Question

Werner Chemical, Inc., leased a protein analyzer on September 30, 2018. The five-year lease agreement calls for Werner to make quarterly lease payments of $420,914, payable each September 30, December 31, March 31, June 30, with the first payment at September 30, 2018. Werner's incremental borrowing rate is 12%. Amortization is recorded on a straightline basis at the end of each fiscal year. The useful life of the equipment is five years. (FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.)

Required:
1. Determine the present value of the lease payments at September 30, 2018.
2. What pretax amounts related to the lease would Werner report in its balance sheet at December 31, 2018?
3. What pretax amounts related to the lease would Werner report in its income statement for the year ended December 31, 2018?
4. What pretax amounts related to the lease would Werner report in its statement of cash flows for the year ended December 31, 2018?

Answer 1

1	Lease agreement term=5 years
	Lease is paid quarterly
	Total lease payment over the lease agreement=5*4=20 quarters
	Incremental borrowing rate=12%
	Incremental borrowing rate per quarter =12%/4=3%
	Use this 3% for present value computation for 20 periods
	First lease payment is made at the beginning of the year (Year 0).Present value will be 1
	Then find present value at 3% for 19 years
	Present value of lease payment=Lease Liability*(Present value interest annuity factor at 3% for 20 years)=420914*15.3238=$ 6450002
2	Lease Liability
	Beginning balance			6450002
	Sep 30,2018 reduction			-420914
	(Note:1)
	Dec 31,2018 reduction			-240041
	(Note:2)
	Ending balance			5789047
	Asset
	Leased Asset			6450002
	Less:Accumulated depreciation			322500
	(Note:3)
	Leased Asset (Net)			6127502
	Notes:
	1. There will be no interest component at the beginning of lease payment.Hence entire lease rental will be deducted from lease liability
	2. Interest component in lease rental=(6450002-420914)*3%=$ 180873
	Principal component=420914-180873=$ 240041
	3.Depreciation is recorded on a straight-line basis
	Depreciation for a year=6450002/5=1290000
	Depreciation for Sep 30 to Dec 31=1290000*3/12=$ 322500
3	Income statement (Partial)
	Interest expense		(Note:2)	180873
	Depreciation expense		(Note:3)	322500
	Total expenses			503373
4	Cashflow statement (Partial)
	Cash flow from operating activities:
	Interest paid on lease		(Note:2)		-180873
	Cash flow from financing activities:
	Lease liability
	Sep 30,2018		(Note:1)		-420914
	Dec 31,2018		(Note:2)		-240041

Answer 2

Note for #4:

Finance lease is answer to #1, significant noncash investing and financing activity.