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

(b) Prepare the journal entry or entries, with explanations, that should be recorded on December 31, 2018, by Ludwick. (Prepare the lease amortization schedule for all five payments.)

Short answer

Depreciation of the leased asset and annual payment on the lease should be recorded.

Step-by-step solution

Meaning of lease agreement

A lease agreement is a bilateral agreement in which the owner of a particular asset gives the other party the right to use it for a specific period of time. The lease agreement can be terminated by either party before the actual maturity date by drafting notice.

Preparing journal entries

Date	Particular	Debit ($)	Credit ($)
Dec. 31, 2018	Depreciation Expense	23,828
	Accumulated Depreciation Capital Leases		23,828
	(To record depreciation of the leased asset based upon a cost to Ludwick of $166,794 and a life of 7 years)
Dec. 31, 2018	Interest Expense	12,679
	Lease Liability	27,321
	Cash		40,000
	(To record annual payment on lease liability of which $12,679 represents interest at 10% on the unpaid principal of $126,794)

Preparing lease amortization schedule

LUDWICK STEEL COMPANY (Lessee) Lease Amortization Schedule (Annuity Due Basis)
Date	Annual Lease Payment	Interest (10%) in Liability	Reduction of Lease Liability	Lease Liability
12/31/17	-			$166,794
12/31/17	$40,000	$ 0	$40,000	126,794
12/31/18	40,000	12,679	27,321	99,473
12/31/19	40,000	9,947	30,053	69,420
12/31/20	40,000	6,942	33,058	36,362
12/31/21	40,000	3,638	36,362	0

Note: There is a rounding error of $2 in the interest (10%) in liability on 12/31/21