Question

Bidwell Leasing purchased a single-engine plane for $400,000 and leased it to Red Baron Flying Club for its fair value of $645,526 on January 1, 2016.

Terms of the lease agreement and related facts were:

a. Eight annual payments of $110,000 beginning January 1, 2016, the inception of the lease, and at each December 31 through 2022. Bidwell Leasing’s implicit interest rate was 10%. The estimated useful life of the plane is eight years. Payments were calculated as follows:

b. Red Baron’s incremental borrowing rate is 11%.

c. Costs of negotiating and consummating the completed lease transaction incurred by Bidwell Leasing were $18,099.

d. Collectibility of the lease payments by Bidwell Leasing is reasonably predictable and there are no costs to the lessor that are yet to be incurred.

Required:

1. How should this lease be classified (a) by Bidwell Leasing (the lessor) and (b) by Red Baron (the lessee)?

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2. Prepare the appropriate entries for both Red Baron Flying Club and Bidwell Leasing on January 1, 2016.

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3. Prepare an amortization schedule that describes the pattern of interest expense over the lease term for Red Baron Flying Club.

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4. Prepare the appropriate entries for both Red Baron and Bidwell Leasing on December 31, 2016 (the second lease payment). Both companies use straight-line depreciation.

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5. Prepare the appropriate entries for both Red Baron and Bidwell Leasing on December 31, 2022 (the final lease payment).

Answer 1

Lease

An agreement of contract that is prepared to transfer the right to use the resources for a particular purpose for stipulated time is called lease contract. The person owning the resource is called lessor and the person, to whom right is transferred, is lessee.

Requirement 1:

Classify the lease:

Criteria for determining the capital lease or operating lease

According to Financial Accounting Standard Board (FASB), the following are four criteria for determining whether a lease is a capital lease or an operating lease:

1. Title transfer provision: The property is transferred to the lessee at the end of the lease period.

2. Bargain purchase provision: The purchase agreement of lease is less than market value.

3. Economic life provision: The economic life of the lease is 75% or more than the property useful life.

4. Value recovery provision: The present value of lease payments is equal to or more than 90% of the property’s market value.

If a lease meets any one of the above four criteria, it would be considered as capital lease. If a lease does not meet any of the above four criteria, it would be considered as operating lease.

The incremental borrowing rate of the lessee is 11% which is more than the implicit rate of the lessor of 10%. Hence, both are required to consider 10% discounting rate for all computations.

• The present value of the minimum lease payments of is more than 90% of the fair value.

• The economic life of the lease is 8 years which is 75% or more than the property useful life.

• The fair value of $645,526 exceeds the lessor’s book value of $400,000. It means the plane was sold at a profit of $245,526 .

• As two criteria are meet; hence, it is a capital lease for both the lessor and lessee.

Requirement 2:

Prepare the journal entries in the books of both RB Flying (Lessee) and BL (Lessor) on January 1, 2016:

RB Flying – Lessee:

Date	Accounts title and explanation	Post Ref.	Debit ($)	Credit ($)
January 1, 2016	Leased Equipment (A+)		645,526
	Lease Payable (L+)			645,526
	(To record the lease payable)
January 1, 2016	Lease Payable (L–)		110,000
	Cash (A–)			110,000
	(To record the payment annual lease payment)

BL – Lessor:

Date	Accounts title and explanation	Post Ref.	Debit ($)	Credit ($)
January 1, 2016	Lease Receivable (A+)		645,526
	Cost of Goods Sold (E–)		400,000
	Sales Revenue (E+)			645,526
	Inventory of Equipment (E+)			400,000
	(To record the lease receivable)
January 1, 2016	Selling Expense (A+)		18,099
	Cash (A–)			18,099
	(To record the selling expense)
January 1, 2016	Cash (A+)		110,000
	Lease Receivable (A–)			110,000
	(To record the receipt of annual lease payment)

Requirement 3:

Prepare an amortization schedule for the Lessee – RB Flying:

Requirement 4:

Prepare the necessary journal entries for both RB Flying (Lessee) and BL (Lessor) on December 31, 2016:

RB Flying – Lessee:

Date	Accounts title and explanation	Post Ref.	Debit ($)	Credit ($)
December 31, 2016	Interest Expense (E–)		53,553
	Lease Payable (L–)		56,447
	Cash (A–)			110,000
	(To record the interest expense)
December 31, 2016	Depreciation Expense (E–)		80,691
	Accumulated Depreciation (A+)			80,691
	(To record depreciation expense)

Working note:

Compute the Depreciation Expense:

BL – Lessor:

Date	Accounts title and explanation	Post Ref.	Debit ($)	Credit ($)
December 31, 2016	Cash (A+)		110,000
	Lease Receivable (A–)			56,447
	Interest Revenue (E+)			53,553
	(To record the receipt of annual cash payment and interest )

Requirement 5:

Prepare the necessary journal entries the books of both RB Flying (Lessee) and BL (Lessor) on December 31, 2022:

RB Flying – Lessee:

Date	Accounts title and explanation	Post Ref.	Debit ($)	Credit ($)
December 31, 2022	Interest Expense (E–)		10,000
	Lease Payable (L–)		100,000
	Cash (A–)			110,000
	(To record the rent expense)
December 31, 2022	Depreciation Expense (E–)		80,691
	Accumulated Depreciation (A+)			80,691
	(To record the payment of prepaid rent)

BL – Lessor:

Date	Accounts title and explanation	Post Ref.	Debit ($)	Credit ($)
December 31, 2022	Cash (A+)		110,000
	Lease Receivable (A–)			100,000
	Interest Revenue (E+)			10,000
	(To record the receipt of annual cash payment and interest )