[payaza2000]

I was under the impression that the first lease payment reduced principal only so the interest expense would be

On January 2, Year 1, Marx Co. as lessee signed a five-year noncancelable equipment lease with annual payments of $200,000 beginning December 31, Year 1. Marx treated this transaction as a capital (finance) lease. The five lease payments have a present value of $758,000 at January 2, Year 1, based on interest of 10%. What amount should Marx report as interest expense for the year ended December 31, Year 1?

Shouldn’t the answer be $0 since the first lease payment reduces principal only? I didn’t quite understand Becker’s explanation?

Choice “b” is correct. The lease term began January 2, Year 1 on a lease valued at $758,000. The first payment of $200,000 was made on December 31, Year 1. Since the interest rate is 10% and one year has expired, Marx Co.’s interest expense is computed as 10% of $758,000 or $75,800. The remainder of the $200,000 payment reduces the obligation under the lease.

FAR 5/6/2015- 84
REG 8/3/2015 - 87
AUD 10/25/2015- 69 1/20/2016 -75
BEC 2/26/2016- 80

Thank you God

[Anonymous]

There is a Great example of this in Becker F5-18 (Becoming very comfortable with this example really helped me with leases)

You are correct in that the initial payment reduces only principal since it is an Annuity due and no interest has accrued.

The question is a little tricky and wants you to accrue year end interest expense before it is paid on Jan 2 of year 2.

Think about it logically. You have INCURRED a years worth of interest (Jan 2- Dec 31 YEAR 1) so your F/S's need to reflect that. Even though the PAYMENT is not made until Jan 1 of YEAR 2. you need to accrue the expense in year 1 in order to match the interest expense to the correct period.

Jan 2, year 1 to record leased asset on lessee books:

Dr: Leased equipment (Asset)

Cr: Obligation under Capital lease (Liability)

Jan 2, year 1 initial payment (No interest accrued)

Dr: Obligation under capital lease (reduces principal – no interest accrued yet, full amount)

Cr: Cash

Dec 31, YEAR 1 ACCRUAL of interest: (Here's where the confusion you were having comes in to play, notice that this is still part of year 1 even though no payment has been made)

Dr: Interest expense

Cr: Interest payable

**Dont forget to accrue year 1 depreciation expense as well

Dr: Depreciation expense

Cr: Leased equipment (Asset)

Jan 2, YEAR 2 PAYMENT

Dr: Interest payable**

Dr Obligations under Capital lease (Liability)

Cr: Cash

**Dont forget to allocate the cash payment between principal and interest using the effective interest method for the Dec 31, year 1 accrual and subsequent payment on Jan 2, year 2

[payaza2000]

Theoretically I am understanding what you are saying. The problem I have is that looking at this problem following what you have (with one exception) said and what you are supposed to do, the journal entries/calculation would be as follows:

January 1, 1

DR Leased Asset $758,000

CR Capital Lease Obligation $758,000

“equipment lease with annual payments of $200,000 beginning December 31, Year 1.” So next JE would be

December 31, 1

DR. Capital Lease Obligation 200,000

CR Cash 200,000

Lease Obligation: $758,000

First Lease Payment: <$200,000>

Lease Obligation: $558,000

Interest accrued @ Year End would be

$558,000* 10%= $55,800

DR Interest Expense 55,800

CR Interest Payable: 55,800

Jan 2, 2

Dr. Interest Payable: 55,800

Dr Lease Obligation 144,200

CR Cash 200,000

Sorry I am so confused. I studied the F5-18. What am I doing wrong?

FAR 5/6/2015- 84
REG 8/3/2015 - 87
AUD 10/25/2015- 69 1/20/2016 -75
BEC 2/26/2016- 80

Thank you God

[san4596]

Paya – you are missing something fundamental here. The lease began on Jan. 2, 20X1 and the first lease payment is due on Dec. 31, 20X1. Interest on capital leases are calculated just like any other loan based on the principal outstanding. The first payment does not reduce the original loan amount before calculating interest on capital leases. So, you have to calculate interest on the full amount of principal outstanding for the entire year of $758K.

However, I think you may be getting mixed up in that some leases have money due at the beginning of the contract. So, if the lease was signed on Jan. 1, 20X1 and the first lease payment was due on Jan. 1, 20X1. You would reduce $758K by the initial lease payment of $200K.

CPA EXAM: DONE!!!!
Ethics Course: Passed
Application Mailed: 3/16/15
Professional Conduct Exam: 97
Certification Date: 4/2/15!!!

[payaza2000]

Thanks guys ( I feel like an idiot) it really helped.

FAR 5/6/2015- 84
REG 8/3/2015 - 87
AUD 10/25/2015- 69 1/20/2016 -75
BEC 2/26/2016- 80

Thank you God

[Author]

Replies