Question of the Week

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

Answer:

The correct answer is: 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:

Present value of buy-back value
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%).