Carla Salons leased equipment from SmithCo on July 1, 2013. The present value of the lease payments discounted at 10% was $80,000. Ten annual lease payments of $12,000 are due at the beginning of each fiscal year beginning July 1, 2013. SmithCo had constructed the equipment recently for $66,000, and its retail fair value was $100,000. Under the new ASU, what amount of interest revenue from the lease should SmithCo report in its December 31, 2013, income statement?

Question

Quizplus · Accepted Answer

The interest revenue from the lease should be recognized using the effective interest method. The interest rate implicit in the lease is not given, so the incremental borrowing rate of 10% should be used. The interest expense for the first year would be: 
Interest expense = Beginning Lease Liability x Incremental Borrowing Rate 
= ($80,000 - $12,000) x 10% 
= $6,800

The interest revenue for the lessor would be the same amount since the interest expense and revenue must net to zero. Therefore, the amount of interest revenue that SmithCo should report in its income statement for 2013 is $6,800/2 = $3,400.

The other options are incorrect:

A) $12,000 is the amount of the lease payment and not the interest revenue 
B) $4,000 is incorrect as it is not clear how this amount was arrived at 
D) $5,000 is incorrect as it does not consider the effective interest method and uses a straight-line method instead.

Carla Salons Leased Equipment from SmithCo on July 1, 2013