On January 1, 2012, Adams Corporation Signed A 7-Year Noncan

On January 1 2012 Adams Corporation Signed A 7 Year Noncancelable Le

On January 1, 2012, Adams Corporation entered into a noncancelable lease agreement for a machine with a term of seven years. The lease required annual payments of $9,214, payable at the beginning of each year starting January 1, 2012. The machine's estimated useful life was eight years, with an unguaranteed residual value of $5,480 at the end of the lease term. Since Adams employs the straight-line depreciation method for its plant assets, it needs to recognize depreciation evenly over the asset's useful life. Adams’s incremental borrowing rate was 11%, and the lessor's implicit rate was unknown. The present value of the lease payments was calculated to be $48,194. The lease is classified as a capital lease—the asset reverts to the lessor at the end of the lease term.

In addition to the lease payments, Adams would record the initial lease, subsequent depreciation, interest expense, and related journal entries for the year ending January 1, 2013. The calculations include the present value of lease payments and the amortization of the leased asset, as well as interest expense based on the lease liability. The journal entries for January 1, 2012, include recognizing the lease asset and liability; for December 31, 2012, recording depreciation and interest expense; and on January 1, 2013, recognizing the second lease payment.

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Introduction

Leasing represents a widespread method for companies to acquire assets, offering benefits such as resource flexibility, deferred capital expenditure, and potential tax advantages. Proper accounting for leases is essential to ensure accurate financial reporting and compliance with accounting standards. The case of Adams Corporation demonstrates typical procedures related to capital lease accounting, including initial recognition, subsequent depreciation, interest expense calculation, and journal entries for lease payments over the lease term.

Lease Accounting Principles and Standards

According to accounting standards such as IFRS 16 and ASC 842, leases are classified primarily into operating and finance (capital) leases. A lease qualifies as a finance lease if it transfers substantially all risks and rewards of ownership to the lessee. For Adams Corporation, the lease is classified as a finance lease due to its terms. Under a finance lease, the lessee recognizes a lease asset and corresponding liability at the lease commencement at the present value of the minimum lease payments (PVMLP). The PVMLP encompasses the annual lease payments discounted at the lessee’s incremental borrowing rate or lessor’s implicit rate when known.

The initial recognition involves recording the leased asset and lease liability at PVMLP. During the lease term, the lessee recognizes interest expense and depreciation expense. The depreciation method is straight-line, consistent with Adams's policy, which necessitates equal expense recognition over the useful life of the leased asset.

Calculating Present Value of Lease Payments

The PVMLP is calculated based on the annual lease payments of $9,214, payable at the beginning of each year, discounted at 11%. This involves the use of present value factors for an annuity due since payments are made at the beginning of each period. As per the problem, the present value factor for an annuity due at 11% over 7 years is approximately 5.23054, leading to a PVMLP of $9,214 x 5.23054 = $48,194.

This PVMLP becomes the lease liability and asset at inception. The residual value is unguaranteed and typically not included in lease recognition unless explicitly guaranteed or part of lease negotiations.

Journal Entries for Adams Corporation

For January 1, 2012 (lease inception):

  • Debit Leased Asset (property, plant, and equipment): $48,194
  • Credit Lease Liability: $48,194

For January 1, 2012 (first lease payment):

  • Debit Lease Liability: $9,214
  • Credit Cash: $9,214

For December 31, 2012 (depreciation):

  • Debit Depreciation Expense: (Lease Asset Value / Useful Life) = $48,194 / 8 = $6,024
  • Credit Accumulated Depreciation—Leased Asset: $6,024

For December 31, 2012 (interest expense):

  • Interest expense = Lease liability at start of year x 11% = ($48,194 - $9,214) x 0.11 ≈ $4,288
  • Debit Interest Expense: $4,288
  • Credit Interest Payable: $4,288

For January 1, 2013 (second lease payment):

  • Debit Lease Liability: $9,214
  • Credit Cash: $9,214

These entries ensure accurate reflection of the lease's financial position and expenses for Adams Corporation, consistent with accounting standards.

Conclusion

Proper lease accounting is critical for transparent financial reporting. The case of Adams illustrates key steps involved in recognizing a capital lease, calculating present values, and recording subsequent depreciation and interest expenses. Adherence to standards such as IFRS 16 and ASC 842 guides companies through this process, ensuring compliance and accurate depiction of lease obligations and asset use.

References

  • FASB Accounting Standards Codification (ASC) 842, Leases.
  • International Financial Reporting Standards (IFRS) 16, Leases.
  • Accounting Standards Update No. 2016-02 (ASC 842) (FASB).
  • Arnold, R., & Bonarrow, S. (2018). Financial accounting (11th ed.). McGraw-Hill Education.
  • Wahlen, J. M., Baginski, S. P., & Bradshaw, M. (2020). Financial reporting, financial statement analysis, and valuation (9th ed.). Cengage Learning.
  • Schroeder, R. G., Clark, M. W., & Cathey, J. M. (2019). Financial accounting theory and analysis (12th ed.). Wiley.
  • Artley, W. L., & Floyd, F. T. (2017). Accounting: Concepts and applications. Cengage Learning.
  • McGraw-Hill Education. (2020). Principles of accounting (Chapter on leases).
  • Financial Accounting Standards Board (FASB). (2016). Summary of ASC 842 Leases.
  • International Accounting Standards Board (IASB). (2016). IFRS Standards and Lease Accounting.

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