XYZ Corporation signed a lease agreement with ABC Company on January 1, 2016 to
ID: 2478274 • Letter: X
Question
XYZ Corporation signed a lease agreement with ABC Company on January 1, 2016 to lease new equipment. The non-cancelable lease has a term of 10 years. There are no purchase or renewal options. XYZ should make the annual lease payment of $70,000 at the end of each year.
The fair value of the equipment at the inception of the lease is $540,521.45. The equipment has an economic life of 15 years. The lease term does not include a guaranteed residual value. The cost of the equipment to ABC Company is $500,000. XYZ Corporation must pay executory costs of general maintenance expenses related to the lease of $1,000 per year on December 31 of each year.
XYZ depreciates the equipment its currently owns on a straight-line basis.XYZ Corporation’s incremental borrowing rate is 6% and the ABC 5% implicit rate in the lease is known to XYC Corporation. There no material uncertainties as to collection of the lease payments or future costs to be incurred under the lease.
Required:
Classify the lease agreement for both the lessee and the lessor. Justify your answer.
Prepare the lessee’s journal entries required for the first year of the lease term. Show all supporting calculations for the journal entries.
Prepare the lessor’s journal entries required for the first year of the lease term. Show all supporting calculations for the journal entries.
Explanation / Answer
XYZ ' Incremental borrowing rate 6% ABC 's implicit Rate 5% The lower of Two , the Lessee's implicit rate to be used for Lease PV calculation PV of Lease Year Lease Payment PV factor @5% PV of Cash flows 1 70,000 0.952 66,666.7 2 70,000 0.907 63,492.1 3 70,000 0.864 60,468.6 4 70,000 0.823 57,589.2 5 70,000 0.784 54,846.8 6 70,000 0.746 52,235.1 7 70,000 0.711 49,747.7 8 70,000 0.677 47,378.8 9 70,000 0.645 45,122.6 10 70,000 0.614 42,973.9 540,521.45 PV of the lease payment = Fair Value Asset Has economic life =15 years Lease Term =10 yrs=10/15=67% of Asset economic life So Lease term is less than 75% of life of asset No purchase option No gurarntee for residual value So the Lease is considered as Operating Lease XYZ Journal Entry Account Title Dr $ Cr $ Dec 31. Lease Rental Expense 70,000 Cash 70,000 Dec 31. Maintenance Expenses 1,000 Cash 1,000 ABC Journal Entry Jan 1.2016. Rental Income 70,000 Cash 70,000 (rental Income rereived) Accumulated Depreciation 36,035 Depreciation Expense 36,035
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