USA Question about capitalized lease agreement

[AndrewMew]

I have a beginner question on this example related to lease capitalization:

It is a 4-year lease, requiring the lessee to pay $10,000 per year. The discount rate is 10%.

From these parameters, we can easily get the allocation of the $10,000 in each year:

Year	Opening Liability	Interest	Principal	Closing Liability
Year 0	NA	NA	NA	$31,700
Year 1	31,700	3,170	6,830	24,870
Year 2	24,870	2,487	7,513	17,357
Year 3	17,357	1,735	8,265	9,092
Year 4	9,092	909	9,092	0

Then the following is the balance sheet of the capitalized lease

Assets	Year 0	Year 1	Year 2	Year 3	Year 4
Leased assets	31,700	31,700	31,700	31,700	31,700
Accumulated depreciation	0	7,925	15,850	23,755	31,700
Net	31,700	23,755	15,850	7,925	0

Liabilities	Year 0	Year 1	Year 2	Year 3	Year 4
Current portion of lease obligation	6,830	7,513	8,265	9,092	0
Long-term debt: lease obligation	24,870	17,357	9,092	0	0
Sum	31,700	24,870	17,357	9,092	0

My questions are:

1. Why do we have to use the straight-line method to depreciate the leased assets? Why can't we just decrease the leased assets by the current portion of lease in each year?
2. Because we depreciate lease assets and lease liabilities in different ways, the lease assets are not equal to the lease liabilities in Year 1, Year 2 and Year 3. How do we re-balance this inequality?

 

[AndrewMew]

Forgot to mention: accounting under US GAAP

 

[BIG E]

I suggest you do your homework assignment on your own.

 

[AndrewMew]

It is not homework. It is an example from the textbook (Page 368 of the Analysis and Use of Financial Statements). I am learning accounting by myself.

 

[kirby]

Andrew

Book you are using to self-teach yourself was published about 2002. It's too out of date. Suggest "Intermediate Accounting" by Kieso. It is huge and pricey but current.

I get that you are asking a conceptual question only. As to question1, keep in mind that you are dealing with two different things here. The asset is, to put it badly, a physical "thing". Depreciation for assets typically uses st line or an accelerated method. Meanwhile, the lease liability is not a physical thing but a future amount due that is calculated using time value of money.

As for question 2, it is not a problem that both amounts are not equal. And at the end of the lease term, both will have a zero value.

 

[AndrewMew]

Thank you for your answer and suggestion! I will put "Intermediate Accounting" to my reading to-do list. My job has little to do with finance. Just want to read textbooks to gain the expertise helping my investment. Therefore, I may continue to ask naive questions here.

As for question 2, it is not a problem that both amounts are not equal. And at the end of the lease term, both will have a zero value.

Because the leased assets are not equal to the lease obligation between the first year and the end year, does it mean that the difference is reflected in the equity section of the balance sheet? I think Assets = Equity + Liabilities should still be held?

 

[kirby]

That is correct, the difference is in equity.