Question

Bullwinkle Corp. leased medical equipment from Rocky Co., signing a lease agreement that stipulates

annual payments of $250,000 on January 1 of each year for a five-year period. The first payment is due at

the signing of the lease transaction on 1/1/17.

Rocky Co. set an implicit rate of 6% in the terms of the agreement, which is equal to the incremental

borrowing rate of Bullwinkle Corp. Rocky has also stipulated a residual value of $400,000 at the end of

the lease term. Bullwinkle is not required to guarantee it.

There is no transfer or ownership and the lease is noncancellable. The fair value of the leased equipment

is $1,415,180 and the equipment cost Rocky Co. $800,000 to manufacture. It has a useful life of 10

years.

1. Classify the lease and provide evidence to substantiate your classification decision.

2. Provide journal entries for both lessee and lessor at the inception of the lease (1/1/17).

3. Provide journal entries to record the necessary adjustments at year-end, 12/31/17.

4. Provide journal entries to record the payment of cash on 1/1/17.

5.

Provide new journal entries adjusting the lease contract on 12/31/17 if the $400,000 guaranteed

residual value were set to $1,000,000 (assume all other information regarding the lease contract

remains constant).

Answer 1

1. It is an Operating Lease because of following reasons:

• No Buyback Option at the end of the lease period.
• The useful life of the assets is more than the lease period.
• No Transfer of Ownership at the end of the lease term

2.

In the Books of Lessee
Date	Account description	Debit	Credit
1-Jan	Right to Use Assets	1,116,276
	Lease Obligation		866,276
	Cash		250,000
	(Being Lease Recorded)
31-Dec	Lease Expenses	250,000
	Right to Use Assets		198,023
	Lease Obligation		51,977
1-Jan	Lease Obligation	250,000
	Cash		250,000
	(Being Lease Rental Paid)

In the Books of Lesser
Date	Account description	Debit	Credit
1-Jan	Lease Receivable	866,276
	Cash	250,000
	Residual Assets	298,903
	Lease Assets		800,000
	Deferred Gross Profit		615,180
	(Being Lease Recorded)
31-Dec	Lease Receivable	51,977
	Residual Assets	17,934
	Deferred Gross Profit	10,089
	Interest Income		80,000
1-Jan	Cash	250,000
	Lease Receivable		250,000

Workings:

Present Value of Lease Cashflow
	Cashflow	PV Factor	Present Value
0	250,000	1	250,000
1	250,000	0.943396	235,849
2	250,000	0.889996	222,499
3	250,000	0.839619	209,905
4	250,000	0.792094	198,023
5		0.747258	-
			1,116,276

Amortization Table
	Lease Expenses	Interest	Lease Obligation	Amortization
0	250,000		866,276
1	250,000	51,977	668,253	198,023
2	250,000	40,095	458,348	209,905
3	250,000	27,501	235,849	222,499
4	250,000	14,151	(0)	235,849
5	-	(0)	(0)	250,000

5)

new journal entries adjusting the lease contract on 12/31/17 if the $400,000 guaranteed

residual value were set to $1,000,000 (assume all other information regarding the lease contract

remains constant).

Present Value of Lease Cashflow
	Cashflow	PV Factor	Present Value
0	250,000	1	250,000
1	250,000	0.943396	235,849
2	250,000	0.889996	222,499
3	250,000	0.839619	209,905
4	250,000	0.792094	198,023
5	1,000,000	0.747258	747,258
			1,863,535

Amortization Table
	Lease Expenses	Interest	Lease Obligation	Amortization
0	250,000		1,613,535
1	250,000	96,812	1,460,347	153,188
2	250,000	87,621	1,297,967	162,379
3	250,000	77,878	1,125,846	172,122
4	250,000	67,551	943,396	182,449
5	-	56,604	1,000,000	193,396

In the Books of Lessee
Date	Account description	Debit	Credit
31-Dec	Right to Use Assets	747,258
	Lease Obligation		747,258
31-Dec	Lease Expenses	250,000
	Right to Use Assets		153,188
	Lease Obligation		96,812

In the Books of Lessee
Date	Account description	Debit	Credit
1-Jan	Lease Receivable	747,258
	Deferred Gross Profit		448,355
	Residual Assets		298,903
31-Jan	Lease Receivable	96,812
	Deferred Gross Profit		16,812
	Interest Income		80,000

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