Question

2. (LESSEE ENTRIES FOR AN OPERATING LEASE).

Assume that Ace Leasing Company and King Company, a lessee, agreed to the lease shown below instead on the one shown in problem 1.

Commencement of Lease Date January 1, 2020

Annual lease payment due at the beginning of the year beginning with January 1, 2020 $137,171

Lease term 6 years

Economic life of leased equipment 10 years

Fair Value of asset at January 1, 2020 $950,000

Lessor’s Implicit Rate 12% Lessee’s incremental borrowing rate 12%

The asset will revert to the lessor at the end of the lease term. The lessee uses straight-line amortization for all leased equipment.

A. Is this an operating or financing lease to the Lessee? Explain.

B. Compute the Lease Liability to be recorded by the Lessee at inception of the lease and compute the ROU Asset to be recorded by the Lessee at inception. Based on those complete the two Lessee entries 1/1/2020.

C. Compute the yearly Lease Expense on King Company financial statements.

D. Compute the Interest Expense for the first two years.

E. Compute the ROU Asset Amortization for the first two years.

F. Prepare the remaining entries for December 31, 2020 (the end of the first year).

Answer 1

A. Lease classification under US GAAP is based on the below criteria. If any of these apply, then the lease is finance.

1. Transfers ownership of the property to lessee at the end of lease term - In this case, it does not

2. Lease contains a bargain purchase - in this case, it is not

3. Lease term is more than or equal to 75% of economic life of asset - in this case life is 10years, and term of lease is 6 years, so it does not meet this criteria

4. NPV of lease payments is more than or equal to 90% of Fair market value of the property. In this case, it does not (see calculations below)

Year	Lease payments	PVF @12%	PV
1	137171	0.892857	122,474
2	137171	0.797194	109,352
3	137171	0.71178	97,636
4	137171	0.635518	87,175
5	137171	0.567427	77,835
6	137171	0.506631	69,495
Total			563,966
FMV of asset			950,000
90% of FMV			855,000

Since none of the specified criteria are met, the lease is operating lease.

B. Lease liability to be recorded is the present value of the lease payments to be made over the lease term. ROU is the sum of Lease liability+any lease payments made prior to the commencement date + any initial direct costs incurred by lessee

The journal entry would be :

Right Of Use asset Dr 563,966

To Lease Liability 563,966

Lease Liability Dr 137,171

To Cash account 137,171

C. Yearly lease expense on the King company financial statements is the annual lease payment amount $137,171

D. Interest expense:

Year 1	Lease Liability	interest @12%
1	563,966	67,675.90
2	494,470.76	59,336.49

Balance in lease liability is determined as follows:

Opening balance - interest expense + payment made = 563,966+67,675.90-137,171 = 494,470.76

E. ROU Asset amortization for first two years:

Year 1	ROU	Credit	Balance
1	563,966	69,495.10	494,470.76
2	494,470.76	77,834.51	416,636.25

F. The journal entry to record the lease expense at the end of the year:

Lease expense Dr 137,171

To Lease Liability 67,675.90

To ROU 69,495.10