Question

At the beginning of 2018, VHF Industries acquired a machine with a fair value of $7,989,010 by signing a three-year lease. The lease is payable in three annual payments of $3.1 million at the end of each year. (FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.)

Required:
1. What is the effective rate of interest implicit in the agreement?
2-4. Prepare the lessee’s journal entries at the beginning of the lease, the first lease payment at December 31, 2018 and the second lease payment at December 31, 2019.
5. Suppose the fair value of the machine and the lessor’s implicit rate were unknown at the time of the lease, but that the lessee’s incremental borrowing rate of interest for notes of similar risk was 7%. Prepare the lessee’s entry at the beginning of the lease.

Answer 1

1)

The Implicit Interest Rate = 8%

Explanation :

Present value of annuity * $ 3,100,000 = $ 7,989,010

Present value of annuity = $ 7989010 / $ 3100000

Present value of annuity = 2.5771

The discount rate for 3 payments that can be equal

to 2.57710 is 8 %

2)

Date	General Journal	Debit	Credit
01-01-2018	Machine      To Lease Payable (To record beginning of lease )	$ 7,989,010	$ 7,989,010

3)

Date	Payment	Interest(8%)	Principal	Balance
01-01-2018				7989010
12/31/2018	3100000	639121 (7989010*8%)	2460879 (3100000-639121)	5528131
12/31/2019	3100000	442250 (5528131*8%)	2657750 (3100000-442250)	2870381
12/31/2020	3100000	229619 (3100000-2870381)	2870381	0

4)

Date	General Journal	Debit	Credit
12/31/2018	Lease Payable Interest Expense               To       Cash (To record first lease payment at December 31,2018)	2460879 639121	3100000
12/31/2019	Lease Payable Interest Expense                 To     Cash (To record lease payment at December 31,2019)	2657750 442250	3100000

5)

Fair value of machine = $3, 100,000 * Cumulative PV Factor at 7% for 3 periods

= $3,100,000 * 2.624 = $ 8134400

Date	General Journal	Debit	Credit
01-01-2018	Machinery        To Lease Payable (To record machinery purchased on lease)	8134400	8134400