Question

On December 15, 2015, Lenny entered into a three-year non-cancellable lease with Emmy
Leasing for the lease of specialized equipment. The lease commences in January 1, 2016 and
requires Lenny to make three lease payments of $200,000 each, on January 1, 2016, December
31, 2016 and December 31, 2017.
On March 31, 2017, following the issuance of their annual financial statements Lenny
discovered the error in accounting for the lease. All lease payments made in 2016 had been
recorded as if the lease was an operating lease however, the lease should have been
accounted for as a capital lease.
The fair value of the leased equipment on the January 1, 2016 was $548,000 and the expected
useful life was 3 years with a residual value of $38,000. The lease did not contain a purchase
option or guaranteed residual value. The implicit rate in the lease is 10% (and is known by
the lessee) and the effective tax rate of Lenny is 40%. Lenny uses the straight-line depreciation
method which is approximately the same for tax reporting purposes.

Prepare the original entries made in 2016 for the lease as an operating lease:

Prepare the entries that should have been made in 2016 to record the lease as a capital
lease:

Prepare the correcting entry to be made in 2017 when the error was discovered:

Answer 1

YEARS	LP	PVF	PV
1	200000	1	200000
2	200000	0.909091	181818.2
3	200000	0.826446	165289.3
			547107.4

a) original entries made in 2016 for the lease as an operating lease

Lease payments	200000
Bank		200000

b) entries that should have been made in 2016 to record the lease as a capital
lease

Right to use asset	547107
Lease liability		547107

c) Correcting entries to be made

SL No	Particulars	Debit	Credit
1	For reversing the lease payment effect
	Lease liability	381818
	Interest payments	18182
	Retained earnings		400000
2	Depreciation	182369
	Accumulated depreciation		182369
3	Income tax	79780
	retained earnings		79780