Question

You are reviewing the financial statements of Trident Incorporated and observed that Trident entered into a significant operating lease for office equipment at the end of the current year. Because of the nature of items leased and the length of the lease, you question the classification of the leases as operating. You are interested in assessing the income statement effect of classifying the lease as an operating versus a finance

Lease. Trident disclosed the following schedule of its lease payments:

Year	Future Lease Payments
2019	$750,000
2020	750,000
2021	750,000
2022	750,000
2023	750,000
Thereafter	3,750,000
Total lease payments	7,500,000
Less imputed interest	2,891,575
Present value of future lease payments	$4,608,425

Given that lease payments in each of the next 5 years total $750,000, you assume that lease payments going forward are also $750,000 per year. To determine the lease term, you divide the total payments of $3,750,000 after 2023 by $750,000 per year to compute an additional 5 years of lease payments after 2023. Therefore, the total lease term is 10 years. You also determine that Trident discount rate is 10%.

Use Trident information to determine its expenses in 2019, 2020, and 2021 related to its operating lease. Determine what the lease expense would be if Trident classified the lease as a finance lease. Assume lease payments occur at the end of each year.

Answer 1

Case 1 : Assuming the lease to be Operating Lease

An operating lease, is treated as a rental contract rather than a financing option.

Accordingly, lease rental paid will be expensed out and interest cost is not recognized

Year	Expense
2019	750000
2020	750000
2021	750000
2022	750000
2023	750000
2024	750000
2025	750000
2026	750000
2027	750000
2028	750000

Case 2 : Assuming the lease to be Finance Lease

A finance lease, is treated as a financing contract rather than a rental contract.

Accordingly, lease rental paid will be expensed out and interest cost is will be recognized

Calculation of intrest expense
Year	Princinpal Outstanding at the beginning (A)	Interest (B = A * 10%)	Gross Total ('C = A+B)	Payment / Installment (D)	Princinpal Outstanding at the end (E = C - D)
2019	4,608,425	460,843	5,069,268	750,000	4,319,268
2020	4,319,268	431,927	4,751,194	750,000	4,001,194
2021	4,001,194	400,119	4,401,314	750,000	3,651,314
2022	3,651,314	365,131	4,016,445	750,000	3,266,445
2023	3,266,445	326,645	3,593,090	750,000	2,843,090
2024	2,843,090	284,309	3,127,399	750,000	2,377,399
2025	2,377,399	237,740	2,615,138	750,000	1,865,138
2026	1,865,138	186,514	2,051,652	750,000	1,301,652
2027	1,301,652	130,165	1,431,817	750,000	681,817
2028	681,817	68,182	750,000	750,000	0

Expense to be recognized
Year	Interest Expense	Lease Rental	Total Expense
2019	460,843	750,000	1,210,843
2020	431,927	750,000	1,181,927
2021	400,119	750,000	1,150,119
2022	365,131	750,000	1,115,131
2023	326,645	750,000	1,076,645
2024	284,309	750,000	1,034,309
2025	237,740	750,000	987,740
2026	186,514	750,000	936,514
2027	130,165	750,000	880,165
2028	68,182	750,000	818,182