Question

Sheridan Leasing Company agrees to lease equipment to Skysong 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 $489,000, and the fair value of the asset on January 1, 2020, is $699,000.
3.		At the end of the lease term, the asset reverts to the lessor and has a guaranteed residual value of $60,000. Skysong estimates that the expected residual value at the end of the lease term will be 60,000. Skysong 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.		Sheridan desires a 9% rate of return on its investments. Skysong’s incremental borrowing rate is 10%, and the lessor’s implicit rate is unknown.

(Assume the accounting period ends on December 31.)

Calculate the amount of the annual rental payment required?

Compute the value of the lease liability to the lessee?

Prepare the journal entries Sheridan would make in 2020 and 2021 related to the lease arrangement

(To record the lease.)

(To record lease payment.)

Suppose Skysong expects the residual value at the end of the lease term to be $50,000 but still guarantees a residual of $60,000. Compute the value of the lease liability at lease commencement.

Answer 1

Requirement 1 Both the lessor and lessee should classify the above lease as Finance Lease. Reason- The lessee holds the asset for the substantial period of the economic life of the asset, i.e, 7 years out of 9 years. Since, lessor fixes the annual rental payments, the implicit rate shall be used to compute the rent. The residual value should be expected irrespective whether guaranteed or not. Fair value of the machine $ 699,000 $ Expected residual value PV Interest (9%, 7th year) PV of residual value (60000*0.54703) 60,000 0.54703 32,822 $ $ PV of Minimum Lease Payments (699000-32822) PV of Annuity Due (9%, 7 years) Annual Rental payment (666178/5.48592) 666,178 5.48592 121,434 $ Requirement 2 Since lessee is unaware of the implicit rate used by the lessor, the incremental borrowing rate of 10% shall be used to discount the lease for the lessee. $ Annual Lease Rentals PV of Annuity Due (10%, 7 years) PV of lease rentals (121434*5.35526) 121,434 5.35526 650,311 $ $ Guaranteed residual value PV (12%, 7th year) PV of residual value (60000*0.51316) 60,000 0.51316 30,790 $ Lease Liability for lessee (650311+30790) $ 681,101

Requirement 3 Lease Ammortization Schedule (lessor) Year Installment amount Interest at 9% Principle Adjustment $ o $ 121,434 $ $ 121,434 $ 1 $ 121,434 $ 51,981 $ 69,453 $ 2 $ 121,434 $ 45,730 $ 75,704 $ 3 $ 121,434 $ 38,917 $ 82,517 $ 4 $ 121,434 $ 31,490 $ 89,944 $ 5 121,434 $ 23,395 $ 98,039 $ 6 $ 121,434 $ 14,572 $ 106,862 $ 7 $ 60,000 $ 4,953 $ 55,047 $ Closing Principle 699,000 577,566 508,113 432,409 349,892 259,948 161,909 55,047 $ (in $) Debit 699,000 (in $) Credit 699,000 489,000 489,000 121,434 121,434 In the Books of Sheridan Leasing Company (Lessor) Date Particulars 01-Jan-20 Lease Receivable Sale (To record the lease) 01-Jan-20Cost of Goods sold Finished Goods Inventory (To record the cost of goods sold) 01-Jan-20 Cash Lease Receivable (To record first lease receipt) 31-Dec-20 Lease Receivable Interest Income (To record the interest receivable on lease) 01-Jan-21 Cash Lease Receivable (To record lease receipt) 31-Dec-21 Lease Receivable Interest Income (To record the interest receivable on lease) 51,981 51,981 121,434 121,434 45,730 45,730

Requirement 4 If the expected residual value be $50,000; then the annual lease payment would change. Fair value of the machine $ 699,000 $ Expected residual value PV Interest (9%, 7th year) PV of residual value (50000*0.54703) 50,000 0.54703 27,352 $ $ PV of Minimum Lease Payments (699000-27352) PV of Annuity Due (9%, 7 years) Annual Rental payment (671648/5.48592) 671,648 5.48592 122,431 $ $ Annual Lease Rentals PV of Annuity Due (10%, 7 years) PV of lease rentals (122431*5.35526) 122,431 5.35526 655,650 $ $ $ Guaranteed residual value PV (12%, 7th year) PV of residual value (60000*0.51316) 60,000 0.51316 30,790 $ Lease Liability for lessee (655650+30790) $ 686,440