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

(c) Prepare the journal entry or entries, with explanations, that should be recorded on December 31, 2019, by Ludwick.

Short answer

Annual depreciation and annual payment on lease should be recorded.

Step-by-step solution

Meaning of Depreciation

Depreciation is defined as the systematic diminution of the estimated cost of a fixed asset until the asset's value is zero or immaterial. Buildings, furniture, office equipment, and machinery are an example of fixed assets. The land is the only exception, which cannot be depreciated since its value increases with time.

Preparing journal entries

Date	Particular	Debit ($)	Credit ($)
Dec. 31, 2019	Depreciation Expense	23,828
	Accumulated Depreciation Capital Leases		23,828
	(To record annual depreciation on assets leased)
Dec. 31, 2019	Interest Expense	9,947
	Lease Liability	30,053
	Cash		40,000
	(To record annual payment on lease liability of which $9,947 represents interest at 10% on the unpaid principal of $99,473)