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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.$48,400

b.$0

c.$75,800

d.$55,800

Explanation

Choice"c"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"b"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"a"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"d"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.