Question

Question 4 Glaus Leasing Company agrees to lease equipment to Jensen Corporation on January 1, 2020. The following information relates to the lease agreement. 1. The term of the lease is 7 years with no renewal option, and the machinery has an estimated economic life of 9 years. 2. The cost of the machinery is $525,000, and the fair value of the asset on January 1, 2020, is $700,000. 3. At the end of the lease term, the asset reverts to the lessor and has a guaranteed residual value of $50,000. Jensen estimates that the expected residual value at the end of the lease term will be 50,000. Jensen amortizes all of its leased equipment on a straight-line basis. 4. The lease agreement requires equal annual rental payments, beginning on January 1, 2020. 5. The collectibility of the lease payments is probable. 6. Glaus desires a 5% rate of return on its investments. Jensen's incremental borrowing rate is 6%, and the lessor's implicit rate is unknown. (Assume the accounting period ends on December 31.) Click here to view factor tables. Discuss the nature of this lease for both the lessee and the lessor. This is a v for Jensen. This is a for Glaus. LINK TO TEXT LINK TO TEXT Calculate the amount of the annual rental payment required. (Round present value factor calculations to 5 decimal places, e.g. 1.25124 and the final answer to 0 decimal places e.g. 58,972.) Annual rental payment $ LINK TO TEXT LINK TO TEXT Compute the value of the lease liability to the lessee. (Round present value factor calculations to 5 decimal places, e.g. 1.25124 and the final answer to 0 decimal places e.g. 58,972.) Present value of minimum lease payments

Answer 1

(a)

This is a finance lease for Jensen since the lease term is greater than 75% of the economic life of the leased asset. The lease term is 78% (7 ÷ 9) of the asset’s economic life. In addition, the present value of the lease payments is greater than 90% of the asset’s fair value, as shown in part (c).

This is a sales-type lease for Glaus (lessor), for the same reasons as for the lessee.

(b)

Calculation of annual rental payment

$700,000 – ($50,000 X .71068*)/6.07569** = $109,365

*Present value of $1 at 5% for 7 periods.
**Present value of an annuity due at 5% for 7 periods.

(c)

Computation of lease liability, or present value of lease payments:
PV of annual payments: $109,365 X 5.91732* = $647,148

*Present value of an annuity due at 6% for 7 periods.

Because the guaranteed residual value is equal to the expected residual value, the lessee would not include any amount of the guaranteed residual value in its calculation of the initial lease liability. Note that Jensen used its incremental borrowing rate because Jensen does not know the implicit rate.

The lease liability only includes the amount expected to be owed under a residual value guarantee. This contrasts with the classification test, which includes the full value of a guaranteed residual. The classification test would be performed as done below:
PV of annual payments: $109,365 X 5.91732* = $647,148
PV of guaranteed residual value: $50,000 X .66506** = 33,253
$680,401

*Present value of an annuity due at 6% for 7 periods.
**Present value of $1 at 6% for 7 periods.

$680,401 ÷ $700,000 = 97%, which is greater than 90%, and thus the lease is a finance lease to the lessee.