Question

Question: (Balance Sheet and Income Statement Disclosure—Lessee) The following facts pertain to a noncancelable lease agreement between Alschuler Leasing Company and McKee Electronics, a lessee, for a computer system.

Inception date	October 1, 2017
Lease term	6 years
Economic life of leased equipment	6 years
Fair value of asset at October 1, 2017	\(300,383
Residual value at end of lease term	–0–
Lessor’s implicit rate	10%
Lessee’s incremental borrowing rate	10%
Annual lease payment due at the beginning of each year, beginning with October 1, 2017	\)62,700

The collectibility of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. The lessee assumes responsibility for all executory costs, which amount to \(5,500 per year and are to be paid each October 1, beginning October 1, 2017. (This \)5,500 is not included in the rental payment of \(62,700.) The asset will revert to the lessor at the end of the lease term. The straight-line depreciation method is used for all equipment.

The following amortization schedule has been prepared correctly for use by both the lessor and the lessee in accounting for this lease. The lease is to be accounted for properly as a capital lease by the lessee and as a direct-financing lease by the lessor.

Date	Annual lease payments/Receipt	Interest (10%) On Unpaid liability/Receivable	Reduction of Lease Liability? Receivable	Balance of Lease Liability/Receivable
10/01/17				\)300,383
10/01/17	\(62,700		\)62,700	237,683
10/01/18	\(62,700	\)23,768	38,932	198,751
10/01/19	\(62,700	19,875	42,825	155,926
10/01/20	\)62,700	15,593	47,107	108,819
10/01/21	\(62,700	10,882	51,818	57,001
10/01/22	\)62,700	5,699*	57,001	0
	\(376,200	\)75,817	\(300,383

*Rounding error is \)1.

(b) Assuming the lessee’s accounting period ends on December 31, answer the following questions with respect to this lease agreement.

(1) What items and amounts will appear on the lessee’s income statement for the year ending December 31, 2017?

Short answer

Interest expense=$5,942

Lease executory expense = $1,375

Depreciation expense $12,516

Step-by-step solution

Meaning of Capital lease

Under a capital lease, the lessee acquires ownership at the end of the termof the lease.Taxable income is reduced because the corporation can claim depreciation on the asset.

Explaining the items and amounts that will appear on the lessee’s income statement for the year ending December 31, 2017

Interest expense	$ 5,942
Lease executory expense	$ 1,375
Depreciation expense	$ 12,516

Working Notes:

Calculation of Interest expense

$$\begin{gathered} \text{Interest}\text{expense}=\text{Interest}\text{on}\text{unpaid}\text{liability}\text{or}\text{receivable}\times \text{Total}\text{month} \\ =\$23,768\times \frac{3}{12} \\ =\$5,942 \end{gathered}$$

Calculation of Lease executory expense

$$\begin{gathered} \text{Lease}\text{executory}\text{expense}=\text{Lease}\text{executory}\text{expense}\times \text{Total}\text{month} \\ =\$5,500\times \frac{3}{12} \\ =\$1,375 \end{gathered}$$

Calculation of Depreciation expense

$$\begin{gathered} \text{Depreciation}\text{expense}=\left(\frac{\text{Fair}\text{value}\text{of}\text{asset}}{\text{Useful}\text{life}}\right)\times \text{Total}\text{month} \\ =\left(\frac{\$300,383}{6}\right)\times \frac{3}{12} \\ =\$50,064\times \frac{3}{12} \\ =\$12,516 \end{gathered}$$