Question

On January 1, 2020, Lessee Inc. enters into a 5-year equipment lease agreement for $33,000 annually (first payment due immediately). The lease grants the lessee an option to renew the lease for an additional 3 years. Lease payments adjust to current market rates for equivalent rentals at the time of renewal. Lessee Inc. is reasonably certain that it will exercise the renewal option due to the customization of the equipment. The estimated useful life of the equipment is 10 years. The lessee is not aware of the implicit rate of the lease, but the lessee’s incremental borrowing rate is 6%.

a)Prepare an amortization schedule of the lease liability.

b)Prepare the entries for Lessee Inc. for years 2020 and 2021.

Answer 1

Since the lessee is certain about renewing the lease, we include this portion for computation of PV of lease:

Year	Lease rental	PV Factor @ 6%	Disocounted Cash flows
0	33000	1.0000	33,000.00
1	33000	0.9434	31,132.08
2	33000	0.8900	29,369.88
3	33000	0.8396	27,707.44
4	33000	0.7921	26,139.09
5	33000	0.7473	24,659.52
6	33000	0.7050	23,263.70
7	33000	0.6651	21,946.88
			217,218.59

So lease ammortisation schedule will be:

Year	Lease Rental	Interest portion		Lease Liability portion		Lease liability o/s
0	33000			33000		184,218.59
1	33000	204923.20*6%	11,053.12	33000-12295.39	21,946.88	162,271.70
2	33000	184218.59*6%	9,736.30	33000-11053.12	23,263.70	139,008.00
3	33000	same way for the rest	8,340.48	same way for the rest	24,659.52	114,348.49
4	33000		6,860.91		26,139.09	88,209.39
5	33000		5,292.56		27,707.44	60,501.96
6	33000		3,630.12		29,369.88	31,132.08
7	33000		1,867.92		31,132.08	-

Journal Entries:

1-Jan-20	Right of use asset a/c Dr	217,218.59
	To Lease Liability a/c		217218.59
1-Jan-20	Lease Liability a/c Dr	33000
	To Cash a/c		33000
31-Jan-20	Depreciation a/c Dr (217218.59/8)	27,152.32
	To Right of Use asset a/c		27,152.32
31-Jan-20	Interest expense a/c Dr	11,053.12
	To Interest Payable		11,053.12
1/1/2021	Lease Liability a/c Dr	21,946.88
	Interest Payable a/c Dr	11,053.12
	To Cash a/c		33,000.00
31-Dec-21	Depreciation a/c Dr (217218.59/8)	27152.3234
	To Right of Use asset a/c		27152.32344
31-Dec-21	Interest expense a/c Dr	9,736.30
	To Interest Payable		9,736.30