Use the following information for questions 104 and 105.
On January 2, 2015, Hernandez, Inc. signed a ten-year noncancelable lease for a heavy duty drill press. The lease stipulated annual payments of $200,000 starting at the beginning of the first year, with title passing to Hernandez at the expiration of the lease. Hernandez treated this transaction as a capital lease. The drill press has an estimated useful life of 15 years, with no salvage value. Hernandez uses straight-line depreciation for all of its plant assets. Aggregate lease payments were determined to have a present value of $1,200,000, based on implicit interest of 10%.
-In its 2015 income statement, what amount of interest expense should Hernandez report from this lease transaction?
A) $0
B) $81,000
C) $108,000
D) $120,000

Question

Quizplus · Accepted Answer

Interest expense for a capital lease is calculated using the implicit interest rate. Here, the aggregate lease payments have a present value of $1,200,000 with implicit interest of 10%. Therefore, the interest expense for the first year is $120,000 ($1,200,000 x 10%). Because the lease is noncancelable and the ownership transfers to Hernandez at the end of the lease term, it meets the criteria for a capital lease. Therefore, Hernandez should report $108,000 (the portion of the $120,000 interest expense that pertains to the first year's lease payment) as interest expense on its 2015 income statement.

Use the Following Information for Questions 104 and 105