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Chapter 21: 3CA_b (page 1251)

Question: (Lessee Capitalization Criteria) On January 1, Santiago Company, a lessee, entered into three noncancelable leases for brand-new equipment, Lease L, Lease M, and Lease N. None of the three leases transfers ownership of the equipment to Santiago at the end of the lease term. For each of the three leases, the present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, is 75% of the fair value of the equipment.

The following information is peculiar to each lease.

  1. Lease L does not contain a bargain-purchase option. The lease term is equal to 80% of the estimated economic life of the equipment.
  2. Lease M contains a bargain-purchase option. The lease term is equal to 50% of the estimated economic life of the equipment.
  3. Lease N does not contain a bargain-purchase option. The lease term is equal to 50% of the estimated economic life of the equipment.

Instructions

(b) What amount, if any, should Santiago record as a liability at the inception of the lease for each of the three leases above?

Short Answer

Expert verified

Answer

Santiago Company should record as a liability at the inception of the lease only for leases L and M.

Step by step solution

01

 Meaning of Lease Capital 

A capital lease is one in which the lessor simply funds the leased asset, and the lessee retains all other ownership rights. As a result, the item is recorded as the lessee's property in the lessee's general ledger as a fixed asset.

02

Explaining the amount that Santiago should record as a liability at the inception of the lease for each of the three leases above.

For Lease L, Santiago Company should record an amount equal to the present value at the beginning of the lease period of the minimum lease payments during the lease duration as a liability at the lease's initiation. This figure eliminates the percentage of the payments that represent the lessor's executory costs, such as insurance, maintenance, and taxes, as well as any profit earned. If the sum so calculated exceeds the fair value of the equipment at the start of the lease, the fair value should be recorded as a liability.

For Lease M, Santiago Company should record an amount computed in the same way as Lease L as a liability at the lease's beginning, and the payment required under the bargain-purchase option should be included in the minimum lease payments at its current value.

For Lease N, Santiago Company should not record a liability at the inception of the lease.

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Most popular questions from this chapter

Question: (Lessee Entries and Balance Sheet Presentation, Capital Lease) On January 1, 2017, Cage Company contracts to lease equipment for 5 years, agreeing to make a payment of \(137,899 (including the executory costs of \)6,000) at the beginning of each year, starting January 1, 2017. The taxes, the insurance, and the maintenance, estimated at \(6,000 a year, are the obligations of the lessee. The leased equipment is to be capitalized at \)550,000. The asset is to be depreciated on a double-declining-balance basis, and the obligation is to be reduced on an effective-interest basis. Cage’s incremental borrowing rate is 12%, and the implicit rate in the lease is 10%, which is known by Cage. Title to the equipment transfers to Cage when the lease expires. The asset has an estimated useful life of 5 years and no residual value.

Instructions

(a) Explain the probable relationship of the $550,000 amount to the lease arrangement.

(Accounting for an Operating Lease) On January 1, 2017, Doug Nelson Co. leased a building to Patrick Wise Inc. The relevant information related to the lease is as follows.

  1. The lease arrangement is for 10 years.
  2. The leased building cost \(4,500,000 and was purchased for cash on January 1, 2017.
  3. The building is depreciated on a straight-line basis. Its estimated economic life is 50 years with no salvage value.
  4. Lease payments are \)275,000 per year and are made at the end of the year.
  5. Property tax expense of \(85,000 and insurance expense of \)10,000 on the building were incurred by Nelson in the first year. Payment on these two items was made at the end of the year.
  6. 6. Both the lessor and the lessee are on a calendar-year basis.

Instructions

(c) If Nelson paid $30,000 to a real estate broker on January 1, 2017, as a fee for finding the lessee, how much should Nelson Co. report as an expense for this item in 2017?

(Lessor Computations and Entries, Sales-Type Lease with Unguaranteed Residual Value) George Company manufactures a check-in kiosk with an estimated economic life of 12 years and leases it to National Airlines for a period of 10 years. The normal selling price of the equipment is \(278,072, and its unguaranteed residual value at the end of the lease term is estimated to be \)20,000. National will pay annual payments of \(40,000 at the beginning of each year and all maintenance, insurance, and taxes. George incurred costs of \)180,000 in manufacturing the equipment and $4,000 in negotiating and closing the lease. George has determined that the collectibility of the lease payments is reasonably predictable, that no additional costs will be incurred, and that the implicit interest rate is 10%.

Instructions

(a) Discuss the nature of this lease in relation to the lessor and compute the amount of each of the following items.

(3) Cost of sales.

Waterworld Company leased equipment from Costner Company. The lease term is 4 years and requires equal rental payments of \(43,019 at the beginning of each year. The equipment has a fair value at the inception of the lease of \)150,000, an estimated useful life of 4 years, and no salvage value. Waterworld pays all executory costs directly to third parties. The appropriate interest rate is 10%. Prepare Waterworld’s January 1, 2017, journal entries at the inception of the lease.

On January 1, 2017, Irwin Animation sold a truck to Peete Finance for \(33,000 and immediately leased it back. The truck was carried on Irwin’s books at \)28,000. The term of the lease is 5 years, and title transfers to Irwin at lease-end. The lease requires five equal rental payments of $8,705 at the end of each year. The appropriate rate of interest is 10%, and the truck has a useful life of 5 years with no salvage value. Prepare Irwin’s 2017 journal entries.
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