(Lessor Entries; Direct-Financing Lease with Option to Purchase) Castle Leasing Company signs a lease agreement on January 1, 2017, to lease electronic equipment to Jan Way Company. The term of the noncancelable lease is 2 years, and payments are required at the end of each year. The following information relates to this agreement:

1. Jan Way Company has the option to purchase the equipment for \(16,000 upon termination of the lease.
2. The equipment has a cost and fair value of \)160,000 to Castle Leasing Company. The useful economic life is 2 years, with a salvage value of \(16,000.
3. Jan Way Company is required to pay \)5,000 each year to the lessor for executory costs.
4. Castle Leasing Company desires to earn a return of 10% on its investment.
5. Collectibility of the payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor.

Instructions

1. Prepare the journal entries on the books of Castle Leasing to reflect the payments received under the lease and to recognize income for the years 2017 and 2018.

Step by step solution

01

Meaning of Lessee

A lessee is a person who is involved in the lease agreement in which the lessor transfers the rights to use the assets to the lessee. The lessee makes payment to the lessor for the asset he acquired as per the lease agreement.

02

Computation of annual Payments.

Cost (fair value) of the leased asset to the lessor Less: Present value of salvage value (residual value in this case)	$160,000 13,223
Amount to be recovered through lease payments	$146,777
Two periodic lease payments	$84,571

Working Notes:-

Calculation of present value of the salvage

$$\begin{gathered} \mathrm{Present}\mathrm{value}\mathrm{of}\mathrm{salvage}=\mathrm{salvage}\mathrm{value}\times \mathrm{present}\mathrm{value} \\ =\$16,000\times 0.82645 \\ =\$13,223 \end{gathered}$$

Note: Present value of 1 at 10% for 2 periods

Calculation of two periodic lease payments

$$\begin{gathered} \mathrm{Two}\mathrm{periodic}\mathrm{lease}\mathrm{payments}=\frac{\mathrm{Amount}\mathrm{recovered}\mathrm{through}\mathrm{lease}}{\mathrm{present}\mathrm{value}\mathrm{of}\mathrm{annuity}} \\ =\frac{\$146,777}{1.73554} \\ =\$84,571 \end{gathered}$$

Note: Present value of an ordinary annuity of 1 for 2 periods at 10%

03

Preparing Lease Amortization Schedule

CASTLE LEASING COMPANY (Lessor) Lease Amortization Schedule
Date	Annual Payment Less Executory Costs	Interest (10%) on Lease Receivable	Recovery of Lease Receivable	Lease Receivable
1/1/17				$160,000
12/31/17	$84,571	$16,000	$68,571	91,429
12/31/18	84,571	9,142	75,429	16,000
		$25,142

Note: Difference of $.1 due to rounding

04

Preparing Journal Entries

Date	Particular	Debit ($)	Credit ($)
Jan. 1, 2017	Lease Receivable	160,000
	Equipment		160,000
Dec. 31, 2017	Cash	89,571
	Executory Costs Payable		5,000
	Lease Receivable		68,571
	Interest Revenue		16,000
Dec. 31, 2018	Cash	89,571
	Executory Costs Payable		5,000
	Lease Receivable		75,429
	Interest Revenue		9,142

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