Lofgreen Company leased an asset for use in its factory. The lease agreement specifies that Lofgreen is to make annual payments of $2,818 payable at the end of each year. The lessor classified the lease as a direct-financing lease since Lofgreen was allowed to lease the asset at its cost of $14,000 (the present value of the lease payments). The lessor receives a 12 percent rate of return on the lease. The estimated residual value at the end of the lease term is zero.
If the lease was classified as a capital lease by Lofgreen, how much annual depreciation would Lofgreen record using the straight-line method?
A) $1,400
B) $1,750
C) $1,310
D) $2,818

Question

Quizplus · Accepted Answer

When a lease is classified as a capital lease, the lessee must record the leased asset as property, plant, and equipment on the balance sheet and depreciate it over its useful life. The annual depreciation is calculated by dividing the cost of the asset (which is equal to the present value of the lease payments) by the lease term. In this case, the cost of the asset is $14,000 and the lease term is one year, so the annual depreciation is $14,000/1 = $14,000.

However, the lease payments are only $2,818 per year, so Lofgreen must also recognize interest expense on the lease liability. The interest expense is calculated using the effective interest method, which is based on the interest rate implicit in the lease. In this case, the interest rate implicit in the lease is 12%, so the interest expense for the first year is ($14,000 + $0)*12% = $1,680.

Therefore, the total lease expense for the first year is $2,818 + $1,680 = $4,498. The annual depreciation is only a portion of this total lease expense, so we need to calculate the portion that represents the depreciation expense:

Depreciation expense = Total lease expense - Interest expense 
Depreciation expense = $4,498 - $1,680 
Depreciation expense = $2,818

Using the straight-line method, the annual depreciation expense is the same each year, so the answer is $2,818. This is choice B.

Lofgreen Company Leased an Asset for Use in Its Factory