To: | Chief Financial Officer of Lessee Inc. |
From: | Annie Kight |
Date: | October 4, 2014 |
Re: | Leased Equipment Recommendation |
After reviewing the various requirements of the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 840 Leases regulations over how to properly account for the leased equipment, I have come up with recommendations of how you should classify the lease, measure the initial minimum lease payment (MLP), calculate the subsequent measurements, and derecognize the leased asset. The remainder of this memo provides my analysis and support for these conclusions.
According to ASC 840-10-25-1, there ...view middle of the document...
” Also, after looking at ASC 840-10-25-5 which states that the MLP should exclude “any guarantee by the lessee of the lessor's debt and the lessee's obligation to pay (apart from the rental payments) executory costs such as insurance, maintenance, and taxes in connection with the leased property.” Therefore, I have concluded that the MLP includes the rental payments of $100,000.00 and the guaranteed residual value that is $20,000.00, but excludes the $2,000.00 of executory costs, such as any expenses related to insurance, maintenance, and taxes.
In order to know which discount rate to use, I looked at ASC 840-10-25-31 which explains that the lessee should use the incremental borrowing rate unless the lessee knows the lessor’s implicit rate and the implicit rate is less than the incremental rate. Since Lessee Inc. knows the lessor’s implicit rate of 10% and it is lower than the 11% incremental borrowing rate, the implicit rate should be chosen to calculate the MLP. I have demonstrated how to make the calculations to determine the MLP below.
Payment | x | Present Value Factor | = | Total |
$100,000.00 | | 2.48685199 | | $248,685.00 |
$20,000.00 | | 0.7513148 | | $15,026.30 |
With the 10% discount rate, the present value of the rent expense for the lease is $248,685.20, and the present value of the guaranteed residual value is $15,026.30. Adding them together makes the MLP $263,711.50. Since the total is not higher than the fair value of the equipment at the lease inception of $265,000.00, according to ASC 840-30-30-3, record the MLP at present value. You should record the journal entry for the inception of this lease as it is shown below:
Dr. Leasehold Asset 263,711.50
Cr. Leasehold Liability 263,711.50
By recording the leasehold asset as I have presented will allow you to have a proper representation of the present value of the lease.
To know how much to expense for each year, make an amortization schedule that will allow you to calculate how much should be expensed each year. Since I already established the use of the implicit rate, the interest expense for the first year will be 10% of the MLP $263,711.50, making it $26,371.15. According to ASC 840-30-35-6, “each minimum lease payment shall be allocated by the lessee between a reduction of the obligation and interest expense to produce a constant periodic rate of interest on the remaining balance of the obligation.” The amortization that I have created is shown below:
Date | Annual Payment | Interest Expense (10%) | Debit to Lease Liability | Lease Liability |
1/1/13 | | | | $263,711.50 |
12/31/13 | $100,000.00 | $26,371.15 | $73,628.85 | $190,082.65 |
12/31/14 | $100,000.00 | $19,008.26 | $80,991.74 | $109,090.91 |
12/31/15 | $100,000.00 | $10,909.09 | $89,090.91 | $20,000.00 |
I used the amortization schedule to complete the journal entry to record how much interest to expense and...