Question

1. On January 1, 2020, Hawkeye Air leased a new airplane for a term of 8 years. The expected life of the airplane is 20 years. There are no rights to purchase the asset at the end of the term, no bargain purchase option, and no residual value guarantee. The lease stipulates that Hawkeye Air makes annual payments of $550,000 beginning at the end of the first year (December 31, 2020). Hawkeye Air has an incremental borrowing rate of 6% and the fair market value of the airplane on January 1, 2020, is $6,250,000 (for simplicity, assume the lessor’s implicit rate is greater than 6%).

a. What journal entries related to the lease arrangement should be recorded during 2020 (assume Hawkeye Air’s fiscal year-end is December 31).

b. Identify any effects the lease arrangement and the associated reporting would have on the balance sheet, income statement, and statement of cash flows for 2020.

c. What is the annual lease payment that results in a present value of minimum lease payments equal to 90% of the fair market value of the airplane ($6,250,000)?

Answer 1

A) Journal entries relating to lease agreement :-

Date	Particulars	Debit Amt	Credit Amt
Dec 31st,2020	Lease Rent expense Dr Cash.   Cr (Lease payment made and expense charged)	$550,000	$550,000

B)

Effect of lease arrangement on balance sheet,income statement and statement of cash flows for 2020:-

1.Effect on balance sheet:

Assets side decreases to due to lease payment by cash(cash balance reduces decreasing asset side)

2.Effect on Income statement:-

There will be an increase in operating expenses which results in decrease of Net income.

3.Effect on Cash flow statement:-

Cash flow of lease payments recorded in cash flows of operating activities .Thus leading to increase in cash outflow of lease payment.

C)

Annual lease payment that results in a present value of minimum lease payments equal to 90% of the fair market value of the airplane ($6,250,000):-

90% of 6,250,000= Annual lease payment× [PVIFA(6%,10yrs)]

5,625,000= Annual lease payment× 7.360

Annual lease payments= 5,625,000÷7.360

=$764266.30

The Annual lease payment which gives the present value of minimum lease payment equal to 90% of Fair market value of asset is $764,266

Note:- Present value interest factor for annuity(PVIFA) refers to the present value of the series of the annuity cashflows to be received in future.