Question

Krawczek Company will enter into a lease agreement with Heavy Equipment Co. where Krawczek will make lease payments over the next five years. The lease is cancelable and requires equal annual payments of $24,800 per year beginning on January 1 of the first year. The last payment will be January 1 of year 5, and Krawczek will continue to use the asset until December 31 of that year. Other important information includes the following:

• The fair value of the equipment is $170,000.
• The applicable discount rate is an 8 percent annual rate.
• The economic life of the asset is 10 years.
• Krawczek does not guarantee the residual value of the asset at the end of the lease, and it does not expect to keep the asset at the end of the term.
• The asset is a standard piece of equipment.

a. Is the lease an operating lease or a financing lease?

• Operating lease

• Financing lease

b. What will be the lease expense shown on the income statement at the end of year 1?

Answer 1

Answer :-

a) Is the lease an operating lease or a financing lease?

The lease is an operating lease. There is no purchase of asset and the there is a lease ( rental ) agreements which meets the criteria of operating lease criteria.

In case of finance lease the asset may be transferred to the lessee at the end of lease period which is not the case here.

In finance lease the lease period is 75% or more of the asset's economic life. The lease period is 5 years and the economic life is 10 years which is only 50%.

The bargain purchase option allows the lessee to purchase the asset that is leased at a much lower price than the fair market value of the asset at some future date, which is not satisfied in this case.

The present value of the lease payments may be 90% or more of the fair value of the asset that is leased. The PV of leased asset which is calculated below at 8% discount rate is $106940.74 which is less than the fair value of $ 170000.

PV = $ 24800 + $ 24800 / 1.08 + $ 24800 / 1.08² + $ 24800 / 1.08³ + $ 24800 / 1.08⁴
PV = $ 24800 + $ 22962.96 + $ 21262 + $ 19687.04 + $ 18228.74
PV = $ 106940.74

If any of the above conditions would have been met the lease will be treated as an finance lease. As none of the four above conditions has been met the above lease is a operating lease.

b. What will be the lease expense shown on the income statement at the end of year 1?

In case of operating lease no asset or liability is reported in the balance sheet, however the annual payment of $ 24800 which is a rental expense or lease expense is recognized in the lessee's income statement. Therefore $ 24800 of lease expense is recorded in the income statement at the end of the year 1.