Question

Assume that on January 1, 2017, Kimberly-Clark Corp. signs a 10-year noncancelable lease agreement to lease a storage building from Sheffield Storage Company. The following information pertains to this lease agreement. 1. The agreement requires equal rental payments of \(72,000 beginning on January 1, 2017. 2. The fair value of the building on January 1, 2017, is \)440,000. 3. The building has an estimated economic life of 12 years, with an unguaranteed residual value of \(10,000. Kimberly-Clark depreciates similar buildings on the straight-line method. 4. The lease is nonrenewable. At the termination of the lease, the building reverts to the lessor. 5. Kimberly-Clark’s incremental borrowing rate is 12% per year. The lessor’s implicit rate is not known by Kimberly-Clark. 6. The yearly rental payment includes \)2,471 of executory costs related to taxes on the property.

Instructions

Prepare the journal entries on the lessee’s books to reflect the signing of the lease agreement and to record the payments and expenses related to this lease for the years 2017 and 2018. Kimberly-Clark’s corporate year-end is December 31.

Short answer

The total debit and credit side of the journal is $757,905.

Step-by-step solution

Meaning of Capital Lease

A capital lease can be termed as the transfer of ownership rights to the lessee at the end of the lease period. The lease is treated as a loan (debt finance), and interest payments are deducted from the income. The lessee has to make payment to the lessor according to the lease agreement.

Calculating the capitalized amount of the lease

Capitalized amount of the lease:
Yearly payment	$72,000
Executory costs	(2,471)
Minimum annual lease payment	$69,529

Calculation of Present value of minimum lease payments

$\begin{array}{rcl}\mathrm{Present}\mathrm{value}\mathrm{of}\mathrm{minimum}\mathrm{lease}\mathrm{payments}& =& \mathrm{Minimum}\mathrm{annual}\mathrm{lease}\mathrm{payments}\times \mathrm{Present}\mathrm{value}\mathrm{of}\mathrm{annuity}\\ & =& \$69,529\times 6.32825\\ & =& \$440,000\end{array}$

Note: Present value of an annuity due of 1 for 10 periods at 12%

Rounded by $3.

Preparing Journal entries

Date	Particular	Debit ($)	Credit ($)
Jan. 1, 2017	Leased Buildings	440,000
	Lease Liability		440,000
Jan. 1, 2017	Executory Costs	2,471
	Lease Liability	69,529
	Cash		72,000
Dec. 31, 2017	Depreciation Expense	44,000
	Accumulated Depreciation Capital Leases		44,000
Dec. 31, 2017	Interest Expense	44,457
	Interest Payable		44,457
Jan. 1, 2018	Executory Costs	2,471
	Interest Payable	44,457
	Lease Liability	25,072
	Cash		72,000
Dec. 31, 2018	Depreciation Expense	44,000
	Accumulated Depreciation Capital Leases		44,000
Dec. 31, 2018	Interest Expense	41,448
	Interest Payable		41,448

Working Notes:-

Preparing Lease Amortization Schedule

KIMBERLY-CLARK CORP. Lease Amortization Schedule (Lessee)
Date	Annual Payment Less Executory Costs	Interest (12%) in Liability	Reduction of the lease liability	Lease liability
1/1/17				$440,000
1/1/17	$69,529	$ 0	$69,529	370,471
1/1/18	69,529	44,457	25,072	345,399
1/1/19	69,529	41,448	28,081	317,318