Stine Leasing Company agrees to lease machinery to Potter Corporation on January

Question

Stine Leasing Company agrees to lease machinery to Potter Corporation on January 1,2007. The following information relates to the lease agreement. The term of the lease is 7 years with no renewal option, and the machinery has an estimated economic life of 9 years. The cost of the machinery is $420,000, and the fair value of the asset on January 1,2007, is $560,000. 3. At the end of the lease term the asset reverts to the lessor. At the end of the lease term the asset has a guaranteed residual value of $80,000. Potter depreciates all of its equipment on a straight-line basis. The lease agreement requires equal annual rental payments, beginning on January 1, 2007. The collectibility of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the amount of costs yet to be incurred by the lessor. Stine desires a 10% rate of return on its investments. Potter's incremental borrowing rate is 11%, and the lessor's implicit rate is unknown. Instructions (Assume the accounting period ends on December Discuss the nature of this lease for both the lessee and the lessor. Calculate the amount of the annual rental payment required. Compute the present value of the minimum lease payments. Prepare the journal entries Potter would make in 2007 and 2008 related to the lease arrangement. Prepare the journal entries Stine would make in 2007 and 2008.

Explanation / Answer

Lease Start Date 1/1/2007 Lease Period 7 Years Useful Life 9 Years 1 Since the Lease Period covers the Substainial Period of Useful Life and Lessor is entitled to Depreciation it is to be classified as Financial Lease for Both the Parties 2 Calculation of Lease Rentals DF @ 10% Yo x 1 Y1 x 0.909091 Y2 x 0.826446 Y3 x 0.751315 Sum of Discount factor 5.355261 Y4 x 0.683013 GRV 45157.91 Y5 x 0.620921 Y6 x 0.564474 Y6 80000 0.564474 ALP= (560000-45158)/5.355 96142.3 3 Present Value of Lease Rentals DF @ 11% Yo 96142.3 1 96142.3 Y1 96142.3 0.900901 86614.68 Y2 96142.3 0.811622 78031.25 Y3 96142.3 0.731191 70298.42 Y4 96142.3 0.658731 63331.91 Y5 96142.3 0.593451 57055.78 Y6 96142.3 0.534641 51401.6 Y6 80000 0.534641 42771.27 PV 545647.2 4 Journals for Potters 1.1.2007 Asset on Lease A/c Dr 545647.2 To Lessor A/c 545647.2 1.1.2007 Lessor A/c Dr 36121.1 Finance Charge A/c 60021.19 To Bank A/c 96142.3 31.12.2007 Depreciation A/c Dr 77949.6 509526.1 To Assets on Lease 77949.6 1.1.2008 Lessor A/c Dr 40094.43 Finance Charge A/c 56047.87 To Bank A/c 96142.3 31.12.2008 Depreciation A/c Dr 77949.6 To Assets on Lease 77949.6 5 Journals for Stine 1.1.2007 Lease Receivable A/c 545647.2 To Assets 420000 To Profit on Sale/Lease A/c 125647.2 1.1.2007 Bank A/c Dr. 96142.3 To Finance Income A/c 60021.19 To Lease Receivable A/c 36121.1 1.1.2008 Bank A/c Dr. 96142.3 To Finance Income A/c 56047.87 To Lease Receivable A/c 40094.43

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