Question

Assume that on January 1, 2020, Kroger Corp. signs a 6-year, non-cancelable lease agreement to lease a storage building from Trancoso Company. The following information pertains to this lease agreement:

1. The agreement requires equal rental payments of $35,000 beginning on December 31, 2020.

2. The fair value of the building on January 1, 2020, is $195,000.

3. The building has an estimated economic life of 12 years, an unguaranteed residual value of $5,000, and an expected residual value of $1,000. Kroger depreciates similar buildings on the straight-line method.

4. The lease is nonrenewable. At the termination of the lease, the building reverts to the lessor.

5. The lessor's implicit rate is 6%, which is known by Kroger.

questions: (1) Determine whether this is a finance or operating lease. Clearly document your rationale and show all necessary calculations. (2) Prepare the journal entries on the lessee's books to reflect the signing of the lease agreement and to record the payments and expenses related to this lease for the years 2020, 2021, and 2022. Kroger's fiscal year-end is December 31.

Answer 1

Lease can be two type: Finacial and operational; accounting treatment is differ for both type of lease. So we have to check whether lease fulfill any condition financial lease, otherwise it will treated as operational lease.

here we will check:

S. No.	Condition	Fullfill
1	The asset transfers to the lessee at the end of the lease term.	NO
2	The lessee has an option to purchase the asset from the lessor at below than fair value	NO
3	The lease term is for a significant part of the asset’s useful economic life - 75%	NO
4	The present value of future lease payments amounts to substantially all of the asset’s fair value - 90%	NO
5	The leased asset is specialised in nature, and may only suit the needs of the lessee without major modification - exclusive use	NO

Working:

Present value
Year	Amount	Discounting factor @ 6%	Net present Value
1	35,000.00	0.9433962	33,018.87
2	35,000.00	0.8899964	31,149.88
3	35,000.00	0.8396193	29,386.67
4	35,000.00	0.7920937	27,723.28
5	35,000.00	0.7472582	26,154.04
6	35,000.00	0.7049605	24,673.62
			172,106.35

	Amount in $
Assets Present Value	195,000
90% of present value	175,500

present value is less tahn 90% ; Assets life is 12 years and cover only 6 years so 75% criteria not met

None of condition is fulfilled so it will be a Operational lease.

Journal entries are as under:

Date	Accounts Title & Explanation	Debit	Credit
Dec. 31, 2020	Lease Expense	35,000.00
	Cash		35,000.00
	(Payment for Buiding lease)
Dec. 31, 2021	Lease Expense	35,000.00
	Cash		35,000.00
	(Payment for Buiding lease)
Dec. 31, 2022	Lease Expense	35,000.00
	Cash		35,000.00
	(Payment for Buiding lease)