Question

2. (LESSEE ENTRIES FOR AN OPERATING LEASE). Assume that Ace Leasing Company and King Company, a lessee, agreed to the lease shown below instead on the one shown in problem 1. Commencement of Lease Date January 1, 2020 Annual lease payment due at the beginning of the year beginning with January 1, 2020 $137,171 Lease term 6 years Economic life of leased equipment 10 years Fair Value of asset at January 1, 2020 $950,000 Lessor's Implicit Rate 12% Lessee's incremental borrowing rate 12% The asset will revert to the lessor at the end of the lease term. amortization for all leased equipment. The lessee uses straight-line A. Is this an operating or financing lease to the Lessee? Explain. B. Compute the lease Liability to be recorded by the Lessee at inception of the lease and compute the ROU Asset to be recorded by the Lessee at inception. Based on those complete the two Lessee entries 1/1/2020.

Answer 1

(A) Is this an operating or financing lease to the Lessee? Explain.

Lease classification under US GAAP is based on the following criteria. If any of the below apply, it is classified as a finance lease:

1. Transfer of ownership of the property at the end of the lease term.

2. It contains a bargain purchase.

3. Lease term is more than or equal to 75% of economic life of the asset.

4. NPV of lease payments is more than or equal to 90% of fair market value of the property.

In the given question,

1. The asset will revert to the lessor at the end of the lease term.

2. It does not contain a bargain purchase.

3. The life of the asset is 10 years and the lease term is 6 years i.e., 60%.

4. NPV of the lease payments:

Here, PVF = 1/(1 + r)ⁿ, where r = 12% = 0.12, n = (1, 2, 3, 4, 5, 6)

$ Lease Payments PVF@12% PV Year (a) (b) (axb) 1 $ 137,171 0.892857 $ 122,474 2 $ 137,171 0.797194$ 109,352 3 137,171 0.711780$ 97,636 4 $ 137,171 0.635518$ 87,175 5 $ 137,171 0.567427$ 77,835 6 $ 137,171 0.506631$ 69,495 Total $ 563,966 FMV of asset $ 950,000 90% of FMV $ 855,000

NPV of lease payments is less than 90% of fair market value of the property.

Therefore, it is an operating lease since none of the above criteria are met.

(B) Entries to be recorded by the Lessee at inception of the lease i.e 1/1/2020:

$\rightarrow$ Lease liability to be recorded is the present value of the lease payments made over the lease term.

$\rightarrow$ ROU Asset to be recorded is the sum of lease liability, any lease payments made prior to the commencement of lease & any initial direct costs incurred by the lessee.

Credit Date Account Title Debit 1-Jan-2020 Right of Use (ROU) Asset $563,966 Lease liability 1-Jan-2020 Lease liability $ 137,171 Cash $563,966 $ 137,171

(C) Yearly lease expense on King Company financial statements:

The yearly lease expense on the King Company financial statements is the annual lease payment i.e., $137,171.

(D) Computation of Interest Expense for the first two years:

Year Outstanding Interest Lease liability @12% $ 563,966 $ 67,675.90 $ 494,470.76 $59,336.49 1 2

Outstanding Lease liability = Opening balance + Interest expense - Lease payment made

= 563,966 + 67,675.90 - 137,171 = $494,470.76

(E) Computation of ROU Asset Amortization for the first two years:

Yearl ROU Asset Credit Balance 1 $ 563,966 $ 69,495.10 $ 494,470.76 (137,171 - 67,675.90) $ 494,470.76 $ 77,834.51 $ 416,636.25 (137,171 - 59,336.49) N

(F) Entry at the end of the first year i.e 12/31/2020:

Credit Date Account Title 31-Dec-2020 Lease expense Lease liability ROU Asset Debit $137,171 $ 67,676 $ 69,495