[SchruteBeet]

Becker FAR Leases Question – Can someone please help me understand why the explanation doesn’t include the PV of the guaranteed residual value of $20,000 in the calculation of the answer? I understand the explanation but then I added 20,000* .322 = 6,440 to the calculation since my understanding is that needs to be included as well.

Robbins, Inc. leased a machine from Ready Leasing Co. The lease qualifies as a capital (finance) lease and requires 10 annual payments of $10,000 beginning immediately. The lease specifies an interest rate of 12% and a purchase option of $10,000 at the end of the tenth year, even though the machine’s estimated value on that date is $20,000. Robbins’ incremental borrowing rate is 14%. The present value of an annuity due of 1 at: 12% for 10 years is 6.328 and 14% for 10 years is 5.946. The present value of 1 at: 12% for 10 years is .322 and 14% for 10 years is .270.
What amount should Robbins record as lease liability at the beginning of the lease term?
A. $62,160
B. $64,860
C. $66,500
D. $69,720
Explanation
Choice “C” is correct. The lessee should record the capital (finance) lease at the lower of (1) present value of minimum lease payments or (2) FV of asset at the inception of lease. The FV is not given. The interest rate is 12% (lessor’s rate is used only if lower or the implicit rate is not known). The lease payments begin immediately (annuity due basis). The bargain purchase option must also be capitalized. The amount capitalized is:
Annual payments, $10,000 x 6.328 63,280
Bargain purchase option, $10,000 x .322 3,220
66,500

 

 

[lam2848]

I just finished Becker's lease section so I'm still fairly new at this topic and not explain this properly. But what I did is this:

1. find the PV of future minimum payments. Start with the 10,000 due annually starting today (Annuity due). Use the 12% as the PV factor (The lower of incremental rate and implicit rate). So you take the 10,000*6.328 = 63,280

2. Then I think the 10,000 purchase option is a bargain purchase option which should be included in the PV calculations. This is a one time payment due in 10 years. So we take the PV of $1 for 10 years at 12%. 10,000*.322 =3,220.

3. Then you add the two and record: 63,280 + 3,220 = 66,500

If I'm not mistaken the 20,000 would be the fair value of the asset (used for the 90% rule).

[Jen-J]

The information's redundant, because they already specify that it's a capital lease (otherwise it would be useful, because it proves that the lease is a capital lease if the written purchase option is at a bargain from the fair value at the end of the lease). They're paying the 10 payments of $10K and the 10K bargain purchase price, so that's the numbers for the calculation.

[SchruteBeet]

I guess my question is, what is the $20,000 amount? It looks like a residual value to me so then shouldn't we be including its PV in the calculation as well?

[Jen-J]

The payments are known, and the purchase option price is known. The fact that we know that the purchase option price is less than the residual is only useful for the OWNS test for it being a capital lease. The amount of the residual has nothing to do with the lease liability – the lessee is never going to pay that amount. They will either pay the purchase option price and keep the item, or pay nothing and return it. The PV calculation of leases with a bargain purchase option includes the present value of the bargain purchase option payment.

(If the lease had a guaranteed residual value due by the lessee to the lessor, then whatever that amount is would be relevant as part of the PV calculation.)

[Yahmon]

@shrutebeet the amounts included in the calculation of the present value of the minimum lease liability depends on what data is provided. If BPO is given you never use the residual value but if BPO is not given then you include the PV of guaranteed residual value and also PV of any non renewal penalty if provided.

FAR 8/20/15 - Passed 77
AUD 10/10/15 -
BEC TBD
REG TBD

[SchruteBeet]

Ahh that makes more sense now. Thanks so much for your input guys!

[SchruteBeet]

Why do we take into account the guaranteed residual value in this question and not the first one?

A company leases a machine from Leasing, Inc. on January 1, year 1. The lease terms include a $100,000 annual payment beginning January 1, year 1. The machine's fair value is $500,000 and the residual value is estimated at $20,000. The company guarantees the residual value. The useful life of the machine is six years, and the lease term is five years. The implicit rate of interest is 6% and is known by the company. The following present value factors are provided:

Five Years Six Years
Present value of $1 at 6% 0.7473 0.7050
Present value of an annuity due at 6% 4.4651 5.2124
Present value of an ordinary annuity at 6% 4.2124 4.9173

What is the value of the machine in the company's balance sheet at lease inception?

A. $446,510

B. $461,456

C. $520,000

D. $535,340

Explanation: B. The value of the machine from the capital lease is the present value of the minimum lease payments (using the annuity due factor) and the present value of the guaranteed residual value, over the five-year lease term, as follows: ($100,000 × 4.4651) + ($20,000 × 0.7473) = $461,456.

[Jott]

in the first problem you are given the residual value of 20,000 for comparison to the purchase option so that you can determine it is a bargain purchase (10,000 < 20,000) and therefore the lease is A) a capital lease and B) the PV of the lease will include the purchase option because it is a bargain. in contrast if the purchase option was for 20,000 or greater this would not be a bargain and the lease may otherwise not be a capital lease and the PV of the lease would not include the PV of the purchase option. note that it does not say the residual value is GUARANTEED in the first problem

in the second problem the residual value is GUARANTEED by the lessee and therefore represents a liability which is why it is included in the PV of the lease

[Author]

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