buy the leased asset at the end of the term by paying an amount significantly less than the expected fair market value of the leased asset at the end of the lease term. When there is a bargain purchase option, the price is set so low that there is a high probability that the lessee will buy the asset (at the end of the lease term).
MINIMUM LEASE PAYMENT do not include any of these:(a) Contingent payments
(b) Executory costs (c) Unguaranteed residual value
CONTINGENT PAYMENTS are made only if certain criteria related to the use of the asset are met. For example, the lease may specify, apart from a fixed amount per period, an additional charge for every unit of production or use of the leased asset.
EXECUTORY COSTS are incurred to maintain the leased asset, such as repairs, insurance, and taxes.
IMPLICIT INTEREST RATE is the rate used by the lessor to calculate the desired lease payment. It is the rate of interest that makes the present value of the minimum lease payments equal to the fair market value of the leased asset.
The lessee’s incremental borrowing rate is the rate of interest that the lessee would have had to pay if the lessee had borrowed the lease liability amount from a lender.
The interest rate to be used for discounting in lease calculations is the lower of the implicit interest rate used by the lessor and the incremental borrowing rate of the lessee.
Lessee Accounting-At Acquisition
Before we start discussing lessee accounting for capital leases, let us first take care of operating leases. Accounting for operating leases by the lessee is relatively easy. Each period, there is one journal entry for the lease expense. If cash is paid, then the journal entry isDEBIT Lease expense
CREDIT Cash
Accounting for capital leases is much more difficult. When the contract has been signed and the lessee starts using the asset, the lessee treats the transaction as an asset purchased and financed by debt. The journal entry for the transaction isDEBIT Leased asset
CREDIT Lease liability
What is the amount to be debited and credited? The amount equals the discounted present value of the minimum lease payments specified in the lease.
Assume that Bruce Company leased a machine from Collins Company on 1/1/2002 and that the lease requires payment of $10,000 at the end of each year for four years. Assuming the relevant discount rate to be 10% (we will discuss how to choose the discount rate later), the present value factor of an ordinary annuity for four years discounted at 10% per period equals (from the relevant table) 3.1699. So the total present value of the lease payments is $31,699 ($10,000 3.1699). This will be the amount debited and credited.
Therefore, the journal entry made by Bruce Company on 1/1/2002 will beDR Leased asset $31,699 CR Lease liability $31,699Note: The phrase “obligations under capital lease” means the same thing as “lease liability” and may be used in some textbooks.
Two additional issues need to be discussed: guaranteed residual value and bargain purchase option. If a lease contains either of these two features, the discounted present value of the amount of residual value or bargain purchase option must also be included in the calculations.
For example, in the preceding example, assume that Bruce Company has guaranteed Collins Company that the residual value of the machine at the end of the lease term will be $5,000. The present value factor for four years at 10% is 0.6830. So the present value of the guaranteed residual value is $3,415 ($5,000 x 0.6830). Hence, the debit to the leased asset and the credit to the leased liability will be $35,114 ($31,699 + $3,415).
Lessee Accounting-After Acquisition
Continuing with the Bruce Company example (without any guaranteed residual value), each of the $10,000 payments made at the end of the years has two components. A part of the total payment goes toward interest on the amount owed, and the remainder goes toward reducing the amount owed.
Interest expense for year ended 12/31/2002 = $31,699.00 0.10 = $3,169.90(Remember: Interest is always calculated based on balance as of the beginning of a period [or the balance as of the end of the previous period]).
The remaining $6,830.10 ($10,000 $3,169.90) is used to reduce the Lease liability account as of 12/31/2002. So, Lease liability as of 12/31/2002 = $31,699.00 $6,830.10 = $24,868.90.
The journal entry related to the payment by the lessee at the end of 2002 is thereforeDR Interest expense $3,169.90DR Lease liability 6,830.10 CR Cash $10,000
Since the leased asset is now on the balance sheet of the lessee, it must be depreciated. Over the term of the lease unless there is a bargain purchase option or the lease becomes the property of the lessee at the end of the lease. If either of these two conditions is present, the economic life of the asset is used for depreciation.
In our example, if the straight-line method is used, the amount of depreciation each year is $7,924.75 (31,699/4). The journal entry for this at the end of 2002 is as followsDR Depreciation expense-leased asset $7,924.75 CR Accumulated depreciation-leased asset $7,924.75
This process is repeated every year. We use the following table to show calculations:
Note: 1. Interest expense as of 12/31/2003 = $24,868.90 0.10 = $2,486.89
2. $7,513.11 ($10,000 $2,486.89) is used to reduce lease liability as of 12/31/2003.So lease liability as of 12/31/2003 = $24,868.90 $7,513.11 = $17,355.79
3. Similarly calculate for other years. However, for the last year, the interest expense becomes a “plug” number and may differ slightly from calculated interest. This is due to rounding errors.
