Learning Resource 9, Lessor Accounting Lesson 3, Sales Type Lease

Learning Resource 9 : Lessor Accounting

Lesson 3
SALES TYPE LEASE

Learning Outcomes:

At the end of this lesson, the students shall be able to:

a. Explain the various concepts pertaining to the following:
 sales type lease on the part of the lessor;
 gross investment and net investment in a sales type lease; and
 profit on sale and interest income in a sales type lease.
b. Demonstrate understanding of the concepts by applying them in solving related
problems;
c. Analyze crucial situations besetting the rigor in solving related problems; and
d. Check on the accuracy of solutions through the concepts and principles applicable
to a sales type lease.

Activity 1
Discussion of Accounting Principles
(Please refer to the prescribed textbook, Chapter 14, Intermediate Accounting,
Volume 2, 2020 edition, by Valix, Peralta & Valix)

1. Accounting considerations
 Gross investment
 Net investment
 Unearned interest income
 Sales
 Cost of goods sold
 Gross profit
 Initial direct cost

2. Illustration
 Computation
 Journal entries

3. Sales type lease with residual value

 Residual value guarantee
 Unguaranteed residual value
 Computation
 Journal entries
 Table of amortization
 Journal entries

4. Return of assets to lessor

5. Sales type lease with purchase option

 Computation
 Journal entry
 Table of amortization
 Journal entries
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Learning Resource 9, Lessor Accounting Lesson 3, Sales Type Lease

6. Exercise of purchase option

 Journal entry
 Nonexercise of purchase option
 Journal entry

7. Actual sale of underlying asset

 Illustration
 Computation
 Journal entry to record the actual sale

8. Disclosures – Lessor

9. Additional disclosure

Activity 2
Application Exercises

Illustrations and sample computations are available in your textbook. Please refer to it as
well.

Activity 3
Evaluation Exercises

General Instructions: You are required to provide solutions/answers to the following

exercises. Supporting computations which are presented in good form shall be part of all
solutions. Answers/solutions to these exercises are to be submitted to the Professor through
her e-mail address or may be sent to her office/home, whichever is convenient. Please take
note of the deadline of submission which will be communicated to all concerned students.

A. Theoretical Exercises (Individual Task)

Choose the correct answer by writing the corresponding letter-answer and a convincing
justification that it is indeed the correct answer via applicable appropriate accounting
principles discussed in Activity 1.

1. Under a sale type lease, what is the meaning of gross investment in the lease?
a. Present value of lease payments
b. Absolute amount of lease payments
c. Present value of lease payments plus present value of unguaranteed residual value
d. Sum of absolute amount of lease payments and unguaranteed residual value

2. Net investment in a sale type lease is equal to

a. Gross investment in the lease less unearned finance income
b. Cost of the underlying asset
c. The lease payments
d. The lease payments less unguaranteed residual value

3. Which statement characterizes a sales type lease?

a. The lessor recognizes only interest revenue over the useful life of the asset.
b. The lessor recognizes only interest revenue over the lease term.
c. The lessor recognizes a dealer profit at lease inception and interest revenue over
the lease term.
d. The lessor recognizes a dealer profit at lease inception and interest revenue over
the useful life of the asset.

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Learning Resource 9, Lessor Accounting Lesson 3, Sales Type Lease

4. The profit on a finance lease transaction for lessors who are manufactures or dealers
should
a. Not be recognized separately from finance income
b. Be recognized in the normal way on the transaction
c. Only be recognized at the end of the lease term
d. Be recognized on a straight line basis over the lease term

5. The sales revenue recognized at the commencement of the lease by a manufacturer or

dealer lessor is the
a. Fair value of the asset
b. Present value of the lease payments
c. Fair value of the asset or present value of the lease payments, whichever is lower.
d. Fair value of the asset or present value of the lease payments, whichever is higher.

6. What is the treatment of an unguaranteed residual value in determining the cost of

goods sold under a sale type lease?
a. The unguaranteed residual value is ignored.
b. The unguaranteed residual value is added to the cost of underlying asset.
c. The unguaranteed residual value is deducted from the cost of the underlying asset
at absolute amount.
d. The unguaranteed residual value is deducted from the cost of the underlying asset
at present value.

