Question

Rexon Company leases equipment to Ten-Care Company beginning January 1, 2016. The lease terms, provisions, and related events are as follows: 1. The lease term is 8 years. The lease is noncancelable and requires equal rental payments to be made at the end of each year. 2. The cost, and also fair value, of the equipment is $500,000. The equipment has an estimated life of 8 years and has a zero estimated value at the end of that time. 3. Ten-Care agrees to pay all executory costs. 4. The lease contains no renewal or bargain purchase option. 5. The interest rate implicit in the lease is 14%. 6. The initial direct costs are insignificant and assumed to be zero. 7. The collectibility of the rentals is reasonably assured, and there are no important uncertainties surrounding the amount of unreimbursable costs yet to be incurred by the lessor. Required: 1. Next Level Assuming that the lease is a direct financing lease from Rexon’s point of view, calculate the amount of the equal rental receipts. 2. Prepare a table summarizing the lease receipts and interest revenue earned by Rexon. 3. Prepare journal entries for Rexon for the years 2016 and 2017.

Answer 1

A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.

A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset.

Title may or may not be transferred eventually at the end of lease.

There are two parties to lease -lessor (Who gives asset) Lessee who uses asset and pay rent.

The commencement of the lease term is the date from which the lessee is entitled to exercise its right to use the leased asset. It is the date of initial recognition of the lease (viz. the recognition of the assets, liabilities, income or expenses resulting from the lease, as appropriate).

Fair value is the amount for which an asset could be exchanged, or a liability settled.

For a lease to be classified as a finance lease are:

(a) the lease transfers ownership of the asset to the lessee by the end of the lease term;

(b) the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised;

(c) the lease term is for the major part of the economic life of the asset even if title is not transferred; (8 years in present situation)

(d) at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset; ($500000) and

(e) the leased assets are of such a specialised nature that only the lessee can use them without major modifications.

Initial Recognition of a finance lease in the books of Lessor:

Lessors shall recognise assets at their balance sheets and present them as a receivable at an amount equal to the net investment in the lease.

Subsequent Measurement

The recognition of finance income shall be based on a pattern reflecting a constant periodic rate of return on the lessor’s net investment in the finance lease.

Gross investment in the lease is the aggregate of:

(a) the minimum lease payments receivable by the lessor under a finance lease, and

(b) any unguaranteed residual value accruing to the lessor.

Net investment in the lease is the gross investment in the lease discounted at the interest rate implicit in the lease.

Unearned finance income is the difference between: Gross Investment and Net Investment.

Calculation of Gross investment in the lease:

Minimum Lease Payment receivable = $40000 per year+ Unguaranteed Residual value $0

Calculation of Net investment in the lease:

Net Investment = Gross Investment Discounted at Interest rate implicit in the lease (14%)

1- Amount of Equal Rental Receipts = Cost = PV of Revenue

Let X be the equal annual rent

= $500000 = X*PVF(14%,1)+X*PVF(14%,2)+X*PVF(14%,3)+X*PVF(14%,4)+X*PVF(14%,5)+X*PVF(14%,6)+X*PVF(14%,7)+X*PVF(14%,8)

X = $500000/4.638 = $107785

2- Lease Receipt and Interest Revenue Earned by Rexon,

Year	MLP (1)	Unguranteed Residual value(2)	Gross Investment (3) = (1+2)	PVF @ 14% (4)	Net Investment (5)	Unearned Finance Income (6) = (3)-(5)
2016	107785		107785	0.877	94548	13237
2017	107785		107785	0.769	82937	24848
2018	107785		107785	0.675	72753	35032
2019	107785		107785	0.592	63818	43968
2020	107785		107785	0.519	55980	51805
2021	107785		107785	0.456	49105	58680
2022	107785		107785	0.399	43075	64710
2023	107785	0	107785	0.351	37785	70000
			862280		500000	362280

(3) Journal Entries:

Initial Recognition

1-1-2016

Leased Asset Receivable Account (Net Investment) Dr. $500000

To Leased Asset   $500000

(Being Receivable against leased asset recorded)

31-12-2016

Bank A/c Dr. $107785

To Leased Asset Receivable Account $94548

To Unearned Finance Income $13237

(Being Lease Rent Received)

31-12-17

Bank A/c Dr. $107785

To Leased Asset Receivable Account $82937

To Unearned Finance Income $24848

(Being Lease Rent Received)