Question

On January 1, 2018, Rick’s Pawn Shop leased a truck from Chumley Motors for a six-year period with an option to extend the lease for three years. Rick’s had no significant economic incentive as of the beginning of the lease to exercise the 3-year extension option. Annual lease payments are $27,000 due on December 31 of each year, calculated by the lessor using a 4% discount rate. Assume that at the beginning of the third year, January 1, 2020, Rick’s had made significant improvements to the truck whose cost could be recovered only if it exercises the extension option, creating an expectation that extension of the lease was “reasonably certain.” The relevant interest rate at that time was 5%. (FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.) Required: 1. Prepare the journal entry, if any, at the beginning of the third year for the lessee to account for the reassessment.

Answer 1

Solution:

1.

No.	Date	General Journal	Debit	Credit
1	Jan 1 , 2020	Right of use asset	$58,227
		Lease Payable		$58,227

January 1, 2018
Lease payable ($27,000 * PVIF $1:( n=6, i=4%))
Lease payable ($27,000 * 5.2421) = $141,537
December 31, 2018
Interest expense (4% * $141,537) = 5,661
Amortization expense ($27,000 - 5,661) = 21,339

In an operating lease, the lessee records interest the normal way (at the effective interest rate) and then "plugs" the right-of-use asset amortization at the amount is needed for interest plus amortization to equal the straight-line lease payment. The lessee records that amount as a single lease expense in the income statement.

December 31, 2019
Interest expense (4% * ($141,537 - 21,339)) =4,808
Amortization expense ($27,000 - 4,808) = 22,192
January 1, 2020 Reassessment:
PV of remaining 7 payments, discounted at 5% ($27,000 * 5.7864)............ $156,233
Liability balance after 2 years ($141,537 - 21,339 - 22,192).................................... 98,006
Increase in balance ............................................................................................$58,227

Also, lessees are required to reassess the classification of a lease when there is a change in the lease term (or a change in the assessment of a lessee option to purchase the underlying asset). Because, with the assumed renewal,the lease term is for the entire useful life of the asset, it would be considered a finance lease rather than an operating lease as previously classified. As a result, we had an operating lease for two years, and now have a seven-year finance lease. So, amortization of the right-of-use asset will be a straight-line allocation of the balance in that account at this point (($141,537 - 21,339 - 22,192] + $58,227) = $156,233 over the next seven years.

December 31, 2020
Interest expense (4% * $156,233) = 6,249
Amortization expense ($156,233 + 7 years) = 22,319