Chapter 14, Problem 11BPSB

Problem 14-11E^C

Capital lease accounting

C3

Braun Company signs a ?ve-year capital lease with Verdi Company for office equipment. The annual year-end lease payment is $20,000, and the interest rate is 10%.

Required

1. Compute the present value of Braun’s lease payments.

2. Prepare the journal entry to record Braun's capital lease at its inception.

3. Complete a lease payment schedule for the ?ve years of the lease with the following headings. Assume that the beginning balance of the lease liability (present value of lease payments) is $75,816. (Hint: To ?nd the amount allocated to interest in year 1, multiply the interest rate by the beginning-of year lease liability. The amount of the annual lease payment not allocated to interest is allocated to principal. Reduce the lease liability by the amount allocated to principal to update the lease liability at each year-end.)

4. Use straight-line depreciation and prepare the journal entry to depreciate the leased asset at the end of year 1. Assume zero salvage value and a ?ve-year life for the of?ce equipment.

Check (1) $75,816

(3) Year 3 ending balance $34,712

Period Ending Date

Beginning Balance of Lease Liability

Interest on Lease Liability

Reduction of Lease Liability

Cash Lease Payment

Ending Balance of Lease Liability

To determine

1)

Introduction:

Present value of lease payments:

• Leasing is an arrangement between two parties whereby one party known as the lessor, rents goods or right to use goods for a period of time that is predetermined and the other party, known as the lessee, pays a rent called Lease Rent.

• The present value of lease payments is calculated to analyze the cost borne to lease the goods or services and is a calculation of the lease rent paid over the lifetime translated into equivalent costs as if it was paid today.

$\begin{array}{l}\text{Present Value of Lease payments = P [(1 - ( 1+ r) ^ n)) / r]}\\ \\ \text{where,}\\ \\ \text{P = Lease Rent Per period}\\ \text{r = Interest Rate per period}\\ \text{n = Number of periods considered for calculation}\end{array}$

To Determine:

Present value of lease payments.

Answer to Problem 11BPSB

Solution:

The present value of lease payments is $ 75,816.

Explanation of Solution

Given:

Annual Lease Rent = $20,000

Number of years = 5 years

Interest rate = 10% per annum

Formula used:

$\begin{array}{l}\text{Present Value of Lease payments = P [(1 - (1 / ( 1+ r) ^ n) / r]}\\ \\ \text{where,}\\ \\ \text{P = Lease Rent Per period}\\ \text{r = Interest Rate per period}\\ \text{n = Number of periods considered for calculation}\end{array}$

Calculation:

$$

$\begin{array}{l}\text{Present Value of Lease payments = \$ 20,000 [1- (1 / ( 1}\text{.1) ^ 5)) / 0}\text{.10]}\\ \\ \text{Present Value of Lease payments = \$ 75,816}\\ \end{array}$

• The present value is calculated to analyze the cost of leasing the asset and computing its value as if the lease payments were to be made today.

• Usually the fair value of the assets matches the present value of the lease payments, and this is an indicator of whether the lease rent is fair or overvalued.

• The lease rents comprise of interest component and hence while calculating the present value of lease payments, the interest rate is used to discount the lease rent.

Conclusion

Hence the present value of lease rent is computed.

To determine

2)

Introduction:

Journal Entries

• Journal entries are the first step in recording financial transactions and preparation of financial statements.

• These represent the impact of the financial transaction and demonstrate the effect on the accounts impacted in the form of debits and credits.

• Assets and expenses have debit balances and Liabilities and Incomes have credit balances and according to the business transaction, the accounts are appropriately debited / credited to reflect the effect of business transactions and events.

To Determine:

Journal entry to record Capital Lease at inception.

Answer to Problem 11BPSB

Solution:

Date	Particulars	Debit ($)	Credit ($)
12.31.XXXX	Office Equipment	75,816
	Lease liability Payable		75,816
	(Being capital lease on office equipment recorded at inception)

Explanation of Solution

• The present value of lease payments is recorded as the value of the assets taken on lease. This is the fair value / cost of acquisition of right to use of the assets.

• The lease liability is the present value of lease calculated using the following formula:

$\begin{array}{l}\text{Present Value of Lease payments = P [(1 - (1 / ( 1+ r) ^ n) / r]}\\ \\ \text{where,}\\ \\ \text{P = Lease Rent Per period}\\ \text{r = Interest Rate per period}\\ \text{n = Number of periods considered for calculation}\end{array}$

• Assets and Expenses have debit balances and must be debited in order to increase their balance and credited in order to decrease their balance.

• Liabilities and Incomes have credit balances and must be debited in order to decrease their balance and credited in order to increase their balance.

