Question

Problem Set 3 (Total 40 pts) Daly Leasing Company (lessor) signs an agreement on January 1, 2017. to lease equipment to XYZ Company (lessee). The following information relates to this greement 1. The term of the non-cancelable lense is 3 years with to renewal option. The equipment has an estimated economic life of 5 years. 2. The fair value of the asset at January 1, 2017, is $80.000. Further, as the underlying asset (the equipment) has a $50.000 cost to the dealer, Daly Leasing Company 3. The asset will revert to the lessor at the end of the lease term. And the guaranteed residual value is 7.000. XYZ expects that it is probable that the expected value of the residual value at the end of the lease will be at least equal to guaranteed amount of $7.000. 4. The agreement requires equal annual rental payments of $25,562.96 to the lessor, beginning on January 1, 2017 5. The lessee's incremental borrowing rate is 5%. The lessor's implicitrate is 4% and is knows to the lessee. 6. XYZ uses the straight-line depreciation method for all equipment 7. Daly Leasing Company and XYZ both have their accounting year-end at December 31. Required: (a) How would XYZ (lessee) classify this lease? Indicate the type of lease and if individual criteria are met (b) Prepare all of the journal entries on XYZ's book related to this lease agreement for Jan 1". 2017.

Answer 1

Requirement (a) The lessor's implicit rate is known to he lessee. Hence, the discount rate applied by the lessee is 4%. Computing Present value of Minimum Lease Payments Year Cash Flow PV at 4% 01-Jan-17 25,562.96 1.00000 01-Jan-18 25,562.96 0.96154 01-Jan-19 25,562.96 0.92456 31-Dec-19 7,000.00 0.88900 Total Disc. Cash Flow 25,563 24,580 23,634 6,223 $ 80,000 o 1 I $ 1) The fair value of lease is equal to the present value of Minimum Lease Payments. 2) Most of the economic life of the asset is included in the lease term, i.e., 60% (3/5) Hence, the above lease is classified as Finance Lease. Requirement (b) Credit | In the books of XYZ book Journal Date Accounts and Explanations Debit 01-Jan-17 Equipment $ 80,000.00 Lease Payable $ (To record Finance lease agreement entered) 80,000.00 01-Jan-17 Lease Payable $ 25,562.96 Cash $ (To record payment of first lease installment) 25,562.96

Requirement (C) Lease Ammortization Schedule Date Annual Lease Payment Interest on Liability 01-01-2017 | 01-01-2017 $ 01-01-2018 $ 01-01-2019 $ 31-12-2019 $ 25,562.96 25,562.96 25,562.96 7,000.00 $ $ $ $ - 2,177.48 1,242.06 269.34 Reduction of Carrying Amount of Lease Liability I Lease Liability 80,000.00 $ 25,562.96 $ 54,437.04 $ 23,385.48 31,051.56 $ 24,320.90 $ 6,730.66 $ 6,730.66 $ Requirement (d) Date Credit | In the books of XYZ book Journal Accounts and Explanations 31-Dec-17 Interest expense Lease Payable (To record interest expense on lease) Debit 2,177.48 $ $ 2,177.48 31-Dec-17 Depreciation expense (80000/3) | $ 26,666.67 Accumulated Depreciation Equipment (To record depreciation expense on equipment) $ 26,666.67

Requirement (e) In the books of XYZ book Journal Date Accounts and Explanations | Debit 01-Jan-18 Lease Payable $ 25,562.96 Cash (To record payment of second lease installment) Credit $ 25,562.96 31-Dec-18 $ 1,242.06 Interest expense Lease Payable (To record interest expense on lease) $ 1,242.06 | 31-Dec-18 Depreciation expense (80000/3) $ 26,666.67 Accumulated Depreciation Equipment |(To record depreciation expense on equipment) $ 26,666.67 Requirement (f) Daly Leasing company will also classify this lease as Finance Lease. Criteria 1) The fair value of lease is equal to the present value of Minimum Lease Payments. 2) Most of the economic life of the asset is included in the lease term, i.e., 60% (3/5) 3) Lease payments are probable.