Question

Krause Company on January 1, 2018, enters into a ten-year noncancelable lease, for equipment having an estimated useful life of 10 years and a fair value to the lessor, Daly Corp., at the inception of the lease of $4,000,000. Krause’s incremental borrowing rate is 8%. Krause uses the straight-line method to depreciate its assets. The lease contains the following provisions: 1. Rental payments of $292,000 including $26,000 for property taxes, payable at the beginning of each six-month period. 2. A guaranteed residual value of $200,000 is expected at the expiration of the lease. Instructions (a) What kind of lease is this to Krause Company? (b) What is the present value of the minimum lease payments? (PV factor for annuity due of 20 semi-annual payments at 8% annual rate, 14.13394; PV factor for amount due in 20 interest periods at 8% annual rate, .45639.) (Round to nearest dollar.) (c) What journal entries would Krause record during the first year of the lease?

Answer 1

b)

Present value of Minimum lease payments:

$

$

Semi-annual payments,net of property taxes

(292000-26000)

266000

Present value @ 4% For 20 years *

14.13394

3759628

Guaranteed residual value

200000

Present value @ 4% For 20th year

0.45639

91278

Present value of Minimum lease payments

3850906

*

Incremental borrowing rate=8%

Lease is payable semi-monthly, Interest per lease period=8*1/2=4%

Total semi-monthly period=10 years*2 semi-annual periods per year=20 semi-annual periods

lease is payable at the beginning of the period

Hence, while computing present value,PV factor for the first period will be 1.

For the next priod will be PV factor for first year

For the next priod will be PV factor for second year and so on

a)

This lease is a capital lease since

Lease term (10 years) covers more than 75% of the useful life (10 years) of equipment

Present value of minimum lease payment ($ 3850906) covers more than 90% of fair value of equipment ($ 4000000)

c)

Date

Account titles and explanation

Debit

Credit

2018

Jan 1.

Leased equipment

3850906

Lease liability

3850906

(Capital lease recorded)

Lease liability

266000

Property taxes

26000

Cash

292000

(lease payment recorded)

July 1.

Lease liability

122604

Property taxes

26000

Interest

(3850906-266000)*4%

143396

Cash

292000

(lease payment recorded)

Dec 31.

Depreciation expense

385091

Accumulated depreciation

385091

(3850906/10)

(Depreciation recorded)

Interest expense

138492

Interest payable

138492

(3850906-266000-122604)*4%

(Interest accrued)