(3) Junk Peddler Inc, leases its carts which it uses to sell trinkets. On Jan 1,
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Question
(3) Junk Peddler Inc, leases its carts which it uses to sell trinkets. On Jan 1, 2014, the company leased a cart and agreed to make lease payments of $20,000 each year. The lease contract has a term of five years, after which the cart can be purchased by Junk Peddler for a nominal price. Assume an effective rate of 10 percent. Compute the annual rental expense if the lease is treated as an operating lease Prepare the journal entry on Jan 1, 2014 if the lease is treated as a capital lease. Compute the total expense associated with the lease during the first year if the lease is treated as a capital lease. Which of the two methods of treatment (operating or capital) would rise to a higher net income in the first year? Which method would give rise to a lower debt/equity ratio? a. b. c. d. e. How can the leases be arranged to treat them as operating!Explanation / Answer
Part a. Since we are treating the lease as an operating lease, the annual lease payment will be as given in the question that is, $20,000 each year for five years. The basic principle of operating lease is that it includes the lease rentals to be calculated on straight line basis, i.e. the same lease rental for each year up to the term of the lease. In the question since the lease rental for each is itself given hence, the same would be taken for calculation.
Part b. A capital lease is the one where you have to consider the effect of time value of money and hence you need to calculate the interest and principal portion of the annual lease payments. The formula for calculation is as below:
PV = SUM[P/(1+r)n] + [RV/(1+r)n]
Where PV = Present Value
P = Annual Lease Payments
r = Interest rate
n = number of years in the lease term
RV = residual value
In our case since the residual value is not mentioned we consider it to be zero
therefore, we have P = $20,000, r = 0.10, n = 5, RV = $0
PV = [20000/(1.10)] + [20000/(1.10)2] + [20000/(1.10)3] + [20000/(1.10)4] + + [20000/(1.10)5] + [0/(1.10)5]
PV = $18,181.81 + $16,528.92 + $15,026.30 + $13,660.27 + $12,418.42 + $0
PV = $75,815.72
Therefore we have, Principal portion = $75,815.72, Interest portion = $20,000*5 - $75,815.72 = $24,184.28
So, the journal entry for the first year will be as follows:
Capital lease liability account A/C DR$18,181.81
Interest expense A/C DR$1,818.19
Accounts payable A/C CR$20,000
Part C: The total lease expense for the lease if treated as a capital lease would be as calculated in the above b point that is total PV of the kart $75,815.72.
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