Buffalo Leasing Company agrees to lease equipment to Carla Corporation on Januar

Question

Buffalo Leasing Company agrees to lease equipment to Carla Corporation on January 1, 2017. The following information relates to the lease agreement.

(Assume the accounting period ends on December 31.)

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 $500,000, and the fair value of the asset on January 1, 2017, is $659,000. 3. At the end of the lease term, the asset reverts to the lessor and has a guaranteed residual value of $103,000. Carla estimates that the expected residual value at the end of the lease term will be 103,000. Carla amortizes all of its leased 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 probable. 6. Buffalo desires a 9% rate of return on its investments. Carla’s incremental borrowing rate is 10%, and the lessor’s implicit rate is unknown.

Explanation / Answer

Solution:

Calculation of Annual Rental Payment

[$659,000 – ($103,000 x 0.54703*)]/5.03295**

$119,742

*PVIFA @ 9%, 7 = 1/1.09^7 = 0.54703

**PVIFA @ 9%, 7 = 5.03295

Present value of minimum lease payments

PV of annual payment $119,742 x 4.86842* = $582,954

Present value of guaranteed residual $103,000 x 0.51316** = $52,855

*PVIFA @ 10%, 7 = 4.86842

**PVIF @ 10%, 7 = 0.51316

Journal entry

1/1/17   Lease Equipment ………………. 635,810

                       Lease liability …………………………. 635,810

Lease liability …………………. 119,742

         Cash …………………………………….. 119,742

12/31/17 Depreciation expense ………………..73,724

                         Accumulated depreciation …………………………..73,724

(635,810 – 119,742)/7

Interest expense …………………51,607

           Interest payable ……………………….51,607

(635,810 – 119,742) x 0.10

1/1/18 Lease liability ……………………68,135

            Interest payable ………………..51,607

                    Cash …………………………………….119,742

12/31/18 Depreciation expense ………..73,724

Accumulated depreciation – capital lease ………….. 73,724

Interest expense ……………44,793

          Interest payable …………….44,793

(635,810 – 119,742 – 68,135) x 0.10

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