(Lessee-Lessor Entries, Sales-Type Lease; Guaranteed Residual Value) Phelps Company leases a building to Walsh, Inc. on January 1, 2020. The following facts pertain to the lease agreement.

1. The lease term is 5 years, with equal annual rental payments of $4,703 at the beginning of each year.
2. Ownership does not transfer at the end of the lease term, there is no bargain purchase option, and the asset is not of a specialized nature.
3. The building has a fair value of $23,000, a book value to Phelps of $16,000, and a useful life of 6 years.
4. At the end of the lease term, Phelps and Walsh expect there to be an unguaranteed residual value of $4,000
5. Phelps wants to earn a return of 8% on the lease, and collectibility of the payments is probable. This rate is known by Walsh.

Instructions

a. How would Phelps (lessor) and Walsh (lessee) classify this lease? How would Phelps initially measure the lease receivable, and how would Walsh initially measure the lease liability and right-of-use asset?

b. Using the original facts of the lease, show the journal entries to be made by both Phelps and Walsh in 2020.

c. Suppose the entire expected residual value of $4,000 is guaranteed by Walsh. How will this change your answer to part a?

d. Assume the same facts as part c, except the expected residual value is $3,000. Does your answer change?

Solution and Explanation:

Calculation of Minimum lease annual payments from (MLP)    

Year  MLP from lessor       Present value                   Present valur of

                  point of view    factor 8%                    cash flows

1                  $4,703                    $4,350.28

2                    $4,703                   $4,030.47

3                   $4,703                $3,729.48

4                 $4,703                $3,456.71

5                   $4,703                $3,198.04

Total of Minimum

lease Payments  $23,515                                       $ 18,764.97

Add    

Unguaranteed

residual value(ugrv)  4000    $2,720.00

Asset to be recorded

in the books of lessor

(sum of mlp +ugrv)  $27,515                             $ 21,484.97

Here        

Gross Investment=$27515        

Lease receivable recorded in in the books of lessor(Phelps)(Mimum lease payments + Unguaranteed residual )value = $21484  $21,484      

Walsh (lessee) shoiuld be recorded the amount of present value of minimum lease payments + Guaranteed Residual value=$18764.97 as asset and liabilty            

b) In the books of phelps (lessor)        

2017.01.01  Lease Recievble from walsh ….Dr  $21,484      

                                 to Asset                              $21,484      

(Being Lease receivable recorded )        

In the books of Walsh (lessee)        

2017.01.01  Asset ac ……………Dr  $18,764        

         to Lease Liabilty(Lessor)               $18,764      

(Being the asset and liabilty recorded )                

2017.12.31  Depreciation ……Dr  3752        

                            to Asset                      3752        

(Beint Depreciation recorded charged during the year recorded 18764/5 provided for 5 years)

Here annual payment started from the at the beginning of year i.e annual lease payments start from 01.01.2018.

c)  If expected residual value of $4000 is guaranteed by walsh no changes will be made in classification of lease and there is no chages in asset recorded in Lessor books. But changes will be made in the books of lessee as present value of guaranteed residual value should be added to asset I.e $18764+Present vlue of $4000    $18764+2720=21484

d)   If expected residual value of $3000 is guaranteed by walsh no changes will be made in classification of lease and there is no chages in asset recorded in Lessor books But changes will be made in the books of lessee as present value of guaranteed residual value should be added to asset    I.e $18764+Present vlue of $3000      $18764+$2040=$20804