Question

Adden Company signs a lease agreement dated January 1, 2016, that provides for it to lease heavy equipment from Scott Rental Company beginning January 1, 2016. The lease terms, provisions, and related events are as follows:

1.	The lease term is 4 years. The lease is noncancelable and requires annual rental payments of $20,000 to be paid in advance at the beginning of each year.
2.	The cost, and also fair value, of the heavy equipment to Scott at the inception of the lease is $68,036.62. The equipment has an estimated life of 4 years and has a zero estimated residual value at the end of this time.
3.	Adden agrees to pay all executory costs.
4.	The lease contains no renewal or bargain purchase option.
5.	Scott’s interest rate implicit in the lease is 12%. Adden is aware of this rate, which is equal to its borrowing rate.
6.	Adden uses the straight-line method to record depreciation on similar equipment.
7.	Executory costs paid at the end of the year by Adden are:

2016	2017
Insurance, $1,500	Insurance, $1,300
Property taxes, $6,000	Property taxes, $5,500

Required:

1.	Next Level Examine and evaluate each capitalization criteria and determine what type of lease this is for Adden.
2.	Prepare a table summarizing the lease payments and interest expense for Adden.
3.	Prepare journal entries for Adden for the years 2016 and 2017.

Answer 1

Part 1:

	Capital Lease Condition (must meet at least one condition)	Present (Y or N)?
1	Ownership transferred at end of lease term?	N
2	Bargain purchase option?	Y
3	Lease term at least 75% of estimated economic life of asset? (4 years / 4 years = 100%)	Y
4	PV of minimum future lease payments at least 90% of the asset’s fair market value? (68036.62 / 68036.62 = 100%)	Y

On the basis of the results of examination and criteria (mentioned above), this lease can be considered as capital lease for Adden

Part 2:

Summary of Lease Payments and Interest Expense for Adden Company
(1)	(2)	(3)	(4)
Date	Annual lease payment	Interest at 12% on unpaid Obligation	Balance of capital lease obligation
January 1, 2016	Before initial payment		68036.62
January 1, 2016	20000.00	0.00	48036.62
December 31, 2016	0.00	5764.39	53801.01
January 1, 2017	20000.00	0.00	33801.01
December 31, 2017	0.00	4056.12	37857.13
January 1, 2018	20000.00	0.00	17857.13
December 31, 2018	0.00	2142.87	20000.00
January 1, 2019	20000.00	0.00	0.00

68036.62 – 20000.00 = 48036.62

48036.62 X 12% = 5764.39

48036.62 + 5764.39 = 53801.01

Part 3:

2016
Jan	1	Leased equipment	68036.62
		Capital lease obligation		68036.62
	1	Capital lease obligation	20000.00
		Cash		20000.00
Dec	31	Interest expense	5764.39
		Accrued interest on capital lease Obligation		5764.39
	31	Insurance expense	1500.00
		Property tax expense	6000.00
		Cash		7500.00
	31	Depreciation Expense: Leased Equipment	17009.16
		Accumulated depreciation: leased equipment ($68,036.62/4)		17009.16
2017
Jan	1	Accrued Interest on Capital Lease Obligation	5764.39
		Capital lease obligation	14235.61
		Cash		20000.00
Dec	31	Interest expense	4056.12
		Accrued interest on Capital Lease Obligation		4056.12
	31	Insurance expense	1300.00
		Property tax expense	5500.00
		Cash		6800.00
	31	Depreciation Expense: Leased Equipment	17009.16
		Accumulated depreciation: leased equipment		17009.16