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.

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.

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

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.