Thus, for example, journal entries for the year ended 12/31/2004 areDR Interest expense $1,735.58DR Lease liability 8,264.42 CR Cash $10,000
In addition, there will be the depreciation entry for the year, which isDR Depreciation expense-leased asset $7,924.75 CR Accumulated depreciation-leased asset $7,924.75
In this problem, it was assumed that the payments were made at the end of each period. If the payments are made at the beginning of each period, note the following:1. The first payment (at the beginning of the lease) is used entirely to reduce the lease liability.2. At the end of each period, an adjusting entry for interest expense (along with a credit
to interest payable) will be needed; the following day, when the payment is made, the interest payable and lease liability are debited, and cash is credited.
Review Question-1
_______ is the owner of a leased asset.
_______ uses a leased asset.
Minimum lease payments include _______.
Minimum lease payments do not include _______.
The leased asset and leased liability must be included on the lessee’s balance sheet if the lease is a(n) ________.
If the lease is classified as a(n) ________, the lessee’s income statement will include a rental expense each period but no interest expense related to the lease.
Accounting by the lessor for an operating lease is relatively easy. The asset remains on the books of the lessor, and each period depreciation is recorded. In addition, rental revenue is recorded each period for the lease payments due from the lessee.
Accounting by the lessor for a capital lease is more difficult. For the lessor, there are two types of capital leases: direct financing and sales type.
A DIRECT FINANCING LEASE is one in which the lessor is a financial institution (for example, a bank or financing company). For the lessor, the lease is an investment and revenue is derived exclusively from the interest component of the lease payments.
A SALES TYPE LEASE is one in which a manufacturer or dealer uses the lease to market an item. In a sales type lease, there are two types of revenue to the lessor: (a) an immediate profit (or loss) at the beginning of the lease and (b) periodic interest revenue (the part of the lease payments that represent the interest).
Lessor Accounting-Direct Financing Lease
We will continue with the example used earlier to illustrate accounting by lessees. Recall that Bruce Company leased a machine from Collins Company and the lease calls for payment of $10,000 at the end of each year for four years. The present value of the lease payments was $31,699.
A payable (liability) for the lessee is a receivable (asset) for the lessor. Interest expense for the lessee is interest revenue for the lessor. Reduction of lease liability for the lessee is reduction of lease receivable for the lessor.
However, there are some differences. The main difference is that the lessor initially records the lease receivable by ignoring the time value of money. So the journal entries for Collins Company, the lessor, are as follows:
At the beginning of the lease (on 1/1/2002):DR Lease receivable $40,000
Note: 1. $40,000 is the total amount of lease payments to be received by the lessor when the time value of money is ignored.
2. Equipment inventory is credited for $31,699 because this is a capital lease, the ownership has transferred from the lessor (to the lessee).
3. The difference between the two amounts represents the total interest expected to be earned over the term of the lease. Since it has not yet been earned, it is unearned revenue (a liability). As interest revenue is earned during the lease period, unearned revenue is reduced each period.
To show journal entries for the subsequent years, we use the same table that we used earlier for lessee accounting with some slight modifications reflecting the fact that we are now discussing accounting by the lessor. The columns now are Cash received as opposed to Cash payment and Interest revenue as opposed to Interest expense. Furthermore, note that we now focus on unearned revenue and its reduction and Lease receivable balance as opposed to Lease liability balance. The Lease receivable balance is reduced each period by the total amount of lease payments.
The table suggests the journal entries each year for the lessor. For example, on 12/31/2003, the journal entries for the lessor areDR Cash $10,000 CR Lease receivable $10,000and DR Unearned revenue $2,486.89 CR Interest revenue $2,486.89
The first journal entry is for the receipt of cash and reduction of lease receivable, the second journal entry is for recognizing interest revenue earned on the lease and the corresponding decrease in unearned revenue.
Lessor Accounting-Sales Type Lease
In a sales type lease the fair market value of the leased asset is usually higher than the book value of the leased asset (in the books of the lessor) at the beginning of the lease. This is a capital lease, which is substantially like the sale of an asset. So the difference between market value and book value becomes a profit that the lessor recognizes at the beginning of the lease.
Let us continue with the previous example, in which Bruce Company leased a machine from Collins Company and paid $10,000 at the end of each year for four years. The only difference relates to the book value of the machine at the start of the lease. Assume that the cost of the machine (which Collins Company may have made or bought from someone else) to Collins Company was $25,000. All other facts remain the same as before.
The journal entry by Collins Company is as follows.DR Lease receivable $40,000 CR Sales revenue $31,699 CR Unearned interest revenue $8,301and DR Cost of goods sold $25,000 CR Equipment inventory $25,000
Note:1. The debit to Lease receivable represents, as before, the fact that the lessor expects to receive $40,000 from the lessee in the future. The credit to Unearned interest revenue arises because we expect to earn that amount as interest revenue in the future. The remainder is sales revenue.
2. The debit to Cost of goods sold and the credit to Equipment inventory are straightforward and represent the fact that ownership of the inventory item has transferred to the lessee.
3. The net effect of these two entries is this: The difference between the credit to Sales revenue and the debit to Cost of goods sold thus is recognized as profit (“manufacturing profit” or “merchandising profit”) in the initial year of the lease. The unearned revenue is recognized as the “financing profit” over the period of the lease.
