Question

Sharke Inc. was incorporated in 2017 to operate as a computer software service firm with an accounting fiscal year ending July 31. Sharke's primary product is an on-line inventory-control system: its customers pay a fixed fee plus usage charges for using the system. On August 1, 2019, Sharke leased a large computer system from the manufacturer. The lease terms are shown below: Annual lease payment $ 62,500.00 paid at the beginning of the year Date of first payment Aug. 1. 2019 Lease term 8 years from date of first payment Implied interest rate in the contract 5% Depreciation method Straight-line Bargain purchase option $ 6,000.00 to be exercised at the end of the 5th year Expected service life of the computer system 8 years This lease is to be accounted for as a finance lease. Following is a schedule of the present value factors (both present value of $1 and present value of annuities due). 7% Present value of Annuity Due for Syrs. Present value of Annuity Due for Syrs. Present value of $1 for 5 yrs. Present value of $1 for 8 yrs. 4.38721 6.38929 0.71299 0.58201 5% 4.54595 6.78637 0.78353 0.67684 Required: 1. Identify the criteria for determining finance leases. 2. Prepare an amortization schedule for this lease agreement Prepare, in general journal form, all entries Sharke should make in its accounting records for the first two fiscal years relating to this lease

Answer 1

ANSWER

As per the given question,

1. Finance lease is a lease that transfers substantially all the risks and rewards associated with the ownership of an asset. The risks related to ownership of an asset include the possibilities of losses from idle capacity or technological obsolescence, and that flowing from variations in return due to changing economic conditions; rewards incidental to ownership of an asset include an expectation of profitable operations over the asset’s economic life and expectation of gain from appreciation in value or the ultimate realization of the residual value. Title may or may not eventually be transferred to the lessee under finance lease arrangements.

2.

PV of lease payments		62500	6.78637	424,148
PV of Bargain purchase option		6000	0.78353	4,701
				428,849
Lease amortization schedule
Year	Cash	Interest Expense	Reduction in lease obligation	Balance of lease obligation
Opening balance				428,849
0	62,500	-	62,500	366,349
1	62,500	18,317	44,183	322,167
2	62,500	16,108	46,392	275,775
3	62,500	13,789	48,711	227,064
4	62,500	11,353	51,147	175,917
5	68,500	8,796	59,704	116,213
6	62,500	5,811	56,689	59,524
7	62,500	2,976	59,524	-0

3. Journal Entries

01-Aug-19
Lease Equipment	Dr	428,849
Lease Liability	Cr	428,849
Lease Liability	Dr	62,500
Cash	Cr	62,500
31-Jul-19
Depreciation Equipment	Dr	53,606
Accumulated Depreciation	Cr	53,606
Interest Expense	Dr	18,317
Lease Liability	Dr	44,183
Payable	Cr	62,500
01-Aug-20
Lease Liability	Dr	62,500
Cash	Cr	62,500
31-Jul-20
Interest Expense	Dr	16,108
Lease Liability	Dr	46,392
Payable	Cr	62,500

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