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 $19,000 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%. (FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.)

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.

Answer 1

1.

Date	Accounts Titles and Explanation		Debit	Credit
1	Right of use asset		36,548
	Lease Payable			36,548

Workings:

Current
Lease payment		19,000
PVAF @ 4%		5.24214
PV of lease payments		99600.60028
For December 2018
Interest on Lease payments	[99600.60028*4%]	3984.024011
Amortization	[19000- 3984.024011]	15,015.9760
For December 2019
Interest on Lease payments	[(99600.60028 - 3984.024011)*4%]	3824.663051
Amortization	[19000- 3984.024011- 3824.663051]	11,191.3129

Proposed:
Lease payment		19,000
PVAF @ 5% for 7 years		5.78637
PV of lease payments		109941.0946
Balance of the lease asfter 2 years	[99600.60028-15016.9760-11191.3129]	73,393.3114
Increase in liability	[109941.0946- 73393.3114]	36,547.7832

2. No journal entry.