4. Compare the journal entries for the sales type and direct financing leases. The main difference is the presence of two additional items for the sales type lease-the credit to Sales revenue and the debit to Cost of good sold. Remember, only in a sales type lease can we have Sales revenue and Cost of goods sold.
Sale-Leasebacks, Leveraged Leases, and Real Estate Leases
A SALE-LEASEBACK occurs when the owner of an asset sells the asset to a purchaser but immediately leases it back from the purchaser. Thus, the owner becomes the lessee, and the purchaser becomes the lessor. This is done for financing and/or tax reasons.
In general, lease accounting for the lessor and the lessee in a sale-leaseback is the same as for any other lease. However, there may be a difference between the book value of the asset (on the books of the owner-lessee) and the price for which the asset is sold to the purchaser. Normally, this would be recognized as a gain or profit by the owner lessee. In the case of a sale-leaseback, this difference between book value and sale price is called a “deferred gain” and is recognized throughout the life of the lease.
LEVERAGED LEASES arise when the lessor borrows from a third party (usually a bank or a financial institution) and uses the borrowed amount to acquire the asset, which is then leased to the lessee. This arises only with sales type leases, not with direct financing leases. Accounting for the lessee is the same as with any other lease, but accounting by the lessor becomes more complex.
Real estate leases involve property such as land, buildings, and equipment. For leases involving buildings only, the usual four criteria for leases apply. For leases involving only land, only the first two of the usual four criteria (ownership at end of lease and bargain purchase option) apply. As land is not depreciated but buildings and equipment are, special rules apply in joint leases involving land and buildings.
If the land value is immaterial (defined as 25% or less of the total fair market value), the usual four criteria for leases must be applied. If land value is material, the total lease value must be allocated between land and buildings. The usual four criteria are applied only to the building part of the lease, but only the first two criteria are applied to the land part of the lease.
Review Question-2:
The leased asset remains on the books of the lessor if the lease is a(n) _______.
In a(n) __________, the lessor earns only interest revenue each period.
In a(n) __________, the lessor earns interest revenue each period and a profit (or loss) at the beginning of the lease.
In a direct financing lease, ________ is debited at the beginning of the lease.
The ________ account is credited at the beginning of both direct financing and sales type leases.
When the lessor finances a lease by borrowing from a third party, the lease is called a(n) __________.
Answers:1. Operating lease 2. Direct financing lease 3. Sales type lease4. Lease receivable 5. Unearned revenue 6. Leveraged lease
Glossary
Bargain purchase option allows the lessee to purchase the leased asset at the end of the lease term by paying an amount significantly less than the expected fair market value at the end of the lease.
Capital lease requires the lease to be treated as a purchase by the lessee and a sale by the lessor. The lessee is required to include the leased asset and the related lease liability on the balance sheet.
Contingent payments are payments made only if certain criteria related to the use of the asset are met.
Direct financing lease is a type of capital lease, in which the lessor earns interest revenue only.
Executory costs are the costs incurred to maintain the leased asset, such as repairs, insurance and taxes.
Guaranteed residual value (GUV) is the amount guaranteed by the lessee (to the lessor) to be the fair value of the leased asset at the end of the lease. If the actual fair market value of the leased asset at the end of the lease is less than the GUV, the lessee must pay the difference between the GUV and the fair market value at the end of the lease.
Lease is a rental contract between a lessor (the owner) and a lessee.
Lessee uses the leased item and pays the lease amount.
Lessor owns the leased item, permits the lessee to use the item, and collects lease payments from the lessee.
Leveraged lease is a lease that the lessor finances by borrowing from a third party (such as a bank or a financial institution). Minimum lease payments are the minimum payments required under the lease contract. They include periodic rental payments, guaranteed residual value, bargain purchase option, and penalties for nonrenewal of the lease.
Operating leases are accounted for as simple rentals by lessor and lessee. The lessee (lessor) records only rental expense (revenue) each period.
Sale-leaseback occurs when the owner of an asset sells the asset to a purchaser but immediately leases it back from the purchaser.
Sales type lease is a capital lease in which the lessor both earns interest revenue through the lease term and records a profit (or loss) at the beginning of the lease.
Demonstration Problem 1Jones Company
Jones Company leased a machine from Klein Company on 1/1/2002 and agreed to pay $20,000 at the end of each year for five years. Jones Company has guaranteed that the machine will be worth $10,000 at the end of the lease period. Prepare an amortization schedule for the lease, and give the journal entries for Jones Company for the first and last years of the lease. (Assume the relevant discount rate to be 10% and that the actual residual value at the end of the lease was $12,000.)
Solution to Demonstration Problem 1, Jones Company
Minimum lease payments include the periodic rental payments of $20,000 and the guaranteed residual value of $10,000 at the end of the lease.
