Question

Entity A leased a machine on January 1, 2018, from LeaseCo for a four-year period. The lease agreement calls for annual payments in the amount of $360,000 on January 1, 2018 and on December 31 of each year beginning on December 31, 2018. The machine's estimated useful life is expected to be four years with no residual value. The appropriate interest rate for this lease is 12%.

1. Calculate the amount to be recorded as a right-of-use asset and the associated lease liability.

2. Using Excel, prepare an amortization schedule for this lease.

	Payments	Effective Interest	Decrease in Bal.	Balance
1
2
3
4

3. Prepare the journal entries at inception of the lease and for the first year (2019).

4. Now assume that the appropriate interest rate for this lease is 8%. Perform steps (1) and (2) again and comment on differences.

5. If this were an operating lease, how would the expense of the lease be reflected in the income statement? Would it be the same each year?   When would you expect the total lease expense to be greater with a finance lease?

Answer 1

1. Calculate the amount to be recorded as a right-of-use asset and the associated lease liability.
PV of an annuity due of $1, n=3, i=12% = 2.40183
PV of payments $360,000 * 2.40183= $864,659.26
Total value = $864,659.26+360,000 =$1,224,659.26

2. Using Excel, prepare an amortization schedule for this lease.

	Payments	Effective Interest	Decrease in Bal.	Balance
	1,224,659.26			1,224,659.26
1	360,000.00	-	360,000.00	864,659.26
2	360,000.00	103,759.11	256,240.89	608,418.37
3	360,000.00	73,010.20	286,989.80	321,428.57
4	360,000.00	38,571.43	321,428.57	-

3. Prepare the journal entries at inception of the lease and for the first year (2019).
December 31, 2018:
Leased asset 1,224,659.26

     Lease payable   1,224,659.26

Lease payable     360,000
         Cash   360,000
December 31, 2019:
Interest expense   103,759.11
Lease payable       256,240.89
                           Cash 360,000
Depreciation expense($1,224,659.26/4)    306,165
          Accumulated depreciation                   306,165

4. Now assume that the appropriate interest rate for this lease is 8%. Perform steps (1) and (2) again and comment on differences.

Step-1:
PV of an annuity due of $1, n=3, i=8% = 2.5771
PV of payments $360,000 * 2.5771= $927,755
Total value = $927,755 +360,000 =$1,287,755
Step-2:

	Payments	Effective Interest	Decrease in Bal.	Balance
	1,287,754.92			1,287,754.92
1	360,000.00	-	360,000.00	927,754.92
2	360,000.00	74,220.39	285,779.61	641,975.31
3	360,000.00	51,358.02	308,641.98	333,333.33
4	360,000.00	26,666.67	333,333.33	-

If interest rate decreased to 8% then, the value of the increase that means we are paying more.

5. If this were an operating lease, how would the expense of the lease be reflected in the income statement? Would it be the same each year?   When would you expect the total lease expense to be greater with a finance lease?
The lease rental payments are simply treated as operating expenses and directly charged to the profit and loss account.
Yes, it will be same for each year.
As we expect, as the lessee makes lease payments, the amount of the lease liability will decrease.

There will be a difference between the amount of the lease payments and the initial liability recorded by the lessee, and this will represent the interest element as well as the depreciation expenses.

As the lessee makes the lease payments (or rental payments) the payment will be made up of both a repayment of the principal (the lease liability), and an interest cost (finance charge).

This finance charge will be treated as a cost of finance in the income statement.

Once the leased asset and lease liability has been recognized in the financial statement, then it will come under finance lease and the ownership of the asset will be the entity.
Here, the repayment of the principal will reduce the unpaid lease liability and the asset should be depreciated over its expected useful life.

.