Question

(Type of Lease; Amortization Schedule) Mike Macinski Leasing Company leases a new machine that has a cost and fair value of $95,000 to Sharrer Corporation on a 3-year noncancelable contract. Sharrer Corporation agrees to assume all risks of normal ownership including such costs as insurance, taxes, and maintenance. The machine has a 3-year useful life and no residual value. The lease was signed on January 1, 2017. Mike Macinski Leasing Company expects to earn a 9% return on its investment. The annual rentals are payable on each December 31.

Instructions

1. Discuss the nature of the lease arrangement and the accounting method that each party to the lease should apply.

Short answer

The lessee should adopt the capital lease method and record the leased asset and lease liability at the present value of the minimum lease payments

Step-by-step solution

Meaning of Lease asset amortization

The amortization of a leased asset is determined by the asset's historical cost, expected economic life, residual value, and the amortization method. Most finance leases are amortized with continuous payments over the term of the lease and are customized to meet the specific needs of the lessee.

explaining the nature of the lease arrangement and the accounting method that each party to the lease should apply

It is a capital lease to the lessee since the lease term exceeds 75% of the asset's economic life and the present value of the minimum lease payments exceeds 90% of the asset's fair value. The lease is a direct financing lease to the lessor if rent collectability is substantially ensured and no significant uncertainty surrounds the number of unreimbursable expenditures yet to be spent by the lessor.

The lessee should use the capital lease method and record the leased asset and lease liability at the present value of the minimum lease payments based on the lessee's incremental borrowing rate or the interest rate implicit in the lease if it is lower than the incremental rate and known to the lessee.

The lessee's depreciation is determined by whether ownership is transferred to the leased or if a bargain buy option is available. If one of these requirements is met, amortization will occur over the asset's economic life. Otherwise, it would be depreciated throughout the length of the lease. Because the asset's economic life and lease term are both three years, the leased asset should be depreciated during this time period.

The lessor should use the direct-financing lease method and replace the $95,000 asset cost with a Lease Receivable of $95,000. (see the schedule below.) Annual interest would be paid at a constant rate relative to the unrecovered net investment.

Cost (fair value of the leased asset)	$95,000
Amount to be recovered by lessor through lease payments	$95,000
Three annual lease payments	$37,530

Working Notes:-

$$\begin{gathered} \mathrm{Three}\mathrm{annual}\mathrm{lease}\mathrm{payments}=\frac{\mathrm{cost}\mathrm{and}\mathrm{fair}\mathrm{value}}{\mathrm{present}\mathrm{value}\mathrm{of}\mathrm{ordinary}\mathrm{annuity}} \\ =\frac{\$95,000}{2.53130} \\ =\$37,530 \end{gathered}$$

Note: Present value of an ordinary annuity of 1 for 3 periods at 9%