Question

Krawczek Company will enter into a lease agreement with Heavy Equipment Co. where Krawczek will make lease payments over the next five years. The lease is cancelable and requires equal annual payments of $23,200 per year beginning on January 1 of the first year. The last payment will be January 1 of year 5, and Krawczek will continue to use the asset until December 31 of that year. Other important information includes the following:

• The fair value of the equipment is $160,000.
• The applicable discount rate is an 8 percent annual rate.
• The economic life of the asset is 10 years.
• Krawczek does not guarantee the residual value of the asset at the end of the lease, and it does not expect to keep the asset at the end of the term.
• The asset is a standard piece of equipment.

A. What will be the lease expense shown on the income statement at the end of year 1?

B. What will be the interest expense shown on the income statement at the end of year 1? (Leave no cells blank – be certain to enter “0” wherever required.)

C. What will be the amortization expense shown on the income statement at the end of year 1? (Leave no cells blank – be certain to enter “0” wherever required.)

Answer 1

In the given circumstances, the lease does not meet any of the requirements to be classified as a financing lease. Therefore, it will be treated as an operating lease and the answers to questions A, B, and C will be based on this assumption.

A.

In case of an operating lease, the annual lease payment is reported in the income statement as lease expense. Therefore, lease expense shown on the income statement at the end of year 1 is $23,200.

B.

Interest expense is $0. Interest is recorded only when the lease is a financing lease.

C.

Amortization expenses is $0. Amortization expense is recorded only when the lease is a financing lease.