Assume that on January 1, 2014, Elmer’s Restaurants sells a computer system to L
ID: 2569545 • Letter: A
Question
Assume that on January 1, 2014, 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.
Date
Account Titles and Explanation
Debit
Credit
Elmer’s Restaurants (Lessee)
1/1/14
(To record sale.)
(To record the lease.)
12/31/14
(To record amortization of profit on sale.)
12/31/14
(To record depreciation.)
(To record payment.)
Liquidity Finance Co. (Lessor)
1/1/14
(To record purchase.)
(To record the leaseback.)
12/31/14
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 insure a rate of return of 10%. 5. The computer has a fair value of $680,000 on January 1, 2014, and an estimated economic life of 10 years. 6. Elmer incurs executory costs of $9,000 per year. (Use Accounts Payable)Explanation / Answer
Solution:-
* Lease should be treated as a capital lease because present value of minimum lease payments equals the fair value of the computer. Also, the lease term is greater than 75% of the economic life of the asset, and title transfers at the end of the lease.
**The credit could also be to a revenue account.
* 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) collectibility of the payments is reasonably assured, (2) no important uncertainties surround the costs yet to be incurred by the lessor, and (3) the cost to the lessor equals the fair market value of the asset at the inception of the lease.
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Date Account Titles and Explanation Debit Credit Elmer’s Restaurants (Lessee)* 1/1/14 Cash 680,000.00 Computer 600,000.00 Unearned Profit on Sale- Leaseback 80,000.00 (To record sale.) Leased Computer Under Capital Leases 680,000.00 Lease Liability 680,000.00 ($110,666.81 X 6.14457) (To record the lease.) Throughout 2014 Executory Costs 9,000.00 Accounts Payable or Cash 9,000.00 12/31/14 Unearned Profit on Sale- Leaseback 8,000.00 Depreciation Expense** 8,000.00 ($80,000 ˜ 10) (To record amortization of profit on sale.) 12/31/14 Depreciation Expense 68,000.00 Accumulated Depreciation 68,000.00 ($680,000 ˜ 10) (To record depreciation.) Interest Expense 68,000.00 Lease Liability 42,666.81 Cash 110,666.81 (To record payment.)