Question

Question: (Lessee Entries and Balance Sheet Presentation, Capital Lease) On January 1, 2017, Cage Company contracts to lease equipment for 5 years, agreeing to make a payment of \(137,899 (including the executory costs of \)6,000) at the beginning of each year, starting January 1, 2017. The taxes, the insurance, and the maintenance, estimated at \(6,000 a year, are the obligations of the lessee. The leased equipment is to be capitalized at \)550,000. The asset is to be depreciated on a double-declining-balance basis, and the obligation is to be reduced on an effective-interest basis. Cage’s incremental borrowing rate is 12%, and the implicit rate in the lease is 10%, which is known by Cage. Title to the equipment transfers to Cage when the lease expires. The asset has an estimated useful life of 5 years and no residual value.

Instructions

(a) Explain the probable relationship of the $550,000 amount to the lease arrangement.

Short answer

The present value of five annual lease payments discounted at 10% is $550,000.

Step-by-step solution

Meaning of Capital lease

The transfer of ownership rights from one party to another at the completion of the lease period is term as a capital lease.A lessee might benefit from capital leasing by purchasing an asset at a lower cost than the market value.

Explaining the probable relationship of the $550,000 amount to the lease arrangement

The amount of $550,000 represents the present value of five annual lease payments of $137,899, less $6,000 in taxes, insurance, and maintenance costs. To put it another way, this is the present value of five $131,899 payments at the beginning of each year, discounted at 10%, less than the implied or incremental rates (since the lessee knows the implied rate).

Taxes, insurance, and maintenance costs are recurring services that the lessor will perform in the future and should not be capitalized. The capitalized amount reflects the full-service aspect of the lessee to which he has provided the asset; Taxes, insurance, and maintenance indicate the lessee's incomplete, untendered services.