Multiple Choice Question 70 Ivanhoe, Inc. leased equipment from Tower Company un

Question

Multiple Choice Question 70

Ivanhoe, Inc. leased equipment from Tower Company under a 4-year lease requiring equal annual payments of $244152, with the first payment due at lease inception. The lease does not transfer ownership, nor is there a bargain purchase option. The equipment has a 4 year useful life and no salvage value. Ivanhoe, Inc.’s incremental borrowing rate is 9% and the rate implicit in the lease (which is known by Ivanhoe, Inc.) is 7%. Assuming that this lease is properly classified as a capital lease, what is the amount of principal reduction recorded when the second lease payment is made in Year 2?

PV Annuity Due

PV Ordinary Annuity

3.62432

3.38721

3.53129

3.23972

PV Annuity Due

PV Ordinary Annuity

3.62432

3.38721

3.53129

3.23972

Explanation / Answer

Compute the amount of lease liability recorded at its inception as follows:

Lease liability at its inception

= Annual lease payments x PV Annuity due (9%, 4)

= $244,152 x 3.62432

= $884,885

The first payment of $244,152 will be made at the inception of the lease. This will reduce the balance of lease liability from $884,885 to $640,733.

Interest on $640,733 at the rate of 7% for the first year = 44,851

Therefore, the second lease payment of $244,152 at the beginning of Year 2 will include $44,851 towards interest and the balance towards principal reduction.

Thus,

Principal reduction recorded when the second lease payment is made in Year 2 = $244,152 - $44,851 = $199,301

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