Reference no: EM133654211

Question: Saola has traditionally purchased all of its manufacturing equipment. However, in 2022 they wereunable to find a vendor willing to sell them a new $12,426,000 machine. After some carefulnegotiations, however, they were able to lease the needed equipment for 5 years. At the end of the leaseSaola will have the option to purchase the equipment for $994,000, the estimated fair value at the endof the lease. They currently plan to exercise the option and keep the equipment at the end of the lease,but that could change if they find a better option.The machine has an estimated economic life of 7 years with no salvage value. The payments on thelease will be $2,412,148. Saola does not know the implicit interest rate used by the vendor, but theirincremental interest rate is 6.0%. The lease period began on May 1, 2022 and the first payment wasmade that day. Subsequent payments will be made each year and should be paid one day before thestart date to ensure that no late penalties are accrued. In addition to the first payment, Saola paid$18,000 in legal and other lease origination fees on May 1, 2022.Saola has decided to keep all of its accumulated depreciation in one account rather than aseparate account for leased assets.

1.) Make the appropriate journal entries, if any, to account for the lease (including anynecessary changes to income tax expense)

2.) Make any necessary changes to the financial statements. Please see the hints about thespecial adjustment to the Statement of Cash Flows

Hints:

Don't forget to check to see how this lease should be classified by Saola

While you will need to add a new 'ROU asset' account to Saola's Balance Sheet, Saola'smanagement wants ALL of the accumulated depreciation and amortization on PPE(including leased assets) to be combined in one account on the balance sheet.

Technically, a Lease Liability should be broken into current and long-term portions onSaola's Balance Sheet based on when the payment will be made. However, for the sake ofsimplicity, classify the entire amount as long-term for this Saola. Remember that the leaseliability balance will also include any accrued, but unpaid interest as of December 31st.

You will need to make three adjustments to your Statement of Cash Flows. The first will befor the actual cash paid ON THE LEASE, and it will be a new line item in the FinancingActivities section. The second will be for the actual cash paid FOR THE INITIAL COSTS,and it will be an increase to the Cash Paid for Equipment. The third is a special adjustmentto the Operating Activities section for the interest expense accrued. Normally when yourecord interest expense, the other account is interest payable, which automatically updateswith the equations in Operating Activities section. However, for this entry, you put theinterest directly into the lease payable account. So, net income has dropped, but nopayments were made. To remove the non-cash interest (i.e. the interest NOT paid this year),you will need to change the equation in the Change in Interest Payable line to include theinterest on the lease. Then, since that line item isn't just the Change in Interest Payableanymore, you'll need to change the title to be Change in Interest Accrued.

Make sure that you round all of your numbers to the nearest dollar! That's a general rule forSaola, and it is especially important with all of the PV estimates and other calculations youwill need to make in this portion of the project. If necessary, use the "rounddown" for yourIncome Tax Expense calculation, since we have done a lot of rounding up to this point in theproject that can easily throw off this calculation and make your B/S off by $1.