Question

1.Carla Vista Corporation enters into an agreement with Yates Rentals Co. on January 1, 2021 for the purpose of leasing a machine to be used in its manufacturing operations. The following data pertain to the agreement:

(a) The term of the noncancelable lease is 3 years with no renewal option. Payments of $485042 are due on January 1 of each year.
(b) The fair value of the machine on January 1, 2021, is $1350000. The machine has a remaining economic life of 10 years, with no salvage value. The machine reverts to the lessor upon the termination of the lease.
(c) Carla Vista depreciates all machinery it owns on a straight-line basis.
(d) Carla Vista’s incremental borrowing rate is 10% per year. Carla Vista does not have knowledge of the 8% implicit rate used by Yates.
(e) Immediately after signing the lease, Yates finds out that Carla Vista Corp. is the defendant in a suit which is sufficiently material to make collectibility of future lease payments doubtful.

If the present value of the future lease payments is $1350000 at January 1, 2021, what is the amount of the reduction in the lease liability for Carla Vista Corp. in the second full year of the lease if Carla Vista Corp. accounts for the lease as a finance lease? (Rounded to the nearest dollar.)

A. $350042

B. $377042

C. $385046

D. $398546

2.On December 31, 2021, Sheridan, Inc. leased machinery with a fair value of $1825000 from Cey Rentals Co. The agreement is a 6-year noncancelable lease requiring annual payments of $350000 beginning December 31, 2021. The lease is appropriately accounted for by Sheridan as a finance lease. Sheridan’s incremental borrowing rate is 11%. Sheridan knows the interest rate implicit in the lease payments is 10%.

  The present value of an annuity due of 1 for 6 years at 10% is 4.7908.
  The present value of an annuity due of 1 for 6 years at 11% is 4.69590.

In its December 31, 2021 balance sheet, Sheridan should report a lease liability of

A. $1643565

B. $1676780

C. $1475000

D.. $1326780

Answer 1

1.
Carla Vista Corporation.
Financial Lease
Date	Annual Lease Payment (A)	Interest on Liability (B)	Reduction of Lease Liability A – B = (C)	Lease Liability (D)
Amt. in $	Amt. in $	Amt. in $	Amt. in $
01/01/2021	–	–	–	1,350,000
01/01/2021	485,042	–	485,042	1,350,000 – 485,042 = 864,958
01/01/2022	485,042	1,350,000 × 10% = 135,000	350,042	864,958 – 350,042 = 514,916
01/01/2023	485,042	864,958 × 10% = 86,496	398,546	514,916 – 398,546 = 116,370
The amount of the reduction in the lease liability for Carla Vista Corp. in the second full year of the lease = $350,042 ∴ The Correct Option is A.

2.
Sheridan. Inc.
Particulars	Amount. (in $)
Annual Payment	350,000
Present Value of Annual Payment	350,000 × 4.7908 = 1,676,780
Report of Lease Liability	1,676,780 – 350,000 = 1,326,780
Sheridan Inc. should report a lease liability of $1,326,780 in its December 31, 2021 Balance Sheet. ∴ The Correct Option is D.

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