Question

Direct Financing Lease (Lessor)

• Caterpillar signed a lease arrangement for an equipment with Sterling Corporation on 1/1/17 on the following terms:

• Lease term is 5 years, non-cancellable, requiring annual payments of 25,981.62 at the beginning of each year (annuity due).

• The equipment has a fair value of 100,000 on 1/1/17, useful life of 5 years, and no residual value

• Sterling pays all executory costs to third parties except for 2,000 in property taxes that is included in the lease payments

• Sterling’s incremental borrowing rate is 11% • Sterling uses straight line depreciation

• Caterpillar sets the annual rental to earn a 10% rate of return and Sterling knows about it.

Answer 1

Solution:

The lease is a capital lease as the lease term equals the useful life of asset. (lease term more than 75% of the asset’s useful life).

The present value of minimum lease payments = more than 90% of the fair market value of the property. (present value = $100,000; FMV = $100,000).

Computation of the present value of the minimum lease payments:

Annual payment = $25,981.62

Less: property taxes (executory costs) $2,000

Minimum lease payments = $23,981.62

Present value annuity due factor, for 10% rate of interest, period 5 is 4.1699

Present value of minimum lease payments = 4.1699 x 23,981.62 = $100,000

Amortization Schedule
Date	Annual lease payment	Executory costs	interest	reduction of lease liability	lease liability
01-01-2017					$100,000
01-01-2017	$25,981.62	$2,000	0	$23,981.62	$76,018.38
01-01-2018	$25,981.62	$2,000	$7,601.84	$16,379.78	$59,638.60
01-01-2019	$25,981.62	$2,000	$5,963.86	$18,017.76	$41,620.84
01-01-2020	$25,981.62	$2,000	$4,162.08	$19,819.54	$21,801.30
01-01-2021	$25,981.62	$2,000	$2,180.13	$21,801.30	0
Total	$129,908.10	$10,000	$19,908.10	$100,000

Entries in the books of Sterling (lessee):

Date	Account Titles	Debit	Credit
01-01-2017	Leased Equipment	$100,000
	Lease Liability		$100,000
	(to record the inception of lease)
01-01-2017	Lease Liability	$23,981.62
	Property Taxes	$2,000
	Cash		$25,981.62
	(To record the first lese payment)
01-01-2018	Lease Liability	$16,379.78
	Property Taxes	$2,000
	Interest Payable	$7,601.84
	Cash		$25,981.62
	(to record annual payment)

Entries in the books of Caterpillar (Lessor):

Date	Account Titles	Debit	Credit
01-01-2017	Lease Receivable	$100,000
	Equipment		$100,000
	(To record inception of lease)
01-01-2017	Cash	$25,981.62
	Lease Receivable		$23,981.62
	Property tax expense		$2,000
	(To record receipt of first annual payment)
Dec 31, 2017	Interest Receivable	$7,601.84
	Interest Revenue		$7,601.84
	(To recognize interest revenue)
Jan 1, 2018	Cash	$25,981.62
	Lease Receivable		$16,379.78
	Interest Receivable		$7,601.84
	Property tax expense		$2,000
	(To record receipt of annual payment)
Dec 31, 2018	Interest Receivable	$5,963.86
	Interest Revenue		$5,963.86
	(To record accrued interest receivable)

Notes:

Computation of lease receivable:

Annual payment = $25,981.62

Less: property taxes (executory costs) $2,000

Minimum lease payments = $23,981.62

Present value annuity due factor, for 10% rate of interest, period 5 is 4.1699

Present value of minimum lease payments = 4.1699 x 23,981.62 = $100,000

The assets section of lessor’s balance sheet at December 31, 2017:

Caterpillar
Balance Sheet (partial) at December 31, 2017
Assets
Current Assets
Interest Receivable	$7,601.84
Lease Receivable	$16,379.78
Investments
Lease Receivable	$59,638.60