Question

(Lessee Entries and Balance Sheet Presentation, Capital Lease) Ludwick Steel Company as lessee signed a lease agreement for equipment for 5 years, beginning December 31, 2017. Annual rental payments of \(40,000 are to be made at the beginning of each lease year (December 31). The taxes, insurance, and the maintenance costs are the obligation of the lessee. The interest rate used by the lessor in setting the payment schedule is 9%; Ludwick’s incremental borrowing rate is 10%. Ludwick is unaware of the rate being used by the lessor. At the end of the lease, Ludwick has the option to buy the equipment for \)1, considerably below its estimated fair value at that time. The equipment has an estimated useful life of 7 years, with no salvage value. Ludwick uses the straight-line method of depreciation on similar owned equipment.

Instructions

1. Prepare the journal entry or entries, with explanations, that should be recorded on December 31, 2017, by Ludwick.

Short answer

The lease liability is $166,794.

Step-by-step solution

Meaning of Capital lease

A capital lease is a mutual agreement in which the lessor agrees to transfer possession of the asset to the lesseeat the end of the lease term. A lessee can benefit from capital leasing because he can buy the asset at a rate cheaper than the market value.

Preparing journal entries

Date	Particular	Debit ($)	Credit ($)
Dec. 31, 2017	Leased Equipment	166,794
	Lease Liability		166,794

To record leased assets and related liability at the present value of 5 future annual payments of $40,000 discounted at 10%.

Working Notes:

Calculation of lease liability

Note: Present value of an annuity due of 1 for 5 periods at 10%.

Date	Particular	Debit ($)	Credit ($)
Dec. 31, 2017	Lease Liability	40,000
	Cash		40,000