Dalarite stheet at December 3l01B7 Finance and Operating Lea

Dalarite stheet at December 3l,01B7 (Finance and Operating Lease) Anthony Incorporated leases a piece of machinery to Irving Company on P21-15 (Lo2,3) January 1, 2017, under the following terms 1. The lease is to be for 4 years with rental payments of $12471 to be made at the beginning of each year 2. The machinery\' has a fair value of $67,000, a book value of s50,000, and an econqmic life of 10 years. of the lease term, both parties expect the machinery to have a residdal value of $25,000. To protect against a large loss, Anthony requests Irving to guarantee $17,500 of the residual value, which Irving agrees to do lease does not transfer ownership at the end of the lease term, does not have any bargain purchase options, and the asset is not of a specialized nature. 5. The implicit rate is 5%, which is known by Irving. 6. Collectibility of the payments is probable. Instructions a) Evaluate the criteria for classification of the lease, and describe the nature of the lease. (b) Prepare the journal entries for Irving for the year 2017. (c) Prepare the journal entries for Anthony for the year 2017. (d) Suppose Irving did not guarantee any amount of the expected residual value. How would your answers to parts (a)-(c) change?

Solution

Answer a:

The two most common types of leases are operating lease and finance lease or capital lease.

The classification of a lease would mainly depend on the following:

1. whether the risks and rewards associated with the ownership of the asset are transfered to the lessee from the lessor or whether are any purchase bargain option at the end of the lease term.

2. the life of the lease is for the significant portion of the economic life the asset.

3. the present value of the minimum rental payments is equals to atleast 90% of the fair value of the asset.

If any of the above conditions are satisfied, the nature of the lease will be finance lease or capital lease.

Application of the above conditions to find out whether the lease is operating lease or finance lease:

Condition -1: Here in the question, it is clearly mentioned that the lessor neither has no intention of transfering the ownership of the asset to the lessor nor gave any purchase bargain option at the end of the lease term. So this condition is not satisfied.

Condition -2: Here in the question, the lease term is less than the economic life of the leased asset. So this condition is not satisfied.

Condition -3:

Minimum lease payments includes annual rental payments and guarnteed residual value.

Calculation of Present value of annual payments and guaranteed residual value:

A. PV of annual payment = Annual payment X Present Value Annuity Factor

= $12,471 X 3.72

= $46,392

B. PV of residual value of the asset  

PV of guaranteed residual value = Residual value X Present value factor

= $17,500 X 0.823

= $14,397

Total Present value (PV) of Minimum lease payments = (A + B) = $46,392 + $14,397 = $60,789

90 % of fair value of asset = $67,000 X 90% =$60,300

Since PV of minimum lease payments is more than the the 90% of fair value of the leased asset, this lease is considered as FINANCE LEASE.