CHL Corporation manufactures specialty equipment with an estimated economic life of 12 years and leases it to Provincial Airlines Corp. for a period of 10 years. Both CHL and Provincial Airlines follow private enterprise GAAP. The equipment’s normal selling price is $210,482 and its unguaranteed residual value at the end of the lease term is estimated to be $15,000. Provincial Airlines will pay annual payments of $25,000 at the beginning of each year and all maintenance, insurance, and taxes. CHL incurred costs of $105,000 in manufacturing the equipment and $7,000 in negotiating and closing the lease. CHL 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 8%.
Instructions
Answer the following questions, rounding all numbers to the nearest dollar.
(a) Discuss the nature of this lease in relation to the lessor and calculate the amount of each of the following items:
1. Gross investment
2. Unearned interest income
3. Sales price
4. Cost of sales
(b) Prepare a 10-year lease amortization schedule for the lease obligation using a computer spreadsheet.
(c) Prepare all of the lessor’s journal entries for the first year of the lease, assuming the lessor’s fiscal year end is five months into the lease. Reversing entries are not used.
(d) Determine the current and non-current portion of the net investment at the lessor’s fiscal year end, which is five months into the lease.
(e) Assuming that the $15,000 residual value is guaranteed by the lessee, what changes are necessary to parts (a) to (d)?
(a) The lease is a sales-type lease because: (1) the lease term exceeds 75% of the asset’s estimated economic life, (2) collectability of payments is reasonably assured and there are no further costs to be incurred, and (3) CHL Corporation realized an element of profit aside from the financing charge.
1. Gross investment is $265,000 (10 annual lease payments of $25,000 each, plus the unguaranteed residual value of $15,000).
2. Unearned interest income, $76,880, is the gross investment of $265,000 less $188,120, the fair market value of the asset and the initial present value of the investment, calculated as follows:
Annual lease payment $ 25,000
Present value of an annuity due of $1 for
10 periods discounted at 8% 7.24689
Present value of the 10 rental payments 181,172
Add present value of estimated residual
value of $15,000 in 10 years at 8%
($15,000 X .46319) 6,948
Initial present value $188,120
| Excel formula =PV(rate,nper,pmt,fv,type) |
| Using a financial calculator: | ||
| PV | $ ? | Yields $188,120 |
| I | 8% | |
| N | 10 | |
| PMT | $ (25,000) | |
| FV | $ (15,000) | |
| Type | 1 | |
3. Sales price is $181,172 (the present value of the 10 annual lease payments); i.e. the initial PV of $188,120 minus the PV of the unguaranteed residual value of $6,948.
4. Cost of sales is $98,052 (the $105,000 cost of the asset less the present value of the unguaranteed residual value of $6,948).
(b) CHL CORPORATION (Lessor)
Lease Amortization Schedule
Annuity Due Basis, Unguaranteed Residual Value
| Beginning of Year | | Annual Lease Payment Plus Residual Value | | Interest (8%) on Net Investment | | Net Investment Recovery | | Net Investment |
| | | | | | | | | |
| Initial PV 1 2 3 4 5 6 7 8 9 10 End of 10 | | (a) — $ 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 15,000 $265,000 | | (b) — — *$ 13,050* * 12,094* * 11,061* * 9,946* * 8,742* * 7,441* * 6,036* * 4,519* * 2,881* * 1,110* *$76,880* | | (c) — $ 25,000 11,952 12,906 13,939 15,054 16,258 17,559 18,964 20,481 22,119 13,890 $188,120 | | (d) $188,120 163,120 151,170 138,264 124,325 109,271 93,013 75,454 56,490 36,009 13,890 0 |
*Rounding error is $1.
(a) Annual lease payment required by lease contract.
(b) Preceding balance of (d) X 8%, except beginning of first year of lease term.
(c) (a) minus (b).
(d) Preceding balance minus (c).
(c) Beginning of Lease Year 1
Lease Payments Receivable.............. 265,000
Cost of Sales.......................... 98,052
Sales.............................. 181,172
Inventory.......................... 105,000
Unearned Interest Income—Leases.... 76,880
(To record the sale and the cost of sales
in the lease transaction)
Selling Expense........................ 7,000
Cash............................... 7,000
(To record payment of the initial direct
costs relating to the lease)
Cash .................................. 25,000
Lease Payments Receivable.......... 25,000
(To record receipt of the first lease
payment)
End of the Year – 5 months after signing lease
Unearned Interest Income—Leases........ 5,438
Interest Income—Leases............. 5,438
(To record interest earned during the
first year of the lease $13,050 X 5/12)
(d) The balance of the net investment should be the net investment of $163,120 plus the interest earned to the end of the year of $5,438, for a total of $168,558. This should be reported as follows:
Current portion $17,388*
Non-current portion 151,170**
Total ($188,120 – $25,000 + $5,438) $168,558
* Lease payment receivable $25,000
Less unearned payment ($13,050 – $5,438) 7,612
Current Portion $17,388
** Non-current:
Total lease payments receivable $215,000
Less unearned ($76,880 – $13,050) 63,830
$151,170
(e) Assuming the $15,000 residual value was guaranteed by the lessee, this would change the initial entry for the sale to be as follows:
Lease Payments Receivable.............. 265,000
Cost of Sales.......................... 105,000
Sales.............................. 188,120
Inventory.......................... 105,000
Unearned Interest Income—Leases.... 76,880
The sales and cost of goods sold would not need to be reduced by the present value of the estimated residual value calculated in part (a) of $6,948.
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