Question

On January 1, 2021, Rick’s Pawn Shop leased a truck from Corey Motors for a six-year period with an option to extend the lease for three years. Rick’s had no significant economic incentive as of the beginning of the lease to exercise the 3-year extension option. Annual lease payments are $14,000 due on December 31 of each year, calculated by the lessor using a 7% discount rate. Assume that at the beginning of the third year, January 1, 2023, Rick’s had made significant improvements to the truck whose cost could be recovered only if it exercises the extension option, creating an expectation that extension of the lease was “reasonably certain.” The relevant interest rate at that time was 8%. (FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.) Required: 1. Prepare the journal entry, if any, at the beginning of the third year for the lessee to account for the reassessment. 2. Prepare the journal entry, if any, at the beginning of the third year for the lessor to account for the reassessment.

Answer 1

1.

No.	Date	General Journal	Debit	Credit
1	Jan 1 , 2023	Right of use asset	25,469
		Lease Payable		25,469

January 1, 2021

Lease payable ($14,000 x 4.7665)*

*<present value of an ordinary annuity of $1: n=6 i=7%>

December 31, 2021

Interest expense (7% x $66731) = 4,671.17

Amortization expense ($14,000 - 4,671.17) = 9,328.83

In an operating lease, the lessee records interest the normal way (at the effective interest rate) and then "plugs" the right-of-use asset amortization at the amount is needed for interest plus amortization to equal the straight-line lease payment. The lessee records that amount as a single lease expense in the income statement.

December 31, 2022

Interest expense (7% x ($66,731 - 9,328.83]) = 4,018.15

Amortization expense ($14,000 - 4018.15) = 9,981.85

January 1, 2023 Reassessment:

*PV of remaining 7 payments, discounted at 8% ($14,000 x 5.2064)............ $72,889.6

Liability balance after 2 years ($66,731 - 9328.83 - 9981.85).................................... 47,420.32

Increase in balance ..............................................................................$25,469

Also, lessees are required to reassess the classification of a lease when there is a change in the lease term (or a change in the assessment of a lessee option to purchase the underlying asset). Because, with the assumed renewal,the lease term is for the entire useful life of the asset, it would be considered a finance lease rather than an operating lease as previously classified. As a result, we had an operating lease for two years, and now have a seven-year finance lease. So, amortization of the right-of-use asset will be a straight-line allocation of the balance in that account at this point (($66,731 - 9328.83 - 9981.85) + $25,469) = $72,889.6 over the next seven years.

December 31, 2023

Interest expense (7% x $72,889.6) = 5,102.27

Amortization expense ($72,899.6/7 years) = 10,412.8

2.

No.	Date	General Journal	Debit	Credit
2		No entry

A lessor is never required to reassess the lease term.  

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