On January 1, Rosewater Company leased a computer for 4 years at a monthly rent of $80, payable at the end of each month. Due to the rate of technical change, the computer is expected to become obsolete within 5 years. At the inception of the lease, the computer was retailing for $3,450. Had Rosewater chosen to purchase the computer instead of leasing it, they could have borrowed the funds at 10%. At a 10% interest rate, the present value of the lease payments is $3,154. Rosewater does not know the rate implicit in the lease. For the month of January, Rosewater should report (to the closest dollar) interest expense of

Answer (A) is correct. Interest expense will be recognized in the amount of $26 [$3,154 × 10% × (1 ÷ 12 months)]. Since Rosewater does not know the lessor’s implicit rate, it is appropriate to use Rosewater’s own incremental borrowing rate to determine whether the lease should be classified as a capital lease. Since the present value of the lease payments is greater than 90% of the fair value of the computer ($3,154 ÷ $3,450 = 91.4%), the lease is appropriately classified as a capital lease and Rosewater will recognize depreciation expense. Since the lease agreement neither provides for transfer of ownership nor contains a bargain purchase option, the computers are depreciated over the lease term (4 years). Monthly depreciation expense will be $66 ($3,154 ÷ 48 months).