4.7 Lease (Solution to Question #2)
First, take note that the solutions presented below will differ from the manner in which an accountant may record the lease’s goings-on. We have ignored below the cash outflow emanating from the periodic lease payments. Similarly, we have ignored any cash inflows that will devolve from the productivity of the leased asset. We have done so in order to focus exclusively on the manner in which a lease will affect the firm’s leverage.
This is a two-part question concerning both 1. depreciation and 2. amortization.
1. Depreciation of Leased Asset
The straight-line deprecation is: $2,076 ÷15 = $138.40
Therefore, the new asset value is: $2,076 – 138 = $1,938
Here are the relevant accounting book entries for the lease’s deprecation – in the first year.
Income Statement / Depreciation Expense (dr) $138.40
Balance Sheet / Accumulated Depreciation (cr) $138.40
The balance sheet will reflect the following:
Gross leased equipment $2,076
Accumulated Depreciation (138)
Net Leased Equipment $1,938
2. Amortization of Lease Obligation
In order to calculate the amortization of the lease obligation, we must figure out how much of the annual payment is principal and how much is interest. The interest is: .05 × $2,076 = $103.80
Total annual (cash) payments on the lease are $200. The income statement will reflect interest expense of $104 (rounded off), leaving $96 as amortization (reduction) of the principal. Therefore, the new lease obligation (liability) is: 2,076 – 96 = 1,980. In accounting terms, we credit cash $200, and we debit both interest expense $104 and amortization of the lease liability $96.
Another way of looking at these calculations is to utilize the approach we used to calculate mortgages. A lease is amortized just like a mortgage. This calculation is illustrated in the following table:
| Year | PMT. | Interest | Amortization | Balance |
| Credit to Cash | Debit to Income Statement | Debit to Balance Sheet | ||
| 0 | – | – | $2,076 | |
| 1 | $200 | (.05)($2,076)= $104 | (200-204)= $96 | ($2,076-96)= $1,980 |
With this, one year into the lease, the balance sheet will look as follows.
(000)
| Inception | A Year Later | Inception | A Year Later | ||
| Current Assets | $200 | $200 | Current Liabilities | $100 | $100 |
| Leased Equipment | 2,076 | 1,938 | Lease Obligation | 2,076 | 1,980 |
| Fixed Assets | 1,800 | 1,800 | Long-term Debt | 900 | 900 |
| Equity | 1,000 | 958 | |||
| Total Assets | $4,076 | $3,938 | Total Debt + Equity | $4,076 | $3,938 |
| Debt Ratio | 75.46% | 75.67% |
While the equipment and the obligation are depreciated and amortized at different rates, they will each sum out to zero at the horizon of the lease. In the first year of the lease, the “Leased Equipment” decreased by $138, whereas the Lease Obligation” decreased by $96 and the Equity decreased by $42 (i.e., 96 + 42 = 138).
The new equity may initially and incorrectly be thought of as a plug number, which is reconciled as per below. In this c