Question

On January 1, Year 1, Company A (the lessee) entered into an 8-year lease agreement with Company B (the lessor) for industrial equipment. Annual lease payments of $14,378 are payable at the end of each year. Company A's incremental borrowing rate is 7%, and the implicit rate in the lease is 5%, which is known to Company A. On January 1, Year 1, the fair value of the equipment is $125,000 and its estimated useful life is 15 years. Company A depreciates its long-lived assets in accordance with the straight-line depreciation method. At lease commencement date, Company B estimates that the total residual value of the equipment at the end of the lease term will be $47,388. Company A guarantees $40,000 of the residual value of the equipment. However, due to expected high usage of the equipment, Company A estimates that the value of the equipment at the end of the lease term will be only $30,000. Information on present value factors is as follows:

Present value of $1 at 5% for 8 periods 0.6768
Present value of $1 at 7% for 8 periods 0.5820
Present value of an annuity of $1 at 5% for 8 periods 6.4632
Present value of an annuity of $1 at 7% for 8 periods 5.9713
Enter the appropriate amounts in the designated cells. Enter all amounts as positive values. Round all amounts to the nearest whole number. If the amount is zero, enter a zero (0). Enter all percentages as a percentage, not a decimal.

For item 2, select the appropriate lease classification option by Company A from the option list provided.

Item

Amount

1. The discount rate for the lease used by Company A
2. Classification of the lease by Company A
3. The amount at which the lease liability was recognized in Company A's financial statements at the lease commencement date
4. The amount of interest expense recognized by Company A in Year 1
5. The carrying amount of the right-of-use asset in Company A's December 31, Year 1, financial statements
6. The amount of Company A's lease liability on December 31, Year 1, after the first required payment was made
7. The amount of the current portion of the lease liability as it is presented in Company A's December 31, Year 1, financial statements

Answer 1

Answer:

1) 5%

2) financial

3) $120,001

4) $      600.05

5) $118,666.67

6) $106.223,05

7) $106.223,05

Explanation:

1) as the implicit rate is known to the company then it should use that one.

2)

PV of the payment and guaranteed residual value:

Present Value of Annuity

$C \times \frac{1-(1+r)^{-time} }{rate} = PV$

C 14,378

time 8

rate 0.05

$14378 \times \frac{1-(1+0.05)^{-8} }{0.05} = PV$

PV $92,928.0731

PRESENT VALUE OF LUMP SUM

$\frac{Maturity}{(1 + rate)^{time} } = PV$  

Maturity  40,000.00

time   8.00

rate  0.05

$\frac{40000}{(1 + 0.05)^{8} } = PV$  

PV   27,073.57

Total value: 120,001.647536178

Percentage of fair value: 120,000 / 125,000 = 0.96

The norm states to classify as financing if:

"Ninety percent or more of the fair value of the underlying asset amounts to substantially all the fair value of the underlying asset"

3) the lease liability will be the $120,001  present value of the cash obligations

4) interest expense

lease liability x interest rate

120,001 x 0.05 = 600.05

5) the right-of-use asset will be depreciated using the straight-line method and all information available for the company so we use the 30,000 residual value expected.

(125,000 - 30,000) / 15 = 6,333.33

125,000 - 6,333.33 depreciation expense = 118,666.67

6)  we need to solve for the lease liability after the first payment:

120,001 + 600.05 = 120,601.05 - 14,378 = 106,223.05

7) the lease liability will be the amount calculated on #6 106,223.05