Question

(Lessee Entries; Finance Lease and Unguaranteed Residual Value) Assume that on December 31, 2016, Kimberly-Clark Corp. signs a 10-year, non-cancelable lease agreement to lease a storage building from Sheffield Storage Company. The following information pertains to this lease agreement.

1. The agreement requires equal rental payments of $71,830 beginning on December 31, 2016.

2. The fair value of the building on December 31, 2016, is $525,176.

3. The building has an estimated economic life of 12 years, a guaranteed residual value of $10,000, and an expected residual value of $7000. Kimberly-Clark depreciates similar buildings on the straigh-line method.

4. The lease is nonrenewable. At the termination of the lease, the building reverts to the lessor.

5. Kimberly-Clark's incremental borrowing rate is 8% per year. The lessor's implicit rate is not known by Kimberly-Clark.

Instructions

(a) Prepare the journal entries on the lesses's books to reflect the signing of the lease agreement and to record the payments and expenses related to this lease for the years 2016, 2017, and 2018. Kinberly-Clark's fiscal year-end is December 31.

(b) Suppose the same facts as above, except that Kimberly-Clark incurred legal fees resulting from the execution of the lease of $5000, and received a lease incentive from Sheffield to enter the lease of $1000. How would the initial measurement of the lease liability and right-of-use asset be affected under this situation?

(c) Suppose that in addition to the $71,830 annual rental payments, Kimberly-Clark is also required to pay $5000 for insurance costs each year on the building directly to the lessor, Sheffield Storage. How would this executory cost affect the initial measurement of the lease liability and right-of-use asset?

(d) Return to the origianal facts in the problem. Now suppose that, at the end of the lease term, Kimberly-Clark took good care of the asset and Shefiield agrees that the fair value of the asset is actually $10,000. Record the entry for Kimberly-Clark at the end of the lease to return control of the storage building to Sheffield (assuming the accrual of interest on the lease liability has already been made).

Answer 1

A) Journal entries: In the books of Kimberly-Clark(lessee)

31st December 2016: Building (leased) a/c Dr. 486611.30

   To lease liability a/c 486611.30

[PV of MLP is less than fair value of $ 525176, So the leased asset and liability should be recognized at $ 486611.3 in the books of lessee.]

   Depreciation    a/c Dr. 40550.94(486611.3/12)

To Machinery a/c 40550.94

Leased Liability    a/c Dr.    32901.12(71830-38928.88)

Finance charge    a/c Dr.    38928.88(486611.3*8/100)

To    Bank a/c    71830

Profit & Loss a/c    Dr.    79479.82   

To Depreciation a/c    40550.94

To Finance charge a/c 38928.88

31st December 2017

Depreciation    a/c Dr. 40550.94(486611.3/12)

   To Machinery a/c 40550.94

Leased Liability    a/c Dr.    35533.18(71830-36296)

Finance charge    a/c Dr.    36296.8(486611.3*8/100)

To    Bank a/c    71830

Profit & Loss a/c    Dr.    76847.74   

To Depreciation a/c    40550.94

To Finance charge a/c    36296.8

31st December 2018

   Depreciation    a/c Dr. 40550.94(486611.3/12)

   To Machinery a/c 40550.94

Leased Liability    a/c Dr.    38375.84(71830-33454.16)

Finance charge    a/c Dr.    33454.16(486611.3*8/100)

To    Bank a/c    71830

Profit & Loss a/c    Dr.    74005.1   

To Depreciation a/c    40550.94

To Finance charge a/c    33454.16