Present value (PV) of minimum lease payments = PV of an ordinary annuity of $20,000 per period for five periods + PV of single sum of $10,000 at the end of five years
PV of annuity = $20,000 3.7908 = $75,816PV of single sum = $10,000 0.6209 = $6,209
Note:1.Interest expense recognized in 2002 = Amount owed during the year Interest rate
= $82,025 0.10= $8,202.50
2. Hence, $11,797.50 ($20,000 - $8,202.50) of the lease payment made at the end of 2002 goes toward reducing the principal.
3. Therefore, the principal owed after lease payment at the end of 2002 = $82,025.00 $11,797.50 = $70,227.50.
4. Similarly, interest expense for 2003 is $7,022.75 ($70,227.50 0.10). Proceed similarly for other years.
Journal entries:
Journal entry at the beginning of the lease:1/1/2002 DR Leased asset $82,025
CR Lease liability $82,025
Journal entries at the end of the first year:12/31/2002 DR Interest expense $ 8,202.50
DR Lease liability 11,797.50 CR Cash $20,000.00
and12/31/2002 DR Depreciation expense-leased asset $16,405
CR Accumulated depreciation-leased asset $16,405Note: Assuming the use of the straight-line method, depreciation expense = $82,025/5 = $16,405 each year.
Journal entries at the end of the last year:12/31/2006 DR Interest expense $ 2,727.19
DR Lease liability 17,272.81 CR Cash $20,000.00
and12/31/2006 DR Depreciation expense-leased asset $16,405
CR Accumulated depreciation-leased asset $16,405and (to return the asset)12/31/2006 DR Leased liability $10,000
CR Lease asset $10,000
Demonstration Problem 2Hess Company
Kraft Company leased a machine from Hess Company on 1/1/2002 and agreed to pay $10,000 at the beginning of each year for three years. Kraft Company has the bargain purchase option to buy the asset, which has an economic life of five years, at the end of the lease for $5,000. The original cost of the machine for Hess Company was $26,000. Prepare an amortization schedule for the lease, and give the journal entries for Hess Company for the first and last years of this sales-type lease. Assume the relevant discount rate to be 10% and that Kraft Company bought the asset at the end of the lease period.
Solution to Demonstration Problem 2, Hess Company
Minimum lease payments include the periodic rental payments of $10,000 and the bargain purchase option $5,000 at the end of the lease.
Present value (PV) of minimum lease payments = PV of an annuity due (because payments are made at the beginning of each period) of $10,000 per period for three periods + PV of single sum of $5,000 at the end of three years
PV of annuity due = $10,000 2.7355 = $27,355.00PV of single sum = $5,000 0.7513 = $3,756.50
PV of minimum lease payments = $27,355.00 $3,756.50 = $31,111.50
Total lease receivable = $10,000 3 + $5,000 = $35,000
Hence, unearned revenue at the beginning of lease = $35,000 $31,111.50 = $3,888.50
Note:1.Interest revenue recognized in 2002 = Amount owed during the year Interest rate
= $21,111.50 0.10= $2,111.15
2. For the sake of brevity, the table lists interest revenue of $2,111.15 only as of 1/1/2003. However, the actual accrual adjustment for this will be posted on 12/31/2002, as shown in the journal entries. Similarly, interest revenue of $1,322.27 will be accrued as of 12/31/2003, even though the table shows this amount only as of 1/1/2004.
Journal entries:
At the beginning of the lease:1/1/2002 DR Lease receivable $35,000
DR Cost of goods sold 26,000 CR Machine inventory $26,000.00 CR Sales 31,111.50 CR Unearned interest revenue 3,888.50
and1/1/2002 DR Cash $10,000
CR Lease receivable $10,000
At the end of the first year:12/31/2002 DR Unearned revenue $2,111.15
CR Interest revenue $2,111.15
Note: On the next day, 1/1/2003 DR Cash $10,000.0
0 CR Lease receivable $10,000.00
At the start of the final year of the lease:1/1/2004 DR Cash $10,000.0
0 CR Lease receivable $10,000.00
At the end of the lease:12/31/2004 DR Unearned revenue $455.08
CR Interest revenue $455.08and12/31/2004 DR Cash $5,000
CR Lease receivable $5,000
Practice Problem 1Elway Company
Elway Company leased a machine from Marino Company on 1/1/2002 and agreed to pay $10,000 at the beginning of each year for three years. Elway Company has the bargain purchase option to buy the asset, which has an economic life of five years, at the end of the lease for $5,000. Prepare an amortization schedule for the lease, and give the journal entries for Elway Company for the first and last years of the lease. Assume the relevant discount rate to be 10% and that Elway Company bought the asset at the end of the lease period.
Solution to Practice Problem 1, Elway Company
Minimum lease payments include the periodic rental payments of $10,000 and the bargain purchase option $5,000 at the end of the lease.
Present value (PV) of minimum lease payments = PV of an annuity due (because payments are made at the beginning of each period) of $10,000 per period for three periods + PV of single sum of $5,000 at the end of three years
PV of annuity due = $10,000 2.7355 = $27,355.00PV of single sum = $5,000 0.7513 = $3,756.50
PV of minimum lease payments = $27,355.00 $3,756.50 = $31,111.50
Note:1.Interest expense recognized in 2002 = Amount owed during the year Interest rate
= $21,111.50 0.10= $2,111.15
2. For the sake of brevity, the table lists interest expense of $2,111.15 only as of 1/1/2003. However, the actual accrual adjustment for this will be posted on 12/31/2002, as shown in the journal entries. Similarly, interest expense of $1,322.27 will be accrued as of 12/31/2003, even though the table shows this amount only as of 1/1/2004.
