Renter’s Dilemma

Hucks, Inc. (Hucks), a publicly traded corporation, plans tolease equipment from Jackson Co. (Jackson) on January 1, 2020, fora period of three years. Lease payments of $100,000 are due toJackson each year. Other expenses (e.g., insurance, taxes, andmaintenance) are also to be paid by Hucks and amount to $2,000 peryear. Jackson will not incur any initial direct costs. The leasecontains no purchase or renewal options and the equipment revertsback to Jackson on the expiration of the lease. The remaininguseful life of the equipment is four years. The fair value of theequipment at lease inception is $265,000. Hucks has guaranteed$20,000 as the residual value at the end of the lease term. The$20,000 represents the expected value of the leased equipment toHucks at the end of the lease term. The salvage value of theequipment is expected to be $2,000 after the end of its economiclife. Hucks’s incremental borrowing rate is 11 percent (Jackson’simplicit rate is 10 percent and is calculable by Hucks from thelease agreement).

The junior accountant of Hucks analyzed the assets under lease,determined whether the lease was an operating lease or financelease, and prepared the applicable journal entries. The senioraccountant of Hucks reviewed the junior accountant’s analysis andprepared a separate analysis. As the finance controller, you weregiven both analyses to determine the correct accounting treatment.Calculations and journal entries performed by your junior andsenior accountant follow:

Present Value of the LeaseObligation

Using the rate implicit in the lease (10 percent), the presentvalue of the guaranteed residual value would be $15,026 ($20,000 x0.7513), and the present value of the annual payments would be$248,685 ($100,000 x 2.4869).

Using the incremental borrowing rate (11 percent), the presentvalue of the guaranteed residual value would be $14,624 ($20,000 x0.7312), and the present value of the annual payments would be$244,371 ($100,000 x 2.4437).

Junior accountant analysis:

Since the equipment reverts back to Jackson, it is an operatinglease. 840

Entry to be posted in years 1, 2, and 3:

Dr. Rentexpense                       $100,000

Dr. Insuranceexpense                  $2,000

             Cr.Cash                                                       $102,000

        (Operating leaserental paid to Jackson)

1. Was the assistant controller’s analysis correct? Why or whynot?

2. Show the correct analysis including all year oneentry(ies)?

3. Use FASB codification to support the answer?