Question

1. Lessee enters into a five-year lease of office space on January 1, and concludes that the agreement is an operating lease. Lessee pays initial direct costs of $5,000. The agreement provides the following:

Lease term	Five years, with the first payment due at lease commencement and the remainder annually at the lease anniversary date thereafter
Annual payments, beginning at lease commencement and annually thereafter	Commencement – $25,000 Year 2 – $26,000 Year 3 – $27,000 Year 4 -- $28,000 Year 5 -- $29,000
Discount rate	4.0%
Present value (PV) of lease payments	$124,645

Complete the following table to show the impact on each year of Lessee’s income statement and balance sheet. Prepare the journal entries for the Lessee at the commencement of the lease and at the end of year 1.

	Initial	Year 1	Year 2	Year 3	Year 4	Year 5
Cash lease payments	$5,000	25,000	26000	27,000	28,000	29,000
Income statement:
Periodic lease expense (straight-line)
Prepaid (accrued) rent for period		29,000
Balance sheet at end of year:
Lease liability		25,000
ROU asset:
Lease liability
Adjust: Accrued rent (cumulative)
Unamortized direct initial costs
ROU asset

Subject Financial Accounting

Answer 1

Disclaimer -

1. If the Lease is an operating lease, then ROU and Lease Liability can not be created because in operating lease, lease rental costs and finance costs are impacted.

2. Initial Direct Costs are assumed to be apportioned on straight line basis, i.e. $ 1,000 p.a irrespective of discounting impact because PV of lease payments have been given as $124,644 in the question which is possible only after ignoring Initial Direct Costs.

Particulars	Initial	Year 1	Year 2	Year 3	Year 4	Year 5	Remarks
Cash Lease Payments	5,000	25,000	26,000	27,000	28,000	29,000	Given in question
Income Statement
Periodic Lease Expense (Straight Line)		25,929	25,929	25,929	25,929	25,929	(PV of lease payments/5) + 1000. Kindly Refer Disclaimer 2 given by me
Prepaid (Accrued) Rent for the period		29,000	29,000	29,000	29,000	29,000	Rent paid in beginning + Unamortised Direct Initial Costs
Balance Sheet at the end of year
Lease Liability							NA as per Disclaimer 1 given by me
ROU Asset:
Lease Liability							NA as per Disclaimer 1 given by me
Adjust: Accrued Rent (Cumulative)		25,929	25,929	25,929	25,929	25,929	(PV of lease payments/5) + 1000. Kindly Refer Disclaimer 2 given by me
Unamortised Direct Initial Costs		4,000	3,000	2,000	1,000	-
ROU Asset							NA as per Disclaimer 1 given by me

Workings
Year	Payment	Discount Rate	PV	Interest
0	25,000	4.00%	25,000	-
1	26,000	4.00%	25,000	1,000
2	27,000	4.00%	24,963	2,037
3	28,000	4.00%	24,892	3,108
4	29,000	4.00%	24,789	4,211
	135,000		124,644	10,356

	Journal Entries
	In the Books of Lessee
Date	Particulars	Dr/Cr.	Dr ($)	Cr ($)
1 Jan	Prepaid Rent A/c	Dr	5,000
	To Bank A/c	Cr		5,000
	(Being Initial direct costs paid)
1 Jan	Prepaid Rent A/c	Dr	25,000
	To Bank A/c	Cr		25,000
	(Being Lease payment made in advance)
31 Dec	Finance Cost A/c	Dr	1,000
	To Prepaid Rent A/c	Cr		1,000
	(Being finance cost booked after which Prepaid rent is $29,000 for Year 1)
31 Dec	Lease Rent A/c	Dr	25,929
	To Prepaid Rent A/c	Cr		25,929
	(Being lease rental booked)