Question

Problem Set 3 (Total 40 pts) Daly Leasing Company (lessor) signs an agreement on January 1, 2017, to lease eqpaipmve to XYZ Company (lessee). The following information relates to this agreement 1. The term of the non-cancelable lease is 3 years with no renewal option. The equipment has an estimated economic life of5 years. 2. The fair value of the asset at January 1, 2017, is $80,000. Further, assume 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 implicit rate is 4% and is known to the lessee. XYZ uses the straight-line depreciation method for all equipment. Daly Leasing Company and XYZ both have their accounting year-end at December 31 6. 7. (a) How would XYZ (lessee) classify this lease? Indicate the type of lease and if individual criteria are met. Required: (b) Prepare all of the journal entries on XYZ's book related to this lease agreement for Jan 1 2017. 5

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 PV at 4% Cash Flow Disc. Cash Flow Year $ 01-Jan-17 25,562.96 1.00000 25,563 $ 01-Jan-18 25,562.96 0.96154 24,580 01-Jan-19 25,562.96 0.92456 23,634 $ 31-Dec-19 7,000.00 0.88900 6,223 $ Total 80,000 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) In the books of xYZ book Journal Accounts and Explanations Credit Debit Date 01-Jan-17 Equipment 80,000.00 Lease Payable (To record Finance lease agreement entered) 80,000.00 Lease Payable 01-Jan-17 25,562.96 Cash 25,562.96 (To record payment of first lease installment)