Question

On January 1, 2015, Bill Inc. leases equipment from Smart Class Inc. for six years requiring an annual payment of $40,000 on December 31 of each year. The first payment was made on December 31, 2015. Bill's incremental borrowing rate is 8 percent and uses straight-line method of depreciation. Which of the following statements is true?

A.) If it's an operating lease, Bill will report an initial lease liability equal to the present value of the entire lease payments.

B.) If it's a capital lease, Bill will report prepaid rent of $40,000 on its December 31, 2015 balance sheet.

C.) Depreciation expense will be recorded irrespective of whether the lease is classified as operating or capital.

D.) Bill would prefer recording this lease as a capital lease.

If it's a capital lease, Bill will recognize interest expense each year over the term of the lease.

Answer 1

The following statement is true:

If it's a capital lease, Bill will recognize interest expense each year over the term of the lease.

Explanation:

For an operating lease no initial lease liability is required to be reported. Therefore, the first statement is incorrect.

In case of a capital lease, no prepaid rent is reported on the balance sheet. Therefore, the second statement is not correct.

No depreciation expense is recorded in case of operating lease. Therefore, the third statement is incorrect.

A capital lease can be recorded only if the lease meets the criteria for capital lease. It is not based on preference. Therefore, the fourth statement is incorrect.

In case of a capital lease, each lease payment includes interest which is recognized each year over the lease term. Therefore, the last statement is correct.