On January 1, 2020, Jeckyll Ltd. signs a 8-year non-cancellable lease agreement to lease a storage building from Hyde Inc. Hyde is in the business of leasing/selling property. Collectibility of the lease payments is reasonably assured and no additional costs are to be incurred by the lessor (other than executory costs). Both the lessor and the lessee are private corporations adhering to ASPE. The following information is available regarding this lease agreement:
1) The agreement requires equal payments at the end of each year.
2) At January 1, 2020, the fair value of the building is $ 1,350,000 and Hyde's book value is $ 1,125,000.
3) The building has an estimated economic life of 8 years, with no residual value. Jeckyll uses straight-line depreciation for all its depreciable assets.
4) At the termination of the lease, title to the building will transfer to the lessee.
5) Jeckyll's incremental borrowing rate is 10%. Hyde Inc. set the annual rental to ensure a 9% rate of return. The lessor's implicit rate is known to Jeckyll.
6) The yearly lease payment includes $ 4,500 executory costs related to taxes on the property.
Rounded to the nearest dollar, how much depreciation expense would Dionne record on this asset for calendar 2020?
A) $ 0
B) $ 108,000
C) $ 168,750
D) $ 140,625

Question

Quizplus · Accepted Answer

To calculate the depreciation expense in the first year, we need to determine the asset's carrying amount, which is the fair value of the building at the inception of the lease, less any leasehold incentives received ($0), plus any initial direct costs incurred (none provided).

Carrying amount = $1,350,000 - $0 + $0 = $1,350,000

We then need to determine the lease term, which is the same as the estimated economic life of the asset, 8 years.

The annual lease payment is not provided, but we can calculate it using the lessor's implicit rate:

PV of lease payments = $1,125,000 
Implicit rate = 9% 
Lease term = 8 years

Using a financial calculator, we can solve for the annual lease payment:

PMT = $181,746

Since the annual lease payment includes $4,500 executory costs related to taxes on the property, the amount of lease payment allocated to the building is:

Lease payment allocated to building = $181,746 - $4,500 = $177,246

Using the straight-line depreciation method, we can calculate the depreciation expense for the first year as:

Depreciation expense = Carrying amount / Lease term = $1,350,000 / 8 = $168,750

Therefore, the answer is C, $168,750.