Eubank Company, as lessee, enters into a lease agreement on January 1, 2014: The
ID: 2474996 • Letter: E
Question
Eubank Company, as lessee, enters into a lease agreement on January 1, 2014: The term of the noncancelable lease is 4 years, with no renewal option. Payments of $784,000 are due on January 1 of each year. The fair value of the equipment on January 1, 2014 is $2,800,000. The equipment has an economic life of 6 years with no salvage value. Eubank depreciates similar machinery it owns using straight-line depreciation. The lessee must pay all related taxes and registrations and executory costs. Eubank's incremental borrowing rate is 12% per year. The lessee is aware that the lessor used an implicit rate of 8% in computing the lease. The PV of four payments of $784,000 at 12% is $2.6 million. The PV of four payments of $784,000 at 8% is $2.8 million. The lease is for earth-moving equipment (excavators and bulldozers). Instructions - Prepare the appropriate lease journal entries on Eubank's books for 2014 and 2015 and 2016.Explanation / Answer
Present value of minimum lease payments at 8% is $ 2.8 million
In the given case, the present value of minimum lease payments equals the fair value of the equipment.
Eubank's books:
Present value of the minimum lease payments: The minimum lease payments consist of the annual lease rentals payable by the lessee at the beginning of each each year, , i.e $ 784,000. Since the lessor's implicit rate (8%) is known, it is used as the discount rate disregarding the lessee's incremental borrowing rate. Therefore, the present value of the minimum lease payments is $ 2.8 million, and not $ 2.6 million.
The next step is to compare the fair value of the equipment with the present value of the minimum lease payments. The lower of the two should be taken as the value at which the lease is recorded. In this case, both are $ 2.8 million. Therefore the lease is recorded both as an asset and a liability by the lessee at $ 2.8 million. On the lessee's balance sheet, the leased equipment appears as a fixed asset, and the Finance Lease Obligation appears as a non-current liability.
Eubank Company the lessee must depreciate the asset for each period. As the recorded value of the asset is $ 2.8 million, and as the lease term is 4 years, Eubank Company records depreciation of $ 2.8 million / 4 = $ 700,000 each year using the straight-line method.
On January 1, 2015: Next lease payment becomes due. As the first lease payment has already been paid in January 2014, outstanding amount is $ 2.8 million - $ 784,000 or $ 2,016,000 . Therefore, the interest component of the lease payment is $ 2,016,000 x 8% or $ 161,280. The amount of principal repaid is $ 784,000 - $ 161,280 or $ 622,720.
On January 1, 2016 : Amount outstanding on the liability is $ 2,016,000 - $ 622,720 = $ 1,393,280. Finance charges on the same is $ 1,393,280 x 8% = $ 111,462
Date Account Titles Debit Credit $ $ January 1, 2014 Leased equipment 2,800,000 Finance lease obligation 2,800,000 Finance lease obligation 784,000 Cash 784,000 Paid the first lease rental December 31, 2014 Depreciation expense, leased equipment 700,000 Accumulated depreciation, leased equipment 700,000 January 1, 2015 Interest expense 161,280 Finance lease obligation 622,720 Cash 784,000 Paid the second lease rental December 31, 2015 Depreciation expense, leased equipment 700,000 Accumulated depreciation, leased equipment 700,000 January 1, 2016 Interest expense 111,462 Finance lease obligation 672,538 Cash 784,000Related Questions
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