Waters Company entered into a direct-financing lease with Toll Company for the use of an asset which cost Waters $240,000. The lease agreement contained a bargain purchase option effective immediately after the fifth rental, which provided that Toll could purchase the asset at that time. The estimated life of the asset was 10 years with an estimated residual value of $400. Assuming that Toll uses straight-line depreciation, Toll's annual depreciation expense would be
A) $22,200.
B) $23,960.
C) $44,400.
D) $48,000.

Question

Quizplus · Accepted Answer

The asset cost is $240,000 and the estimated residual value is $400. Therefore, the depreciable amount is $240,000 - $400 = $239,600.
The lease agreement's term is for 10 years, and it contains a bargain purchase option effective immediately after the fifth rental. Therefore, the lease term is 5 years, which is half the asset's estimated life.
Using straight-line depreciation, Toll's annual depreciation expense would be depreciable amount divided by the lease term, or $239,600 ÷ 5 = $47,920.
However, because Toll has a bargain purchase option, it is considered the owner of the asset for accounting purposes. Therefore, Toll's annual depreciation expense should be reduced by the estimated residual value of $400, or $47,920 - $400 = $47,520.
Therefore, Toll's annual depreciation expense would be $23,960 ($47,520 ÷ 2).

Waters Company Entered into a Direct-Financing Lease with Toll Company