Question

Pharoah Leasing Company agrees to lease equipment to Novak Corporation on January 1, 2020. The following information relates to the lease agreement. 1. The term of the lease is 7 years with no renewal option, and the machinery has an estimated economic life of 9 years. 2. The cost of the machinery is $525,000, and the fair value of the asset on January 1, 2020, is $713,000. 3. At the end of the lease term, the asset reverts to the lessor and has a guaranteed residual value of $45,000. Novak estimates that the expected residual value at the end of the lease term will be 45,000. Novak amortizes all of its leased equipment on a straight-line basis. 4. The lease agreement requires equal annual rental payments, beginning on January 1, 2020. 5. The collectibility of the lease payments is probable. 6. Pharoah desires a 11% rate of return on its investments. Novak’s incremental borrowing rate is 12%, and the lessor’s implicit rate is unknown. (Assume the accounting period ends on December 31.)

Discuss the nature of this lease for both the lessee and the lessor. This is a for Novak. This is a for Pharoah.

Calculate the amount of the annual rental payment required. (Round present value factor calculations to 5 decimal places, e.g. 1.25124 and the final answer to 0 decimal places e.g. 58,972.) Annual rental payment $

Compute the value of the lease liability to the lessee. (Round present value factor calculations to 5 decimal places, e.g. 1.25124 and the final answer to 0 decimal places e.g. 58,972.) Present value of minimum lease payments $

Prepare the journal entries Novak would make in 2020 and 2021 related to the lease arrangement. (Credit account titles are automatically indented when amount is entered. Do not indent manually. If no entry is required, select "No Entry" for the account titles and enter 0 for the amounts. Round answers to 0 decimal places e.g. 58,972. Record journal entries in the order presented in the problem.) Date Account Titles and Explanation Debit Credit (To record the lease.) (To record lease payment.) (To record amortization.) (To record interest.) (To record amortization.) (To record interest.)

Prepare the journal entries Pharoah would make in 2020 and 2021 related to the lease arrangement. (Credit account titles are automatically indented when amount is entered. Do not indent manually. If no entry is required, select "No Entry" for the account titles and enter 0 for the amounts. Round answers to 0 decimal places e.g. 58,972. Record journal entries in the order presented in the problem.) Date Account Titles and Explanation Debit Credit (To record the lease.) (To record lease payment.)

Suppose Novak expects the residual value at the end of the lease term to be $35,000 but still guarantees a residual of $45,000. Compute the value of the lease liability at lease commencement. Lease liability $

Answer 1

Pharoah Leasing
	Lease Term	7
	Economic Life	9
	Fair Value	$ 7,13,000.00
	Guaranteed Residual Value	$     45,000.00
	Cost Price	$ 5,25,000.00
	Rate of Return	11%
	Incremental Borrowing rate	12%
	P.V of $1 @11% for 7 years	0.48166
	P.V of $1 @12% for 7 years	0.45235
	P.V of annuity @11% for 7 years	4.7122
	P.V of annuity @12% for 7 years	4.5638
	Annual Rental=((Fair Value-Residual value* P.V of $1 11% for 7 years))/P.V of annuity 11% for 7 years=($713000-($45000*.48166))/4.7122	$   1,46,710
	Present Value of minimum lease payment
	P.V of annual payment=(annual lease payment* P.V of annuity 12% for 7 years)=($146710*4.5638)	$   6,69,554
	P.V of Residual payment=(Guaranteed Residual payment*P.V of $1 @12% for 7 years)=($45000*.45235)	$      20,356
	Total	$   6,89,909
	Entries in the books of Novak
Date	Particular	Debit	Credit
01-01-2020	Lease Equipment	$       6,89,909
	To Lease Liability		$       6,89,909
	(Being amount of lease payment)
01-01-2020	Lease liability	$       1,46,710
	To Cash		$       1,46,710
	(Being amount of lease
31-12-2020	Depreciation Expense( Calculation below)	$           92,130
	To Accumulated Depreciation		$           92,130
	(Being amount of Depreciation)		$                    -
31-12-2020	Interest Expense	$           65,184
	To Interest Payable($658090-$124529)*10%		$           65,184
01-01-2021	Lease liability($146710-$65184)	$           81,526
	Interest Payable	$           65,184
	To Cash		$       1,46,710
	(Being amount of lease liability)
31-12-2021	Depreciation Expense	$           92,130
	To Accumulated Depreciation		$           92,130
	(Being amount of Depreciation)
31-12-2021	Interest Expense	$           55,401
	To Interest Payable($689909-$146710-$81526)*12%		$           55,401
	In the books of Pharoah Leasing
Date	Particular	Amt (Dr)	Amt (Cr)
01-01-2020	Lease Receivable	$       7,13,000
	Cost of goods sold	$       5,25,000
	To Sales Revenue		$       7,13,000
	To Inventory		$       5,25,000
	(Being amount of sale of Machinery)
01-01-2020	Cash	$       1,46,710
	To Lease Receivable		$       1,46,710
	(Being amount received for lease payment)
31-12-2020	Interest Receivable	$           62,292
	To Interest Revenue($713000-$146710)*11%		$           62,292
01-01-2021	Cash	$       1,46,710
	To Lease Receivable($146710-$62292)		$           84,418
	To Interest Receivable		$           62,292
	(Being amount of Cash received for lease payment and interest)
31-12-2021	Interest Receivable	$           53,006
	To Interest Revenue($713000-146710-$84418)*11%		$           53,006
	(Being amount of Interest Receivable)
	Calculation of Depreciation
	Fair value=(A)	$ 6,89,909.34
	Guaranteed residual payment=(B)	$     45,000.00
	Lease Term=(C )	7
	Depreciation=(A-B)/(C )	$           92,130