Question

On January 1, 2017, Cage Company contracts to lease equipment for 5 years, agreeing to make a payment of $120,987 at the beginning of each year, starting January 1, 2017. The leased equipment is to be capitalized at $550,000. The asset is to be amortized on a double-declining-balance basis, and the obligation is to be reduced on an effective-interest basis. Cage’s incremental borrowing rate is 6%, and the implicit rate in the lease is 5%, which is known by Cage. Title to the equipment transfers to Cage at the end of the lease. The asset has an estimated useful life of 5 years and no residual value.

Instructions:

(a) Prepare the journal entry or entries that Cage should record on January 1, 2017.

(b) Prepare the journal entries to record amortization of the leased asset and interest expense for the year 2017. Include an amortization schedule.

(c) Prepare the journal entry to record the lease payment of January 1, 2018, assuming reversing entries are not made.

(d) What amounts will appear on the lessee’s December 31, 2017 balance sheet relative to the lease contract? Prepare a partial balance sheet showing the amounts.

(e) How would the value of the lease liability in part (b) change if Cage also agreed to pay the fixed annual insurance on the equipment of $2,000 at the same time as the rental payments?

Answer 1

A. DR. Fixed Assets a/c $550000

CR. Cash a/c $120987

CR. Lease Liability a/c $429013

(Being asset taken on lease and initial payment done and liability recorded)

Depreciation schedule:-

Year Book value at the beginning Depreciation Closing book value

1 550000 220000((550000*40%) 330000

2 330000 132000((330000) 198000

3 198000 79200 118800

4 118800 59400* 59400

5 59400 59400 0

NOTE:- As the depreciation is higher in the 4th and 5th year so it is better to adopt straight line method.

B. DR. Depreciation a/c $220000

CR. Accumulated Depreciation a/c $220000

(Being depreciation accumulated)

DR. Depreciation a/c $132000

CR. Accumulated Depreciation a/c $132000

(Being depreciation accumulated)

DR. Depreciation a/c $79200

CR. Accumulated Depreciation a/c $79200

DR. Depreciation a/c $59400

CR. Accumulated Depreciation a/c $59400

DR. Depreciation a/c $59400

CR. Accumulated Depreciation a/c $59400

Calculation of interest and principal amount:-

Opening Interest 6% Payment Closing

Year 0 550000 ------- -120987 429013

Year 1 429013 21451 -120987 329477

Year 2   329477 16474 -120987 224964

Year 3 224964 11248 -120987 115225

Year 4 115225 5762 -120987 0

DR. Profit & Loss a/c $21451

CR. Interest a/c $21451

(Being interest expense recognised)

DR. Lease liability a/c $99536

DR. Interest a/c $21451

CR. Cash a/c $120987

DR. Lease liability a/c $104513

DR. Interest a/c $16474

CR. Cash a/c $120987

DR. Lease liability a/c $109739

DR. Interest a/c $11248

CR. Cash a/c $120987

DR. Lease liability a/c $115226

DR. Interest a/c $5761

CR. Cash a/c $120987

C.DR. Lease liability a/c $99536

DR. Interest a/c $21451

CR. Cash a/c $120987

(Being lease payment on January 1,2018)

D. Balance sheet as on 31st Dec,2017

LIABILITIES:-

Financial lease $330000