7. The excess of the fair value of underlying asset at the inception of the lease over the
carrying amount shall be recognized by the dealer lessor as
a. Unearned income from a sales type lease
b. Unearned income from a direct financing lease
c. Manufacturer profit from a sales type lease
d. Manufacturer profit from a direct financing lease

8. In a lease that is recorded as a sales type lease by the lessor, interest revenue
a. Does not arise
b. Shall be recognized over the lease term using the interest method
c. Shall be recognized over the lease term using the straight line method
d. Shall be recognized in full as revenue at the inception of the lease

B. Practical Exercises

I. Group Task

Solve the following problems by group with supporting computations presented in good form.

1. On January 1, 2020, ANA Company leased equipment to MAE Company for an eight-
year period expiring January 1, 2028.

Equal payments under the lease are Ᵽ600,000 and are due on January 1 of each year.
The first payment was made on January 1, 2020. The rate of interest contemplated is
10%.

The cash selling price of the equipment is Ᵽ3,520,000, and the cost of the equipment is
Ᵽ2,800,000. Ana Company paid initial direct cost of Ᵽ50,000 in negotiating and arranging
the lease. The lease is appropriately recorded as a sales type lease.

Required:
Prepare journal entries on the book of Anne Company for 2020 and 2021.

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Learning Resource 9, Lessor Accounting Lesson 3, Sales Type Lease

2. On January 1, 2020, FLOR Company, dealer in equipment, leased equipment to LYN

Company. The lease is appropriately accounted for as a sale by Flor Company and as
a purchase by Lyn Company.

The lease is for 10-year period which approximates the useful life of the asset. The first
of 10 equal annual payments of Ᵽ500,000 was made on January 1, 2020.

Flor Company purchased the equipment for Ᵽ2,675,000 and established a list selling
price of Ᵽ3,375,000 on the equipment. Flor Company used the perpetual inventory
system.

The present value on January 1, 2020 of the rent payments over the lease term
discounted at 12% was Ᵽ3,165,000.

Required:
Prepare journal entries for 2020 and 2021 on the books of Flor Company and Lyn
Company.

3. JOHN Company used leases as a method of selling products. At the beginning of current
year, John Company leased equipment to MAR Company with the following information:
Annual rental payable at the end of each lease year 700,000
Cost of equipment to John 2,000,000
Unguaranteed residual value 400,000
Useful life of equipment and lease term 8 years
Implicit interest rate in the lease 12%
PV of an ordinary annuity of 1 for 8 periods at 12% 4.968
PV of 1 for 8 periods at 12% 0.404

At the end of the lease the equipment will revert to the lessor. Both lessor and lessee
report on a calendar year basis, depreciate all assets on the straight line, and use the
perpetual inventory system.

Required:
Prepare journal entries on the books of John Company and Mar Company for the
current year.

4. TOM Company is a dealer in machinery. The perpetual inventory system is used. At the
beginning of current year, a machinery was leased to JERRY Company with the
following provisions:
Annual rental payable at the end of each year 3,000,000
Lease term and useful life of machinery 5 years
Cost of machinery 8,000,000
Residual value guarantee 1,000,000
Initial direct cost paid by Tom 300,000
Implicit interest rate 12%
PV of an ordinary annuity of 1 for 5 periods at 12% 3.60
PV of 1 for 5 periods at 12% 0.57

Required:
Prepare journal entries on the books of Tom Company and Jerry Company for the
current year.

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Learning Resource 9, Lessor Accounting Lesson 3, Sales Type Lease

5. MEL Company used leases a method of selling products and followed the perpetual
inventory system.

In early 2020, Mel Company completed construction of a passenger ferry for use
between Bacolod and Iloilo.

On April 1, 2020, the ferry was leased to another entity on a contract specifying that
ownership of the ferry will transfer to the lessee at the end of the lease term.
Cost of ferry to Mel Company 6,000,000
Annual rental payable in advance 900,000
Estimated residual value 300,000
Implicit interest rate 10%
Lease period 20 years
Date of first rental payment April 1, 2020
PV of an annuity of 1 in advance at 10% for 20 periods 9.36
PV of 1 at 10% for 20 periods 0.15

Required:
1. Determine the total financial revenue.
2. Determine the gross profit on sale.
3. Prepare journal entries for 2020 and 2021.

6. ROSE Company is a dealer in equipment. On January 1, 2020, the entity leased an

equipment to another entity. The lease is appropriately recorded as a sales type lease.
Annual rental payable at the beginning of each year 800,000
Lease term 8 years
Useful life of equipment 10 years
Cost of equipment 3,100,000
Purchase option 400,000
Implicit interest rate 10%
PV of annuity of 1in advance at 10% for 8 periods 5.87
PV of 1 at 10% for 8 periods 0.47

It is reasonably certain that the lessee will exercise the purchase option on the expiration
of lease on December 31, 2027.

