Question

Krawczek Company will enter into a lease agreement with Heavy Equipment Co. where Krawczek will make lease payments over the next five years. The lease is cancelable and requires equal annual payments of $32,000 per year beginning on January 1 of the first year. The last payment will be January 1 of year 5, and Krawczek will continue to use the asset until December 31 of that year. Other important information includes the following:

• The fair value of the equipment is $215,000.
• The applicable discount rate is an 8 percent annual rate.
• The economic life of the asset is 10 years.
• Krawczek does not guarantee the residual value of the asset at the end of the lease, and it does not expect to keep the asset at the end of the term.
• The asset is a standard piece of equipment.

a. Is the lease an operating lease or a financing lease?

• Operating lease

• Financing lease

b. What will be the lease expense shown on the income statement at the end of year 1?

c. What will be the interest expense shown on the income statement at the end of year 1? (Leave no cells blank – be certain to enter “0” wherever required.)

d. What will be the amortization expense shown on the income statement at the end of year 1? (Leave no cells blank – be certain to enter “0” wherever required.)

Answer 1

PV of all the lease payments = PV of beginning of the period annuity of lease payments = - PV (Rate, Nper, PMT, FV, Type) = - PV(8%,5,32000,0,1) = $137,988.06

(Type is 1 as the payments are made at the beginning of the period)

Part (a)

The correct answer is the first option stating "Operating Lease" as:

• PV of lease payment < fair value of equipment.
• Lease term ( 5 years ) < economic life of asset ( 10 years )
• Asset is a standard piece of equipment and not specifically made for lessee
• Krawczek does not expect to keep the asset after lease term.

Part (b)

The lease expense shown on the income statement at the end of year 1 = Annual lease payment = $ 32,000

Part (c)

Since it's an operating lease there will be no interest expense nor any amortization.

Hence, the interest expense shown on the income statement at the end of year 1 = 0

Part (d)

The amortization expense shown on the income statement at the end of year 1 = 0