On January 1, 2018, Penn Corporation signed a ten-year noncancelable lease for c
ID: 2555054 • Letter: O
Question
On January 1, 2018, Penn Corporation signed a ten-year noncancelable lease for certain machinery. The terms of the lease called for Penn to make annual payments of $100,000 at the beginning of each year for ten years with title to pass to Penn at the end of this period. The first payment was paid on Jan. 1, 2018. The machinery has an estimated useful life of 15 years and no salvage value. Penn uses the straight-line method of depreciation for all of its fixed assets. Penn accordingly accounted for this lease transaction as a finance lease. The lease payments were determined to have a present value of $724,689 at an effective interest rate of 8%. With respect to this capitalized lease, Penn should record for 2018
a. lease expense of $100,000.
b. interest expense of $48,313 and amortization expense of $72,469.
c. interest expense of $49,975 and amortization expense of $48,313.
d. interest expense of $49,975 and amortization expense of $72,469.
The answer is C. Please show me how to get it?
Explanation / Answer
The lease payments are at the beginning of the year.
Therefore, the present value of all lease payments include the amount that is paid on the 01/01/2018 i.e. at the inception of the lease, which it self is a present value figure.
Thus, we need to deduct it to get the actual amount of lease which equals to $724,689-$100,000 = $624,689
$624,689 is the borrowed amount which is repaid in 9 equal installments of $100,000 each (Total installments were 10, but since 1 installment is paid at the inception itself, only 9 are unpaid).
In the first year, 2018, the interest expense, would be for entire year, because lease began from 01/01/2018.
Interest rate is 8%, so to calculate interest expense, we have the calculate interest at the given perecentage on the borrowed amount = 8% * $624,689
which results in interest expense of $ 49,975
Next is calculation of amortization expense:
In case of lease, the present value of lease payments is the cost of the underlying asset.
Thus, in our case, it is $724,689
The asset is amortized using straight line method of depreciation and it has a useful life of 15 years. Salvage is not given, we assume it is zero.
Therefore, amortization expense = (Cost of asset - salvage value) / Useful life
= ($724,689-0)/15
= $48,313
Thus, the answer is C option