East Company leased a new machine from North Company
on May 1, year 1, under a lease with the following information:

Lease term 10 years

Annual rental payable at beginning of each lease year $40,000

Useful life of machine 12 years

Implicit interest rate 14%

Present value of an annuity of one in advance for ten

periods at 14% 5.95

Present value of one for ten periods at 14% 0.27

East has the option to purchase the machine on May 1, year 11 by
paying $50,000, which approximates the expected fair value of
the machine on the option exercise date. On May 1, year 1, East
should record a capitalized lease asset of

(b) The requirement is to determine the amount to be
recorded as a capitalized leased asset. This is a capital lease for
the lessee because the lease term exceeds 75% of the economic
life of the leased asset (10/12 > 75%). In a capital lease, the lessee
records as an asset and liability the present value (PV) of the
minimum lease payments (unless the PV exceeds the asset’s FV,
in which case the FV is recorded). The minimum lease payments
include rentals, and a lessee-guaranteed residual value or a bargain
purchase option. Only rentals apply in this case. Note that
the $50,000 purchase option is not a bargain purchase option
that the lessee would be compelled to exercise. A bargain purchase
option is an option to purchase the leased asset at an
amount less than its expected fair value. Therefore, the present
value of the minimum lease payments is $238,000 ($40,000 ×
5.95).