Nichols Fruits leased farm equipment from King Machinery on January 1, 2016. The

Question

Nichols Fruits leased farm equipment from King Machinery on January 1, 2016. The present value of the lease payments discounted at 10% was $40 million. Ten annual lease payments of $6 million are due at the beginning of each year beginning January 1, 2016. King had constructed the equipment recently for $33 million. With this lease agreement, control is considered to be transferred to the lessee at the beginning of the lease. The total increase in earnings (pretax) in King's 2016 income statement would be:

            A)         $3.4 million.

            B)         $6.0 million.

            C)         $17.0 million.

            D)         $20.4 million.

The text says the answer is $20.4M. I understand how to calculate the interest which equals $3.4M. Where does the $17M difference come from specifically? I think the profit is $7M, the difference between the PV of $40M and the Manufacturing cost of $33M. Please give specifics on this. Thank you.

I copied the question exactly as it is in the text. I thought $20.4M was an error as well and thought the answer should be $10.4M, as you confirmed. I think I'm all set as long as we both agree the answer should be $10.4M. Thank you.

Explanation / Answer

Answer is $10.4 million is right answer

Yes,$20.4M was an error.

Control is transferred so the lessor is allowed to record revenue, and would debit lease receivablefor the $40 million present value of the payments.

The asset would be credited for its book value of$33 million. The difference of $7 million is profit on the "sale." Interest revenue is (10% x [$40 - 6]) =$3.4 million. The total increase in earnings is $7 + 3.4 = $10.4 million.

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