Answered Essay: On January 1, 2011, ABC Company leased a copier from XYZ. The four-year lease agreement specifies annual payments of $

On January 1, 2011, ABC Company leased a copier from XYZ. The four-year lease agreement specifies annual payments of $100,000 beginning January 1, 2011, the inception of the lease, and at each January 1 thereafter through 2014. The useful life of the copier is estimated to be ten years. Before deciding to lease, ABC considered purchasing a copier for its cash price of $479,079. If funds were borrowed to buy the copier, the interest rate would have been 10%. ABC Company paid a commission of $4,000 to arrange this lease.

a)         How would this lease be classified? Explain your answer.

b)         Prepare the journal entries on January 1 and December 31, for ABC Company for 2011, 2012 and 2013.

Expert Answer

 

  1. How would this lease be classified? Explain your answer.

Answer:

We apply the four classification criteria:

Since none of the below four classification criteria is met, this is an operating lease     

1 Does the agreement specify that ownership of the asset transfers to the lessee? he agreement specify that No
2 Does the agreement contain a bargain purchase option? NO
3 Is the lease term equal to 75% or more of the expected economic life of the asset? No (4 years < 75% of 10 years)
4 Is the present value of the minimum lease payments equal to or greater than 90% of the fair value of the asset? NO**

No** = $100,000 * PVF @10% for 4 years = $100,000 * 3.48685 = $348,685 present Value

  1. Prepare the journal entries on January 1 and December 31, for ABC Company for 2011, 2012 and 2013.

Answer:

Journal Entries:

At Each of the Four Payment Dates: (On the date of Lease rent payment)

In books of ABC (Lessee):

Prepaid Lease rent          Dr           $100,000

Cash                      Cr            $100,000

(Record of Annual lease payments)

At the End of Each Year:

In books of ABC (Lessee):

Lease Rent expense       Dr           $100,000

Prepaid rent       Cr            $100,000

Note:

Advance payments are considered prepayments of rent. They are deferred and allocated to rent over the lease term.

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