Question

The Harris Company is the lessee on a four-year lease with the following payments at the end of each year: Year 1: Year 2: Year 3: Year 4: $19,500 $24,500 $29,500 $ 34,500 An appropriate discount rate is 7 percentage, yielding a present value of $90,024. a-1. If the lease is an operating lease, what will be the initial value of the right-of-use asset? Initial value of the right-of-use asset a-2. If the lease is an operating lease, what will be the initial value of the lease liability? Initial value of the lease liability

Answer 1

This question is based upon the two types of Leases and their presentation in the books of account. The two types of leases here are, Operating Lease and Finance Lease. Operating Lease is the lease where the lessee uses the asset but the ownership rights(risk and rewards) are with the lessor itself. While the other one, Financial Lease is a lease where the risk and the return get transferred to the lessee.
Under the Operating Lease, the lessee does not own the asset, therefore it is not shown in the Balance Sheet (also means no depreciation/amortization is charged), the lessee only records the lease payments as operating expenses in the income statement.
Under the Finance Lease, the ownership rights of the asset are transferred to the lessee, therefore the asset is shown as an asset, while the lease is considered as a liability in the balance sheet. The lessee records the lease, interest and depreciation expenses in the income statement.
Considering an Operating Lease
a-1. Initial Value of the right-of-use asset.
The initial value of the right-of-use asset would be $ 0. Since in operating lease, ownership rights stay with the lessor, hence no asset is recorded.
a-2. Initial Value of the lease liability.
The initial value of the lease liability would be $ 0. Since the operating lease does not require the lease liability to be recorded in the balance sheet.
a-3. Lease expense on the income statement on Year1.
The lease expense to be shown in the income statement would be $19,500 in Year 1.
a-4. Interest expense on the income statement on Year1.
The Interest expense to be shown in the income statement would be $0. Since operating lease doesn't require to record any liability in the balance sheet.
a-5. Amortization expense on the income statement on Year1.
The Amortization expense to be shown in the income statement would be $0. Since operating lease doesn't require to record any asset in the balance sheet.
Considering a Finance Lease
b-1. Initial Value of the right-of-use asset.
The initial value of the right-of-use asset would be $90,024. Under Finance Lease, the asset is recorded at the fair value on commencement of the lease.
b-2. Initial Value of the lease liability.
The initial value of the lease liability would be $90,024. Under Finance Lease, lease liability is calculated as the present value of the lease payments over the lease term discounted(as provided in the problem).
b-3. Lease expense on the income statement on Year1.
The lease expense to be shown in the income statement would be $13,198 in Year 1.
Working: Lease Expense = Lease Payment - Interest for Year 1
Working : Lease Expense = $19,500 - ($90,024*7%)
Working : Lease Expense = $19,500 - $6,302
Working : Lease Expense = $13198
b-4. Interest expense on the income statement on Year1.
The Interest expense to be shown in the income statement would be $6,302. Working: ($90,024*7%)
b-5. Amortization expense on the income statement on Year1.
The Amortization expense to be shown in the income statement would be $22,506. Working: ($90,024 / 4 years) Assuming The Harris Company uses the straight-line method for amortization.