Question

2. Lessee accounting-finance lease Krause Company on January 1, 2018, enters into a nine-year noncancelable lease for equipment having an estimated useful life of 10 years and a fair value to the lessor, Daly Corp., at the inception of the lease of $4,000,000. Krause's incremental borrowing rate is 8%. Krause uses the straight-line method to depreciate its assets. The lease contains the following provisions: 1. Rental payments of $266,000 for property taxes, payable at the beginning of each six-month period. 2. An option allowing the lessor to extend the lease one year beyond the lease term. 3. A guarantee by Krause Company that Daly Corp. will realize $200,000 from selling the asset at the expiration of the lease. However, the actual residual value is expected to be $120,000. Instructions (a) What kind of lease is this to Krause Company? (b) What should be considered the lease term? (c) What is the present value of the lease payments (1) for classification of the lease and (2) for measurement of the lease liability? (PV factor for annuity due of 20 semi-annual payments at 8% annual rate, 14.13394; PV factor for amount due in 20 semi-annual interest periods at 8% annual rate, .45639.) (Round to nearest dollar.) (d) What journal entries would Krause record during the first year of the lease? (Include an amortization schedule through 1/1/19 and round to the nearest dollar.)

Answer 1

　

1) Solution: Finance lease

Explanation:

Noncancelable period	9 Years
Period covered by lessor extension option	1 Year
Lease term	10 Years

Factor for present value of an annuity due, 20 periods, 4%	14.13394
Semi-annual payments, net of executory costs	266,000
(14.13394 * 266,000)	3,759,628
Factor for present value of $1 due in 20 interest periods at 4%	0.45639
Residual guarantee (200,000 * 0.45639)	91,278
Present value of lease payments (3,759,628 + 91,278)	3,850,906

　

Since the lease term is for 10 years (as computed above) exceeds 75% of the estimated useful life of equipment. Moreover, the present value of the minimum lease payments exceeds 90% (calculations done in below in part-b and part-c) of the equipment's fair value (4,000,000)

2) Solution: 10 years

Explanation:

Noncancelable period	9 Years
Period covered by lessor extension option	1 Year
Lease term	10 Years

　

3) Solution:

-- The present value of the lease payments is $3,850,906

-- The present value of the lease payments for measurement of lease liability is 3,796,139

Working:

Factor for present value of an annuity due, 20 periods, 4%	14.13394
Semi-annual payments, net of executory costs	266,000
(14.13394 * 266,000)	3,759,628
Factor for present value of $1 due in 20 interest periods at 4%	0.45639
Residual guarantee (200,000 * 0.45639)	91,278
Present value of lease payments (3,759,628 + 91,278)	3,850,906

Factor for present value of an annuity due, 20 periods, 4%	14.13394
Semi-annual payments, net of executory costs	266,000
Present value of rental payments (14.13394 * 266,000)	3,759,628
Factor for present value of $1 due in 20 interest periods at 4%	0.45639
Residual guarantee less expected RV [(200,000-120,000) * 0.45639]	36,511
Present value of lease payments(3,759,628 + 36,511)	3,796,139

　

4)

Date	Account	Debit	Credit
Jan-01	Right-of-Use Asset	3,796,139
	Lease Liability		3,796,139
Jan-01	Lease Liability	266,000
	Cash		266,000
Dec-31	Lease Liability	124,795
	Interest expense	141,205
	Cash		266,000

	Semi annual lease payment	Interest (4%)	Reduction on lease liability	Lease Lliability
Initial PV				3,796,135
Jan-18	266,000		266,000	3,530,135
Jul-18	266,000	141,205	124,795	3,405,340
Jan-19	266,000	136,214	129,786	3,275,554