Renter's Dilemma

Hucks, Inc. (Hucks), a publicly traded corporation, plans to lease equipment from Jackson Co. (Jackson) on January 1, 2020, for a period of three years.Lease payments of $100,000 are due to Jackson each year. Other expenses (e.g., insurance, taxes, and maintenance) are also to be paid by Hucks and amount to $2,000 per year. Jackson will not incur any initial direct costs. The lease contains no purchase or renewal options and the equipment reverts back to Jackson on the expiration of the lease. The remaining useful life of the equipment is four years. The fair value of the equipment at lease inception is $265,000. Hucks has guaranteed $20,000 as the residual value at the end of the lease term. The $20,000 represents the expected value of the leased equipment to Hucks at the end of the lease term. The salvage value of the equipment is expected to be $2,000 after the end of its economic life. Hucks's incremental borrowing rate is 11 percent (Jackson's implicit rate is 10 percent and is calculable by Hucks from the lease agreement).

The junior accountant of Hucks analyzed the assets under lease, determined whether the lease was an operating lease or finance lease, and prepared the applicable journal entries. The senior accountant of Hucks reviewed the junior accountant's analysis and prepared a separate analysis. As the finance controller, you were given both analyses to determine the correct accounting treatment. Calculations and journal entries performed by your junior and senior accountant follow:

Present Value of the Lease Obligation

Using the rate implicit in the lease (10 percent), the present value of the guaranteed residual value would be $15,026 ($20,000 x 0.7513), and the present value of the annual payments would be $248,685 ($100,000 x 2.4869).

Using the incremental borrowing rate (11 percent), the present value of the guaranteed residual value would be $14,624 ($20,000 x 0.7312), and the present value of the annual payments would be $244,371 ($100,000 x 2.4437).

Junior accountant analysis:

Since the equipment reverts to Jackson, it is an operating lease.

Entry to be posted in years 1, 2, and 3:

Dr. Rent expense $100,000

Dr. Insurance expense $2,000

Cr. Cash $102,000

(Operating lease rental paid to Jackson)

Senior accountant analysis:

Step 1 - Lease classification

The lease term is for three years. The useful life of the equipment is four years. Since the lease term is for a major part of the useful life of the equipment, it is a finance lease.

Step 2 - Computation of the lease asset and obligation

Since Hucks's incremental borrowing rate is greater than the implicit rate in the lease, compute the present value of the minimum lease payments using the 11 percent rate.

Present value of the minimum lease payments = $100,000 x 2.4437 = $244,371.

Step 3 - Allocation of payments between interest and lease obligation

Since interest must be charged on the straight-line method, the following is the allocation of the interest and the reduction in the lease liability.

Year	Cash Payment	Interest Expense (11%)	Reduction in Lease Obligation	Balance of Lease Obligation
0				$244,371
1	$100,000	$26,881	$73,119	$171,252
2	$100,000	$26,881	$73,119	$98,133
3	$100,000	$26,881	$73,119	$25,014

Entry to be posted in year 1 for capitalization of equipment:

Db. Equipment $244,371

Cr. Lease obligation $244,371

Entry to be posted in years 1, 2, and 3 for payment:

Dr. Rent expense $2,000

Dr. Interest expense $26,881

Dr. Lease obligation $73,119

Cr. Cash $102,000

(Finance lease rental paid to Jackson)

Issues

1. Which set of lease rules apply to this transaction?
2. How should Hucks classify this lease?
3. Pursuant to the classification in Issue 2, how should Hucks record the lease initially?
4. Pursuant to the classification in Issue 2, how should Hucks record each lease payment?