Answer:
1) Determine the lease type for Baillie Power and explain why.
The lease should be treated as an operating lease because:
- ownership is not transferred at the end of the lease
- the lease term represents only 40% of the asset's useful life
- the present value of the lease agreement is only 45% of the asset's value
- no bargain purchase option exists
effective interest rate:
1.08 = (1 + r)⁴
⁴√1.08 = ⁴√(1 + r)⁴
1.01943 = (1 + r)
r = 1.943%
we must first determine the present value of the lease payments:
PV = (quarterly payment x annuity factor) + quarterly payment
- quarterly payment = $15,000
- PV annuity factor, 7 periods, 1.943% = 6.48620
PV = ($15,000 x 6.48620) + $15,000 = $112,293
2) Prepare a lease amortization schedule and appropriate entries for Baillie Power from the beginning of the lease through December 31, 2021. December 31 is the fiscal year end for each company. Appropriate adjusting entries are recorded at the end of each quarter.
amortization schedule:
quarter lease payment interest lease liability's carrying value
1 $15,000 $0 $97,293
2 $15,000 $1,890 $84,183
3 $15,000 $1,636 $70,819
4 $15,000 $1,376 $57,195
5 $15,000 $1,111 $43,306
6 $15,000 $841 $29,147
7 $15,000 $566 $14,713
8 $15,000 $287 $0
January 1, 2021, lease equipment from Courtney Leasing
Dr Right of use asset 112,293
Cr Lease liability 112,293
January 1, 2021, first lease payment
Dr Lease expense 15,000
Cr Cash 15,000
Dr Lease liability 15,000
Cr Right of use asset 15,000
March 31, 2021, second lease payment
Dr Lease expense 15,000
Cr Cash 15,000
Dr Lease liability 13,110
Cr Right of use asset 13,110
June 30, 2021, third lease payment
Dr Lease expense 15,000
Cr Cash 15,000
Dr Lease liability 13,364
Cr Right of use asset 13,364
September 30, 2021, fourth lease payment
Dr Lease expense 15,000
Cr Cash 15,000
Dr Lease liability 13,624
Cr Right of use asset 13,624
December 31, 2021, fifth lease payment
Dr Lease expense 15,000
Cr Cash 15,000
Dr Lease liability 13,889
Cr Right of use asset 13,889
March 31, 2022, sixth lease payment
Dr Lease expense 15,000
Cr Cash 15,000
Dr Lease liability 14,159
Cr Right of use asset 14,159
June 30, 2022, seventh lease payment
Dr Lease expense 15,000
Cr Cash 15,000
Dr Lease liability 14,434
Cr Right of use asset 14,434
September 30, 2022, eighth lease payment
Dr Lease expense 15,000
Cr Cash 15,000
Dr Lease liability 14,713
Cr Right of use asset 14,713
3) What will be the effect of the lease on Baillie Power's earnings for the first year (ignore taxes)?
Operating leases (lease expense + interest expense) decrease the company's income, but they do not represent a depreciation expense (only financial lessees do).
Total lease expenses during year 1 = $15,000 x 5 = $75,000
4) What will be the balance in the balance sheet accounts of Baillie Power related to the lease at the end of the first year (ignore taxes)?
Right of use asset $43,306
Lease liability $43,306
