Alt Corporation enters into an agreement with Yates Rentals Co. on January 1, 20

Question

Alt Corporation enters into an agreement with Yates Rentals Co. on January 1, 2013 for the purpose of leasing a machine to be used in its manufacturing operations.

The following data pertain to the agreement:
(a)          The term of the noncancelable lease is 3 years with no renewal option. Payments of $310,426 are due on December 31 of each year.
(b)          The fair value of the machine on January 1, 2013, is $800,000. The machine has a remaining economic life of 10 years, with no salvage value. The machine reverts to the lessor upon the termination of the lease.
(c)           Alt depreciates all machinery it owns on a straight-line basis.
(d)          Alt's incremental borrowing rate is 10% per year. Alt does not have knowledge of the 8% implicit rate used by Yates.

(e)          Immediately after signing the lease, Yates finds out that Alt Corp. is the defendant in a suit which is sufficiently material to make collectibility of future lease payments doubtful.

If the present value of the future lease payments is $800,000 at January 1, 2013, what is the amount of the reduction in the lease liability for Alt Corp. in the second full year of the lease if Alt Corp. accounts for the lease as a capital lease? (Rounded to the nearest dollar.)

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Explanation / Answer

Answer:

Year 1:

Cash Payment = $310,426

Discount rate = 10%

Interest Expense = $800,000 * 10% = $80,000

Reduction in Lease liability = Cash Payment - Interest expense = $310,426 - $80,000 = $230,426

Lease Liability at the end of year 1 = $800,000 - $230,426 = $569,574

Year 2:

Interest Expense = Lease Liability at the beginning of year 2 * 10% = $569,574*10% = $56,957.40

Reduction in the lease liability in the second full year = Cash payment - Interest expense = $310,426 - $56,957.40 = $253,469 (rounded off to the nearest dollar)

Reduction in the lease liability for Alt Corp. in the second full year = $253,469

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