Horton Company, as lessee, enters into a lease agreement on July 1, 2008, for equipment. The following data are relevant to the lease agreement: 1. The term of the non-cancelable lease is 4 years, with no renewal option. Payments of 422,689 are due on June 30, of each year. 2. The fair value of the equipment on July, 2008 is 1,400,000. The equipment has an economic life of 6 years with no salvage value. 3. Horton depreciates similar machinery it owns on the sum-of-the year's digits basis. 4. The lessee pays all executory costs. 5. Horton's incremental borrowing rate is 10% per year. The lessee is aware that the lessor used an implicit rate of 8% in computing the lease payments (present value factor for 4 periods at 8%,3.31213; at 10% 3.16986.
a) Indicate the type of lease Horton Company has entered into and what accounting treatment is applicable.
b) Prepare the journal entries on Horton's books that relate to the lease agreement for the following dates: (round all amounts to the nearest dollar. Include a partial amortization schedule)
July 1, 2008
December 31, 2008
June 30, 2009
December 31, 2009
a) Based on the information provided, Horton Company has entered into a capital lease. This is because the lease term is for a major part of the asset's economic life (4 out of 6 years), and the present value of the lease payments exceeds 90% of the fair value of the equipment.
For accounting treatment, Horton Company should record the leased equipment as an asset and the lease payable as a liability on its balance sheet. The lease payments should be allocated between interest expense and reduction of the lease liability.
b) Journal entries on Horton's books for the lease agreement, including a partial amortization schedule, are as follows:
July 1, 2008:
Leased Equipment (Asset) $1,400,000
Lease Payable (Liability) $1,405,070 ($422,689 x 3.31213)
To record the capital lease at the beginning of the lease term.
December 31, 2008:
Interest Expense $112,406 ($1,405,070 x 10%)
Lease Payable (Liability) $422,689 (Payment made)
To record the first semi-annual payment and interest expense for the year.
June 30, 2009:
Interest Expense $112,054 ($1,292,381 x 10%)
Lease Payable (Liability) $422,689 (Payment made)
To record the second semi-annual payment and interest expense for the year.
December 31, 2009:
Interest Expense $110,905 ($1,179,692 x 10%)
Lease Payable (Liability) $422,689 (Payment made)
To record the third semi-annual payment and interest expense for the year.
Partial Amortization Schedule:
Year 1 (2008-2009)
- Lease Liability: $1,405,070 - $422,689 - $422,689 = $559,692
Year 2 (2009-2010)
- Lease Liability: $559,692 - $422,689 - $422,689 = $0
Please note that the remaining entries for subsequent years should follow the same pattern, with the interest expense calculated using the lease liability for the beginning of the respective year.
a) Based on the information given, the lease agreement entered into by Horton Company is a capital lease. A capital lease is a lease agreement that meets one or more of the following criteria:
1. The lease transfers ownership of the asset to the lessee by the end of the lease term.
2. The lease contains a bargain purchase option, allowing the lessee to purchase the asset at a price significantly below its fair value.
3. The lease term is equal to or greater than 75% of the estimated economic life of the asset.
4. The present value of the lease payments is equal to or greater than 90% of the fair value of the leased asset.
In this case, the lease agreement meets criterion 1 (the term of the lease is 4 years, which is equal to 66.67% of the equipment's economic life of 6 years). Therefore, it is considered a capital lease.
The accounting treatment for a capital lease involves recognizing the leased asset and corresponding lease liability on the lessee's balance sheet. The leased asset is depreciated over its useful life, and the lease liability is gradually reduced as lease payments are made.
b) To prepare the journal entries on Horton's books for the lease agreement, we need to calculate the initial lease liability and allocate the lease payments between interest expense and reduction of the lease liability.
July 1, 2008:
No journal entry is required on this date.
December 31, 2008:
- Calculate the lease payment for the period:
The lease payment is $422,689 per year, so for the first six months, the lease payment would be $422,689 / 2 = $211,344.50.
- Record the journal entry:
Leased Equipment $211,345
Lease Liability $211,345 (To record the initial lease liability and recognize the leased asset)
June 30, 2009:
- Record the journal entry for the lease payment:
Lease Liability $211,345 (To reduce the lease liability)
Cash or Lease Payable $211,345 (To record the lease payment)
December 31, 2009:
- Calculate the lease payment for the period:
The lease payment is $422,689 per year, so for the second year, the lease payment would be $422,689.
- Record the journal entry for the lease payment:
Lease Liability $422,689 (To reduce the lease liability)
Cash or Lease Payable $422,689 (To record the lease payment)
Please note that these are simplified journal entries based on the given information. It is always recommended to consult a professional accountant or refer to specific accounting standards for accurate and comprehensive accounting treatment.