Question

Recording Entries for Finance Lease-No Residual On January 1, 2020, Ashe Company entered into a 5-year equipment lease (with no renewal options) requiring payments of $10,000, with the first payment due immediately. The lessor's implicit interest rate, known to Ashe, is 6%. Ownership of the equipment remains with the lessor at expiration of the lease. There is no option to purchase the property at the end of the lease term and the equipment is expected to have no residual value. The equipment has an estimated economic life of 5 years. a. How would Ashe Company classify the lease?

Answer 1

Ashe Company would classify the lease as a finance lease because it meets all of the following criteria:

The lease term is for 75% or more of the economic life of the equipment.
The present value of the lease payments is equal to or greater than 90% of the fair value of the equipment.
The lease does not contain a purchase option that the lessee is reasonably certain to exercise.
The lease transfers ownership of the equipment to the lessee at the end of the lease term.
Since the lease meets all of these criteria, Ashe Company would record the lease as a finance lease on its balance sheet. The lease would be classified as an asset, called right-of-use (ROU) asset, and a liability, called lease liability. The ROU asset would be recorded at the present value of the lease payments, and the lease liability would be recorded at the same amount.

The journal entry to record the lease on January 1, 2020 would be:

Dr. ROU asset 10,000
Cr. Lease liability 10,000
Ashe Company would then make monthly payments to the lessor over the course of the lease term. The lease payments would be comprised of interest expense and principal repayment. The interest expense would be calculated using the implicit interest rate of the lease. The principal repayment would be the difference between the lease payment and the interest expense.

At the end of the lease term, the lease liability would be fully repaid, and the ROU asset would be fully depreciated.

Here is a table showing the journal entries that Ashe Company would make for the lease:

Date Account Debit Account Credit
January 1, 2020 ROU asset Lease liability
December 31, 2020 Interest expense Lease liability
December 31, 2020 Lease payment Cash
... ... ...
December 31, 2024 Interest expense Lease liability
December 31, 2024 Lease payment Cash

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