Journal entries:
Journal entries at the beginning of the lease:1/1/2002 DR Leased asset $31,111.50
CR Lease liability $31,111.50and1/1/2002 DR Leased liability $10,000.00
CR Cash $10,000.00
Journal entry at the end of the first year:12/31/2002 DR Interest expense $2,111.15
CR Interest payable $2,111.15and12/31/2002 DR Depreciation expense-leased asset $6,222.30
CR Accumulated depreciation-leased asset $6,222.30Note: Depreciation expense = $31,111.50/5 = $6,222.30 each year.Five years is used for depreciation because there is a bargain purchase option.
Note: On the very next day, on 1/1/2003, the journal entry will be1/1/2003 DR Interest payable $2,111.15
DR Lease liability 7,888.85 CR Cash $10,000.00
Journal entry at the beginning of the last year:1/1/2004 DR Interest payable $1,322.27
DR Lease liability 8,677.73 CR Cash $10,000.00
Journal entry at the end of the last year:12/31/2004 DR Depreciation expense-leased asset $6,222.30
CR Accumulated depreciation-leased asset $6,222.30and (to pay $5,000 and buy the asset)12/31/2004 DR Interest expense $ 455.08
DR Lease liability 4,544.92 CR Cash $5,000
and (to record the machine purchased)12/31/2004 DR Machine $12,444.60
DR Accumulated depreciation-leased asset 18,666.90 CR Leased Asset $31,111.50
Note:At the end of the lease, after three years:1. Accumulated depreciation on the leased asset = $6,222.30 3 = $18,666.902. Book value of the machine = $31,111.50 $18,666.90 = $12,444.60
Practice Problem 2Rice Company
Young Company leased a machine from Rice Company on 1/1/2002 and agreed to pay $20,000 at the end of each year for four years. Young Company has guaranteed that the machine will be worth $10,000 at the end of the lease period. Prepare an amortization schedule for the lease and give the journal entries for Rice Company for the first and last years of the lease if the lease is a direct financing lease. (Assume the relevant discount rate to be 10% and that the actual residual value at the end of the lease was $12,000.)
Solution to Practice Problem 2, Rice Company
Minimum lease payments include the periodic rental payments of $20,000 and the guaranteed residual value of $10,000 at the end of the lease.
Present value (PV) of minimum lease payments = PV of an ordinary annuity of $20,000 per period for five periods + PV of single sum of $10,000 at the end of five years
PV of annuity = $20,000 3.7908 = $75,816PV of single sum = $10,000 0.6209 = $6,209
PV of minimum lease payments = $75,816 $6,209 = $82,025
Total lease receivable = $20,000 5 $10,000 = $110,000
Hence, unearned revenue at the beginning of lease = $110,000 $82,025 = $27,975
At the end of the first year:12/31/2002 DR Cash $20,000
CR Lease receivable $20,000and12/31/2002 DR Unearned revenue $8,202.50
CR Interest revenue $8,202.50
Journal entries at the end of the last year of the lease:12/31/2006 DR Cash $20,000
CR Lease receivable $20,000and12/31/2006 DR Unearned revenue $2,727.19
CR Interest revenue $2,727.19and12/31/2002 DR Machine inventory $10,000
CR Lease receivable $10,000
Practice Problem 3Sapp Company
Sapp Company leased a machine from King Company on 1/1/2002. The terms of the lease are as follows:Lease term 3 years (6 semiannual periods)Semiannual rental payments $12,000 (beginning of each period)Economic life of asset 4 yearsUnguaranteed residual value $4,000Incremental borrowing rate 12%Contingent rental payments Extra $2,000 if machine is used
more than 1,200 hours per period
Give the journal entries for Sapp Company for the first and last years of the lease.
Solution to Practice Problem 3, Sapp Company
The lease term is three years, and the economic life of asset is four years.Hence, the lease term is 75% of the economic life of the asset.Hence, this is a capital lease. Minimum lease payments do not include the unguaranteed residual value or contingent payments. Hence, minimum lease payments include only periodic rental payments of $12,000 each, made at the beginning of each period for six periods.
Also, since interest rate is 12% per year, relevant rate is 6% per period.
Present value (PV) of minimum lease payments = PV of an annuity due= $12,000 5.2124= 62548.80
Note:1. To calculate interest, remember to use 6% per period, not 12% (which is the interest rate per year).
2. For the sake of brevity, the table lists interest expense of $3,032.93 only as of 7/1/2002. However, the actual accrual adjustment for this will be posted on 6/30/2002, as shown in the journal entries. Similarly, interest expense for other periods will be accrued at the end of each period.
