On January 2, 2005, the Wilcox Studios leased six computers for use in the engineering department. The lease period is for 13 years and the estimated economic life of the leased property is 15 years. The lease does not contain automatic title transfer or a bargain purchase option. Lease payments are $9,000 per year, payable each December 31. The incremental borrowing rate for Wilcox is 12 percent and the implicit interest rate (known by Wilcox) is 10 percent. The company uses straight-line depreciation for this type of equipment.

Provide the necessary journal entries to record the transactions for Wilcox for the period January 2, 2005 through December 31, 2006.

I have:
Dec 31 2005
Rent Expense 9,000
Cash 9,000

Dec 31 2006
Rent Expense 9,000
Cash 9,000

Is this correct? If not please Help!

ArcSine

Sasham, in this case you're dealing with a lease term (13 yrs) which is roughly 87% of the economic life of the assets (15 yrs). Whenever the lease term is > 75% of the asset's economic life--as in this case--the lease is a "capital" lease.

This means that you treat the computers as if they were actually purchased by Wilcox. Wilcox is also deemed to have given a promissory note to the lessor to pay for the purchase, and this hypothetical note will be amortized by the 13 annual lease payments.

First compute the present value of the 13 annual payments. Use the 10% implicit interest rate, as this is the rate used by the lessor to "price" the lease, and it's reasonable to assume that the lessor has the best knowledge about the computers' actual value.

The PV you come up with is the deemed purchase price of the computers. Record this amount with a debit to "Fixed Assets: Computers", and a credit to "Note Payable: Capital Lease" (or whatever accounts you're provided in your text for this purpose).

Then record straight-line depreciation for the two years, based on the deemed purchase price you computed above.

Finally, prepare an amortization schedule for the amortization of the Note Payable (or at least for the first two annual payments). From this schedule or computation you'll record the first two lease payments (one each year) with debits to "Interest Expense" and "Note Payable"; your amortization schedule will give you the proper breakdown between principal and interest for each of these two payments.

OK, a quick recap: For the first year, you need to book (1) the original purchase of the computers, for a price equal to the PV of the lease payments; (2) straight-line depreciation for the first year; and (3) the first lease payment, which you'll treat as a payment on the Note, with a principal component and an interest component. For the second year, you'll record another year of depreciation, and the second lease (i.e., "loan") payment.

That ought to get you started in the right direction. Best of luck!