13.7 Flashcards
A 6-year capital lease entered into on December 31, Year 4, specified equal minimum annual lease payments due on December 31 of each year. The first minimum annual lease payment, paid on December 31, Year 4, consists of which of the following?
Interest expense:
Lease liability:
No
Yes
Under the effective-interest method, interest is recognized to account for a change in value due to the passage of time. Given that the first payment is made at the inception of the lease, no time has passed. Thus, the first payment reduces the lease liability, but no interest is recognized.
On January 1, Year 1, a shipping company sells a boat and leases it from the buyer in a sale-leaseback transaction. At the end of the 10-year lease, ownership of the boat reverts to the shipping company. The fair value of the boat at the time of the transaction was less than its undepreciated cost. Which of the following outcomes most likely will result from the sale-leaseback transaction?
The shipping company will recognize in the current year a loss on the sale of the boat.
If the sale-leaseback transaction qualifies as a capital lease (the lease provides for the transfer of ownership), the gain or loss on the sale is normally deferred. A loss occurs when the carrying amount is greater than the fair value. In this instance, the full loss is recognized immediately. As the undepreciated cost (carrying amount) is greater than the fair value of the boat, the company will recognize the full loss immediately in the current year.
Benedict Company leased equipment to Mark, Inc., on January 1, Year 2. The lease is for an 8-year period expiring December 31, Year 9. The first of 8 equal annual payments of $600,000 was made on January 1, Year 2. Benedict had purchased the equipment on December 29, Year 1, for $3,200,000. The lease is appropriately accounted for as a sales-type lease by Benedict. Assume that the present value at January 1, Year 2, of all rent payments over the lease term discounted at a 10% interest rate was $3,520,000. What amount of interest income should Benedict record in Year 3 (the second year of the lease period) as a result of the lease?
$261,200
The net investment to be recorded by the lessor at 1/1/Year 2 is given as $3,520,000, the present value of the minimum lease payments discounted at 10%. The net investment is immediately reduced by the $600,000 lease payment on 1/1/Year 2, resulting in a carrying amount for Year 2 of $2,920,000. Interest earned for the Year 2 at a rate of 10% ($2,920,000 × 10%) is $292,000. Thus, the $600,000 1/1/Year 3 lease payment consists of the $292,000 interest component and a $308,000 reduction of the net investment. Because the Year 3 net investment balance is $2,612,000 ($2,920,000 – $308,000), interest income for Year 3 is $261,200 ($2,612,000 × 10%).
Which one of the following statements with respect to leases is correct?
An operating lease is treated like a rental contract between the lessor and lessee.
An operating lease is a transaction in which the lessee rents the right to use the lessor’s assets without acquiring a substantial portion of the benefits and risks of ownership. Thus, an operating lease is treated like a rental contract between the lessor and lessee.
In Year 4, hail damaged several of Toncan Co.’s vans. Hailstorms had frequently inflicted similar damage to Toncan’s vans. Over the years, Toncan had saved money by not buying hail insurance and either paying for repairs or selling damaged vans and then replacing them. In Year 4, the damaged vans were sold for less than their carrying amount. How should the hail damage cost be reported in Toncan’s Year 4 financial statements?
The actual Year 4 hail damage loss in continuing operations, with no separate disclosure.
Because Toncan sold its damaged vans for less than their carrying amount, the company suffered a loss. The actual loss should be reported even though the company is uninsured against future hail damage and a contingency exists. With respect to future hailstorms, no asset has been impaired and no contingent loss should be recorded. Furthermore, this occurrence is not unusual or infrequent, and a separate disclosure is not needed.
Beal, Inc., intends to lease a machine from Paul Corp. Beal’s incremental borrowing rate is 14%. The prime rate of interest is 8%. Paul’s implicit rate in the lease is 10%, which is known to Beal. Beal computes the present value of the minimum lease payments using
10%
A lessee should compute the present value of the minimum lease payments using its incremental borrowing rate unless
The lessee knows the lessor’s implicit rate, and
The lessor’s implicit rate is less than the lessee’s incremental borrowing rate.
If both conditions are met, the lessee must use the lessor’s implicit rate. The 10% implicit rate is less than Beal’s 14% incremental borrowing rate, and Beal has this information, so the rate to be used is 10%.
On December 30, Year 3, Ames Co. leased equipment under a capital lease for 10 years. It contracted to pay $40,000 annual rent on December 31, Year 3, and on December 31 of each of the next 9 years. The capital lease liability was recorded at $270,000 on December 30, Year 3, before the first payment. The equipment’s useful life is 12 years, and the interest rate implicit in the lease is 10%. Ames uses the straight-line method to depreciate all equipment. In recording the December 31, Year 4, payment, by what amount should Ames reduce the capital lease liability?
$17,000
A lease payment has two components: interest expense and the portion applied to the reduction of the lease obligation. The effective-interest method requires that the carrying amount of the obligation at the beginning of each interest period be multiplied by the appropriate interest rate to determine the interest expense. The difference between the minimum lease payment and the interest expense is the amount of reduction in the carrying amount of the lease obligation. The carrying amount at the beginning of the period was $230,000 ($270,000 – $40,000 annual rent), and the interest expense is $23,000. Hence, the reduction in the lease liability is $17,000 ($40,000 – $23,000).
