Question

Sky Mountain, as lessee, enters into a lease agreement on May 1, 2020, for an Animal Outfit with Outfit Inc. The following data are relevant to the lease agreement:

• The term of the noncancelable lease is 10 years, with no renewal option. Payments of $140,000 are due at the beginning of each year, starting today.
• The fair value of the outfit is $1,000,000 (a quite unique costume). The outfit has an economic life of 13 years with no salvage value.
• Sky Mountain depreciates similar outfits on a straight-line basis.
• $2,000 Executory costs are paid by the lessee on an annual basis, of which are included in the above rent payment to the lessor.
• Sky Mountain’s incremental borrowing rate is 8% per year and the implicit rate is unknown.

Instructions:

1. Indicate the type of lease Sky Mountain has entered into. (2 points): ______________________
2. Prepare a partial amortization schedule for the lessee that goes up to 5/1/22. (4 points)

Date	Lease payment	Executory Costs	interest expense	reduction in liability	lease liability
5/1/20
5/1/20
5/1/21
5/1/22

Prepare the journal entries on Sky Mountain’s books that relate to the lease agreement for the following dates: 5/1/20 (2 JE’s), 12/31/20 (2 JE’s), and 5/1/21 (1 JE).  

Prepare the journal entries on Outfit Inc’s books that relate to the lease agreement for the following date: 5/1/20 (2 JE’s)  

Answer 1

	Present value of lease payment	$ 1,000,000	( (140,000 - 2,000 ) x ( 1 + 6.246377 ) )
a.)	The lease is Finance lease for Sky Mountain because the present value of lease payments ( $ 1,000,000 ) is equal to the fair value ( $ 1,000,000 ) of Animal outfit.
b.)	Date	Lease Payment	Executory costs	Interest Expense	Reduction in liability	Lease Liability
	01-05-2020					1,000,000
	01-05-2020	140,000	2,000		138,000	862,000
	01-05-2021	140,000	2,000	68,960	69,040	792,960
	01-05-2022	140,000	2,000	63,437	74,563	718,397
	Journal entries in books of Sky Mountain
	Date	Account Titles	Debit	Credit
	01-05-2020	Right of use asset	1,000,000
		Lease Liability		1,000,000
	01-05-2020	Lease Liability	138,000
		Executory costs Prepaid	2,000
		Cash		140,000
	31-12-2020	Amortization Expense	66,667
		Right of use asset		66,667
		(1,000,000 / 10 ) x 8/12
	31-12-2020	Interest Expense	45,973
		Interest payable		45,973
		(1,000,000 - 138,000 ) x 8% x 8/12
	01-05-2021	Lease Liability	69,040
		Executory costs Prepaid	2,000
		Interest Expense (68,960 - 45,973 )	22,987
		Interest payable	45,973
		Cash		140,000
	Journal entries in books of Outfit Inc.
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