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 $28,800 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 $195,000.
• 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

a. To be classified as an financing lease the following conditions needs to be met:

i. the lease term should cover atleast 75% of the total useful life of asset or

ii. the lessee should get an option to buy the asset at the end of lease term

iii. the asset should get transferred to the lessee after the completion of lease term

Since none of them applies to this particular scenario this is an Operating lease.

b. Since this is an Operating expense, the total lease expense will be the annual payments that needs to be made. So the lease expense for year 1 will be $28,800.

c. In case of Operating lease only the lease expense is shown on the income statement which includes the interest expense. Just like a rent expense is shown. So there will be no interest expense shown separately.

d. Since the Asset ownership is not going to be transferred to the lessee. There will be no amortization expense showed by him. However the lessor will be recording $19,500 as depreciation expense in his books.