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Chapter 10: Problem 20

Leases On January 1, Lorraine, Inc., entered into a lease contract. The lease contract was a ten-year lease for a computer with \(\$ 15,000\) annual lease payments due at the end of each year. Lorraine took possession of the computer on January 1. The present value of the lease payments under the lease contract is \(\$ 108,703\). The lease contract is a finance lease. Prepare the joumal entry for this lease on January \(1 .\)

Short Answer

Expert verified
Debit Leased Equipment $108,703; Credit Lease Liability $108,703.

Step by step solution

01

Recognize the Lease as a Finance Lease

Since the lease is classified as a finance lease, Lorraine, Inc. should record the leased asset and liability at the present value of the lease payments on January 1st. This complies with the accounting standards for finance leases, where the asset and liability are initially recorded at the present value of the minimum lease payments.
02

Record the Leased Asset

Lorraine, Inc. should debit the leased asset account to reflect acquiring the asset. The present value of the lease payments, which is the value of the asset, is \[ \text{Leased Asset} = \$108,703 \]
03

Record the Lease Liability

Simultaneously, Lorraine, Inc. should credit the lease liability account to reflect the obligation to make lease payments. This liability amount is equal to the present value of the lease payments:\[ \text{Lease Liability} = \$108,703 \]
04

Prepare the Journal Entry

Now, prepare the journal entry using the values calculated:- Debit: Leased Equipment\[ \text{Debit} = \\(108,703 \]- Credit: Lease Liability\[ \text{Credit} = \\)108,703 \]

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Finance Lease
A finance lease, as opposed to an operating lease, allows the lessee to use the asset for most of its useful life. The lessee, in this case, has significant ownership-like risks and benefits. This means that the lessee acts almost like an owner during the term of the lease. In general, a lease qualifies as a finance lease if it meets certain criteria:
  • The lease term covers the major part of the asset's useful life.
  • The present value of lease payments approximates the asset's fair value.
  • There is a transfer of ownership at the end of the lease or a purchase option.
In the case of Lorraine, Inc., the lease is considered a finance lease because the present value of the lease payments is substantial, and the lease term spans ten years, which is significant. This makes the terms similar to a purchase agreement.
Journal Entries
Journal entries are a fundamental part of bookkeeping and accounting. They ensure that company transactions are recorded accurately in the financial statements. For a finance lease, initial recognition involves recording both an asset and a liability:
  • Debit the leased asset account: This reflects that the company has now gained control over the asset. For Lorraine, Inc., the debit would be the leased equipment account with a value of $108,703.
  • Credit the lease liability account: Simultaneously, this represents the obligation to pay for the asset over time. The credit entry for Lorraine is also $108,703.
These initial entries set the stage for future adjustments and payments. As payments are made, Lorraine will reduce the lease liability with additional journal entries. These entries keep the balance sheet balanced and track the company's financial obligations accurately.
Present Value of Lease Payments
The present value of lease payments is a crucial component in lease accounting. It represents the total value of a series of payments, discounted to the present day using a specific interest rate. This mathematics gives us a clearer picture of the lease's real cost:
  • The present value helps record the leased asset and liability at the fair value.
  • It takes into consideration the time value of money 鈥� money now is worth more than money later.
For Lorraine, Inc., the present value of $108,703 was calculated using the lease's terms and an appropriate discount rate. This number represents the cost of the lease in today's terms, justifying the initial entries made in the books. It's important to be precise with this value, as it influences the financial statements' accuracy.

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Most popular questions from this chapter

Leases On January 1, Cheryl, Inc., entered into a lease contract. The lease contract was an eightyear lease for a sound system with \(\$ 28,000\) annual lease payments due at the end of each year. Cheryl took possession of the sound system on January 1. The present value of the lease payments under the lease contract is \(\$ 173,778\). The lease contract is a finance lease. Prepare the journal entry for this lease on January \(1 .\)

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