Cinci Co. leased equipment for its entire 10-year useful life, agreeing to pay $50,000 at the start of the lease term on December 31, Year 1, and $50,000 annually on each December 31 for the next 9 years. The present value on December 31, Year 1, of the ten lease payments was $337,951. The interest rate for both the lessee and the lessor was 10%. The December 31, Year 1, present value of the lease payments using Allen's incremental borrowing rate of 12% was $298,500. Allen made timely first and second lease payments. Required:
What amount should Allen report as capital lease liability in its December 31, Year 2, balance sheet?

The amount that Allen should report as capital lease liability in its December 31, Year 2, balance sheet is $266,746.

Explanation:

From the question, it can be seen that 10% is used by the lessee. The reason is that the 10% is what is known by the lessee and it is also lower than 12%. Therefore, we have:

Balance of the lease liability after the first payment = Present value on December 31 of Year 1 - Amount of the first payment = $337,951 - $50,000 = $287,951

It should noted that there is no interest in the amount of the first payment as it was an immediate payment.

Interest expense in Year 2 = 10% * Balance of the lease liability after the first payment = 10% * 287,951 = $28,795

Lease liability paid in Year 2 = Cash paid - Interest expense in Year 2 = $50,000 - $28,795 = $21,205

The journal entries at December 31, Year 2 will then be as follows:

Accounts Title                                 Debit ($)               Credit ($)    

Lease liability                                    21,205

Interest expense                              28,795

Cash                                                                                  50,000

(To record lease payment.)                                                              

Therefore, we have:

Capital lease liability on December 31 of Year 2 = Balance of the lease liability after the first payment - Lease liability paid in Year 2 = $287,951 - $21,205 = $266,746

Therefore, the amount that Allen should report as capital lease liability in its December 31, Year 2, balance sheet is $266,746.

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