Question

On January 1, 2017, Galactus Corp. (lessor) entered into a noncancellable lease agreement with Blade Corp. (lessee) for machinery which was carried in Galactus’s accounting records at $2,265,000 and had a fair value of $2,400,000. Minimum lease payments under the lease agreement, which expires on December 31, 2026, total $3,550,000. Payments of $355,000 are due each January 1. The first payment was made on January 1, 2017 when the lease agreement was finalized. The interest rate of 10% which was stipulated in the lease agreement is the implicit rate set by the lessor. The effective interest method is being used. Blade expects the machine to have a ten-year life with no residual value, and be depreciated on a straight-line basis. Collectability of the rentals is reasonably assured, and there are no important uncertainties surrounding the costs yet to be incurred by Galactus. Both entities are small private corporations that follow ASPE.

Instructions

a.   From the lessee's viewpoint, what kind of lease is the above agreement? From the lessor's viewpoint, what kind of lease is the above agreement?

b.   Ignoring income taxes, what should be the income reported by Galactus from the lease for calendar 2017?

c.   Ignoring income taxes, what should be the expenses incurred by Blade from this lease for the calendar 2017?

d.   What journal entries should be recorded by Blade Corp. on January 1, 2017?

e.   What journal entries should be recorded by Galactus Corp. on January 1, 2017?

Answer 1

Answers :

(a) From lessee's viewpoint the lease is financial lease because present value of minimum lease payments ($ 2,366,00) covers    almost all of the fair value ($ 2,400,000) of machinery and the lease terms covers all of the life of machinery.

   From lessor's viewpoint also it is finance lease

(b) Income of Galactus (Lessor) by lease :

    lease rentals - depreciation

= ($ 3,550,000 - $ 2,400,000) = $ 1,150,000

(c) Expenses to be incurred by Blade (lessee) from the lease for calendar year 2017

    Interest charges of $ 319,500 will be expended by blade which is calculated as follows

    [$3,550,000 - 3,55,000] * 10%

(d) Journal entries to be recorded by Blade Corp. on January 1, 2017

    Machinery a/c                            Dr.                      $3,550,000

                 To Galactus                                                                       $3,550,000

    Lease Rentals a/c                   Dr.                       $355,000

                  To Bank                                                                            $355,000

    Profit & Loss a/c                     Dr.                       $319,500

                    To Interest Charges                                                          $319,500

(d) Journal entries to be recorded by Galactus Corp. on January 1, 2017

     Bank a/c                            Dr.                       $355,000

                To Blade                                                                          $355,000

     Depreciation a/c                 Dr.    $240,000

                 To Machinery                                                                 $240,000

    Interest a/c                          Dr.                      $ 319,500

                 To Profit & Loss a/c                                                       $ 319,500

Working Note :

Calculation of present value of minimum lease payment

As lease rentals are payable at the beginning of the year present value annuity @ 10% for 10 years will be calculated as

[PV @ 10% for 9 years + 1] = 5.76+1 = 6.76

$ 355,000 * 6.76 = $ 2,399,800