Question

(Accounting for an Operating Lease) On January 1, 2017, a machine was purchased for \(900,000 by Young Co. The machine is expected to have an 8-year life with no salvage value. It is to be depreciated on a straight-line basis. The machine was leased to St. Leger Inc. on January 1, 2017, at an annual rental of \)210,000. Other relevant information is as follows.

1. The lease term is for 3 years.
2. Young Co. incurred maintenance and other executory costs of \(25,000 in 2017 related to this lease.
3. The machine could have been sold by Young Co. for \)940,000 instead of leasing it.
4. St. Leger is required to pay a rent security deposit of \(35,000 and to prepay the last month’s rent of \)17,500.

Instructions

(a) How much should Young Co. report as income before income tax on this lease for 2017?

Short answer

The income before income tax is $72,500.

Step-by-step solution

Meaning of Straight-line depreciation

Straight-line depreciation refers to the depreciation in which the depreciation amount is equal at the end of each year. It can be found by dividing the value of the asset by the total useful life of the asset.

Explaining the report by Young Co. on income before income tax on this lease for 2017

Annual rental revenue	$210,000
Less: maintenance and other executory costs	25,000
Depreciation	112,500
Income before income tax	$ 72,500

Working Notes:

Calculation of Depreciation amount

$$\begin{gathered} \mathrm{Depreciation}=\frac{\mathrm{Machine}\mathrm{cost}}{\mathrm{useful}\mathrm{life}} \\ =\frac{\$900,000}{8} \\ =\$112,500 \end{gathered}$$