Roman Company leased equipment from Koenig Company on July 1, 2015, for an eight-year period expiring June 30, 2023. Equal annual payments under the lease are $600,000 and are due on July 1 of each year. The first payment was made on July 1, 2015. The rate of interest contemplated by Roman and Koenig is 8%. The cash selling price of the equipment is $3,723,750 and the cost of the equipment on Koenig's accounting records was $3,300,000. Assuming that the lease is appropriately recorded as a sale for accounting purposes by Koenig, what is the amount of profit on the sale and the interest income that Koenig would record for the year ended December 31, 2015?

Question

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The cash selling price of the equipment is $3,723,750, which is greater than the cost of the equipment on Koenig's accounting records of $3,300,000. The difference between these two amounts represents Koenig's profit on the sale, which is $423,750 ($3,723,750 - $3,300,000).

To calculate the interest income, we can use the effective interest method. Under this method, interest income is calculated by multiplying the outstanding lease receivable balance at the beginning of the period by the contractual interest rate. The outstanding lease receivable balance at the beginning of the period is the present value of the remaining lease payments, discounted using the interest rate implicit in the lease (in this case, 8%).

On July 1, 2015, the outstanding lease receivable balance was $3,410,000 ($3,723,750 - $313,750, the first lease payment received). To calculate the present value of the remaining lease payments, we can use an annuity due formula:

PV = PMT x [(1 - (1 / (1 + r)n)) / r] x (1 + r)

where:
PMT = annual lease payment = $600,000
r = interest rate = 8%
n = number of periods = 7 (lease term is 8 years, but first payment was made on July 1, 2015)

PV = $3,410,000 x [(1 - (1 / (1 + 8%)^7)) / 8%] x (1 + 8%) = $3,410,000 x 5.74663 = $19,585,921.30

Therefore, the interest income for the year ended December 31, 2015, is $124,950 ($19,585,921.30 x 8%).

Roman Company Leased Equipment from Koenig Company on July 1