Concept explainers
Initial direct costs; sales-type lease
• LO15–2, LO15–7
Bidwell Leasing purchased a single-engine plane for its fair value of $645,526 and leased it to Red Baron Flying Club on January 1, 2018.
Terms of the lease agreement and related facts were:
- a. Eight annual payments of $110,000 beginning January 1, 2018, the beginning of the lease, and at each December 31 through 2024. Bidwell Leasing’s implicit interest rate was 10%. The estimated useful life of the plane is eight years. Payments were calculated as follows:
- b. Red Baron’s incremental borrowing rate is 11%.
- c. Incremental costs of negotiating and consummating the completed lease transaction incurred by Bidwell Leasing were $18,099.
Required:
- 1. How should this lease be classified (a) by Bidwell Leasing (the lessor) and (b) by Red Baron (the lessee)?
- 2. Prepare the appropriate entries for both Red Baron Flying Club and Bidwell Leasing on January 1, 2018.
- 3. Prepare an amortization schedule that describes the pattern of interest expense over the lease term for Red Baron Flying Club.
- 4. Determine the effective rate of interest for Bidwell Leasing for the purpose of recognizing interest revenue over the lease term.
- 5. Prepare an amortization schedule that describes the pattern of interest revenue over the lease term for Bidwell Leasing.
- 6. Prepare the appropriate entries for both Red Baron and Bidwell Leasing on December 31, 2018 (the second lease payment). Both companies use straight-line
depreciation. - 7. Prepare the appropriate entries for both Red Baron and Bidwell Leasing on December 31, 2024 (the final lease payment).
(1)
Sales-type lease
Sales type is a parallel type of direct financing whereby the owner (lessor) purchases the equipment to lease it and received the interest revenue over the period of lease for equipment, apart from the recognition of profit from sale of equipment.
The criteria for defining the lease as finance lease or operating lease
As per the notes issued by Financial Accounting Standard Board (FASB), the following are four criteria to determine is a lease is a capital lease or an operating lease:
- Transfer of title: The asset is transferred to lessee at the end of the lease period concerned.
- Purchase option: The purchase option is exercisable when the purchase price is sufficiently lower than expected fair value.
- Economic life: The economic life of the lease period is 75% or more than the useful life of the asset.
- Value recovery: Present value of lease payments is greater or equal to 90% of the fair value.
If a particular lease fulfils any one of the above four criteria, then it is considered as finance lease. If a lease does not fulfil any of the above four criteria, it would be considered as operating lease.
Initial direct cost
Initial direct cost refers to the cost that
- (a) Related directly with the completing a lease agreement
- (b) Important for acquiring a lease
- (c) Would not have been incurred had the lease agreement not occurred.
To Classify: the type of lease by BL company (Lessor) and by RB Company (Lessee)
Explanation of Solution
BL Company (Lessor)
Here at least one (Two in this scenario) classification criterion are met, this is a finance lease. As the fair value is the lessor’s cost, also no selling profit, in this sales type lease.
RB Company (Lessee)
Since at least one (Two in this scenario) criteria are met, this is finance lease to the lessee. The lessee records the present value of lease payments as right-of-use asset and lease payable.
S.No | Classification criteria | Does it satisfy? | |
1 | Does the lease agreement specify about ownership transfer? | No | |
2 | Does the lease agreement state about bargain purchase option? | No | |
3 | Does the term of lease constitute major part of the expected economic life of the asset? | Yes | Lease term = 8 years Useful life = 8 years |
4 | Is the present value of lease payments greater than or equal to substantially (90%) all of the market/fair value of the asset? | Yes | Present value (1) = $645,526 Fair value = $645,526 |
5 | Is the asset is of such a specialized nature which is expected to have an alternative use to lessor at the end of the term of lease? | No |
Table (1)
Working note:
The present value of lease payments is calculated as below:
(2)
To Prepare: the appropriate entries for RB Company (Lessee) and BL Company (Lessor) on January 01, 2018.
Explanation of Solution
Prepare journal entries for RB Company (Lessee)
Date | Account Title and Explanation | Post Ref | Debit ($) | Credit ($) |
2018 | ||||
January 01 | Right-of-use asset (1) | 645,526 | ||
Lease Payable | 26,427 | |||
(To record the lease payable) | ||||
January 01 | Lease payable | 110,000 | ||
Cash | 110,000 | |||
(To record the quarterly lease payments) |
Table (2)
Prepare journal entries for BL Company (Lessor)
Date | Account Title and Explanation | Post Ref | Debit ($) | Credit ($) |
2018 | ||||
January 01 | Lease Receivable | 645,526 | ||
Equipment | 645,526 | |||
(To record the lease receivable) | ||||
January 01 | Lease receivable | 18,099 | ||
Cash | 18,099 | |||
(To record the initial direct cost) | ||||
January 01 | Cash | 110,000 | ||
Lease receivable | 110,000 | |||
(To record the lease payments received) |
Table (3)
(3)
To Prepare: amortization schedule for RB Company (Lessee)
Explanation of Solution
Prepare amortization schedule as follows:
Lease Amortization Schedule | ||||
A | B | C | D | E |
Date | Lease Payment($) | Effective Interest (10% × Outstanding balance) ($) | Payment Reduction ($) (B –C) |
Outstanding Balance($) (E –D) |
645,526 | ||||
1/1/2018 | 110,000 | 110,000 | 535,526 | |
12/31/2018 | 110,000 | 53,553 | 56,447 | 479,079 |
12/31/2019 | 110,000 | 47,908 | 62,092 | 416,986 |
12/31/2020 | 110,000 | 41,699 | 68,301 | 348,685 |
12/31/2021 | 110,000 | 34,869 | 75,131 | 273,554 |
12/31/2022 | 110,000 | 27,355 | 82,645 | 190,909 |
12/31/2023 | 110,000 | 19,091 | 90,909 | 100,000 |
12/31/2024 | 110,000 | 10,000 | 100,000 | 0 |
880,000 | 234,474 | 645,526 |
Table (4)
The amortization table is prepared to present the pattern of interest expenses throughout the period. The schedule shows the lease balance and effective interest change over the 8- term period of lease using effective interest rate of 10%. Each lease payment after the first payment includes both the interest and amount that represents the reduction of outstanding balance. At the end of the lease period, the outstanding balance becomes zero.
