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Chapter 21: Q. 21-13E-a (page 1244)

(Accounting for an Operating Lease) On January 1, 2017, a machine was purchased for \(900,000 by Young Co. The machine is expected to have an 8-year life with no salvage value. It is to be depreciated on a straight-line basis. The machine was leased to St. Leger Inc. on January 1, 2017, at an annual rental of \)210,000. Other relevant information is as follows.

  1. The lease term is for 3 years.
  2. Young Co. incurred maintenance and other executory costs of \(25,000 in 2017 related to this lease.
  3. The machine could have been sold by Young Co. for \)940,000 instead of leasing it.
  4. St. Leger is required to pay a rent security deposit of \(35,000 and to prepay the last month’s rent of \)17,500.

Instructions

(a) How much should Young Co. report as income before income tax on this lease for 2017?

Short Answer

Expert verified

The income before income tax is $72,500.

Step by step solution

01

Meaning of Straight-line depreciation

Straight-line depreciation refers to the depreciation in which the depreciation amount is equal at the end of each year. It can be found by dividing the value of the asset by the total useful life of the asset.

02

Explaining the report by Young Co. on income before income tax on this lease for 2017

Annual rental revenue

$210,000

Less: maintenance and other executory costs

25,000

Depreciation

112,500

Income before income tax

$ 72,500

Working Notes:

Calculation of Depreciation amount

Depreciation=Machinecostusefullife=$900,0008=$112,500

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Most popular questions from this chapter

(Lessor and Lessee Accounting and Disclosure) Sylvan Inc. entered into a noncancelable lease arrangement with Breton Leasing Corporation for a certain machine. Breton’s primary business is leasing; it is not a manufacturer or dealer. Sylvan will lease the machine for a period of 3 years, which is 50% of the machine’s economic life. Breton will take possession of the machine at the end of the initial 3-year lease and lease it to another, smaller company that does not need the most current version of the machine. Sylvan does not guarantee any residual value for the machine and will not purchase the machine at the end of the lease term.

Sylvan’s incremental borrowing rate is 10%, and the implicit rate in the lease is 9%. Sylvan has no way of knowing the implicit rate used by Breton. Using either rate, the present value of the minimum lease payments is between 90% and 100% of the fair value of the machine at the date of the lease agreement.

Sylvan has agreed to pay all executory costs directly, and no allowance for these costs is included in the lease payments. Breton is reasonably certain that Sylvan will pay all lease payments. Because Sylvan has agreed to pay all executory costs, there are no important uncertainties regarding costs to be incurred by Breton. Assume that no indirect costs are involved.

Instructions

(a) With respect to Sylvan (the lessee), answer the following.

  1. What type of lease has been entered into? Explain the reason for your answer.

Question: (Balance Sheet and Income Statement Disclosure—Lessee) The following facts pertain to a noncancelable lease agreement between Alschuler Leasing Company and McKee Electronics, a lessee, for a computer system.

Inception date

October 1, 2017

Lease term

6 years

Economic life of leased equipment

6 years

Fair value of asset at October 1, 2017

\(300,383

Residual value at end of lease term

–0–

Lessor’s implicit rate

10%

Lessee’s incremental borrowing rate

10%

Annual lease payment due at the beginning of each year, beginning with October 1, 2017

\)62,700

The collectibility of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. The lessee assumes responsibility for all executory costs, which amount to \(5,500 per year and are to be paid each October 1, beginning October 1, 2017. (This \)5,500 is not included in the rental payment of \(62,700.) The asset will revert to the lessor at the end of the lease term. The straight-line depreciation method is used for all equipment.

The following amortization schedule has been prepared correctly for use by both the lessor and the lessee in accounting for this lease. The lease is to be accounted for properly as a capital lease by the lessee and as a direct-financing lease by the lessor.

Date

Annual lease payments/Receipt

Interest (10%)

On Unpaid liability/Receivable

Reduction of Lease Liability?

Receivable

Balance of Lease Liability/Receivable

10/01/17

\)300,383

10/01/17

\(62,700

\)62,700

237,683

10/01/18

\(62,700

\)23,768

38,932

198,751

10/01/19

\(62,700

19,875

42,825

155,926

10/01/20

\)62,700

15,593

47,107

108,819

10/01/21

\(62,700

10,882

51,818

57,001

10/01/22

\)62,700

5,699*

57,001

0

\(376,200

\)75,817

\(300,383

*Rounding error is \)1.

Instructions

(a) Assuming the lessee’s accounting period ends on September 30, answer the following questions with respect to this lease agreement.


(2) What items and amounts will appear on the lessee’s balance sheet at September 30, 2018?

Question: (Lessee Entries and Balance Sheet Presentation, Capital Lease) On January 1, 2017, Cage Company contracts to lease equipment for 5 years, agreeing to make a payment of \(137,899 (including the executory costs of \)6,000) at the beginning of each year, starting January 1, 2017. The taxes, the insurance, and the maintenance, estimated at \(6,000 a year, are the obligations of the lessee. The leased equipment is to be capitalized at \)550,000. The asset is to be depreciated on a double-declining-balance basis, and the obligation is to be reduced on an effective-interest basis. Cage’s incremental borrowing rate is 12%, and the implicit rate in the lease is 10%, which is known by Cage. Title to the equipment transfers to Cage when the lease expires. The asset has an estimated useful life of 5 years and no residual value.

Instructions

(a) Explain the probable relationship of the $550,000 amount to the lease arrangement.

Question: (Lessee Entries and Balance Sheet Presentation, Capital Lease) On January 1, 2017, Cage Company contracts to lease equipment for 5 years, agreeing to make a payment of \(137,899 (including the executory costs of \)6,000) at the beginning of each year, starting January 1, 2017. The taxes, the insurance, and the maintenance, estimated at \(6,000 a year, are the obligations of the lessee. The leased equipment is to be capitalized at \)550,000. The asset is to be depreciated on a double-declining-balance basis, and the obligation is to be reduced on an effective-interest basis. Cage’s incremental borrowing rate is 12%, and the implicit rate in the lease is 10%, which is known by Cage. Title to the equipment transfers to Cage when the lease expires. The asset has an estimated useful life of 5 years and no residual value.

Instructions

(b) Prepare the journal entry or entries that should be recorded on January 1, 2017, by Cage Company.

What are “initial direct costs” and how are they accounted for?
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