Headland Leasing Company agrees to lease machinery to Sage Corporation on Januar

Question

Headland Leasing Company agrees to lease machinery to Sage Corporation on January 1, 2017. The following information relates to the lease agreement.

(Assume the accounting period ends on December 31.)

Calculate the amount of the annual rental payment required.

Compute the present value of the minimum lease payments.

Prepare the journal entries Sage would make in 2017 and 2018 related to the lease arrangement

Prepare the journal entries Headland would make in 2017 and 2018.

1. The term of the lease is 7 years with no renewal option, and the machinery has an estimated economic life of 9 years. 2. The cost of the machinery is $514,000, and the fair value of the asset on January 1, 2017, is $677,000. 3. At the end of the lease term, the asset reverts to the lessor and has a guaranteed residual value of $90,000. Sage depreciates all of its equipment on a straight-line basis. 4. The lease agreement requires equal annual rental payments, beginning on January 1, 2017. 5. 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. 6. Headland desires a 10% rate of return on its investments. Sage’s incremental borrowing rate is 11%, and the lessor’s implicit rate is unknown. Annual rental payment

Explanation / Answer

1. Computation of amount of annual rental payment Fair value of the asset $677,000 Residual value of the asset $90,000 Annual Rental payment {677,000 - (90000 x 0.51818)/5.35526} $117,709 Present value of annuity at 10% for 7 years = 5.35526 Present value at 10% for 7years = 0.51818 2. Present value of minimum lease payment Present value of annual rental payment (117709 x 5.23054) $615,682 Present value of residual value (90000 x 0.48166) $43,349 Present value of minimum lease payment $659,031 Interest rate = 11% Period = 7years 3. Journal entries in the books of Sage in 2017 and 2018 1-Jan-17 Leased Equipment $659,031      Leased Liability $659,031 (To record leased equipment) 1-Jan-17 Leased Liability $117,709       Cash $117,709 (To record annual rental payment) 31-Dec-17 Depreciation $81,290     Accumulated Depreciation-Capital Lease $81,290 ($659031 - $90000)/7 (To record Depreciation for 2017) 31-Dec-17 Interest Expense $59,545      Interest Payable $59,545 (To record Interest expense for 2017) ($659031 -$ 117709) x 11% 1-Jan-18 Leased Liability $58,164 Interest payable $59,545        Cash $117,709 (To record annual rental payment) 31-Dec-18 Depreciation $81,290     Accumulated Depreciation-Capital Lease $81,290 ($659031 - $90000)/7 (To record Depreciation for 2018) 31-Dec-18 Interest Expense $53,147      Interest Payable $53,147 (To record Interest expense for 2018) ($659031 -$ 117709 - $58164) x 11% 4. Journal Entries in the Books of Headland in 2017 and 2018 1-Jan-17 Lease Receivable $677,000 Cost of Goods Sold $514,000      Sales Revenue $677,000      Inventory $514,000 1-Jan-17 Cash $117,709      Lease Receivable $117,709 (To record annual lease payment received) 31-Dec-17 Interest Receivable $55,929       Interest Revenue $55,929 (To record Interest for 2017) (677000 - 117709 ) x 10% 1-Jan-18 Cash $117,709      Interest Receivable $55,929      Loan Receivable $61,780 (To record annual lease payment received) 31-Dec-18 Interest Receivable $49,751       Interest Revenue $49,751 (To record Interest for 2018) (677000 - 117709 - 61780) x 10%

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