On January 1, Year 4, Nori Mining Co. (lessee) entered into a 5-year lease for drilling equipment. Nori accounted for the acquisition as a capital lease for $240,000, which includes a $10,000 bargain purchase option. At the end of the lease, Nori expects to exercise the bargain purchase option. Nori estimates that the equipment’s fair value will be $20,000 at the end of its 8-year life. Nori regularly uses straight-line depreciation on similar equipment. For the year ended December 31, Year 4, what amount should Nori recognize as depreciation expense on the leased asset?
$27,500
When a lease is capitalized because title passes to the lessee at the end of the lease term or because the lease contains a bargain purchase option, the depreciation period is the estimated economic life of the asset. The asset should be depreciated in accordance with the lessee’s normal depreciation policy for owned assets. Nori regularly uses the straight-line method. Hence, depreciation expense is $27,500 [($240,000 leased asset – $20,000 salvage value) ÷ 8-year economic life].
Wyatt Co. has a probable loss that can only be reasonably estimated within a range of outcomes. No single amount within the range is a better estimate than any other amount. The loss accrual should be
The minimum of the range.
Because the loss is probable and can be reasonably estimated, it should be accrued if the amount is material. If the estimate is stated within a given range and no amount within that range appears to be a better estimate than any other, the minimum of the range should be accrued.
On January 1 of the current year, Tell Co. leased equipment from Swill Co. under a 9-year sales-type lease. The equipment had a cost of $400,000 and an estimated useful life of 15 years. Semiannual lease payments of $44,000 are due every January 1 and July 1. The present value of lease payments at 12% was $505,000, which equals the sales price of the equipment. Using the straight-line method, what amount should Tell recognize as depreciation expense on the equipment in the current year?
$56,111
The lessee capitalizes the lease because the present value of the minimum lease payments (excluding executory costs) is at least equal to 90% of the excess of the fair value of the leased property to the lessor. The fair value to the lessor is presumably the sales price. Given that the sale price equals the present value of the minimum lease payments, the latter amount equals 100% of the lessor’s fair value. Thus, the lessee records an asset and an obligation for $505,000. The lessee should depreciate the asset in a manner consistent with its normal depreciation policy. Given straight-line depreciation, annual depreciation expense is $56,111 ($505,000 ÷ 9 years). The estimated useful life is used only if a bargain purchase option exists and most likely will be exercised.
Ichabod Company is the plaintiff in two lawsuits. The first suit involves a competitor who has made an exact copy of one of Ichabod’s products, and Ichabod is suing for patent infringement. The attorneys estimate a $5,000,000 award for Ichabod; however, it is anticipated that the case will be in litigation for 2 to 3 years before final resolution.
The second case also involves patent infringement; however, in this instance, the attorneys do not believe Ichabod has a strong case. It is estimated that the company has a 50% chance of winning and the award, if any, would be in the $250,000 to $1,000,000 range. The most appropriate amount to be recorded as a gain contingency is
$0
Gain contingencies are not recorded; they are recognized only when realized. A gain contingency must be adequately disclosed.
At the inception of a capital lease, the guaranteed residual value should be
Included as part of minimum lease payments at present value.
A capital lease is recorded at the present value of the minimum lease payments. Minimum lease payments from the lessee’s perspective include the minimum rental payments (excluding executory costs) required during the lease term and the amount of a bargain purchase option. If no such option exists, the minimum lease payments equal the sum of (1) the minimum rental payments, (2) the amount of residual value guaranteed by the lessee, and (3) any nonrenewal penalty imposed. From the lessor’s perspective, minimum lease payments also include residual value guaranteed by a financially capable third party unrelated to the lessee or lessor.
What are the components of the lease receivable for a lessor involved in a direct-financing lease?
The minimum lease payments plus residual value.
The lessor may use the net method or the gross method of accounting for a direct-financing lease. If the lessor elects the net method, it debits the receivable at the inception of the lease for the sum of the present values of (1) the minimum lease payments (including any guaranteed residual value) and (2) any unguaranteed residual value. The credit is to the leased asset. No sales revenue is recognized because the lease is a direct-financing, not a sales-type, lease. If the lessor elects the gross method, the lease receivable equals the sum of the undiscounted lease payments, and an additional credit is made to unearned interest income.
Quick Company’s lease payments are made at the end of each period. Quick’s liability for a capital lease will be reduced periodically by the
Minimum lease payment less the portion of the minimum lease payment allocable to interest.
The lease liability consists of the present value of the minimum lease payments. The lease liability is reduced by the portion of the lease payment attributable to the lease liability. This amount is the lease payment less the interest component of the payment. Thus, the liability is decreased by the minimum lease payment each period less the portion of the payment allocable to interest.
Kew Apparel, Inc., leases and operates a retail store. The following information relates to the lease for the year ended December 31, Year 4:
- The store lease, an operating lease, calls for a base monthly rent of $1,500 due the first day of each month.
- Additional rent is computed at 6% of net sales over $300,000 up to $600,000 and 5% of net sales over $600,000, per calendar year.
- Net sales for Year 4 were $900,000.
- Kew paid executory costs to the lessor for property taxes of $12,000 and insurance of $5,000.
For Year 4, Kew’s expenses relating to the store lease are
$68,000
This lease is properly classified as an operating lease. The expenses for Year 4 relating to this lease should include the fixed monthly rental payment, the contingent rental payments, and the executory costs. The Year 4 expenses, as indicated below, amount to $68,000.
Monthly rent ($1,500 × 12 months): $18,000
Additional rent [($600,000 – $300,000) × 6%]: 18,000
[($900,000 – $600,000) × 5%]: 15,000
Executory costs (property taxes): 12,000
(insurance) : 5,000
Total expenses $68,000
