(Lessee-Lessor Accounting for Residual Values) Goring Dairy leases its milking equipment from King Finance Company under the following lease terms.

1. The lease term is 10 years, noncancelable, and requires equal rental payments of \(30,300 due at the beginning of each year starting January 1, 2017.
2. The equipment has a fair value and cost at the inception of the lease (January 1, 2017) of \)220,404, an estimated economic life of 10 years, and a residual value (which is guaranteed by Goring Dairy) of $20,000.
3. The lease contains no renewable options, and the equipment reverts to King Finance Company upon termination of the lease.
4. Goring Dairy’s incremental borrowing rate is 9% per year. The implicit rate is also 9%.
5. Goring Dairy depreciates similar equipment that it owns on a straight-line basis.
6. Collectibility of the payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor.

Instructions

(b) Prepare the journal entries for the lessee and lessor at January 1, 2017, and December 31, 2017 (the lessee’s and lessor’s year-end). Assume no reversing entries.

Step by step solution

01

Meaning of Lessee

A person who takes land, equipment, building or any property on lease is called a lessee. A lessee is not the owner of the property instead, he has the right to use it. Lease payments are usually made monthly.

02

Preparing journal entries (Lessee)

Date	Particular	Debit ($)	Credit ($)
Jan. 1, 2017	Leased Equipment	220,404
	Lease Liability		220,404
Jan. 1, 2017	Lease Liability	30,300
	Cash		30,300
Dec. 31, 2017	Interest Expense	17,109
	Interest Payable		17,109
Dec. 31, 2017	Depreciation Expense	20,040
	Accumulated Depreciation Capital Leases		20,040

Working Notes:

Calculation of Lease Liability

$\begin{array}{rcl}\text{Lease}\text{liability}\text{for}\text{value}\text{annuity}& =& \text{Rental}\text{payments}\times \text{present}\text{value}\text{of}\text{annuity}\\ & =& \$30,300\times 6.99525\\ & =& \$211,956\end{array}$

$\begin{array}{rcl}\text{Lease}\text{liability}\text{forpresent}\text{value}& =& \text{Residual}\text{value}\times \text{present}\text{value}\text{of}\text{\$ 1}\\ & =& \$20,000\times 0.42241\\ & =& \$8,448\\ & & \end{array}$

$\begin{array}{rcl}\text{Lease}\text{liability}& =& \text{Lease}\text{liability}\text{for}\text{value}\text{annuity}+\text{laese}\text{liability}\text{for}\text{present}\text{value}\\ & =& \$211,956+\$8,448\\ & =& \$220,404\end{array}$

Calculation of interest payable

$$\begin{gathered} \text{Interest}\text{payable}=\left(\text{Equipment}\text{value}-\text{rental}\text{payments}\right)\times \text{borowwing}\text{rate} \\ =\left(\$220,404-\$30,300\right)\times 9\% \\ =\$190,104\times \frac{9}{100} \\ =\$17,109 \end{gathered}$$

Calculation of accumulated depreciation

localid="1660713678371" $\begin{array}{rcl}\text{Accumulated}\text{depreciation}& =& \frac{\text{Equipment}\text{value}-\text{residual}\text{value}}{\text{Lease}\text{term}}\\ & =& \frac{\$220,404-\$20,000}{10}\\ & =& \frac{\$200,404}{10}\\ & =& \$20,040\end{array}$

03

Preparing journal entries (Lessor)

Date	Particular	Debit ($)	Credit ($)
Jan. 1, 2017	Lease Receivable	220,404
	Equipment		220,404
Jan. 1, 2017	Cash	30,300
	Lease Receivable		30,300
Dec. 31, 2017	Interest Receivable	17,109
	Interest Revenue		17,109

Working Notes:

Calculation of interest receivable

$\begin{array}{rcl}\text{Interest}\text{receivable}& =& \left(\text{Eqipment}\text{value}-\text{rental}\text{payments}\right)\times \text{Implicit}\text{rate}\\ & =& \left(\$220,404-\$30,300\right)\times \frac{9}{100}\\ & =& \$190,104\times \frac{9}{100}\\ & =& \$17,109\end{array}$

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