Pisa, Inc.leased equipment from Tower Company under a four-year lease requiring equal annual payments of $86,038, 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 residual 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?

Question

Quizplus · Accepted Answer

Since there is no residual value, the total lease payments will add up to the total cost of the asset, which in this case is $86,038 * 4 = $344,152.

To calculate the present value of the lease payments, we can use either Pisa, Inc.'s incremental borrowing rate of 10% or the rate implicit in the lease of 8%. Using the implicit rate will give us the same answer as using the present value formula for an annuity due:

PV = PMT * ((1 - (1 / (1 + r)^n)) / r) * (1 + r)

Where PV is the present value of the lease payments, PMT is the annual lease payment, r is the implicit rate, and n is the number of periods.

PV = $86,038 * ((1 - (1 / (1 + 0.08)^4)) / 0.08) * (1 + 0.08)
PV = $284,038.21

This means that Tower Company is financing $284,038.21 of the total cost of the asset, and Pisa, Inc. will need to record this amount as a leased asset on their balance sheet.

To calculate the annual depreciation expense, we can divide the leased asset's cost by its useful life of 4 years:

Depreciation expense = $284,038.21 / 4
Depreciation expense = $71,009.55

Since Pisa, Inc. uses the straight-line method to depreciate similar assets, they will record a depreciation expense of $71,009.55 each year for the duration of the lease. In the first year, however, they will only record depreciation for the portion of the year that the asset is in use, which is 1/4 of the total annual expense:

Depreciation expense in Year 1 = $71,009.55 * 1/4
Depreciation expense in Year 1 = $17,752.39

Adding the depreciation expense of $17,752.39 to the interest expense of $22,723.90 (found by subtracting the present value of the first lease payment of $86,038 from the leased asset's cost), we get a total lease expense of $40,476.29 for the first year. Therefore, the answer is C) $76,942.

Pisa, IncLeased Equipment from Tower Company Under a Four-Year Lease Requiring