• Office equipment is an asset and must be debited in order to establish the asset. Lease liability is a liability and hence must be credited in order to record the liability at inception.

Conclusion

Hence the transaction of recording the capital lease at inception is journalized.

To determine

3)

Introduction:

Present value of lease payments:

• Leasing is an arrangement between two parties whereby one party known as the lessor, rents goods or right to use goods for a period of time that is predetermined and the other party, known as the lessee, pays a rent called Lease Rent.

• The present value of lease payments is calculated to analyze the cost borne to lease the goods or services and is a calculation of the lease rent paid over the lifetime translated into equivalent costs as if it was paid today.

$\begin{array}{l}\text{Present Value of Lease payments = P [(1 - (1 / ( 1+ r) ^ n) / r]}\\ \\ \text{where,}\\ \\ \text{P = Lease Rent Per period}\\ \text{r = Interest Rate per period}\\ \text{n = Number of periods considered for calculation}\end{array}$

To Calculate:

Lease Repayment schedule for 5 years

Answer to Problem 11BPSB

Solution:

Period Ending Date	Beginning Balance of Lease Liability	Interest on Lease Liability	Reduction of Lease Liability	Cash Lease Payment	Ending Balance of Lease Liability
2018	$ 75,816.00	$ 7,581.60	$ 12,418.40	$ 20,000.00	$ 55,816.00
2019	$ 63,397.60	$ 6,339.76	$ 13,660.24	$ 20,000.00	$ 49,737.36
2020	$ 49,737.36	$ 4,973.74	$ 15,026.26	$ 20,000.00	$ 34,711.10
2021	$ 34,711.10	$ 3,471.11	$ 16,528.89	$ 20,000.00	$ 18,182.21
2022	$ 18,182.21	$ 1,818.22	-	$ 20,000.00	-

Explanation of Solution

• Beginning Balance of Lease Liability is the present value of the lease payments over the lifetime of the lease agreement. It is computed based on the interest rate and annual lease payments.

• Interest on Lease Liability is computed by calculating the interest rate on the beginning balance of the lease liability outstanding. The interest reduces over time as the principal reduces.

• Reduction of Lease Liability is the difference between the Cash lease payment and the Interest on lease liability. It signifies the principal portion of the lease liability repaid.

• Cash Lease Payment is the annual cash lease rent paid. It consists of both interest and principal.

• Ending Balance of Lease Liability is the difference between the opening balance of the lease liability and the Reduction of Lease Liability. It signifies the principal portion of the lease liability outstanding.

Conclusion

Hence the lease repayment schedule is prepared.

To determine

4)

Introduction:

Depreciation

• Depreciation is the expense of wear and tear of assets owing to their usage over the lifetime of the assets. It signifies the reduction in value of assets over the useful life of the asset.

• There are two methods of calculating depreciation $–$ Straight line method where the asset is depreciated equally over its useful life.

• The other method is the written down value or reducing balance method, whereby the assets are depreciated over their useful life by a fixed percentage every year calculated on the opening balance.

Journal Entries

• Journal entries are the first step in recording financial transactions and preparation of financial statements.

• These represent the impact of the financial transaction and demonstrate the effect on the accounts impacted in the form of debits and credits.

• Assets and expenses have debit balances and Liabilities and Incomes have credit balances and according to the business transaction, the accounts are appropriately debited / credited to reflect the effect of business transactions and events.

To Determine:

Journal entry to record depreciation of the assets on straight line basis.

Answer to Problem 11BPSB

Solution:

Date	Particulars	Debit ($)	Credit ($)
12.31.2019	Depreciation Expense	15,163
	Accumulated Depreciation		15,163
	(Being depreciation expense on office equipment recorded)

Explanation of Solution

• The present value of lease payments is recorded as the value of the assets taken on lease. This is the fair value / cost of acquisition of right to use of the assets.

• Assets are depreciated over a period of 5 years on a straight line basis. Depreciation is calculated as follows:

$\begin{array}{l}\text{Yearly Depreciation = Acquisition Value / Useful Life}\\ \\ \text{Yearly Depreciation = \$ 75,816 / 5 = \$15, 163}\text{.}\end{array}$

• Assets and Expenses have debit balances and must be debited in order to increase their balance and credited in order to decrease their balance.

• Liabilities and Incomes have credit balances and must be debited in order to decrease their balance and credited in order to increase their balance.

• Depreciation Expense is an expense and has a debit balance and must be debited to indicate increase in expense. Accumulated Depreciation is a liability and must be credited to indicate increase in liability.

Conclusion

Hence the transaction to depreciate the assets has been journalized.