Question

(Lessee Entries, Capital Lease with Monthly Payments) Shapiro Inc. was incorporated in 2016 to operate as a computer software service firm with an accounting fiscal year ending August 31. Shapiro’s primary product is a sophisticated online inventory-control system; its customers pay a fixed fee plus a usage charge for using the system.

Shapiro has leased a large, Alpha-3 computer system from the manufacturer. The lease calls for a monthly rental of \(40,000 for the 144 months (12 years) of the lease term. The estimated useful life of the computer is 15 years.

Each scheduled monthly rental payment includes \)3,000 for full-service maintenance on the computer to be performed by the manufacturer. All rentals are payable on the first day of the month beginning with August 1, 2017, the date the computer was installed and the lease agreement was signed. The lease is noncancelable for its 12-year term, and it is secured only by the manufacturer’s chattel lien on the Alpha-3 system.

This lease is to be accounted for as a capital lease by Shapiro, and it will be depreciated by the straight-line method with no expected salvage value. Borrowed funds for this type of transaction would cost Shapiro 12% per year (1% per month). Following is a schedule of the present value of \(1 for selected periods discounted at 1% per period when payments are made at the beginning of each period.

Periods Present (months)	Present Value of \)1 per Period Discounted at 1% per Period
1	1.000
2	1.990
3	2.970
143	76.658
144	76.899

Instructions

Prepare all entries Shapiro should have made in its accounting records during August 2017 relating to this lease. Give full explanations and show supporting computations for each entry. Remember, August 31, 2017, is the end of Shapiro’s fiscal accounting period and it will be preparing financial statements on that date. Do not prepare closing entries.

Short answer

Minimum lease payments =$2,845,263

Interest accrued = $28,083

Depreciation = $19,759

Step-by-step solution

Meaning of Capital lease

A capital lease is one that gives the lessee all the rights that come with ownership of the asset while payments are still being made. A capital lease is a type of finance. It is a long-term lease that is neither reversible nor cancelable.

Preparing journal entries for August 1, 2017

Date	Particular	Debit ($)	Credit ($)
Aug. 1, 2017	Leased Equipment	2,845,263
	Lease Liability		2,845,263

Working Notes:

Notes: This is a capital lease because the lease term exceeds 75% of the asset’s useful life.

The leased computer and the related liability are recorded at the present value of the minimum lease payments, excluding the maintenance charge, as follows:

Date	Particular	Debit ($)	Credit ($)
Aug. 1, 2017	Maintenance and Repairs Expense	3,000
	Lease Liability	37,000
	Cash		40,000

Note: This entry is for the first payment due under the leasing agreement, which was due on August 1, 2017. Since the agreement commenced on August 1, no interest is recognized on that date. Maintenance costs of $3,000 are included in the cash purchase.

Preparing journal entries for August 31, 2017

Date	Particular	Debit ($)	Credit ($)
Aug. 31, 2017	Interest Expense	28,083
	Interest Payable		28,083

Interest accrued on the unpaid balance of the lease liability from August 1 to August 31, 2017, is computed as follows:

$\begin{array}{rcl}\text{Interest}\text{accured}& =& \left[\text{Lease}\text{equipment}-\left(\text{Monthly}\text{rental}-\text{Maintenace}\text{cost}\right)\right]\times \text{Discounted}\text{rate}\\ & =& \left[\$2,845,263-\left(\$40,000-\$3,000\right)\right]\times 1\%\\ & =& \left[\$2,845,263-\$37,000\right]\times \frac{1}{100}\\ & =& \$28,083\end{array}$

Depreciation is recorded for one month of the use of the computer using the lease term:

$\begin{array}{rcl}\text{Depreciation}& =& \text{Lease}\text{equipment}\times \frac{\text{Used}\text{month}}{\text{Total}\text{month}}\\ & =& \$2,845,263\times \frac{1}{144}\\ & =& \$19,759\end{array}$