Question

Assume that on December 31, 2019, Kimberly-Clark Corp. signs a 10-year, non-cancelable lease agreement to lease a storage building from Sheffield Storage Company. The following information pertains to this lease agreement.

1.		The agreement requires equal rental payments of $68,499 beginning on December 31, 2019.
2.		The fair value of the building on December 31, 2019 is $501,036.
3.		The building has an estimated economic life of 12 years, a guaranteed residual value of $10,000, and an expected residual value of $5,600. Kimberly-Clark depreciates similar buildings on the straight-line method.
4.		The lease is nonrenewable. At the termination of the lease, the building reverts to the lessor.
5.		Kimberly-Clark’s incremental borrowing rate is 8% per year. The lessor’s implicit rate is not known by Kimberly-Clark.

A. Prepare the journal entries on the lessee’s books to reflect the signing of the lease agreement and to record the payments and expenses related to this lease for the years 2019, 2020, and 2021. Kimberly-Clark’s fiscal year-end is December 31. (Credit account titles are automatically indented when amount is entered. Do not indent manually. Round answers to 0 decimal places e.g. 5,275.)

B. Suppose the same facts as above, except that Kimberly-Clark incurred legal fees resulting from the execution of the lease of $5,000, and received a lease incentive from Sheffield to enter the lease of $1,000. How would the initial measurement of the lease liability and right-of-use asset be affected under this situation?

C. Suppose that in addition to the $68,499 annual rental payments, Kimberly-Clark is also required to pay $5,000 for insurance costs each year on the building directly to the lessor, Sheffield Storage. How would this executory cost affect the initial measurement of the lease liability and right-of-use asset? (Round answer to 0 decimal places, e.g. 5,275.)

Answer 1

Kimberly-Clark Corp. (a) Requirement 1 Amounts may differ due to rounding resulting from more precise calculations in Excel as compared to the solutions manual. Amount to be capitalized includes: Minimum annual lease payment Guaranteed residual value $ $ 68,499 10,000 Present value of minimum lease payments using Excel's PV function: Minimum annual lease payment $ 4,96,405 PV(8% 10,68,499, 1) Guaranteed residual value 2,038 PV(8%,10 (10000-5600)) Lease liability $ 4.98,443 Credit Debit 4,98,443 12-31-19 Right-of-Use Asset Lease Liability 4,98,443 68,499 12-31-19 Lease Liability Cash 68,499 49,844 12-31-20 Amortization Expense Right-of-Use Asset 49,844 12-31-20 Lease Liability Interest Expense Cash 34,104 34,395 68,499 49,844 12-31-21 Amortization Expense Right-of-Use Asset 49,844 12-31-21 Lease Liability Interest Expense Cash 36,832 31,667 68,499 Lease Amortization Schedule Annual Lease Payment Interest Reduction (8%) of on Liability Lease Liability Date 12-31-19 12-31-19 12-31-20 12-31-21 $ $ 68,499 6 8,499 6 8,499 S - 34,395 31,667 68,499 34,104 36,832 Lease Liability $ 4,98,443 4,29,944 3,95,840 3,59,008

(b) Requirement 2 $ Incurred legal fees resulting from the execution of the lease Received a lease incentive from Sheffield to enter the lease 5,000 1,000 How would the initial measurement of the lease liability and right-of-use asset be affected under this situation? Calculation of the right-of-use asset: Lease liability Lease incentive Legal fees Right-of-use asset $ 4,98,443 (1,000) 5,000 $ 5,02,443 Initial direct costs and lease incentives do not affect the initial measurement of the lease liability. Instead, they only affect the measurement of the right-of-use asset. Initial direct costs incurred by the lessee increase the right-of-use asset, whereas a lease incentive decreases the value of the right-of-use asset. (c) Requirement 3 Annual payment for insurance costs on the building $ 5,000 How would this executory cost affect the initial measurement of the lease liability and right- of-use asset? Present value of minimum lease payments using Excel's PV function: Minimum annual lease payment $ 4,96,405 Guaranteed residual value 2,038 Annual insurance payment 36,234 PV(8%, 10,5000,0,1) Lease liability $ 5,34,677 The annual insurance payments of $5,000 are considered part of the annual payments to the lessor similar to the rental payments, as they do not transfer a separate good or service to the lessee, but rather are part of the payment to use the leased asset and are attributable to the lease component. Therefore, the present value of the $5,000 annual payments should be included in the initial measurement of the lease liability, and thus the right-of-use asset as well.