3. Interest expense for the year ended 12/31/2002 = $3,032.93 $2,494.90 = $5,527.83
4. Interest expense for the year ended 12/31/2003 = $1,924.60 $1,320.07 = $3,244.67
Journal entries:
Journal entries at the beginning of the lease:1/1/2002 DR Leased asset $62,548.80
CR Lease liability $62,548.80and1/1/2002 DR Leased liability $12,000.00
CR Cash $12,000.00
Journal entry on 6/30/2002:6/30/2002 DR Interest expense $3,032.93
CR Interest payable $3,032.93
Journal entry on 7/1/2002: 7/1/2002 DR Interest payable $3,032.93
DR Lease liability 8,967.07 CR Cash $12,000.00
Journal entry on 12/31/2002: 12/31/2002 DR Interest expense $2,494.90
CR Interest payable $2,494.90and12/31/2002 DR Depreciation expense-leased asset $20,849.60
CR Accumulated depreciation-leased asset $20,849.60Note: Depreciation expense = $62,548.80/3 = $20,849.60 each year.To calculate depreciation, three years is used because there is no bargain purchase option, and the lease does not become the lessee’s property at the end of the lease.
Journal entry at the beginning of the last year:1/1/2004 DR Interest payable $ 1,320.07
DR Lease liability 10,679.93 CR Cash $12,000.00
Journal entry on 6/30/2004:6/30/2004 DR Interest expense $678.70
CR Interest payable $678.70
Journal entry on 7/1/2004: 7/1/2004 DR Interest payable $ 678.70
DR Lease liability 11,321.30 CR Cash $12,000.00
Journal entry at the end of the last year:12/31/2004 DR Depreciation expense-leased asset $20,849.60
1. Minimum lease payments do not includea. minimum lease payments.b. penalties for non-renewal of lease.c. unguaranteed residual value.d. bargain purchase option.
2. A lease will be classified as a capital lease ifa. the leased asset belongs to lessor at the end of the lease.b. the lease term is 50 percent of the economic life of the asset.c. the present value of minimum lease payments equals 75% of fair market value of the asset.d. there is a bargain purchase option.
3. For a capital lease, the amount recorded as a liability by the lessee isa. equal to the sum of the minimum lease payments.b. more than the sum of the minimum lease payments.c. equal to the present value of the minimum lease payments.d. more than the present value of the minimum lease payments.
4. Lee Company has leased an asset from Smith Company, and has agreed to pay $10,000 at the end of each year for six years. The lease is deemed to be a capital lease. The interest expense recorded by Lee Company during the fourth year of the lease will bea. equal to the interest expense recorded in the fifth year.b. more than the interest expense recorded in the fifth year.c. less than the interest expense recorded in the fifth year.d. more than the interest expense recorded in the third year.
5. In calculating the amount to be capitalized by the lessee at the beginning of the lease, bargain purchase option price isa. added at the exercise price.b. added at the present value of the exercise price.c. subtracted at the exercise price.d. excluded from the calculation.
6. In a direct financing lease, the lessor will recognizea. only interest revenue, over the course of the lease term. b. both interest revenue and gross profit over the course of the lease term.c. interest revenue over the course of the lease term and gross profit from sale at the beginning of the lease.
d. only interest revenue at the beginning of the lease term.
7. Jones Company leased a machine from Suchon Company on 1/1/2002. The lease term calls for payment of $10,000 at the beginning of each period for 4 years. The incremental borrowing rate of Jones Company is 12% and the implicit rate used by Suchon Company is known to be 10%. What amount will Jones Company report as a capital lease liability on its balance sheet dated 12/31/2002? (Assume the following present value of annuity due numbers [rounded]: 10% for 4 years = 3.5; 12% for 4 years = 3.4.)a. $35,000b. $34,000c. $24,000d. $25,000
8. Alpha Company leased a machine from Beta Company on 1/1/2002 and makes annual payments of $10,000 at the end of each year for three years. The present value of the minimum lease payments is $24,000. The lease term is for three years, and the economic life of the asset is four years. The lease contains a bargain purchase option. Using the straight-line method, the depreciation expense recorded by Alpha Company for the year ended 12/31/2002 will bea. $6,000.b. $8,000.c. $7,500.d. $10,000.
9. David Company leased a machine to Brock Company for a 7-year period, beginning on 1/1/2002. The fair market value of the leased asset is $55,000, and the cost of the asset to David Company was also $55,000. The annual payments made at the end of each period are $11,297 (rounded), and the implicit interest rate is 10%. The dealer’s profit to be recognized by David Company in 2002 isa. $15,000.b. $5,500.c. $24,079.d. 0.
10. The net carrying value of a capitalized lease asset on the books of the lessee will be periodically reduced bya. the amount of the periodic rental payments allocated to interest.b. the amortization of the asset.c. the amount of the periodic rental payments allocated to reduction of principal.d. the total minimum lease payments.
Homework Problem 1Marshall Company
Marshall Company leased a machine from Parker Company on 1/1/2002. The lease terms are as follows:Lease term 3 yearsAnnual rental payments $8,000 (beginning of each period)Economic life of asset 5 yearsBargain purchase option price $10,000Incremental borrowing rate 10%
Give the journal entries for Marshall Company for the first and last years of the lease, assuming that Marshall Company bought the asset at the end of the lease period (round your answers to the nearest dollar).
