Question

Question: (Lessor and Lessee Accounting and Disclosure) Sylvan Inc. entered into a noncancelable lease arrangement with Breton Leasing Corporation for a certain machine. Breton’s primary business is leasing; it is not a manufacturer or dealer. Sylvan will lease the machine for a period of 3 years, which is 50% of the machine’s economic life. Breton will take possession of the machine at the end of the initial 3-year lease and lease it to another, smaller company that does not need the most current version of the machine. Sylvan does not guarantee any residual value for the machine and will not purchase the machine at the end of the lease term.

Sylvan’s incremental borrowing rate is 10%, and the implicit rate in the lease is 9%. Sylvan has no way of knowing the implicit rate used by Breton. Using either rate, the present value of the minimum lease payments is between 90% and 100% of the fair value of the machine at the date of the lease agreement.

Sylvan has agreed to pay all executory costs directly, and no allowance for these costs is included in the lease payments. Breton is reasonably certain that Sylvan will pay all lease payments. Because Sylvan has agreed to pay all executory costs, there are no important uncertainties regarding costs to be incurred by Breton. Assume that no indirect costs are involved.

Instructions

(b) With respect to Breton (the lessor), answer the following.

(3) How should Breton determine the appropriate amount of earnings to be recognized from each lease payment?

Short answer

Answer

Breton will record payments received as a reduction in the receivables, and for the income recognition, Breton will use the 9% implicit rate.

Step-by-step solution

Meaning of Interest Revenue

Interest revenue is the income earned by trade from any investments it makes or the debt it holds. Interest revenue can be found by deducting present value with rental payments. The difference amount is multiplied by the implicit interest rate.

Explaining the determination of the appropriate amount of earnings to be recognized from each lease payment by Breton

Breton will record payments received as a decrease in the receivable over the lease's term. By adding the implicit interest rate to the diminishing balance of the lease receivable, interest is recognized as interest income. The implicit rate is the rate of interest used to discount the total of payments and unguaranteed residual value to the machine's fair worth at the lease's start date. The effective interest technique of amortization is the name given to this type of revenue recognition. Breton will utilize the implicit rate of 9% in this scenario.