Question

On January 1, 2020, Winthrop Inc. entered into a lease agreement to lease equipment:

• 5-year lease term
• Annual lease payments are $10,000
• First payment is on January 1, 2020 and the other payments are on 31 December each year
• At the end of the lease the leased asset will revert to the lessor
• The asset’s economic life is estimated at 10 years
• Winthrop could have obtained equivalent financing from its bank at a rate of 5%
• Winthrop’s fiscal year end is December 31
• The equipment has a fair value of $70,000

Required:

1. Calculate the present value of the lease payments.
2. Prepare the amortization table.
3. Classify the lease agreement.
4. Prepare the journal entry(ies) for the lessee for the 2020 fiscal year related to the lease arrangement.

Answer 1

Given in question,

Number of periods	5
Incremental borrowing rate	5%
Rental payments (beginning of each year)	10,000

a) Present value of the lease payments (Discounted at 5%)

Year	Date	Lease	PVF @ 5%	PV	PVF
0	1-Jan-20	10,000	1.00	10,000	t=0 i.e. 1/(1+5%)^0
2	31-Dec-21	10,000	0.91	9,070	t=2 i.e. 1/(1+5%)^2	First payment is on January 1, 2020 and the other payments are on 31 December each year
3	31-Dec-22	10,000	0.86	8,638	t=3 i.e. 1/(1+5%)^3
4	31-Dec-23	10,000	0.82	8,227	t=4 i.e. 1/(1+5%)^4
5	31-Dec-24	10,000	0.78	7,835	t=5 i.e. 1/(1+5%)^5
			Lease liability	43,771

Notes for student

Discount Rate for the Lease
For a lessee, the discount rate for the lease is the rate implicit in the lease unless that rate cannot be readily determined. In that case, the lessee is required to use its incremental borrowing rate.

Incremental Borrowing Rate
The rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.

b) Lease amortization table

Date	Lease Payment	Interest @ 5%	Principal	Lease Liability
1-Jan-20				43,771
1-Jan-20	10,000		(10,000)	33,771
31-Dec-20		1,689 [33,771 X 5%]	-	35,460
31-Dec-21	10,000	1,773 [35,460 X 5%]	(8,227) [1,773 - 10,000]	27,232 [35,460 - 8,227]
31-Dec-22	10,000	1,362	(8,638)	18,594
31-Dec-23	10,000	930	(9,070)	9,524
31-Dec-24	10,000	476	(9,524)	-

c) Classification of lease

This lease is an operating lease for the following reason:

• The lease does not transfers ownership of the equipment to the lessee by the end of the lease term.
• The lease does not grant an option to purchase the equipment.
• The lease term is not for the major part of the remaining economic life (10 years) i.e. lease covers only 50% of the economic life of the underlying asset
• The present value of the sum of the lease payments (i.e. $43,771) is lower than the fair value (i.e. $70,000 as provided in the question).

If any one of the above condition was satisfied then the lease would be a finance lease.

d)  Journal entries for the lessee for the 2020 fiscal year related to the lease arrangement

Date	Particulars	Dr/Cr	Debit	Credit
1-Jan-20	Right-of-use Asset	Dr	43,771
	Lease liability	Cr		43,771
1-Jan-20	Lease liability	Dr	10,000
	Bank	Cr		10,000
31-Dec-20	Lease expense	Dr	10,000		In operating lease - Right-of-use asset is not amortized like in finance lease - it is accounted as Lease expnse
	Lease liability	Cr		1,689	From lease amortisation table [Interest of year 1 accrued on 31 December 2020]
	Right-of-use Asset	Cr		8,311	[Plug variable i.e. 10,000 - 1,689]