1. Lessee leases asset from Lessor. Fair market value of the asset currently is

Question

1. Lessee leases asset from Lessor. Fair market value of the asset currently is $500,000. Asset is new and has a remaining economic life of 10 years. Lease term is for 7 years. Implict rate on lease is 12% and this rate is known by Lessee. Lessor believes asset will be worth $150,000 at end of lease term (i.e., residual value-150,000). Lessor requires that Lessee guarantee $45,000 of the $150,000 residual value. Lessee believes that asset will be worth at least 45,000 at end of lease term. Lease payments of 94,691 are made annually at year-end. Lease inception date is January 1. a. Assume cost of leased asset FMV of the asset at lease inception. Classify the lease, book the lease (both Lessee and Lessor entries), and prepare journal entry (both Lessee and Lessor entries) for the first lease payment due December 31. b. Assume Lessor's cost of lease asset-400,000. Classify the lease, book the lease (both Lessee and Lessor entries), and prepare journal entry (both Lessee and Lessor entries) for the first lease payment due December 31.

Explanation / Answer

There exists two alternative answers . I have solved it both ways and I believe both are correct. basically Lessor would like to follow the capitalisation method where he receives interest component of lease on higher side while lessee will choose a discount model where interest component will be on lower side. Discount Model Capitalisation Model PVIF@12% Year Year Cashf flow Present Value Interest 0 0 1 7 1 94691 0.8928571 84545.54 10145.464 6 2 94691 0.7971939 75487.09 19203.915 5 3 94691 0.7117802 67399.18 27291.817 4 4 94691 0.6355181 60177.84 34513.158 3 5 94691 0.5674269 53730.22 40960.784 2 6 94691 0.5066311 47973.41 46717.593 1 7 94691 0.4523492 42833.4 51857.6 7 7 150000 0.4523492 67852.38 499999.1 The lease will be classified as Finance lease as it covers most of the period of economic life of asset Requirement a In the Books of lessor Capitalisation method Discount Model Date Account Title & explanation Debit Credit Debit Credit Amount in $ Amount in $ Amount in $ Amount in $ Jan-01 Lease Receivable 500000 500000 Leased Asset 500000 500000 To record the inception of lease Dec-31 Cash 94691 94691 Lease Receivable 42833.4 84545.54 Interest Income 51857.6 10145.46 In the Books of Lessee Jan-01 Leased Asset 500000 500000 Lease payable 500000 500000 To record the inception of lease Dec-31 Lease Payable 42833.4 84545.54 Interest expense 51857.6 10145.46 Cash 94691 94691 Requirement b If cost of leased asset is $400000, then only first entry relating to inception of lease in the books of lesser will change. Rest of all entry including in the books of Lessee will remain same. Jan-01 Lease Receivable 500000 500000 Leased Asset 400000 500000 Profit on leased asset 100000 100000 To record the inception of lease

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