The Lessor Company has a machine with a fair market value of S100,000 that it le

Question

The Lessor Company has a machine with a fair market value of S100,000 that it le ten-year period to Lessee Company. The machine has a remaining usetul ne Lease payments of $14,225 are made at the beginning of each year and the first pay immediately upon signing. Th end of the lease term (although the lessee is not guaranteeing this amount). A "resi is the amount that the used equipment is expected to be worth to the lessor when the asser returned at the end of the lease term. Lessees do not include any unguaranteed resi life of twelve years. ent is due idual value" dual values when calculating the present value of future lease payments (i.e., lessee accounting complete e machine is expected to have a $10,000 residual value at the The lessor's implicit rate is 10% and the lessee's ignores any unguaranteed residual value incremental borrowing rate is 12%. 1. Calculate the lease obligation that would be recorded by the lessee at the signing of this lease. 2. Calculate the interest expense reported by the lessee in the first year. 3. Now change the facts a little bit. Assume that the lease contract requires the lessee to guarantee the residual value of $10,000. U.S. GAAP requires the lessee to include this guaranteed residual value when calculating the present value of future lease payments. Recalculate your answers to part 2 (lease obligation at signing) and part 3 (interest expense in the first year) under this new assumption that the Lessee guarantees this residual value.

Explanation / Answer

1. Lease obligation that would be recorded by the lessee at the signing of this lease: Interest rate is the lesser of the Lessor's implicit rate 10% & the Lessee's incremental borrowing rate 12% . So,it is 10% PV of lease payments =PV of annuity-due payments of 14225 for 10 periods at 10% interest rate 14225*6.75902=                                                                                  ( PVOAdue F 10%, 7yrs.) 96147 (residual value not guaranteed) 2. Interest expense reported by the Lessee in the first year= (96147-14225)*10%= 8192 Unguaranteed residual Value-lease amortisation Year Annuity Payment Tow.int Payment tow.Prin. Prin. bal 96147 0 14225 0 14225 81922 1 14225 8192 6033 75889 2 14225 7589 6636 69253 3 14225 6925 7300 61953 4 14225 6195 8030 53924 5 14225 5392 8833 45091 6 14225 4509 9716 35375 7 14225 3538 10687 24688 8 14225 2469 11756 12932 9 14225 1293 12932 0 10 0 0 0 142250 46103 96147 3. Lessee guarantees the residual value PV of lease payments =PV of annuity-due payments of 14225 for 10 periods at 10% interest rate 14225*6.75902= 96147 Plus: residual value guaranteed at end of 10 yrs. ----10000*0.38554=3855.43---(PV F10%,10 yrs.) Minimum lease payments=96147+3855.43= 100002 Or $ 100000 Interest expense reported by the Lessee in the first year= (100000-14225)*10%= 8577.5 or 8578 Guaranteed residual Value-lease amortisation Year Annuity Payment Tow.int Payment tow.Prin. Prin. bal 100000 0 14225 0 14225 85775 1 14225 8578 5648 80128 2 14225 8013 6212 73915 3 14225 7392 6833 67082 4 14225 6708 7517 59565 5 14225 5956 8269 51296 6 14225 5130 9095 42201 7 14225 4220 10005 32196 8 14225 3220 11005 21191 9 14225 2119 12106 9085 10 10000 908 9092 -7 152250 52243 100007

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