On January 1, 2011, Palmer Company leased equipment to Woods Corporation. The fo

Question

On January 1, 2011, Palmer Company leased equipment to Woods Corporation. The following information pertains to this lease. The term of the noncancelable lease is 6 years, with no renewal option. The equipment reverts to the lessor at the termination of the lease. Equal rental payments are due on January 1 of each year, beginning in 2011. The fair value of the equipment on January 1, 2011, is $200,000, and its cost is $150,000. The equipment has an economic life of 8 years, with an unguaranteed residual value of $10,000. Woods depreciates all of it equipment on a straight-line basis. Palmer sets the annual rental to ensure an 11% rate of return. Woods’ incremental borrowing rate is 12%. The implicit rate of the lessor is not known to Woods. Collectibility of lease payments is reasonably predictable and no important uncertainties surround the amount of costs yet to be incurred by the lessor. REQUIRED: a) Discuss the nature of this lease to Woods. b) Prepare all the necessary journal entries for Woods through January 1, 2012. c) Discuss the nature of this lease to Palmer. d) If the cost of this lease had been $200,000, how with this have changed your answer to Part (c)? e) Had the title of the lease transferred at the end of the lease, how with this have changed your depreciation calculation for Woods?

Explanation / Answer

Part A)

The nature of this lease to Woods is "Capital (Finance) Lease". It is so because the lease term is 75% [6/8*100] of the economic life of the asset. Additionally, the present value of the minimum lease payments (calculated below) would be more than 90% of the fair value of the asset. The present value of the minimum lease payments is calculated as follows:

To determine the minimum lease payments, we need to calculate the value of annual rental payment as below:

Annual Rental Payment = [Fair Value of Equipment - (Unguaranteed Residual Value*Present Value Interest Factor of $1 at 11% for 6Years)]/Present Value Interest Factor of An Annuity Due at 11% for 6 Years

Using Present Value Tables, we get,

Annual Rental Payment = [200,000 - (10,000*10,000*.53464)]/4.69590 = $41,452

Now, we can calculate the Present Value of Minimum Lease Payments as follows:

Present Value of Minimum Lease Payments = Annual Rental Payment*Present Value Interest Factor of An Annuity Due at 12% for 6 Years = 41,452*4.60478 = $190,877.

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Part B)

The journal entries for Woods are as follows:

___________

Part C)

The nature of this lease to Palmer is "Capital (Finance) Lease". It is so because:

a) Collectibility of lease payments is reasonably predictable.

b) Lease term is 75% [6/8*100] of the economic life of the asset.

c) There are no important uncertainties surrounding the costs yet to be incurred by the lessor.

It will be characterized as a "Sales Type Lease" as the the fair value of $200,000 is more than the cost of $150,000.

___________

Part D)

If the fair value of the asset is equal to the cost of the asset, while all the other things remain constant, the lease will be characterized as "Direct-Financing Lease".

___________

Part E)

In this given case, the depreciation will be calculated over the economic life of the asset as against the period of lease term. The depreciation expense will, therefore, be $23,860 (190,877/8).

Date Account Titles Debit Credit 01/01/12 Leased Equipment $190,877 Lease Liability $190,877 (To record the present value of lease obligation) Lease Liability $41,452 Cash $41,452 (To record the first lease payment) 12/31/12 Depreciation Expense (190,877/6) $31,813 Accumulated Depreciation – Capital Lease $31,813 (To record the value of depreciation on the capital lease) Interest Expense [(190,877 – 41,452)*12%] $17,931 Interest Payable $17,931 (To record the interest due on the lease)

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