On January 1, 2015, Dean Corporation signed a ten-year noncancelable lease for certain machinery. The terms of the lease called for Dean to make annual payments of $150,000 at the end of each year for ten years with the title passing to Dean at the end of this period. The machinery has an estimated useful life of 15 years and no salvage value. Dean uses the straight-line method of depreciation for all of its fixed assets. Dean accordingly accounted for this lease transaction as a capital lease. The lease payments were determined to have a present value of $1,006,512 at an effective interest rate of 8%. With respect to this capitalized lease, Dean should record for 2015
A) lease expense of $150,000.
B) interest expense of $67,101 and depreciation expense of $57,102.
C) interest expense of $80,521 and depreciation expense of $67,101.
D) interest expense of $68,522 and depreciation expense of $100,652.

Question

Quizplus · Accepted Answer

Since this is considered a capitalized lease, the lease payments need to be recorded as a liability and an asset on the balance sheet. The liability will decrease each year as payments are made, and the asset will decrease as the machinery depreciates.

In the first year, the lease payment of $150,000 needs to be split into the interest expense and the reduction of the liability (principal). The interest expense is calculated as the effective interest rate (8%) multiplied by the beginning liability ($1,006,512). This results in an interest expense of $80,521. The reduction of the liability is the difference between the lease payment and the interest expense, which is $69,479 ($150,000 - $80,521).

For the depreciation expense, it is calculated as the cost of the asset ($1,006,512) divided by the useful life (15 years), which results in $67,101.

Therefore, for 2015, Dean should record interest expense of $80,521 and depreciation expense of $67,101.

On January 1, 2015, Dean Corporation Signed a Ten-Year Noncancelable