Big Corporation enters into a 6-year lease of equipment with Tiny Company, receiving annual lease payments of $9,500, payable at the end of each year. Tiny provides a residual value guarantee of $13,000. The equipment has a 9-year estimated remaining economic life, a carrying amount of $54,000, and a fair value of $62,000 at the commencement date. Big expects the residual value of the equipment to be $20,000 at the end of the 6-year lease term. The lease does not transfer ownership of the underlying asset to Tiny or contain an option for Tiny to purchase the underlying asset. Big incurs $2,000 in initial direct costs in connection with obtaining the lease, and no amounts are prepaid by Tiny to Big. The rate implicit in the lease is 5.5 percent. However, Big Corporation has serious concerns as to the collectability of the lease as the lessee intends to make the lease payments primarily from income from the business in which the equipment will be used. There is considerable competition in the industry and Tiny Company has limited experience. a. Upon the inception of the lease, how should Big classify this lease? (Please provide a citation that supports your conclusion.) b. At the end of year 1, Tiny makes the first payment, but it is still not probable that all payments will be collected. How is this payment recorded? c. At the end of year 4, Tiny makes the annual payment and collectability on the remainder of the lease is now likely. How should Big record this transaction?
Big Corporation enters into a 6-year lease of equipment with Tiny Company, receiving annual lease payments of $9,500, payable at the end of each year. Tiny provides a residual value guarantee of $13,000. The equipment has a 9-year estimated remaining economic life, a carrying amount of $54,000, and a fair value of $62,000 at the commencement date. Big expects the residual value of the equipment to be $20,000 at the end of the 6-year lease term. The lease does not transfer ownership of the underlying asset to Tiny or contain an option for Tiny to purchase the underlying asset. Big incurs $2,000 in initial direct costs in connection with obtaining the lease, and no amounts are prepaid by Tiny to Big. The rate implicit in the lease is 5.5 percent. However, Big Corporation has serious concerns as to the collectability of the lease as the lessee intends to make the lease payments primarily from income from the business in which the equipment will be used. There is considerable competition in the industry and Tiny Company has limited experience.
a. Upon the inception of the lease, how should Big classify this lease? (Please provide a citation that supports your conclusion.)
b. At the end of year 1, Tiny makes the first payment, but it is still not probable that all payments will be collected. How is this payment recorded?
c. At the end of year 4, Tiny makes the annual payment and collectability on the remainder of the lease is now likely. How should Big record this transaction?
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