Solution to Homework Problem 1, Marshall Company
This is a capital lease because there is a bargain purchase option.
Minimum lease payments include periodic rental payments of $8,000 each and the bargain purchase option price of $10,000.
Present value of rental payments = $8,000 2.7355 = $21,884Present value of bargain purchase option = $10,000 0.7513 = $7,513
Total present value of minimum lease payments = $21,884 $7,513 = $29,397
Journal entries at the beginning of the lease:1/1/2002 DR Leased asset $29,397
CR Lease liability $29,397and1/1/2002 DR Leased liability $8,000
CR Cash $8,000
Journal entry on 12/31/2002: 12/31/2002 DR Interest expense $2,140
CR Interest payable $2,140and12/31/2002 DR Depreciation expense-leased asset $5,879
CR Accumulated depreciation-leased asset $5,879Note: Depreciation expense = $29,397/5 = $5,879 each year.Five years is used for depreciation because there is a bargain purchase option.
Journal entry at the beginning of the last year:1/1/2004 DR Interest payable $1,554
DR Lease liability 6,446 CR Cash $8,000
Journal entry at the end of the last year: 12/31/2004 DR Depreciation expense-leased asset $5,879
CR Accumulated depreciation-leased asset $5,879and12/31/2004 DR Interest expense $909
CR Interest payable $909and12/31/2004 DR Interest payable $ 909
DR Lease liability 9,091 CR Cash $10,000
and12/31/2004 DR Equipment $11,760
DR Accumulated depreciation-leased asset 17,637 CR Leased equipment $29,397
Homework Problem 2Glenn Company
Thomas Company leased a machine from Glenn Company on 1/1/2002. The lease terms are as follows:Lease term 3 yearsAnnual rental payments $8,000 (beginning of each period)Economic life of asset 4 yearsGuaranteed residual value $10,000Historical cost of machine $23,000Incremental borrowing rate 10%
Give the journal entries for Glenn Company for the first and last years of the lease (round your answers to the nearest dollar).
Solution to Homework Problem 2 Glenn Company
This is a capital lease because the lease term is for 75% of the economic life of the asset.
Minimum lease payments include the periodic rental payments of $8,000 and the guaranteed residual value of $10,000 at the end of the lease.
Present value of rental payments = $8,000 2.7355 = $21,884Present value of guaranteed residual value = $10,000 0.7513 = $7,513
Total present value of minimum lease payments = $21,884 $7,513 = $29,397
Historical cost of machine = $23,000, so this is a sales-type lease for lessor.Manufacturer’s profit to lessor at inception of lease = $29,397 $23,000 = $6,397.
Total lease receivable = $8,000 3 $10,000 = $34,000
Hence, unearned revenue at the beginning of lease = $34,000 $29,397 = $4,603.
At the beginning of the lease:1/1/2002 DR Lease receivable $34,000
DR Cost of goods sold 23,000 CR Machine inventory $23,000 CR Sales 29,397 CR Unearned interest revenue 4,603
At the end of the first year:12/31/2002 DR Unearned revenue $2,140
CR Interest revenue $2,140
Journal entries during the last year of the lease:1/1/2004 DR Cash $8,000
CR Lease receivable $8,000and12/31/2004 DR Unearned revenue $909
CR Interest revenue $909and12/31/2004 DR Machine inventory $10,000
CR Lease receivable $10,000
Homework Problem 3
1. Minimum lease payments includea. minimum lease payments.b. penalties for non-renewal of lease.c. contingent lease payments.d. both a and b.
2. A lease will be classified as a capital lease ifa. the leased asset belongs to lessor at the end of the lease.b. the lease term is 80% of the economic life of the asset.c. the present value of minimum lease payments equals 75 percent of fair market value of the asset.d. the lessee can buy the asset for the fair market value at the end of the lease.
3. For a capital lease, the amount recorded as a receivable by the lessor isa. equal to the sum of the minimum lease payments.b. more than the sum of the minimum lease payments.c. equal to the present value of the minimum lease payments.d. more than the present value of the minimum lease payments.
4. Brokaw Company has leased an asset from King Company and has agreed to pay $10,000 at the end of each year for six years. The lease is deemed to be a capital lease. The lease liability on the balance sheet of Brokaw Company at the end of the fourth year of the lease will bea. equal to the lease liability on the balance sheet at the end of the fifth year.b. more than the lease liability on the balance sheet at the end of the fifth year.c. less than the lease liability on the balance sheet at the end of the fifth year.d. more than the lease liability on the balance sheet at the end of the third year.
5. In calculating the amount to be capitalized by the lessee at the beginning of the lease, guaranteed residual value isa. added at the present value of the guaranteed value.b. added at the guaranteed value.c. subtracted at the present value of the guaranteed value.d. excluded from the calculation.
