On January 1, 2021, Puma Company signs a 10-year agreement to lease a standard non-specialized storage building from Reebok, Inc. The following information pertains to this lease agreement:

6. 1. The agreement requires rental payments of $120,000 at the beginning of each year.
   2. The carrying value and fair value of the building on January 1, 2021 is $2.5 million.
   3. The building has an estimated economic life of 50 years, with no residual value. Reebok depreciates similar buildings using the straight-line method.
   4. The lease does not contain a renewable option clause. At the termination of the lease, the building reverts to the lessor.
   5. Puma’s incremental borrowing rate is 14% per year. Reebok has set the annual rental payments to ensure an 11% rate of return (this rate is disclosed in the lease agreement).
   6. Executory costs are estimated to be $25,000 annually, related to taxes on the property and maintenance, and will be paid by Reebok.
7. Both entities have fiscal year-ends on December 31.

Instructions

1. What is the appropriate lease classification for Puma the lessee? Provide support for your answer.
2. Provide all necessary 2021 and 2022 journal entries for Puma to properly record the lease.

Answer rating: 100% (QA)

Solution of a and b is given below Lessee Accounting Puma Company The leasee should use a single accounting model for all type of lease The lease liability and the ROU asset are measured on the commencement date using the Implicit rate of interest ie 11 pa in this caseor incremental borrowing rateif implicit rate is not known at lease commencement date The lease liability is accounted for by the interest method subsequently and the ROU asset is subject depreciation on the straightline basis over the lease term of 10 year The leasee shall record the lease liability and right in use asset at the Present value of Lease payment expected residual value if the same is guaranteed as calculated below Year Payments Cash flows Present Value Factor 11pa Discounted Cash flows Present value 1 12000000 100000 120000 2 12000000 090090 108108 3 12000000 081162 97395 4 12000000 073119 87743 5 12000000 065873 79048 6 12000000 059345 71214 7 12000000 053464 64157 8 12000000 048166 57799 9 12000000 043393 52071 10 12000000 039092 46911 Total 1200000 784446 Lease Amortisation Schedule Beg of year Annual Lease Payments Plus expected residual value Interest on lease liability Reduction of lease Liability Lease liability 0 784446 1 120000 120000 664446 2 120000 73089 46911 617535 3 120000 67929 52071 565464 4 120000 62201 57799 507665 5 120000 55843 64157 443508 6 120000 48786 71214 372293 7 120000 40952 79048 293246 8 120000 32257 87743 205503 9 120000 22605 97395 108108 10 120000 11892 108108 0 Note As the lease payment is made at the beginning of the year interest will be calculated on Opening lease liability less lease payment In the books of Lessee a Journal Entries Year Particulars Debit Credit 01012021 Right of Use Asset 784446 Cash 120000 Lease liabilty 669446 To record initially recognise the leaserelated asset and liability 31122021 Interest expense 73089 Interest payable 73089 To record interest on lease liab ... View the full answer