On January 2, Year 1, Marx Co. as lessee signed a five-year noncancelable equipment lease with annual payments of $200,000 beginning December 31, Year 1. Marx treated this transaction as a capital (finance) lease. The five lease payments have a present value of $758,000 at January 2, Year 1, based on interest of 10%. What amount should Marx report as interest expense for the year ended December 31, Year 1?
A. $0
B. $48,400
C. $55,800
D. $75,800
Answer:D
Choice "D" is correct. The lease term began January 2, Year 1 on a lease valued at $758,000. The first payment of $200,000 was made on December 31, Year 1. Since the interest rate is 10% and one year has expired, Marx Co.'s interest expense is computed as 10% of $758,000 or $75,800. The remainder of the $200,000 payment reduces the obligation under the lease.
Choice "A" is incorrect. If the first payment had been made on January 2, the amount of interest would have been $0 because none of the lease term had elapsed. Interest accrued between January 2 and December 31, which Marx must account for.
Choice "B" is incorrect. Marx will pay 5 x $200,000 or 1,000,000 over the life of the lease or $1,000,000 - $758,000 = $242,000 total interest over the lease term. Simple interest for each of the five years would be $242,000 / 5 or $48,400. However, lease interest expense is computed using the effective interest method.
Choice "C" is incorrect. If the first payment had been made on January 2, the amount of interest would have been $0 because none of the lease term had elapsed, and the lease obligation would have been reduced by the $200,000 of the payment leaving an obligation of $558,000. Under these circumstances the interest expense accrued between January 2 and December 31, which Marx must account for would be 10% of the reduced amount or $55,800.