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 $33,600 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 $225,000.
• 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. Is the lease an operating lease or a financing lease?

• Operating lease

• Financing lease

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

c. 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.)

d. 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

Present value of the lease payments = $ 33,600 x [ { 1 - ( 1 / 1.08 ) ⁵ } / 0.08 ] x 1.08 = $ 33,600 x 4.3121 = $ 144,887

Percentage of the present value of minimum lease payments = $ 144,887 / $ 225,000 = 0.6439 or 64.39 % or less than 90 %.

Lease term is 50 % of the economic life of the asset. This is less than 75 %.

As the asset is returned at the end of the lease term by the lessee, risks and rewards of ownership do not pass from the lessor to the lessee.

There is no bargain purchase option at the end of the lease term.

a. Operating Lease.

As the lease does not satisfy any of the four requirements of a financing lease, it is to be classified as an Operating Lease.

b. $ 33,600, as lease rent expense.

c. $ 0.

As this is an operating lease, and not a financing lease, there would be no interest expense.

d. $ 0.