Pisa, Inc. leased equipment from Tower Company under a four-year lease requiring equal annual payments of $172,076, with the first payment due at lease inception. The lease does not transfer ownership, nor is there a bargain purchase option. The equipment has a 4-year useful life and no salvage value. Pisa, Inc.'s incremental borrowing rate is 10% and the rate implicit in the lease (which is known by Pisa, Inc.) is 8%. Pisa, Inc. uses the straight-line method to depreciate similar assets. What is the amount of depreciation expense recorded by Pisa, Inc. in the first year of the asset's life?

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Since there is no transfer of ownership and no bargain purchase option, the lease is classified as an operating lease. The implicit rate in the lease is lower than Pisa, Inc.'s incremental borrowing rate, which indicates that Tower Company has included financing costs in the lease payments. Thus, the annual lease payment of $172,076 includes both payment for the use of the equipment and interest on the lease liability. Using the interest rate implicit in the lease, we can calculate the present value of the lease payments to be $600,000 ($172,076 x 3.4845). This is the amount that Tower Company is financing for the lease. The difference between the present value of the lease payments and the cost of the equipment ($600,000 - $600,000) is the interest expense for the lease, which is recognized by Pisa, Inc. over the term of the lease. The amount of depreciation expense recorded by Pisa, Inc. in the first year of the asset's life is calculated as the cost of the equipment ($600,000) divided by the useful life in years (4), which is $150,000.

Pisa, Inc Leased Equipment from Tower Company Under a Four-Year Lease