Question

Lessee enters into a three-year lease of equipment and concludes that the agreement is a finance lease because the lease term is for a major part of the remaining economic life of the underlying asset (also three years). In addition, Lessee pays initial direct costs of $3,000. Also, assume that Lessee has guaranteed the residual value of the equipment at the end of the lease term, has concluded that it is probable that Lessee will owe $6,000 to Lessor as a result of that residual value guarantee. The arrangement provides the following:

Lease term	Three years
Annual payments, beginning at the end of year one and annually thereafter	Year 1 – $20,000 Year 2 – $24,000 Year 3 – $28,000
Discount rate	4.235%
PV of lease payments	$66,000

• Complete the following schedule to show the impact on the income statement and balance sheet.

	Initial	Year 1	Year 2	Year 3
Cash lease payments
Cash payments for initial direct costs
Cash payments for RVG
Income statement:
Lease expense recognized:
Interest expense
Amortization expense
Total periodic expense
Balance sheet:
ROU asset (including unamortized initial direct costs and RVG)
Lease liability

• Prepare the journal entries at the time of the lease commencement and for Year 1 of the lease term.

Answer 1

	Initial	Year 1	Year 2	Year 3
Cash lease payments	$               -	$         20,000	$      24,000	$       28,000
Cash payment for initial direct cost	$         3,000	$                 -	$               -	$                -
Cash payment for RVG	$               -	$                 -	$               -	$         6,000

Income statement
Lease expense recognized	Year 1	Year 2	Year 3
Interest expense	$         3,020	$           2,300	$         1,380
Amortization expense	$      24,767	$         24,767	$      24,767
Total periodic expense	$      27,787	$         27,067	$      26,147

Balance sheet -

Working note -

Year	Interest	Instalment paid	Repayment of principal	Balance
0				$       71,300
1	$         3,020	$         20,000	$      16,980	$       54,320
2	$         2,300	$         24,000	$      21,700	$       32,620
3	$         1,380	$         34,000	$      32,620	$                 0

Right of use asset
PV of lease payment	$ 71,300.00
Initial direct cost	$   3,000.00
	$ 74,300.00

ROU asset - $74300

Lease liability - $71,300

Journal entries at the time of lease commencement -

Date
	Right of use asset	$74,300
	Lease liability		$71,300
	Cash		$3,000
	[To record lease liability]

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