Question

On January 1, 2020, a machine was purchased for $900,000 by Young Co. The machine is expected to have an 8-year life with no salvage value. It is to be depreciated on a straight-line basis. The machine was leased to St. Leger Inc. for 3 years on January 1, 2020, with annual rent payments of $150,955 due at the beginning of each year, starting January 1, 2020. The machine is expected to have a residual value at the end of the lease term of $562,500, though this amount is unguaranteed.

a. How much should Young report as income before income tax on this lease for 2020?

b. Record the journal entries St. Leger would record for 2020 on this lease, assuming its incremental borrowing rate is 6% and the rate implicit in the lease is unknown.

c. Suppose the lease was only for one year (only one payment of the same amount at commencement of the lease), with a renewal option at market rates at the end of the lease, and St. Leger elects to use the short-term lease exception. Record the journal entries St. Leger would record for 2020 on this lease.

Answer 1

Part 1

Annual rent revenue	$        150,955
Less: Depreciation expense (900000/8)	$        112,500
Income before income tax	$          38,455

Part 2

Year	PV factor @6%	PVA factor @6%
1	1.00000	1.00000
2	0.94340	1.94340
3	0.89000	2.83339
Lease liability (150955*2.83339)		$ 427,714

Lessee
Lease Amortization Schedule
Date	Annual Lease Payment	Interest on Liability	Reduction of Lease Liability	Lease Liability
January 1, 2020				$     427,714
January 1, 2020	$     150,955		$       150,955	$     276,759
January 1, 2021	$     150,955	$     16,606	$       134,349	$     142,410
January 1, 2022	$     150,955	$       8,545	$       142,410	$                  0
Interest on Liability = Beginning Lease Liability * 6%
Reduction of Lease Liability = Annual Lease Payment - Interest on Liability
Lease Liability = Beginning Lease Liability - Reduction of Lease Liability

Lessee
Journal entries
Date	Accounts title	Debit	Credit
January 1, 2020	Right of use Asset	$        427,714
	Lease liability		$      427,714
	(To record the lease)
January 1, 2020	Lease liability	150,955
	Cash		150,955
	(to record Lease liability paid)
December 31, 2020	Interest expense	16,606
	Lease liability		16,606
	(To record accrued interest expense.)

Part 3

Lessee
Journal entries
Date	Accounts title	Debit	Credit
January 1, 2020	Prepaid rent	$        150,955
	Cash		$      150,955
	(To record the prepaid rent)
December 31, 2020	Rent expense	$        150,955
	Prepaid rent		$      150,955
	(To record the expired the prepaid rent)