Question

Rebecca Company acquired an equipment on a 10-year non‑cancelable lease on January 1, 20X1. There were annual lease payments of $100 at the end of each of the ten years. The market interest rate was 10% compounded annually. Assume that the lease year coincides with the fiscal year. Present value of $1 annuity (n=10, i=10%) = 6.1446. Note that the useful life of the equipment is 12 years.

1. According to GAAP, is the above lease a capital or an operating lease? Why?
2. Irrespective of your answer to part 1, assume that the lease is a capital lease. Show the entries that the company will make at the inception of the lease and during the first two years of the lease term. (Use straight-line amortization method)

Answer 1

(1) According to GAAP, is the above lease a capital or an operating lease? Why?

Under US GAAP

lease is qualified as capital lease if....

• lease trasfer substantially all risk and reward incidental to nature of ownership
• term of lease cover atleast 75% of useful life of asset
• Present value of lease payment is greater than or equal to 90% of fair value of lease asset
• lessee has option to purchase lease asset at end of lease term

Lease is operating lease if....

• is for short term
• cancelable at option of both lessor and lessee
• do not transfer ownership of underlying asset
• repairing and maintenance expense is on lessor

in the present case lease term cover more than 75% of useful life of the asset (i.e. 83.33%) and lease is non cancellable too.hence lease must be capital lease as per US GAAP provisions

(2) entries that the company will make at the inception of the lease and during the first two years of the lease term.

SR no	Particular	Dr	Cr
1	At inception of lease
	equipment (WN 1)	614
	To lease liability		614
	(asset and liability recognised at pv of minimum lease payment)
2	At the end of first year
	Inetrest expense (WN 2)	61
	Lease liabilty (100-61)	39
	To Cash		100
	(lease rent paid)
3	Depreciation	61
	equipment		61
	(depreciation exp. Recognized over lease term) (614/10)
4	At the end of Second year
	Inetrest expense (WN 2)	58
	Lease liabilty (100-58)	42
	To Cash		100
	(lease rent paid)
5	Depreciation	61
	equipment		61
	(depreciation exp. Recognized over lease term) (614/10)

(WN 1)

PV of minimum lease payment	lease rent x Present value of $1 annuity (n=10, i=10%)
=	100 x 6.1446
=	614

(WN 2)

Year	Opening balance	interest	payment	Closing bal
A	B	C	D	B+C-D
1	614	61	100	575
2	575	58	100	533
3	533	53	100	486
4	486	49	100	435
5	435	43	100	378
6	378	38	100	316
7	316	32	100	248
8	248	25	100	173
9	173	17	100	90
10	90	9	100	-1