Question

Company A (the lessee) enters into a 5-year, noncancelable lease with Company B for non-specialized manufacturing equipment to be used in its operations. Information related to the lease are as follows:

            Fair value of equipment                                      $800,000

            Company A’s incremental borrowing rate               5%

            Company B’s implicit rate (known)                             4.5%

            Residual of equipment at end of lease

              (guaranteed by Company A)                        $100,000

            Economic life of equipment                              8 years

            Lease payment schedule

                At inception                                                        $  40,000

                At end of year 1                                                $  65,000

                At end of year 2                                                $  80,000

                At end of year 3 – 5                                          $100,000

            Present value of lease payments @ 4.5%       $507,611

            Present value of lease payments @ 5%          $499,827

1.         What type of lease is this for Company A?

2.         What entries would Company A make for the first two years of this lease?

Answer 1

Answer to Part 1

Finance lease is also known as capital lease.

The charecteristics of Financial lease is as below:

A Finance lease is a long-term and non cancelable lease.

A financial lease allows the lessee to have a purchase option at less than the fair market value of the asset.

Risk and Reawrds related to asset are with the lessee.

In the given question Company A entered into a lease which is noncancelable with Company B so it is a Finance lease.

Answer to part 2

If lessor's implicit interest rate is available, we have to consider the implicit interest rate.

In the given question Company B's interest rate is 4.5%.

Present value of lease payments @4.5% is $507,611

The right of use asset and lease liability of the Company A is $507,611

Note : For referance purpose i have attached below calculation how $507,611 arrived.

Table of lease liability repyment is as below.

Entries in the books of Company A

Year 1

Capitalising the asset

Debit Right of use Asset $507,611

Credit Lease Libility $507,611

Being Asset and liability recognised in the books of Company A

Lease Payment

Debit Lesae Liablity $65,000

Credit Cash $65,000

Being amount of Lease payment paid for First year.

Interest Expenses

Debit Interest Expenses $21,035

Credit Lease Liability $21,035.

Being interest expenses recognised in income statement.

Amortization expenses

Debit Amortization expenses $63,451 ($507,611/8)

Credit Right of use Asset $63,451.

Being asset is amortized over a period of 8 years and recognised for first year.

Year 2

Lease Payment

Debit Lesae Liablity $80,000

Credit Cash $80,000

Being amount of Lease payment paid for First year.

Interest Expenses

Debit Interest Expenses $19,056

Credit Lease Liability $19,056

Being interest expenses recognised in income statement.

Amortization expenses

Debit Amortization expenses $63,451 ($507,611/8)

Credit Right of use Asset $63,451.

Being asset is amortized over a period of 8 years and recognised for second year.