Question

At January 1, 2021, Café Med leased restaurant equipment from Crescent Corporation under a nine-year lease agreement. The lease agreement specifies annual payments of $21,000 beginning January 1, 2021, the beginning of the lease, and at each December 31 thereafter through 2028. The equipment was acquired recently by Crescent at a cost of $180,000 (its fair value) and was expected to have a useful life of 13 years with no salvage value at the end of its life. (Because the lease term is only 9 years, the asset does have an expected residual value at the end of the lease term of $76,604.) Crescent seeks a 8% return on its lease investments. By this arrangement, the lease is deemed to be an operating lease. (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. What will be the effect of the lease on Café Med’s earnings for the first year (ignore taxes)? (Enter decreases with negative sign.)
2. What will be the balances in the balance sheet accounts related to the lease at the end of the first year for Café Med (ignore taxes)?

1.	Effect on earnings
2.	Lease payable balance (end of year)
	Right-of-use asset balance (end of year)

Answer 1

Since the lease is operating lease

1)

Cafe Med is a lessee and the annual payment to lessor is treated as expense for the year.

So the annual lease rental of $21,00 is treated as expense in current year.

So the Earnings will come down by $21,000 in year 1. i.e. -$21,000

2)

Since it is operating lease, there will be no recognition of lease liability and Right of use of asset. So no leased asset in books of Lessee.

A. Effect on earnings is already stated in above point (-$21,000)

B. Lease payable balance will be nil

But there is an advance payment of $21,000 at 31st December relating to next year. This will be shows as Deferred Rental Expense (or Prepaid Expense).

C. No balance in Right of Use Leased asset