Question

Terry has traditionally purchased all of its manufacturing equipment. However, in 2020 they were unable to find a vendor willing to sell them a new $5,078,000 machine. After some careful negotiations, however, they were able to lease the needed equipment for 5 years. At the end of the lease Terry will have the option to purchase the equipment for $406,000, the estimated fair value at the end of the lease. They currently plan to exercise the option and keep the equipment at the end of the lease, but that could change if they find a better option.

The machine has an estimated economic life of 7 years with no salvage value. The payments on the lease will be $985,702. Terry does not know the implicit interest rate used by the vendor, but their incremental interest rate is 5.5%. The lease period began on May 1, 2020 and the first payment was made that day. Subsequent payments will be made each year and should be paid one day before the start date to ensure that no late penalties are accrued. In addition to the first payment, Terry paid $16,000 in legal and other lease origination fees on May 1, 2020.

Terry has decided to keep all of its accumulated depreciation in one account rather than create a separate account for leased assets

QUESTION: Make the appropriate journal entries, if any, to account for the lease (including any necessary changes to income tax expense) tax rate is 25%

Answer 1

Concept:-

Interest rate implicit in the lease:-

When the lessor gives an asset on lease (particularly on finance lease), the total amount, which he receives over a period by giving the asset on lease, includes the element of interest plus payment of principle amount of asset. The rate at which the interest amount is calculated can be simply called implicit rate of interest/implied int rate.

It is the discounted rate at which

Fair value of lease asset = P.V. (Mimimum lease payment + any residual value guaranteed to lessor)

Asset initial recognition:-

Fair value of the leased asset at the inception of lease, or

P.V OF Mnimum lease payment from the lessee point of view, whichever is lower.

P.V of 5.5.% for 5 years
End of year	P.V. of int factor	Periodic lease payment	P.V. of lease payments
1	0.947867299	9,85,702	9,34,315
2	0.898452416	9,85,702	8,85,606
3	0.851613664	9,85,702	8,39,437
4	0.807216743	9,85,702	7,95,675
5	0.765134354	9,85,702	7,54,194
	4.270284476	49,28,510	42,09,228
The leased asset should be recognized at p.v. of lease payments
Apportionment of Finance lease. Rate of interest @ 5.5%
	A (P.Y -D)	B	C	D (B-C)
Year	Liability	MLP	Finance charge @ 5.5% into lease liability	Principle amt of reduction
0	42,09,228	0	0	0
1	34,55,033.49	985702	2,31,507.54	7,54,194.46
2	26,59,358.33	985702	1,90,026.84	7,95,675.16
3	18,19,921.04	985702	1,46,264.71	8,39,437.29
4	9,34,314.69	985702	1,00,095.66	8,85,606.34
5	0.00	985702	51,387.31	9,34,314.69

In the books of Terry
Journal entry	Assuming year ending on december
May-1 2020	Equipment (Leased) A/c    Dr	42,09,228
	To Lease liability A/c		42,09,228
Dec 31, 2020	Lease liability A/c	7,54,194
	To A		7,54,194
Dec-31-2020	Depreciation a/C Dr	4,00,879
	To equipment (leased A/c)		4,00,879
	(4209228/7)*8/12
Dec-31-2020	Finance charge   A/c   Dr	1,54,338.36
	To A		1,54,338
	231508*8/12
April -31st 2021	Finance charge A/c	77,169.18
	To A		77,169
	231508*4/12
April -31st 2021	A    A/c	9,85,702
	To Cash		9,85,702