Millet Sales Corp., a public company, is planning to acquire new computers with a total value of $ 60,000 on January 1, 2021. They have a choice of leasing the computers for a three-year period, or purchasing them and financing the purchase by issuing a note payable. Details of the two alternative arrangements are as follows:
1. Lease option: Three annual lease payments of $ 22,446 due on December 31 of each year. Millet would purchase the computers at the end of the three years for $ 2.00.
2. Financing option: Millet would make a down payment of $ 10,000 and issue a 6%, 3-year note payable for the remaining balance, with annual blended payments of $ 18,705 required on December 31 of each year.
Instructions
a) Is the lease arrangement an operating or finance lease? Explain your choice. Record any entry required on January 1, 2021.
b) Prepare the amortization table for the note payable. Record any entry required on January 1, 2021.
(a)
| Particulars | Operating Lease | Financial Lease |
| Risk & Rewards | A lease in which all the risks and rewards related to asset ownership remain with the lessor for the leased asset is called an operating lease. In this type of lease, the asset is returned by the lessee after using it for the agreed-upon lease term. | In a financial lease, the risks and rewards related to asset ownership are transferred to the lessee. In this type of lease, the asset is not returned by the lessee after using it for the agreed-upon lease term |
| Ownership | The ownership of the asset remains with the lessor for the entire lease period. | The ownership transfer option is available at the end of the lease period to the lessee. The title may or may not be transferred eventually. |
In the above case, the Millet would purchase the asset at the end of 3 years which means the risk and rewards of the asset will be transferred to the lessee, which means it is a financial lease.
Journal Entry:-
1 January 2021 Finance Liability A/c Dr. $22,446
To Cash A/c $22,446
(Being first annual payment made).
(b)
Amortization Table:-
| Year | Opening Balance($) (A) | Interest($) (B) | Installment($) (C) | Closing Balance($) (D)=(A+B-C) |
| 0 | 60000 | - | 10000 | 50000 |
| 1 | 50000 | 50000*6% 3000 | 18705 | 34295 |
| 2 | 34295 | 34295*6% =2057.70 | 18705 | 17647.70 |
| 3 | 17647.70 | 17647.70*6% =1058.862 | 18705 | 0 Differences of points arise due to round off |
Annual Blended Payments of $18705 include the interest as well as the principal amount.