On January 1, 20X0, a company leases equipment for 8 years, its entire life. Payments are $10,000 per year on January 1 with the first one made immediately. The present value of these payments at the lessee's incremental borrowing rate of 10 percent per year is assumed to be $58,000. The present value of these payments at the lessor's implicit interest rate (which is known by the lessee) of 8 percent is assumed to be $62,000. What amount of interest expense should the lessee recognize for 20X0?
Question
On January 1, 20X0, a company leases equipment for 8 years, its entire life. Payments are 58,000. The present value of these payments at the lessor's implicit interest rate (which is known by the lessee) of 8 percent is assumed to be $62,000. What amount of interest expense should the lessee recognize for 20X0?
Solution 1
The lessee should recognize the interest expense based on the incremental borrowing rate, as this is the rate the lessee would have incurred to borrow over a similar term and with similar security.
Here's how to calculate it:
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The lease liability at the beginning of the year is the present value of the lease payments, which is $58,000.
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Multiply this lease liability by the lessee's incremental borrowing rate of 10 percent to calculate the interest expense.
So, 5,800.
Therefore, the lessee should recognize $5,800 as interest expense for 20X0.
Solution 2
The lessee should recognize the interest expense based on the incremental borrowing rate, as this is the rate the lessee would have incurred to borrow over a similar term and with similar security.
Here's how to calculate it:
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The lease liability at the beginning of the year is the present value of the lease payments, which is $58,000 (calculated using the lessee's incremental borrowing rate of 10%).
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The lease payment made on January 1, 20X0 reduces this liability by 48,000 (10,000).
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The interest expense for the year is then calculated by multiplying this lease liability by the incremental borrowing rate. So, 4,800.
Therefore, the lessee should recognize an interest expense of $4,800 for 20X0.
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