Illustrative Problem 1 – Direct Financing Lease – with residual value

On January 01, 2020, Camia Mchineries, Inc. leased a construction equipment to Company Cee
with the following information:

Cost of Equipment 3,760,100

Residual value guarantee 400,000
Useful life and lease term 4 years
Implicit interest rate 10%

The annual rental is payable in advance on January 01 of each year starting January 01, 2020.

The relevant present value factors are:

Present value of 1 at 10% for 4 periods 0.6830
Present value of an annuity of 1 in advance at 10% for 4 periods 3.4869

** Note that the residual value is guaranteed, therefore, the equipment will revert to the lessor at
the end of the lease term
Step 1 : Computation of Annual Rental

Cost of Machinery 3,760,100

Less: Present value of residual value (400,000x.683) 273,200
Net investment to be recovered from rental 3,486,900
Divide by PV of 1in advance at 10% for 4 periods 3.4869
Annual Rental 1,000,000

Step 2 – Compute the amount of unearned interest income

Gross rentals (1,000,000 x 4 years) 4,000,000
Add: Residual value-guaranteed 400,000
Gross Investment 4,400,000
Less: Net Investment - cost of machinery 3,760,100
Unearned Interest Income 639,900

Table of Amortization
Date Payment Interest Principal Present Value
1/1/2020 3,760,100.00
1/1/2020 1,000,000 1,000,000 2,760,100.00
1/1/2021 1,000,000 276,010 723,990 2,036,110.00
1/1/2022 1,000,000 203,611 796,389 1,239,721.00
1/1/2023 1,000,000 123,972 876,028 363,693.10
1/1/2024 400,000 36,307 363,693 0.00
Note: The rental payments is in advance, hence, the first year rental is applied to principal
alone.
Journal Entries:
4,400,00
Jan. 01, 2020 Lease Receivable 0
3,760,10
Construction Equipment 0
Unearned Interest Income 639,900
1,000,00
Jan. 01, 2020 Cash 0
1,000,00
Lease Receivable 0
Dec. 31, 2020 Unearned Interest Income 276,010
Interest Income 276,010

1,000,00
Jan. 01, 2021 Cash 0
1,000,00
Lease Receivable 0
Dec. 31, 2021 Unearned Interest Income 203,611
Interest Income 203,611