Q:
You are currently reviewing the following information for JKL Corp:
 Starting date of lease: January 1st, 2002 Annual year-end lease payments: \$32,000 Term of Lease: 5 years Buy-back value at end of term: \$55,000 Interest rate implicit on the lease: 11% Interest rate on company's general debt: 13%

If the company uses the capitalized lease method of accounting, what would be the interest expense during the second year of the inception of the lease?
A) \$14,906
B) \$16,600
C) \$15,750
D) \$14,490
A:

 Year Lease Payments Interest Expense BV of Lease 0 \$150,909 1 \$32,000 \$16,600 135,509 2 32,000 14,906 118,415 3 32,000 13,025 99,440 4 32,000 10,938 78,378 5 32,000 8,622 55,000

Interest Expense = (Book Value of Capitalized Lease at beginning of period) x (Effective Interest Rate)
Step 1: Beginning Book Value of Capitalized Lease = present value of lease + present value of the buy-back value.
TI BAII:
FV = -55,000
I = 11%
N = 5
CPT PV = 32,640
Present value of lease
PMT = -32000
I = 11%
N = 5
CPT PV = 118,269
Book value = 32,640 + 118,269 = \$150,909
Step 2: Interest Expense = Previous BV of lease x interest rate

We'll show just the first figure for this step:
= 150909 x 11% = \$16,600
Step 3: Book value = Previous BV of lease - lease payment + interest expense
Again, we'll run an example of the first figure for this step:
Book Value (year 1) = 150909 - 32000 + 16600 = \$135,509
Therefore, the interest expense during the second year of the lease would be \$14,906 (135509 x 11%).

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