On 1 January 20X1, Oryx entered into a contract to lease a specialised machine for three years. The contract contains an option to extend the lease term for a further year. Oryx believes that it is reasonably certain to exercise this option. The machine has a usefut life of ten years.
Oryx will make lease payments of $1 million per year for the initial term and
SO 8 million per year for the option period. All payments are due at the end of the year. To obtain the lease, Oryx incurs inital direct costs of SO 1 milion.
The interest rate within the lease is not readily determinable. Ory's incremental rate of borrowing is 10%
What entries will Oryx post on 1 January 20X1 in respect of this lansa?

Question

On 1 January 20X1, Oryx entered into a contract to lease a specialised machine for three years. The contract contains an option to extend the lease term for a further year. Oryx believes that it is reasonably certain to exercise this option. The machine has a usefut life of ten years.
Oryx will make lease payments of $1 million per year for the initial term and
SO 8 million per year for the option period. All payments are due at the end of the year. To obtain the lease, Oryx incurs inital direct costs of SO 1 milion.
The interest rate within the lease is not readily determinable. Ory's incremental rate of borrowing is 10%
What entries will Oryx post on 1 January 20X1 in respect of this lansa?

Accepted Answer

To determine the accounting entries Oryx will post on 1 January 20X1 regarding the lease of the specialized machine, we need to calculate the present value of the lease payments and recognize the right-of-use asset and lease liability. 1. **Lease Payments**: - For the initial three years: $1 million per year. - For the optional fourth year: $8 million. 2. **Present Value Calculation**: Since the interest rate is not readily determinable, we will use Oryx's incremental borrowing rate of 10%. - **Present Value of Lease Payments for the Initial Term (3 years)**: $$ PV = \sum \left( \frac{C}{(1 + r)^t} \right) $$ Where $C$ is the cash flow ($1 million), $r$ is the interest rate (10%), and $t$ is the year. $$ PV = \frac{1,000,000}{(1 + 0.10)^1} + \frac{1,000,000}{(1 + 0.10)^2} + \frac{1,000,000}{(1 + 0.10)^3} $$ $$ PV = 909,091 + 826,446 + 751,315 = 2,486,852 $$ - **Present Value of Lease Payment for the Optional Year**: $$ PV = \frac{8,000,000}{(1 + 0.10)^4} = \frac{8,000,000}{1.4641} \approx 5,464,000 $$ - **Total Present Value of Lease Payments**: $$ Total PV = 2,486,852 + 5,464,000 = 7,950,852 $$ 3. **Initial Direct Costs**: Oryx incurs initial direct costs of $1 million, which will be added to the right-of-use asset. 4. **Journal Entries on 1 January 20X1**: - **Right-of-Use Asset**: $$ Right-of-Use Asset = Total PV + Initial Direct Costs = 7,950,852 + 1,000,000 = 8,950,852 $$ - **Lease Liability**: $$ Lease Liability = Total PV = 7,950,852 $$ The journal entries will be: - Debit Right-of-Use Asset: $8,950,852 - Credit Lease Liability: $7,950,852 - Credit Cash (or Accounts Payable) for Initial Direct Costs: $1,000,000 This reflects the recognition of the right-of-use asset and the corresponding lease liability on Oryx's balance sheet. If you have any further questions or need clarification on any part of this process, feel free to ask!

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