Question

Forrest, Inc. has entered an agreement to lease an old warehouse with a useful life of 5 years and a fair value of $20,000 from United Corporation. The agreement stipulates the following. Rental payments of $4,638 are to be made at the start of each year of the 5-year lease. No residual value is expected at the end of the lease. Forrest must reimburse United each year for any real estate taxes incurred for the year. Last year, the cost of real estate taxes was $700, though these costs vary from year to year. Forrest must make a payment of $500 with the rental payment each period to cover the insurance United has on the warehouse. Forrest paid legal fees of $1,000 in executing the lease. Assuming Forrest’s incremental borrowing rate is 8% and the rate implicit in the lease is unknown, prepare the journal entry to record the initial lease liability and right-of-use asset for Forrest

Answer 1

The present value of the lease payments is approximately $18,518.2. The initial lease liability and right-of-use asset are recorded below.

How did we arrive at the record?

To record the initial lease liability and right-of-use asset, you need to calculate the present value of the lease payments. The formula to calculate the present value of an annuity is:

`\[ PV = PMT * \left(1 - (1)/((1 + r)^n)\right) / r \]`

where:

- PV is the present value of the annuity,

- PMT is the annual payment,

- r is the discount rate (interest rate), and

- n is the number of periods.

In this case, PMT is the annual rental payment, r is the incremental borrowing rate (8%), and n is the number of years (5).

Let's calculate the present value:

`\[ PV = \$4,638 * \left(1 - (1)/((1 + 0.08)^5)\right) / 0.08 \]`

Now, calculate PV:

`\[ PV \approx \$18,518.2 \]`

So, the present value of the lease payments is approximately $18,518.2.

Now, let's prepare the journal entry:

1. Initial Recognition:

- Debit: Right-of-Use Asset: $18,518.2

- Credit: Lease Liability: $18,518.2

2. Additional Costs:

- Debit: Right-of-Use Asset

- Insurance Payment: $500

- Legal Fees: $1,000

- Credit: Cash or Bank: $1,500

The journal entry for the initial recognition of the lease liability and right-of-use asset is as follows:

Date Account Debit ($) Credit ($)

MM/DD/YYYY Right-of-Use Asset 18,518.2

Lease Liability 18,518.2

Additional Costs

Right-of-Use Asset 1,500

Cash or Bank 1,500