Question

Tamarisk Steel Company, as lessee, signed a lease agreement for equipment for 5 years, beginning December 31, 2020. Annual rental payments of $61,020 are to be made at the beginning of each lease year (December 31). The interest rate used by the lessor in setting the payment schedule is 7%; Tamarisk’s incremental borrowing rate is 9%. Tamarisk is unaware of the rate being used by the lessor. At the end of the lease, Tamarisk has the option to buy the equipment for $5,000, considerably below its estimated fair value at that time. The equipment has an estimated useful life of 7 years, with no salvage value. Tamarisk uses the straight-line method of depreciation on similar owned equipment.

1. Prepare the journal entries, that Tamarisk should record on December 31, 2021.

2. Prepare the journal entries, that Tamarisk should record on December 31, 2022.

3. What amounts would appear on Tamarisk’s December 31, 2022, balance sheet relative to the lease arrangement?

Answer 1

Solution

Tamarisk Steel Company

1. Journal entries that Tamarisk should record on December 31, 2021:

Date	Account Titles and Explanation	Debit	Credit
31-Dec-21	Leased Equipment	$265,617
	Lease Liability	$265,617
	(to record inception of lease)
31-Dec-21	Lease Liability	$61,020
	Cash		$61,020
	(To record first lease payment)

Computations:

Present value of lease payments = (annual lease payment x present value of annuity due factor) + (residual value x present value factor)

Using the incremental borrowing rate for Tamarisk,

Present value of annuity due factor at 9% for 5 years = 4.2997

Present value of $1 at 9% ,year 5 = 0.6499

Annual lease payments = $61,020

Residual value = $5,000

Present value of lease payments = (61,020 x 4.2997) + (5,000 x 0.6499) = 262,368 + 3,249.50

= $265,617.20

Note – Since annual lease payment is made at the start of the year, the present value annuity due factor table value is used for 9% at 5 years.

2. Journal entries to be recorded on December 31, 2022:

Date	Account Titles and Explanation	Debit	Credit
31-Dec-22	Interest Expense	$18,414
	Lease Liability	$42,606
	Cash		$61,020
	(To record interest expense and annual lease payment)
31-Dec-22	Depreciation Expense	$52,123
	Accumulated Depreciation - Leased Equipment	$52,123
	(To record depreciation on leased equipment)

Computations:

Interest expense on Dec 31, 2022 –

= (265,617 – 61,020) x 9% = $18,414

Lease liability = 61,020 – 18,414 = $42,606

Lease liability balance = 265,617 – 61,020 – 42,606 = $161,991

Depreciation expense = (265,617 – 5,000)/5 = $52,123

3. What amount would appear on Tamarisk’s December 31, 2022 balance sheet relative to the lease arrangement:

Tamarisk Steel Company
Balance Sheet (Partial) at December 31, 2022
Property, Plant and Equipment
Leased Equipment	$265,617
Less: accumulated depreciation	$52,123	$213,494
Long-term Liabilities
Lease Liability	$161,991