Question

Company A leased new equipment from Lessor Corp. on January 1, 2017, for a period of three years. Lease payments of $100,000 are due to Lessor Corp. each year with the first payment due on January 1, 2017. The annual lease payment includes $2,000 per year designated to cover maintenance costs associated with the equipment. The lease contains no purchase or renewal options and the equipment reverts to Lessor Corp. on the expiration of the lease. The remaining useful life of the equipment is four years. The fair value of the equipment at lease inception is $265,000. Company A has guaranteed $20,000 as the residual value at the end of the lease term. The $20,000 represents the expected value of the leased equipment to the lessee at the end of the lease term. The salvage value of the equipment is expected to be $2,000 after the end of its economic life. The lessee’s incremental borrowing rate is 11 percent (Lessor’s implicit rate is 10 percent and is calculable by the lessee from the lease agreement). Company A has not elected to early adopt ASC 842 to account for any of their leases.

The assistant controller of Company A analyzed the assets under lease, determined whether the lease was an operating lease or capital lease, and prepared the applicable journal entries. The controller of Company A reviewed the assistant controller’s analysis and prepared a separate analysis. As the CFO, you were given both analysis to determine the correct accounting treatment. Calculations and journal entries performed by the assistant controller and controller are below.

Assistant controller analysis:

Since the equipment reverts to Lessor Corp., it is an operating lease.

Entries to be posted in Years 1, 2, and 3:

Dr. Lease expense                           $100,000

Dr. Insurance expense                       $2,000

Cr. Cash                                                        $102,000

Controller analysis:

Step 1 — Lease classification

The lease term is for three years. The useful life of the equipment is four years. Since the lease term is for a major part of the useful life of the equipment, it is a capital lease.

Step 2 — Computation of the lease asset and obligation

Since the lessee’s incremental borrowing rate is greater than the lessor’s implicit rate in the lease, compute the present value of the minimum lease payments using the 11 percent rate.

Present value of the minimum lease payments = $100,000 × 2.4437 = $244,370.

Step 3 — Allocation of payments between interest and lease obligation

Since interest must be charged on the straight-line method, the following is the allocation of the interest and the reduction in the lease liability.

                                                                                                Reduction in             Balance of

                                                                 Interest                     Lease                         Lease

Year             Cash Payment             Expense (11%)        Obligation               Obligation

    0                                                                                                                              $244,370

    1                  $100,000                        $26,881                $73,119                     $171,251

    2                  $100,000                        $26,881                $73,119                     $ 98,131

    3                  $100,000                        $26,881                $73,119                     $ 25,012

Journal entry in Year 1 to record the payments:

Dr. Rent expense                                         $ 2,000

Dr. Interest expense                                   $26,881

Dr. Lease obligation                                   $73,119

Cr. Cash                                                                    $102,000

Required:

1. Was the assistant controller’s analysis correct? Why or why not?

2. Was the controller’s analysis correct? Why or why not?

3. If neither answer is correct, show the correct analysis including all 2017 entries needed to account for this lease.

Be sure to provide appropriate authoritative sources for positions taken.

Answer 1

1. Assistant controller analysis is wrong as he has treated this as Operating Lease.

It is a finance lease because the lease term is the major part of the remaining life of the assets.

2. Controller’s analysis is also incorrect because of following:

He has not considered guaranteed residual value in its calculation.

He has not recorded the Assets. We have to create the Lease obligation and the assets in case of Finance Lease.

3.

	Installment	Present Value Factor	Present Value
1	100000	0.900900901	90,090.09
2	100000	0.811622433	81,162.24
3	100000	0.731191381	73,119.14
4	100000	0.658730974	65,873.10
4	20000	0.658730974	13,174.62
		Fair Value of Assets	323,419.19

	Opening	Installment	Interest	Closing
0	323,419.19			323,419.19
1		100000	35,576.11	258,995.30
2		100000	28,489.48	187,484.78
3		100000	20,623.33	108,108.11
4		100000	11,891.89	20,000.00

	Account description	Debit	Credit
1	Equipment	323,419.19
	Lease obligation		323,419.19
2	Interest Expenses	35,576.11
	Lease obligation	64,423.89
	To Bank		100,000.00
4	Depreciation	75,854.80
	Equipment		75,854.80