On January 1, 2020, X-Man Corp. signed a ten-year non-cancellable lease for new machinery. The terms of the lease called for X-Man to make annual payments of $ 100,000 at the end of each year for ten years, with title to pass to X-Man at the end of the lease period. X-Man accordingly accounted for this lease transaction as a finance lease. The machinery has an estimated useful life of 15 years and no residual value. X-Man uses straight-line depreciation for all of its property, plant and equipment. The lease payments were determined to have a present value of $ 671,008 at an effective interest rate of 8%. It was also determined that the fair value of the machinery on January 1, 2020 was $ 674,000. With respect to this lease, for the year ending December 31, 2020, X-Man should report (rounded to the nearest dollar)
A) lease expense of $ 100,000, and depreciation expense of $ 44,734.
B) interest expense of $ 53,681 and depreciation expense of $ 67,101.
C) interest expense of $ 53,681 and depreciation expense of $ 44,734.
D) interest expense of $ 53,920 and depreciation expense of $ 44,933.

Question

Quizplus · Accepted Answer

Interest expense is calculated on the lease liability at the beginning of the year, which is the present value of the lease payments ($671,008) at the effective interest rate of 8%. Thus, interest expense for the year is $671,008 * 8% = $53,680.64, rounded to $53,681. Depreciation expense is calculated on the basis of the asset's useful life. Since the machinery has a useful life of 15 years and no residual value, the depreciation expense is the initial value of the machinery ($671,008) divided by its useful life (15 years), resulting in $44,733.87, rounded to $44,734.