Laura Leasing Company signs an agreement on January 1, 2017, to lease equipment

Question

Laura Leasing Company signs an agreement on January 1, 2017, to lease equipment to Sage Hill Company. The following information relates to this agreement. 1. The term of the non-cancelable lease is 3 years with no renewal option. The equipment has an estimated economic life of 5 years. 2. The fair value of the asset at January 1, 2017, is $78,000 3. The asset will revert to the lessor at the end of the lease term, at which time the asset is expected to have a residual value of $6,000, none of which is guaranteed. 4. The agreement requires equal annual rental payments of $25,178 to the lessor, beginning on January 1, 2017. 5. The lessee's incremental borrowing rate is 5%. The lessor's implicit rate is 4% and is unknown to the lessee 6. Sage Hill uses the straight-line depreciation method for all equipment.

Explanation / Answer

First, we need to perform the capital versus operating lease test: There is no title transfer at lease end, so the first test for capital lease accounting is not met. There is also no bargain purchase option , so the second test for capital lease accounting is not met.
The lease term is 3 years while the useful life is 5 years. 3 years is less than 75% of 5 years (3 versus 3.75), so the third test for capital lease accounting is not met.
In order to perform the fourth test, we need to calculate the present value of the minimum lease payments.YOU HAVE giveN us a present value of $71,994, which is greater than 90% of the fair value of the asset (90% of $78,000 is $70,200). As a result, this is a capital lease per the fourth test, and as such capital lease accounting needs to be applied.

NOTE:The unguaranteed residual value is not subtracted when depreciating the leased asset.

DATE PARTICULARS DEBIT CREDIT 1/1/17 LEASED EQUIPMENT $71,994 LEASE LIABILITY $71,994 (TO RECORD THE LEASE) 1/1/17 LEASE LIABILITY $25,178 CASH $25,178 (TO RECORD LEASE PAYMENT) 31/12/17 INTEREST EXPENSE $2,341 INTEREST PAYABLE $2,341 (TO RECORD INTEREST EXPENSE) 31/12/17 DEPRCIATION EXPENSE($71,994/3) $23,998 ACCUMULATED DEPRICIATION- CAPITAL LEASE $23,998 (TO RECORD AMMORTISATION OF RIGHT TO USE ASSET) 1/1/18 INTEREST PAYABLE $2,341 INTEREST EXPENSE $2,341 (TO REVERSE INTEREST EXPENSE) 1/1/18 INTEREST EXPENSE $2,341 LEASE LIABILITY $22,837 CASH $25,178 (TO RECORD LEASE PAYMENT) 31/12/18 INTEREST EXPENSE $1,199 INTEREST PAYABLE 1,199 (TO RECORD INTEREST EXPENSE) 31/12/18 DEPRCIATION EXPENSE $23,998 ACCUMULATED DEPRICIATION- CAPITAL LEASE $23,998

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