On January 1, 2018, Rick’s Pawn Shop leased a truck from Chumley Motors for a si

Question

On January 1, 2018, Rick’s Pawn Shop leased a truck from Chumley Motors for a six-year period with an option to extend the lease for three years. Rick’s had no significant economic incentive as of the beginning of the lease to exercise the 3-year extension option. Annual lease payments are $30,000 due on December 31 of each year, calculated by the lessor using a 4% discount rate. Assume that at the beginning of the third year, January 1, 2020, Rick’s had made significant improvements to the truck whose cost could be recovered only if it exercises the extension option, creating an expectation that extension of the lease was “reasonably certain.” The relevant interest rate at that time was 5%.

Required:

1. Prepare the journal entry, if any, at the beginning of the third year for the lessee to account for the reassessment.
2. Prepare the journal entry, if any, at the beginning of the third year for the lessor to account for the reassessment.

Explanation / Answer

1. No entry in 3rd year. The entry will only be made on atual reclassification.

2. No entry in 3rd year. The entry will only be made on atual reclassification.

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