On January 1, 2020, Evans Company entered into a non-cancelable lease for a machine to be used in its manufacturing operations. The lease transfers control of the machine to Evans by the end of the lease term. The term of the lease is 8 years, which equals the useful life of the asset. The lease payment made by Evans on January 1, 2020, was one of eight equal annual payments. At the commencement of the lease, the criteria established for classification as a finance lease by the lessee were met.Instructionsa.    What is the theoretical basis for the accounting standard that requires certain long-term leases to be capitalized by the lessee? Do not discuss the specific criteria for classifying a specific lease as a finance lease.b.    How should Evans account for this lease at its commencement?c.    What expenses directly related to lease liability and right-of-use asset will Evans incur during the first year of the lease, and how will these expenses be determined?d.    How should Evans report the lease transaction on its December 31, 2020, balance sheet?

Question
Asked Jan 25, 2020
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On January 1, 2020, Evans Company entered into a non-cancelable lease for a machine to be used in its manufacturing operations. The lease transfers control of the machine to Evans by the end of the lease term. The term of the lease is 8 years, which equals the useful life of the asset. The lease payment made by Evans on January 1, 2020, was one of eight equal annual payments. At the commencement of the lease, the criteria established for classification as a finance lease by the lessee were met.

Instructions

a.    What is the theoretical basis for the accounting standard that requires certain long-term leases to be capitalized by the lessee? Do not discuss the specific criteria for classifying a specific lease as a finance lease.

b.    How should Evans account for this lease at its commencement?

c.    What expenses directly related to lease liability and right-of-use asset will Evans incur during the first year of the lease, and how will these expenses be determined?

d.    How should Evans report the lease transaction on its December 31, 2020, balance sheet?

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Expert Answer

Step 1

Lease:

 

Lease is a contractual agreement whereby the right to use an asset for a particular period of time is provided by the owner of the asset to the user of the asset. The owner, who possesses the asset, is termed as ‘Lessor’ and user, to whom the right is transferred to, is termed as ‘Lessee’.

 

Operating lease:

 

An operating lease is as often cancellable and incorporates maintenance. Operating leases are for a period essentially shorter than the asset’s monetary life, consequently the lessor regularly does not recover his complete investment amid the time of the necessary lease.

 

Capital lease:

 

In capital lease, all the ownership risks and responsibilities are transferred from the lessor to the lessee.

 

In case, the lease is transferring “substantially all” of the risks and benefits essential to the ownership of property by meeting any one of the four criteria established by GAAP then that lease is classified as a capital lease.

Step 2

a.

 

The economic effect of a long term capital lease is comparable to that of an instalment debt purchase. In such type of lease, substantial or entire risks and benefits incidental to the ownership of the property transfer to the lessee and therefore, the lease should be classified as finance lease.

Step 3

b.

 

For a finance lease, a lessee should account for it as an asset at the commencement and the total amount equal to the present value at the beginning of the lease for the minimum lease payments, minus any executory costs along with any profit thereon, should be ...

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