(4)
the effective rate of interest for BL Company (Lessor) for the purpose of recognizing interest revenue over the lease term.
Explanation of Solution
First, calculate the net investment.
The net investment is higher: $645,526 + $18,099 = $663,625
Then, calculate the present value table amount from the given data:
Now, match the present value annuity with the rates of interest in the present value annuity table to ascertain the applied rate of interest.
When matching the present value annuity amount (6.03295) with the annuity table, we could find that the value 6.03295 falls in 8 years column under 9% rate of interest.
Therefore, effective rate of interest is 9%
(5)
To Prepare: amortization schedule for BL Company (Lessor)
Explanation of Solution
Prepare amortization schedule as follows:
Lease Amortization Schedule | ||||
A | B | C | D | E |
Date | Lease Payment($) | Effective Interest (9% × Outstanding balance) ($) | Payment Reduction ($) (B –C) |
Outstanding Balance($) (E –D) |
663,625 | ||||
1/1/2018 | 110,000 | 110,000 | 553,625 | |
12/31/2018 | 110,000 | 49,826 | 60,174 | 493,451 |
12/31/2019 | 110,000 | 44,411 | 65,589 | 427,862 |
12/31/2020 | 110,000 | 38,508 | 71,492 | 356,369 |
12/31/2021 | 110,000 | 32,073 | 77,927 | 278,443 |
12/31/2022 | 110,000 | 25,060 | 84,940 | 193,503 |
12/31/2023 | 110,000 | 17,415 | 92,585 | 100,918 |
12/31/2024 | 110,000 | 9,083 | 100,917 | 0 |
880,000 | 216,375 | 663,625 |
Table (5)
The amortization table is prepared to present the pattern of interest expenses throughout the period. The schedule shows the lease balance and effective interest change over the 8- term period of lease using effective interest rate of 9%. Each lease payment after the first payment includes both the interest and amount that represents the reduction of outstanding balance. At the end of the lease period, the outstanding balance becomes zero.
(6)
To Prepare: appropriate entries for RB Company (Lessee) and BL Company (Lessor) as on December 31, 2018. (Second lease payments)
Explanation of Solution
Prepare journal entries for RB Company (Lessee)
Date | Account Title and Explanation | Post Ref | Debit ($) | Credit ($) |
2018 | ||||
December 31 | Amortization expense (2) | 80,691 | ||
Right-of-use asset | 80,691 | |||
(To record amortization expense.) | ||||
December 31 | Interest expense (From table 4) | 53,553 | ||
Lease payable | 56,447 | |||
Cash | 110,000 | |||
(To record the lease payments and interest expense) |
Table (6)
Working note:
Calculate the amortization expense for the asset
Prepare journal entries for BL Company (Lessor)
Date | Account Title and Explanation | Post Ref | Debit ($) | Credit ($) |
2018 | ||||
December 31 | Cash | 110,000 | ||
Lease receivable | 60,174 | |||
Interest revenue (From table 5) | 49,826 | |||
(To record interest revenue.) |
Table (7)
(7)
To Prepare: appropriate entries for RB Company (Lessee) and BL Company (Lessor) as on December 31, 2024. (Final lease payments)
Explanation of Solution
Prepare journal entries for RB Company (Lessee)
Date | Account Title and Explanation | Post Ref | Debit ($) | Credit ($) |
2024 | ||||
December 31 | Amortization expense (2) | 80,691 | ||
Right-of-use asset | 80,691 | |||
(To record amortization expense.) | ||||
December 31 | Interest expense (From table 4) | 10,000 | ||
Lease payable | 100,000 | |||
Cash | 110,000 | |||
(To record the lease payments and interest expense) |
Table (8)
Prepare journal entries for BL Company (Lessor)
Date | Account Title and Explanation | Post Ref | Debit ($) | Credit ($) |
2024 | ||||
December 31 | Cash | 110,000 | ||
Lease receivable | 100,918 | |||
Interest revenue (From table 5) | 9,082 | |||
(To record interest revenue.) |
Table (9)
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