On January 1, 2020, Marlene Corp. enters into an agreement with Dietrich Rentals Inc. to lease a machine from them. Both corporations adhere to ASPE. The following data relate to the agreement:
1) The term of the non-cancellable lease is three years with no renewal option. Payments of $ 271,622 are due on December 31 of each year.
2) The fair value of the machine on January 1, 2020, is $ 700,640. The machine has a remaining economic life of 10 years, with no residual value. The machine reverts to the lessor upon the termination of the lease.
3) Marlene depreciates all its machinery on a straight-line basis.
4) Marlene's incremental borrowing rate is 10%. Marlene does not have knowledge of the 8% implicit rate used by Dietrich.
5) Immediately after signing the lease, Dietrich discovers that Marlene is the defendant in a lawsuit that is sufficiently material to make collectibility of future lease payments doubtful.
Assume the present value of the lease payments is $ 700,000 at January 1, 2020.
If Marlene accounts for this lease as a finance lease, what is the amount of the reduction in the lease obligation in calendar 2021? (Round to the nearest dollar.)
A) $ 201,622
B) $ 215,622
C) $ 221,784
D) $ 232,873

Question

Quizplus · Accepted Answer

To determine the reduction in the lease obligation in calendar 2021, we need to calculate the interest expense and the principal payment for the year. The interest expense is calculated as the beginning lease obligation at the start of the year multiplied by the interest rate. The principal payment is the total lease payment minus the interest expense.

Beginning lease obligation on January 1, 2021:
PV of remaining lease payments at Jan. 1, 2020 = $700,000
Plus: Interest expense for 2020 ($700,000 x 10%) = $70,000
Lease obligation on Jan. 1, 2021 = $770,000

Interest expense in 2021:
Beginning lease obligation on Jan. 1, 2021 = $770,000
Interest rate = 10%
Interest expense for 2021 = $77,000

Principal payment in 2021:
Total lease payment for 2021 = $271,622
Minus: Interest expense for 2021 = $77,000
Principal payment in 2021 = $194,622

Therefore, the reduction in the lease obligation in calendar 2021 is $221,784 ($770,000 - $194,622 - $354,594). The correct answer is C.