On January 1,2014,O'neil,Inc.signed a noncancelable lease for a silver polishing machine.The machine has an estimated useful life of nine years.The term of the lease is a six-year term with title passing to O'neil at the end of the lease.The agreement called for annual payments of $40,000 starting at the end of the first year.Assume aggregate lease payments were determined to have a present value of $200,000,based on implicit interest of 12 percent.What amount of interest expense should O'neil report in its 2014 income statement from this lease transaction?
A) $0
B) $16,000
C) $24,000
D) $33,333

Question

Quizplus · Accepted Answer

To determine the interest expense, we need to first calculate the lease liability, which is the present value of lease payments.

PV of lease payments = $200,000
Annual lease payment = $40,000

Using the formula for present value of an ordinary annuity:
PV = A x [(1 - (1 + r)-n) / r]

With A = $40,000, r = 12%, and n = 6, we can solve for PV:
PV = $40,000 x [(1 - (1 + 0.12)-6) / 0.12]
PV = $156,144.68

Therefore, the lease liability is $156,144.68, and the difference between the lease liability and total lease payments ($200,000 - $156,144.68 = $43,855.32) represents the total interest expense over the life of the lease.

To determine the interest expense for 2014, we need to calculate the interest component of the first lease payment:
Interest expense = lease liability x interest rate
Interest expense = $156,144.68 x 0.12
Interest expense = $18,737.36

However, since the lease payments do not begin until the end of the first year, only one payment has been made, which is $40,000. Therefore, the interest expense for 2014 is:
Interest expense for 2014 = $40,000 - $18,737.36
Interest expense for 2014 = $21,262.64

Since the question asks for the amount of interest expense in the 2014 income statement, the correct answer is (C) $24,000.