On December 31, 2013, Perry Corporation leased equipment to Admiral Company for a five-year period. The annual lease payment, excluding executory costs, is $40,000. The interest rate for this lease is 10%. The payments are due on December 31 of each year. The first payment was made on December 31, 2013. The normal cash price for this type of equipment is $125,000 while the cost to Perry was $105,000. For the year ended December 31, 2013, by what amount will Perry's pretax earnings increase from this lease?

Question

Quizplus · Accepted Answer

To determine the amount by which Perry's pretax earnings will increase from this lease in the year ended December 31, 2013, we need to calculate the interest income and amortization of the leased equipment.

Interest Income = (Lease Receivable × Interest Rate) = ($40,000 × 10%) = $4,000
Lease Receivable = Total lease payments = $40,000

Amortization of leased equipment = [(Cost of Equipment – Lease Incentive) / Lease Term] = [($105,000 – 0) / 5] = $21,000

Therefore, the total amount by which Perry's pretax earnings will increase from this lease in the year ended December 31, 2013, is ($4,000 + $21,000) = $25,000. However, this is not listed as an answer choice.

The annual lease payment of $40,000 is higher than the amortization expense of $21,000, which means that Perry will have $19,000 of taxable income for the year. ($40,000 - $21,000 = $19,000)
Perry's pretax earnings increase will be equal to the interest income of $4,000 for a total of $23,000 ($19,000 + $4,000). 
The closest answer choice to this amount is A) $20,000, which is $3,000 lower than the correct amount. Therefore, A) $20,000 is the best choice.

On December 31, 2013, Perry Corporation Leased Equipment to Admiral