Question

Hi I have a question about calculating depreciation expense for leases. Please look at the two examples below. In the first example the lease term is used to calculate depreciation expense. In the second example the economic life of the asset is used to calculate the depreciation expense. Can someone explain why the lease term is used in one and not the other? thank you.

Example 1:Refer to the following lease amortization schedule. The 10 payments are made annually starting with
the inception of the lease. Title does not transfer to the lessee and there is no bargain purchase option
or guaranteed residual value. The asset has an expected economic life of 12 years. The lease is
noncancelable.

Payment	Cash Payment	Effective Interest	Decrease in Balance	Balance
				63282
1	10000		10000	53282
2	10000	6394	3606	49676
3	10000	5961	4039	45638
4	10000	5477	4523	41114
5	10000	4934	5066	36048
6	10000	4326	5674	30373
7	10000	3645	6355	24018
8	10000	2882	7118	16901
9	10000	?	?	?
10	10000	?	?	?

What would the lessee record as annual depreciation on the asset using the straight-line
method?
a. $ 5,328.
b. $ 6,328. (63282/10) (The lease term of ten years is used to calculate depreciation expense instead of the economic life)
c. $ 6,392.
d. $10,000.

Example 2:Refer to the following lease amortization schedule. The five payments are made annually starting with
the inception of the lease. A $2,000 bargain purchase option is exercisable at the end of the five-year
lease. The asset has an expected economic life of eight years.

Payment	Cash Payment	Effective Interest	Decrease in Balance	Balance
				34600
1	8000	????	???	26600
2	8000	2660	5340	21260
3	8000	2126	5874	15386
4	8000	1539	6461	8925
5	8000	??	??	??
6	2000	182	1818	0

What would the lessee record as annual depreciation on the asset using the straight-line
method, assuming no residual value?
a. $3,325.

b. $6,920.
c. $4,325. (34600/8) (The economic life of 8 years is used to calculate depreciation expense instead of the lease term)
d. $5,320.

Answer 1

Solution :

Example 1:

In the first example, economic life of asset is 12 years and lease term is 10 years. However lease terms does not transfer the title at the end of lease terms and does not contain bargain purchase option. Therefore useful period of lessee is only 10 years after that asset will be transferred to the lessor.

Therefore in this example lease term of ten years is used to calculate depreciation expense instead of the economic life.

Example 2:

In the 2nd example, lease terms consist of bargain purchase option, it means at the end of lease term if lessee exercise bargain purchase option then title of asset will be transferred to lessee. Therefore lessee can use the assets upto its economic life.

Hence in this example economic life of 8 years is used to calculate depreciation expense instead of the lease term.