Question

Assume that on January 1, 2017, Elmer’s Restaurants sells a computer system to Liquidity Finance Co. for \(680,000 and immediately leases the computer system back. The relevant information is as follows.

1. The computer was carried on Elmer’s books at a value of \)600,000.
2. The term of the noncancelable lease is 10 years; title will transfer to Elmer.
3. The lease agreement requires equal rental payments of \(110,666.81 at the end of each year.
4. The incremental borrowing rate for Elmer is 12%. Elmer is aware that Liquidity Finance Co. set the annual rental to ensure a rate of return of 10%.
5. The computer has a fair value of \)680,000 on January 1, 2017, and an estimated economic life of 10 years.
6. Elmer pays executory costs of $9,000 per year.

Instructions

Prepare the journal entries for both the lessee and the lessor for 2017 to reflect the sale and leaseback agreement. No uncertainties exist, and collectibility is reasonably certain.

Short answer

The total debit and credit sides of the journal of Elmer’s Restaurants is$1,555,667.

The total debit and credit sides of the journal of Liquidity Finance Co. is $1,470,667.

Step-by-step solution

Meaning of Lease

A lease is a valid agreement made between the lessor and the lessee. In a lease, the lessor is the owner, whereas the lessee only has the right to use the property or equipment. The term of the lease is fixed in the lease agreement.

Preparing journal entries for Elmer’s Restaurants

Date	Particular	Debit ($)	Credit ($)
Jan. 1, 2017	Cash	680,000
	Equipment		600,000
	Unearned Profit on Sale Leaseback		80,000
Jan. 1, 2017	Leased Equipment	680,000
	Lease Liability		680,000
Throughout 2017	Executory Costs	9,000
	Accounts Payable (Cash)		9,000
Dec. 31, 2017	Unearned Profit on Sale Leaseback	8,000
	Depreciation Expense		8,000
Dec. 31, 2017	Depreciation Expense	68,000
	Accumulated Depreciation Capital Leases		68,000
Dec. 31, 2017	Interest Expense	68,000
	Lease Liability	42,667
	Cash		110,667

Working Notes:

Calculation of Lease Liability

$$\begin{gathered} \mathrm{Lease}\mathrm{Liability}=\mathrm{Rental}\mathrm{payments}\times \mathrm{Present}\mathrm{value}\mathrm{of}\mathrm{anorinary}\mathrm{annuity} \\ =\$110,666.81\times 6.14457 \\ =\$680,000 \end{gathered}$$

Calculation of Depreciation expense

$$\begin{gathered} \mathrm{Depreciation}\mathrm{Expense}=\frac{\mathrm{Fair}\mathrm{value}\mathrm{of}\mathrm{computer}-\mathrm{Book}\mathrm{value}\mathrm{of}\mathrm{computer}}{\mathrm{Noncanceable}\mathrm{lease}\mathrm{year}} \\ =\frac{\$680,000-\$600,0000}{10} \\ =\frac{\$80,000}{10} \\ =\$8,000 \end{gathered}$$

Calculation of accumulated depreciation

$$\begin{gathered} \mathrm{Accumulated}\mathrm{Depreciation}=\frac{\mathrm{Fair}\mathrm{value}\mathrm{of}\mathrm{computer}}{\mathrm{Useful}\mathrm{Life}} \\ =\frac{\$680,000}{10} \\ =\$68,000 \end{gathered}$$

Notes:

• Since the present value of the minimum lease payments equals the fair value of the computer, the lease should be classified as a capital lease. Furthermore, the lease period exceeds 75% of the asset's economic life and title transfers at the conclusion of the lease.
• Present value of an ordinary annuity for 10 periods at 9%
• The credit could also be to a revenue account

Preparing partial lease amortization schedule

Partial Lease Amortization Schedule
Date	Annual Lease Payments	Interest (10%)	Amortization	Balance
1/1/17				$680,000
12/31/17	$110,667	$68,000	$42,667	637,333

Preparing journal entries for Liquidity Finance Co.

Date	Particular	Debit ($)	Credit ($)
Jan. 1, 2017	Equipment	680,000
	Cash		680,000
Jan. 1, 2017	Lease Receivable.	680,000
	Equipment		680,000
Dec. 31, 2017	Cash	110,667
	Lease Receivable		42,667
	Interest Revenue		68,000

Note: The lease should be treated as a direct financing lease because the present value of the minimum lease payments equals the fair value of the computer, and

1. Payment collectability is reasonably assured,
2. No significant uncertainties surround the costs yet to be incurred by the lessor, and
3. The cost to the lessor equals the asset's fair value at the start of the lease.