Glaus Leasing Company agrees to lease equipment to Jensen Corporation on January 1, 2020. The following information relates to the lease agreement.

1. The term of the lease is 7 years with no renewal option, and the machinery has an estimated economic life of 9 years.
2. The cost of the machinery is $525,000, and the fair value of the asset on January 1, 2017, is $700,000.
3. At the end of the lease term, the asset reverts to the lessor and has a guaranteed residual value of $50,000. Jensen estimates that the expected residual value at the end of the lease term will be $50,000. Jensen amortizes all of its leased equipment on a straight-line basis.
4. The lease agreement requires equal annual rental payments, beginning on January 1, 2017.
5. The collectibility of the lease payments is probable.
6. Glaus desires a 5% rate of return on its investments. Jensen's incremental borrowing rate is 6%, and the lessor's implicit rate is unknown. Instructions (Assume the accounting period ends on December 31.)

Required:
(a) Discuss the nature of this lease for both the lessee and the lessor.
(b) Calculate the amount of the annual rental payment required.
(c) Compute the value of the lease liability to the lessee.
(d) Prepare the journal entries Jensen would make in 2017 and 2018 related to the lease arrangement.
(e) Prepare the journal entries Glaus would make in 2017 and 2018 related to the lease arrangement.
(f) Suppose Jensen expects the residual value at the end of the lease term to be $40,000 but still guarantees a residual of $50,000. Compute the value of the lease liability at lease commencement.

Solution:

a. It is a capital lease to Jensen, because the leasing period is more than 75% of the economic existence of the rented asset. The leasing duration is 78% (7-9) of the economic life of the commodity. That is a capital lease to Glaus, since the collectibility of the lease fees is fairly stable, there are no significant surprises regarding the expenses remaining to be borne by the lessor, so there is a lea. If the market valuation ($700,000) of the property equals the expense of the lessor ($525,000), the contract is a sale-type deal.

b. Calculation of annual rental payment:

= $121,130

**Present value of $1 at 10% for 7 periods.

**Present value of an annuity due at 10% for 7 periods

c. Computation of present value of minimum lease payments:

PV of annual payments: $121,130 X 5.23054 =

PV of guaranteed residual value:

$50,000 X   0.48166 = 24,083

**Present value of an annuity due at 11% for 7 periods.

**Present value of $1 at 11% for 7 periods

d. 1/1/14     Leased Equipment................................681,741

                                          Lease Liability...............................681,741

                 Lease Liability.......................................121,130

                                          Cash...............................................121,130

12/31/14         Depreciation Expense..........................  83,106

             Accumulated Depreciation—Capital Leases    

                 ($681,741 – $100,000) ÷ 7                     ..........83,106

                  Interest Expense...................................  61,667

                  Interest Payable    ($681,741 – $121,130) X .11......61,667

1/1/15            Lease Liability.......................................  59,463

                      Interest Payable....................................  61,667

                                              Cash...............................................121,130

12/31/15           Depreciation Expense..........................  83,106

         Accumulated Depreciation - Capital Leases..........................83,106

                  Interest Expense...................................  55,126

e) 1/1/14         Lease Receivable..................................700,000

                                 Cost of Goods Sold..............................525,000

                       Sales Revenue...............................700,000

                                          Inventory........................................525,000

                     Cash.......................................................121,130

                                             Lease Receivable..........................121,130

12/31/14          Interest Receivable...............................  57,887

                 Interest Revenue    [($700,000 – $121,130) X .10]....57,887

1/1/15                Cash.......................................................121,130

                                          Lease Receivable..........................63,243

                         Interest Receivable.......................57,8871

2/31/15           Interest Receivable...............................  51,563

Interest Revenue

($700,000 – $121,130 - $63,243) X .10...............................51,5635