Question

On January 1, 2015 IBM leases an equipment from Omaha Inc. for an annual lease rental of $20,000. The lease term is five years and the lessor's interest rate implicit in the lease is 8%. The lessee's incremental borrowing rate is 8.25%. The useful life of the equipment is five years and its estimated residual value equals its removal cost. Annuity tables indicate that the present value of an annual lease rental of $1 (at 8% rate) is $3.993. The fair value of leased equipment equals the present value of rentals. (Assume the lease is capitalized.) Required: Prepare IBM’s accounting entries for 2015. Compute and illustrate the effect on the income statement for the year ended December 31, 2015, and for the balance sheet as of December 31, 2015. Construct a table showing payments of interest and principal made every year for the five-year lease term. Construct a table showing expenses charged to the income statement for the five-year lease term if the equipment is purchased. Show a column for (1) amortization, (2) interest, and (3) total expenses. In one paragraph, discuss the income and cash flow implications from this capital lease.

Answer 1

Solution:

Preparing the IBM's Accounting Entries for 2015:

Date	General Journal	Debit	Credit
1/1/2015	Enter into Lease Contract
	Leased Property Under Capital Leases	$79,860
	Lease Obligation Under Capital Leases		$79,860
12/31/2015	Payment of Rental
	Interest on Leases	$6,388.801
	Lease Obligaitons Under Capital Leases	$13,611.20
	Cash		$20,000
	Amortization of Property Rights
	Amortaization of Leased Property under Capital Leases	$15,9722
	Leased Property under Capital Leases		$15,972

Calculation and Illustration of the Effect on the Income Statement for the Year Ended December 31, 2015, and for the balance sheet as of December 31, 2015:

Balance Sheet December 31, 2015
Assets		Liabilities
Leased Property Under Capital Leases	$63,888	Lease Obligations under Capital Leases	$66,248.80

Income Statement For Year Ended December 31, 2015
Amortization of leased property	$15,972
Interest on leases	$6,388.80
Total lease‑related cost for 2015	$22,360.80

Constructing a Table showing payments of interest and principal made every year for the five-year lease term:

Payments of Interest and Principal
Year	Total Payment	Interest at 8%	Payment of Principal	Principal Balance
				$79,860.00
1	$20,000	$6,388.80	$13,611.20	$66,248.80
2	$20,000	$5,299.90	$14,700.10	$51,548.70
3	$20,000	$4,123.90	$15,876.10	$35,672.60
4	$20,000	$2,853.80	$17,146.20	$18,526.40
5	$20,000	$1,482.10	$18,526.40	-
	$100,000	$20,148.50	$79,860.00

Constructing a Table showing expenses charged to the income statement for the five-year lease term if the equipment is purchased:

Expenses to Be Charged to Income Statement
Year	Lease Expense	Amortization	Interest	Total Expenses
1	$20,000	$15,972	$6,388.80	$22,360.80
2	$20,000	$15,972	$5,299.90	$21,271.90
3	$20,000	$15,972	$4,123.90	$20,095.90
4	$20,000	$15,972	$2,853.80	$18,825.80
5	$20,000	$15,972	$1,482.10	$17,454.10
	$100,000	$79,860.00	$20,148.50	$100,000

Discussing the income and cash flow implications from this capital lease:

Income and Cash Flow Implications from the Capital Lease are in the Part c and Part d. The student should note that reported expenses exceed the cash flows in earlier years, while the reverse occurs in later years.