On January 1, 2014, Fargo Corp. enters into a ten-year non-cancellable lease wit
ID: 2462452 • Letter: O
Question
On January 1, 2014, Fargo Corp. enters into a ten-year non-cancellable lease with Wells Ltd. for equipment having a useful life of 11 years and a fair value of $6,000,000. Fargo's incremental borrowing rate is 8%, but they do not know Well's implicit rate. Fargo uses the straight-line method to depreciate assets The lease contains the following provisions: 1) Semi-annual lease payments of $438,000 (including $38,000 for property taxes), payable on January 1 and July 1 of each year 2) A guarantee by Fargo Corp. that Wells Ltd. will realize $200,000 from selling the asset at the expiration of the lease. However, the actual residual value is expected to be $120,000. a) What is the total amount of minimum lease payments over the life of the lease? b) Calculate the present value of the minimum lease payments. PV factor for annuity due of 20 semi-annual payments at 8% annual rate, 14.13394; PV factor for $1 due in 20 interest periods at 8% annual rate, .45639. Round to the nearest dollar. c) What kind of lease is this to Fargo corp? Why? d) Present the journal entries that Fargo would record during the first year of the lease.Explanation / Answer
Answer:a The undiscounted minimum lease payments are:
Semi-annual rental payments. ..................................................................... $ 438,000
Less executory costs. .................................................................................. (38,000 ) ............................................................................................................ 400,000
Number of payments over lease term. ........................................................ 20 ............................................................................................................ 8,000,000
Residual guarantee. ..................................................................................... 200,000
Minimum lease payments. .............................................................................$8,200,000
Answer:b The present value of the minimum lease payments is:
Factor for present value of an annuity due, 20 periods, 4%. .......... 14.13394
Semi-annual payments, less executory costs. ................................ $ 400,000
(OR 20 N 4 i 400000 PMT CPT PV => 5,653,576). ...................... $5,653,576
Factor for present value of $1 due in 20 semi-annual interest periods at 4%. ................................................................................ 0.45639
Guaranteed residual . ....................................................................$200,000 91,278
(OR 20 N 4 i 200000 FV CPT PV => 91,277)
Present value of lease payments. .................................................... $5,744,854
Answer:c This lease is a capital lease to Fargo Corp. because its 10 year term exceeds 75% of the equipment's estimated useful life. In addition, the present value of the minimum lease payments exceeds 90% of the current fair value of the equipment ($6,000,000).
Answer:d
Jan 1, 2014
Equipment under Lease. .................................................................. 5,744,854
To Obligations under Lease. .......................................................... 5,744,854
AND
Obligations under Lease. ................................................................. 400,000
Property Taxes. ................................................................................ 38,000
To Cash. ......................................................................................... 438,000
(These two entries can be combined)
Jul 1, 2014
Obligations under Lease…. ............................................................. 186,206
Property Taxes. ................................................................................ 38,000
Interest Expense. ............................................................................. 213,794
To Cash. ......................................................................................... 438,000
Dec 31, 2014
Depreciation Expense. ..................................................................... 511,350*
To Accumulated Depreciation—Leased Equipment. ..................... 511,350
Interest Expense. ............................................................................. 206,346
To Interest Payable. ....................................................................... 206,346
*($5,744,854 – 120,000) ÷ 11 = $511,350
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