Question
On January 1, 2017, Louis Corp. enters into a ten-year non-cancellable lease with Coles Ltd. for equipment having an estimated useful life of 11 years and a fair value of $6,000,000. Louis's incremental borrowing rate is 8%, but they do not know Coles’ implicit rate. Louis uses the straight-line method to depreciate assets. The lease contains the following provisions:
1. Semi-annual lease payments of $438,000 (including $38,000 for property taxes), payable on January 1 and July 1 of each year.
2. A guarantee by Louis Corp. that Coles Ltd. will realize $200,000 from selling the asset at the expiration of the lease (residual value).
Both companies adhere to ASPE.
Instructions
a. Calculate the undiscounted minimum lease payments over the life of the lease.
b. Calculate the present value of the minimum lease payments.
c. What kind of lease is this to Louis Corp.? Why?
d. Present the journal entries that Louis would record during the first year of the lease. Include an amortization schedule through January 1, 2018 and round values to the nearest dollar.
Answer:a The undiscounted minimum lease payments are:
Semi-annual rental payments. ..................................................................... $ 438,000
Less executory costs. .................................................................................. (38,000 ) ............................................................................................................ 400,000
Number of payments over lease term. ........................................................ 20 ............................................................................................................ 8,000,000
Residual guarantee. ..................................................................................... 200,000
Minimum lease payments. .............................................................................$8,200,000
Answer:b The present value of the minimum lease payments is:
Factor for present value of an annuity due, 20 periods, 4%. .......... 14.13394
Semi-annual payments, less executory costs. ................................ $ 400,000
(OR 20 N 4 i 400000 PMT CPT PV => 5,653,576). ...................... $5,653,576
Factor for present value of $1 due in 20 semi-annual interest periods at 4%. ................................................................................ 0.45639
Guaranteed residual . ....................................................................$200,000 91,278
(OR 20 N 4 i 200000 FV CPT PV => 91,277)
Present value of lease payments. .................................................... $5,744,854
Answer:c This lease is a capital lease to Fargo Corp. because its 10 year term exceeds 75% of the equipment's estimated useful life. In addition, the present value of the minimum lease payments exceeds 90% of the current fair value of the equipment ($6,000,000).
Answer:d
Jan 1, 2014
Equipment under Lease. .................................................................. 5,744,854
To Obligations under Lease. .......................................................... 5,744,854
AND
Obligations under Lease. ................................................................. 400,000
Property Taxes. ................................................................................ 38,000
To Cash. ......................................................................................... 438,000
(These two entries can be combined)
Jul 1, 2014
Obligations under Lease…. ............................................................. 186,206
Property Taxes. ................................................................................ 38,000
Interest Expense. ............................................................................. 213,794
To Cash. ......................................................................................... 438,000
Dec 31, 2014
Depreciation Expense. ..................................................................... 511,350*
To Accumulated Depreciation—Leased Equipment. ..................... 511,350
Interest Expense. ............................................................................. 206,346
To Interest Payable. ....................................................................... 206,346
*($5,744,854 – 120,000) ÷ 11 = $511,350
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