Question

Baillie Power leased high-tech electronic equipment from Courtney Leasing on January 1, 2021. Courtney purchased the equipment from Doane Machines at a cost of $250,000, its fair value. (FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.)
Related Information:
Lease term 2 years (8 quarterly periods)
Quarterly lease payments $15,000 at Jan. 1, 2021, and at Mar. 31, June 30, Sept. 30, and Dec. 31 thereafter
Economic life of asset 5 years
Interest rate charged by the lessor 8%
Required:
1) Determine the lease type for Baillie Power and explain why.
2) Prepare a lease amortization schedule and appropriate entries for Baillie Power from the beginning of the lease through December 31, 2021. December 31 is the fiscal year end for each company. Appropriate adjusting entries are recorded at the end of each quarter.
3) What will be the effect of the lease on Baillie Power's earnings for the first year (ignore taxes)?
4) What will be the balance in the balance sheet accounts of Baillie Power related to the lease at the end of the first year (ignore taxes)?

Answer 1

Answer:

1) Determine the lease type for Baillie Power and explain why.

The lease should be treated as an operating lease because:

• ownership is not transferred at the end of the lease
• the lease term represents only 40% of the asset's useful life
• the present value of the lease agreement is only 45% of the asset's value
• no bargain purchase option exists

effective interest rate:

1.08 = (1 + r)⁴

⁴√1.08 = ⁴√(1 + r)⁴

1.01943 = (1 + r)

r = 1.943%

we must first determine the present value of the lease payments:

PV = (quarterly payment x annuity factor) + quarterly payment

• quarterly payment = $15,000
• PV annuity factor, 7 periods, 1.943% = 6.48620

PV = ($15,000 x 6.48620) + $15,000 = $112,293

2) Prepare a lease amortization schedule and appropriate entries for Baillie Power from the beginning of the lease through December 31, 2021. December 31 is the fiscal year end for each company. Appropriate adjusting entries are recorded at the end of each quarter.

amortization schedule:

quarter        lease payment       interest         lease liability's carrying value

1                      $15,000                  $0                           $97,293

2                     $15,000              $1,890                         $84,183

3                     $15,000              $1,636                         $70,819

4                     $15,000              $1,376                         $57,195

5                     $15,000                $1,111                         $43,306

6                     $15,000                $841                          $29,147

7                     $15,000                $566                          $14,713

8                     $15,000                $287                               $0

January 1, 2021, lease equipment from Courtney Leasing

Dr Right of use asset 112,293

    Cr Lease liability 112,293

January 1, 2021, first lease payment  

Dr Lease expense 15,000

    Cr Cash 15,000

Dr Lease liability 15,000

    Cr Right of use asset 15,000

March 31, 2021, second lease payment

Dr Lease expense 15,000

    Cr Cash 15,000

Dr Lease liability 13,110

    Cr Right of use asset 13,110

June 30, 2021, third lease payment

Dr Lease expense 15,000

    Cr Cash 15,000

Dr Lease liability 13,364

    Cr Right of use asset 13,364

September 30, 2021, fourth lease payment

Dr Lease expense 15,000

    Cr Cash 15,000

Dr Lease liability 13,624

    Cr Right of use asset 13,624

December 31, 2021, fifth lease payment

Dr Lease expense 15,000

    Cr Cash 15,000

Dr Lease liability 13,889

    Cr Right of use asset 13,889

March 31, 2022, sixth lease payment

Dr Lease expense 15,000

    Cr Cash 15,000

Dr Lease liability 14,159

    Cr Right of use asset 14,159

June 30, 2022, seventh lease payment

Dr Lease expense 15,000

    Cr Cash 15,000

Dr Lease liability 14,434

    Cr Right of use asset 14,434

September 30, 2022, eighth lease payment

Dr Lease expense 15,000

    Cr Cash 15,000

Dr Lease liability 14,713

    Cr Right of use asset 14,713

3) What will be the effect of the lease on Baillie Power's earnings for the first year (ignore taxes)?

Operating leases (lease expense + interest expense) decrease the company's income, but they do not represent a depreciation expense (only financial lessees do).

Total lease expenses during year 1 = $15,000 x 5 = $75,000

4) What will be the balance in the balance sheet accounts of Baillie Power related to the lease at the end of the first year (ignore taxes)?

Right of use asset $43,306

Lease liability $43,306