Question

Part VI: Lessee and Lessor on January 1, 2019 enter into a 4-year non-cancelable lease, with two renewal options of one year each, for equipment having a useful life of 12 years. Lessee's incremental borrowing rate is 8% while Lessor's implicit rate is 5% and known to Lessee. The Lessee uses the straight-line method of depreciation. The lease contains the following provisions: 1. Annual rental payments of $20,000 payable at the beginning of each year, starting January 1, 2019. 2. A termination penalty assures the renewal of the lease for the additional two years. here is a guaranteed residual value at the end of the lease for $10,000. 4. The equipment has a cost of $110,000 and fair value of $114,052. Collectability of lease payments is probable. INSTRUCTIONS: (a) What kind of lease is this to the lessee and lessor? (b) Prepare the journal entries on the books of Lessee and Lessor through December 31, 2024. (©) Prepare the journal entries on the books of Lessce and Lessor through December 31, 2024, assuming that the residual value is unguaranteed. (d) What if there is a bargain purchase option of S10,000 at the end of the lease.

Answer 1

a) Answer is   Operational Lease .  

Explanatioin: There are two types of leases:

1. Finance Lease

2. Operating Lease

Finance Lease: A lease in which all risks and rewards are transferred to the owner of assets. The title may or may not eventually be transferred.

Examples of Finance Lease are:

1. Lease in which Assets is transferred to lessee at the end of lease term

2. Lease term in which lessee has the option to purchase the assets form lessor at the price which is lower than fair price on the date when option become exercisable

3. Lease term Covers complete economic life of the asset even if title is not transferred

4. Lease term in which present value of the minimum lease payments is equal to or substantially covers the fair value of the leased asset

5. Leased asset is of a specialized nature. Ex Ambulance (the lessee can use it without major modifications being made)

Operating Lease: Any other lease other than finance lease is considered as an Operating Lease.

So in the above question it was clearly mentioned that the lease is for 4 non cancelable years but the life of the asset is 12 years . so it was not covering the above 3rd point. Therfore it is Operating Lease

b) Journal Entries in the books of lessor at 31dec 2024

1. Depreciation A/c Dr 9167 (110000$/12)

To Equipment A/c Cr 9167

(Being depreciation provided on equipment)

2. Profit & loss A/c Dr 9167 $

To Depreciation A/c Cr 9167 $

(Being depreciation transferred to P & L Acc  at the end of the year)

3. Lease rent A/c Dr 20000$

To Profit & loss A/c Cr 20000$

(Being Lease rent transferred to P & L Acc  at the end of the year)

Journal Entries in the books of lessee at 31dec 2024

1. Profit & loss A/c Dr 20000 $

To Lease Rent paid A/c Cr 20000$

(Being lease rent paid transferred to P & L at the year end)