Question

A Lessee enters into a 3-year lease contract to lease a computer with annual lease payments of $10,000 to be paid at the ending of each year. Lessee's borrowing rate is 10%. Answer each question independently. Assume a straight line depreciation method to calculate depreciation expense.

Present value of an ordinary annuity of $1: PVF-OA (3,10%) = 2.48685

A) If this is classified as a capital lease, compute interest expense and depreciation expense that the lessee should recognize in the income statement for the first year.

B) If this lease is classified as an operating lease, the lessee would report $10,000 as lease expense. Based on your answer to a), what type of lease (operating or capital lease) does the lessee prefer if the lessee wants to report a higher net income for the first year?

Answer 1

Lease term = 3 years

Annual lease payment at the end of each year = $10000 Lease borrowing rate = 10%

Present value of ordinary annuity = 2.48685

Then Present value of lease liability :-

= Annual lease payment× annuity factor (3yrs, 10%)

= $10000×2.48685

= $24868.50

A) $24868.50 shall be the amount at which the lessee shall record the asset at the inception of the lease (under capital lease option).

Hence, interest expense at 1st year end

= $24868.50×10%

= $2486.85

And depreciation expense for first year

= $24868.50 ÷ 3years

= $ 8289.50

Total amount debited to income statement in the first year in this case shall be

= interest expense + dep. Expense

=$2486.85 + 8289.50

=$10776.35

B)If this lease is classified as an operating lease, the lessee would report $10,000 as lease expense and this $10000 shall be debited to income statement.

Hence, under capital lease option total debit to income is $10776.35 (as calculated above) and under operating lease option it is $10000 as there shall be no interest/dep. Expense under operating lease.

Therefore if the lessee wants to report higher net income in the first year of lease then he should adopt operating lease option as debiting $10000 as expense rather than $10776.35 would lead to lesser expense and higher net income.

Note:- tax rate not given in question and hence the same is not considered.