The perpetual inventory system is used by Rose Company.

Required:
1. Determine the unearned interest income on January 1, 2020
2. Determine the gross profit on sale.
3. Prepare journal entries for 2020 and 2021.
4. Prepare journal entry on December 31, 2027 to record the exercise of the bargain
purchase option by the lessee.
5. Prepare journal entry on December 31, 2027 if the bargain purchase option is not
exercise by the lessee and the fair value of the leased asset is Ᵽ250,000.

II. Individual Task

Solve the following problems with solutions presented in good form; and choose the correct
answer (re: letter-answer) from the given probable answers.

1. On January 1, 2020, KIM Company entered into a lease agreement with OLIVE
Company for a machine which was carried on the accounting records of Kim Company
at Ᵽ2,000,000.

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Learning Resource 9, Lessor Accounting Lesson 3, Sales Type Lease

Total payments under the lease which expires on December 31, 2029 aggregate
Ᵽ3,550,800 of which Ᵽ2,400,000 represents cost of the machine to Olive Company.
Payments of Ᵽ355,080 are due each January 1, of each year.

The interest rate of 10% which was stipulated in the lease is considered fair and
adequate compensation to Kim Company.

Olive Company expects the machine to have a 10-year life, no residual value and be
depreciated on a straight line basis. The lease qualifies as a sales type lease.

1. What amount should be recognized by Kim as profit from sale for the year ended
December 31, 2020?
a. 1,150,800 b. 1,550,800 c. 400,000 d. 355,080

2. What amount of interest income should be recognized by Kim for the year ended
December 31, 2020?
a. 244,080 b. 200,000 c. 204,492 d. 240,000

3. What total income before tax should be recognized by Kim from the lease for the
year ended December 31, 2020?
a. 204,492 b. 604,492 c. 355,080 d. 755,080

2. KRISTEL Company used leased as a method of selling products. In 2020, kRISTEL

Company completed construction of a passenger ferry.

On January 1, 2020, the ferry was leased to the Super Ferry line on a contract specifying
that ownership of the ferry will transfer to the lessee at the end of the lease period.
Original cost of the ferry 8,000,000
Fair value of ferry at lease date 13,000,000
Lease payment in advance 1,500,000
Residual value 2,000,000
Implicit interest rate 12%
Date of first lease payment January 1, 2020
Lease term 20 years
Present value of an annuity due of 1 at 10% for 20 periods 8.37
Present value of 1 at 12% for 20 periods 0.10

1. What is the gross investment in the lease?

a. 30,000,000 b. 32,000,000 c. 10,000,000 d. 38,000,000

2. What is the net investment in the lease?

a. 12,555,000 b. 13,000,000 c. 12,755,000 d. 8,000,000

3. What is the gross profit on the sale for 2020?

a. 6,555,000 b. 4,555,000 c. 5,000,000 d. 7,000,000

4. What is the interest income for 2020?

a. 1,506,600 b. 1,560,000 c. 1,326,600 d. 1,380,000

3. JOY Company is a dealer in equipment. At the beginning of current year, an equipment

was leased to another entity with the following provisions:
Annual rental payable at the end of each year 1,500,000
Lease term useful life of machinery 5 years
Cost of equipment 4,000,000
Residual value-unguaranteed 500,000
Implicit interest rate 12%
PV of an ordinary annuity of 1 at 12% for 5 periods 3.60
PV of 1 at 12% for 5 periods 0.57

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Learning Resource 9, Lessor Accounting Lesson 3, Sales Type Lease

At the end of the lease term the equipment will revert to the lessor. The entity incurred
initial direct cost of Ᵽ200,000 in finalizing the lease agreement.

1. What is the gross investment on the lease?

a. 7,500,000 b. 8,000,000 c. 4,000,000 d. 4,500,000

2. What is the net investment in the lease?

a. 5,400,000 b. 5,685,000 c. 4,000,000 d. 3,500,000

3. What interest income should be reported for current year?

a. 682,200 b. 648,000 c. 900,000 d. 960,000

4. What amount should be reported as gross profit on sale?

a. 1,485,000 b. 1,685,000 c. 3,500,000 d. 4,000,000

*****

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