On May 1, 2020, Charles Corp. leased equipment to Darwin Inc. for one year under an operating lease. Instead of leasing it, Darwin could have bought the equipment from Charles for $ 800,000 cash. At this time, Charles's accounting records showed a book value for the equipment of $ 700,000. Depreciation on the equipment in 2020 was $ 90,000. During 2020, Darwin paid $ 22,500 per month rent to Charles for the 8-month period, and Charles incurred maintenance and other related costs under the terms of the lease of $ 16,000. The net income before income taxes reported by Charles from this lease for the year ended December 31, 2020, should be
A) $ 74,000.
B) $ 90,000.
C) $ 164,000.
D) $ 180,000.

Question

Quizplus · Accepted Answer

Since this is an operating lease, Charles would continue to recognize the equipment as an asset on their books and would only recognize the lease payments as rental revenue.

First, we need to calculate the total rental revenue received from Darwin:
$22,500 per month x 8 months = $180,000

Next, we need to calculate the net book value of the equipment at the end of the lease term:
Book value at inception = $700,000
Depreciation for 2020 = $90,000
Book value at end of 2020 = $610,000 (700,000 - 90,000)

Since Darwin is only leasing the equipment for one year, they will not be able to fully depreciate the asset. Therefore, at the end of the lease term, the equipment will have a residual value of $610,000.

Now we can calculate the gain/loss on the lease for Charles:
Rent revenue received = $180,000
Less: Maintenance & other related costs incurred = $16,000
Net rental income = $164,000

If Darwin had chosen to purchase the equipment for $800,000, Charles would have recognized a gain of $100,000 ($800,000 - $700,000). However, since Darwin only leased the equipment, Charles will only recognize rental income of $164,000.

Therefore, the net income before income taxes reported by Charles from this lease for the year ended December 31, 2020, should be $74,000 ($164,000 - $90,000 depreciation expense).