Question

On July 1, 2020, AMC entered into a lease agreement to lease specialty equipment for a 6-year term. Annual lease payments are $20,000, payable at the beginning of each lease year (July 1). At the end of the lease the leased asset will revert to the lessor. The asset’s economic life is estimated at 7 years. AMC could have obtained equivalent financing from its bank at a rate of 14%.

AMC’s fiscal year end is December 31. AMC uses straight-line amortization for its equipment.

Required:

1. Prepare the journal entry(ies) for AMC for the 2020 fiscal year related to the lease arrangement.
2. Compare and contrast the effect on financial statements if a lease is classified as an operating lease versus a capital lease.

Answer 1

a) Since the lease term which is 6 years covers the significant economic life of the leased asset(7 years), the lease should be classified as capital lease.(otherwise known as Finance lease).

Returning back of leased asset at the end of the lease term doesn’t alter the above conclusion.

Therefore, the lessor, AMC should recognize the leased asset in its books and provide for depreciation for the leased asset over the term of the lease

Asset should be recognized at the Present value of minimum lease payments discounted at the incremental borrowing rate i.e., 20000 per year for 6 years to be discounted at 14% bank incremental borrowing rate.

Years	Lease rentals	Present value factor @14% (1/(1.14)^n)	Present value
1	20000	1.00000	20,000.00
2	20000	0.87719	17,543.86
3	20000	0.76947	15,389.35
4	20000	0.67497	13,499.43
5	20000	0.59208	11,841.61
6	20000	0.51937	10,387.37
			88,661.62

Therefore asset should be recorded at $88662. And should be depreciated over the lease term.

Journal entries:

Date	Particulars	Debit	Credit
July 01,2020	Equipment a/c Dr	88662
	To Lease liability		88662
July 01,2020	Lease liability a/c Dr	20000
	To Bank a/c		20000
Dec 31, 2020	Finance cost a/c Dr	6206
	To Lease liability (88662*14% *6/12)		6206
Dec 31, 2020	Depreciation a/c Dr	7388
	To Equipment (88662/6 * 6/12)		7388

b. Compare and contrast the effect on financial statements if a lease is classified as an operating lease versus capital lease

If the lease is operating lease, only the lease rentals are booked as expense in the books of the lessee in the each year. The equipment will not be recognized in the books of AMC, the lessee. Only the rental expense, $20000 will be recognized for over lease term of 6 years, every year as an expense. There will be not any other effect on the Financials apart from the rental expense of $ 20000

IF the lease is capital lease, lessee AMC shall recognize the equipment asset in its books and shall recognize corresponding lease liability at Present value of minimum lease payments and accordingly recognize interest expense, depreciation in its books. The detailed entries to be posted are given in the point a.