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ACTG 4650 Assignment 12 Due April 26 Epps Corp. leased equipment from Anderson Inc. on January 1, 2015, for a period of three years. Lease payments of $100,000 are due to Anderson Inc. each year. Other expenses (e.g., insurance, taxes, maintenance) are also to be paid by Epps Corp. and amount to $2,000 per year. The lease contains no purchase or renewal options and the equipment reverts back to Anderson Inc. 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. Epps Corp. 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 the lessee 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. The lessee's incremental borrowing rate is 11 percent (Lessor's implicit rate is 10 percent and is calculable by the lessee from the lease agreement). The assistant controller of Epps Corp. analyzed the assets under lease, determined whether the lease was an operating lease or capital lease, and prepared the applicable journal entries. The controller of Epps Corp. reviewed the assistant controller's analysis and prepared a separate analysis. As the CFO, you were given both analysis to determine the correct accounting treatment. Calculations and journal entries performed by the assistant controller and controller are below. 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 0.7513), and the present value of the annual payments would be $248,690 ($100,000 2.4869). Using the incremental borrowing rate (11 percent), the present value of the guaranteed residual value would be $14,624 ($20,000 0.7312), and the present value of the annual payments would be $244,370 ($100,000 2.4437). Assistant controller analysis: Since the equipment reverts back to Anderson Inc., it is an operating lease. Entries to be posted in Years 1, 2, and 3: Dr. Lease expense Dr. Insurance expense Cr. Cash $100,000 $2,000 $102,000 (Operating lease rental paid to Anderson Inc.) Controller 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 capital lease. Step 2 Computation of the lease asset and obligation Since the lessee's incremental borrowing rate is greater than the lessor's 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 2.4437 = $244,370. Step 3 Allocation of payments between interest and lease obligation Since interest has to be charged on the straight-line method, the following is the allocation of the interest and the reduction in the lease liability. Reduction in Balance of Interest Lease Lease Year Cash Payment Obligation 0 1 $100,000 2 $100,000 3 $100,000 Expense (11%) Obligation $26,881 $26,881 $73,119 $73,119 $244,370 $171,251 $ 98,131 $26,881 $73,119 $ 25,012 Journal entry in Year 1 to record the payments: Dr. Rent expense Dr. Interest expense Dr. Lease obligation Cr. Cash $ 2,000 $26,881 $73,119 $102,000 Required: 1. Was the assistant controller's analysis correct? Why or why not? 2. Was the controller's analysis correct? Why or why not? 3. If neither answer is correct, show the correct analysis including the year one entry. Be sure to provide appropriate authoritative sources for positions taken