(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

(e) Suppose the useful life of the milking equipment is 20 years. How large would the residual value have to be at the end of 10 years in order for the lessee to qualify for the operating method? (Assume that the residual value would be guaranteed by a third party.) (Hint: The lessee’s annual payments will be appropriately reduced as the residual value increases.)

Step by step solution

01

Meaning of Operating method

An operating lease is a type of lease that allows one party, the lessee, to use an asset owned by another party, the lessor, in exchange for rental payments that are less than the asset's economic rights for a set period of time and without transferring any ownership rights at the end of the lease term.

02

Explaining how large would be the residual value have to be at the end of 10 years in order for the lessee to qualify for the operating method

The 90% of the equipment value $220,404 is $198,364. The difference between the present value and the residual value is $22,040 the future value can be computed as below:

$\begin{array}{rcl}\text{Future}\text{value}& =& \text{Difference}\text{of}\text{present}\text{and}\text{residual}\text{value}\times \text{future}\text{value}\\ & =& \$22,040\times 2.36736\\ & =& \$52,177\end{array}$

Note: The future value for n = 10, and i= .09

As a result, the residual value had to be more than $52,177.

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