6. In a sales type lease, the lessor will recognizea. only interest revenue, over the course of the lease term. b. both interest revenue and gross profit over the course of the lease term.c. interest revenue over the course of the lease term and gross profit from sale at the beginning of the lease.d. only interest revenue at the beginning of the lease term.
7. James Company leased a machine from Best Company on 1/1/2002. The lease term calls for payment of $10,000 at the beginning of each period for four years. The implicit rate used by Best Company is known to be 10%. What amount will James Company report as interest expense related to the lease liability on its income statement for the year ended 12/31/2002? (Assume the following present value of annuity due numbers [rounded]: 10% for 4 years = 3.5.)a. $4,000b. $3,500c. $2,500d. $0
8. Gamma Company leased a machine from Delta Company on 1/1/2002 and makes annual payments of $10,000 at the end of each year for three years. The present value of the minimum lease payments is $24,000. The lease term is for three years, and the economic life of the asset is four years. The lease becomes the property of Delta Company at the end of the lease. Using the straight-line method, the depreciation expense recorded by Gamma Company for the year ended 12/31/2002 will bea. $6,000.b. $8,000.c. $7,500.d. $10,000.
9. Parcells Company has leased a machine to Carroll Company for a five-year period, beginning on 1/1/2002. The fair market value of the leased asset is $55,000, and the cost of the asset to Parcells Company was $45,000. The annual payments made at the beginning of each period are $13,190 (rounded), and the implicit interest rate is 10%. The dealer’s profit to be recognized by Parcells Company in 2002 isa. $20,950.b. $5,500.c. $10,950.d. $10,000.
10. The net carrying value of a lease liability on the books of the lessee will be periodically reduced bya. the amount of the periodic rental payments allocated to interest.b. the amortization of the asset.c. the amount of the periodic rental payments allocated to reduction of the principal.d. the total minimum lease payments.
Homework Problem 4
1. Minimum lease payments do not includea. contingent lease payments.b. a bargain purchase option.c. an unguaranteed residual value.d. either a or c.
2. A lease will be classified as a capital lease ifa. the leased asset belongs to the lessor at the end of the lease.b. the lease term is 51% of the economic life of the asset.c. the present value of minimum lease payments equals 92% of the fair market value of asset.d. the lessee can buy the asset for the fair market value at the end of the lease.
3. For an operating lease, the amount recorded as the value of the leased asset by the lessee isa. equal to the sum of the minimum lease payments.b. more than the sum of the minimum lease payments.c. equal to the present value of the minimum lease payments.d. zero.
4. Lara Company has leased an asset from Perry Company and has agreed to pay $10,000 at the end of each year for six years. The lease is deemed to be a capital lease. The interest revenue recorded by Perry Company during the fourth year of the lease will bea. equal to the interest revenue recorded in the fifth year.b. more than the interest revenue recorded in the fifth year.c. less than the interest expense revenue in the fifth year.d. more than the interest revenue in the third year.
5. In calculating the amount to be capitalized by the lessee at the beginning of the lease, unguaranteed residual value isa. added at the present value of the guaranteed value.b. added at the guaranteed value.c. subtracted at the present value of the guaranteed value.d. excluded from the calculation.
6. In a direct financing lease, the lessor records lease payments receivable equal toa. the present value of periodic rental payments minus the guaranteed residual value.b. the present value of periodic rental payments plus the present value of guaranteed residual value.
c. the periodic rental payments plus the guaranteed residual value.d. the periodic rental payments minus the guaranteed residual value.
7. Brown Company leased a machine from Read Company on 1/1/2002. The lease term calls for payment of $10,000 at the beginning of each period for four years. The implicit rate used by Read Company is known to be 10%. What amount will Read Company report as the balance of total lease payments receivable from this lease on its balance sheet as of 12/31/2002? (Assume the following present value of annuity due numbers [rounded]: 10% for 4 years = 3.5.)a. $30,000b. $35,000c. $25,000d. $40,000
8. Bush Company leased a machine from Dole Company on 1/1/2002 and makes annual payments of $8,000 at the end of each year for three years. The present value of the minimum lease payments is $21,000. The lease term is for three years, and the economic life of the asset is four years. The lease becomes the property of Bush Company at the end of the lease. Using the straight-line method, the depreciation expense recorded by Bush Company for the year ended 12/31/2002 will be
a. $7,000.b. $5,250.c. $6,000.d. $8,000.
9. Gore Company leased a machine to Bradley Company for a seven-year period beginning 1/1/2002. The fair market value of the leased asset is $55,000, and the cost of the asset to Gore Company was also $55,000. The annual payments made at the end of each period are $11,297 (rounded), and the implicit interest rate is 10%. The interest revenue to be recognized by Gore Company in 2002 is (rounded to the nearest dollar)
a. $4,370.b. $5,500.c. $24,079.d. $0.
10. The difference between the fair value of leased property at the beginning of the lease and its cost or carrying amount will be classified by the lessor asa. the unearned revenue from a sales type lease.b. the unearned revenue from a direct financing lease.c. the dealer’s profit from a sales type lease.d. the dealer’s profit from a direct financing lease.
