Question

On January 2, 2020, Micheal (lessee) entered into a 10-year non-cancelable lease with Thomas (lessor) for equipment. The following facts relate to the transaction:

-The equipment has an estimated useful life of 13 years.

-There is no purchase option. Transfer of ownership to Michael is not stipulated in the lease contract.

-The fair value to Thomas (lessor) at the inception of the lease was $4,000,000. Lessor's cost was $3,775,000. Sales commissions were $2,500.

-Michael's incremental borrowing rate is 10%. The implicit annual rate in the lease (known to Michael) is 8%.

- Michael and Thomas use straight-line depreciation.

-The lease requires rental payments of $266,000, payable on 1/2/20 and subsequently on 6/30 and 12/31.

-Michael guarantees that Thomas will realize $200,000 from selling the asset at the end of the lease. The expected residual value is $120,000.

1. Refer to the original facts. However, also assume that Micheal had to pay semi-annual insurance premiums ranging from an estimated $800 to $2,100 and that Micheal incurred $2,400 to execute the lease. Discuss at what amount Micheal should record the ROU asset.

Given Tip: Credit Cash 2,400 for initial direct cost; executory costs are variable

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Answer 1

1	Present value of lease payment for leasee
	The lease liability and the ROU asset are measured on the commencement date using the Implicit rate of interest or incremenTotal borrowing rate(if implicit rate is not known)(i.e., 8% p.a. in this case) at lease commencement date . Lease liability is calculated by taking Present value of Lease payment less any incentive received and expected residual value(guaranteed) . Further any Initial direct cost be added ROU asset , if any. and variable lease payment(Insurance premiumin this case) to be excluded from calculation of lease liability. The lease liability is accounted for by the interest method subsequently and the ROU asset is subject depreciation on the straight-line basis over the lease term of 10 year.
	The leasee shall record the lease liability (Present value of Lease payment & expected residual value, as guaranteed ) & right in use asset in the given case. Implicit rate=8/2= 4%, for 20 terms. The calculation is as under
	Year	Payments (Cash flows)	Present Value Facr @4%p.a.	Discounted Cash flows/ Present value
	a	b	c	d=b*c
	1	$                    266,000.00	1	$                             266,000
	2	$                    266,000.00	0.96154	$                             255,769
	3	$                    266,000.00	0.92456	$                             245,932
	4	$                    266,000.00	0.88900	$                             236,473
	5	$                    266,000.00	0.85480	$                             227,378
	6	$                    266,000.00	0.82193	$                             218,633
	7	$                    266,000.00	0.79031	$                             210,224
	8	$                    266,000.00	0.75992	$                             202,138
	9	$                    266,000.00	0.73069	$                             194,364
	10	$                    266,000.00	0.70259	$                             186,888
	11	$                    266,000.00	0.67556	$                             179,700
	12	$                    266,000.00	0.64958	$                             172,789
	13	$                    266,000.00	0.62460	$                             166,143
	14	$                    266,000.00	0.60057	$                             159,753
	15	$                    266,000.00	0.57748	$                             153,608
	16	$                    266,000.00	0.55526	$                             147,700
	17	$                    266,000.00	0.53391	$                             142,020
	18	$                    266,000.00	0.51337	$                             136,557
	19	$                    266,000.00	0.49363	$                             131,305
Beg	20	$                    266,000.00	0.47464	$                             126,255
End	21	$                    120,000.00	0.45639	$                               54,766
	Total	$                      5,440,000		$                         3,814,394
	ROU asset will be
	Initial Lease liability	$               3,814,394
	Add: Initial direct cost	$                       2,400
	ROU asset	$               3,816,794
	Accordingly Micheal should record ROU asset at $38,16,794.
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