FAR 60 - Leases 1 - Capital Leases/Direct Financing/Sales Type Leases Flashcards Preview

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Flashcards in FAR 60 - Leases 1 - Capital Leases/Direct Financing/Sales Type Leases Deck (54):
1

On June 1 of the current year, a company entered into a real estate lease agreement for a new building. The lease is an operating lease and is fully executed on that day. According to the terms of the lease, payments of $28,900 per month are scheduled to begin on October 1 of the current year and to continue each month thereafter for 56 months. The lease term spans five years. The company has a calendar year end. What amount is the company's lease expense for the current calendar year?

$188,813 The first four months of the lease term require no lease payments. However, each month bears the same lease expense under the matching principle because the firm will receive the same benefit from the lease each month. The monthly lease expense is the ratio of total lease payments to the length of the lease term in months. Lease payments total $1,618,400 ($28,900 x 56). The number of months in the lease term is 60 (5 x 12). Therefore the monthly lease expense is $1,618,400/60 = $26,973.33. The firm occupied the property for 7 months during the current calendar year (June - December inclusive). Therefore the lease expense for the current calendar year is $188,813 ($26,973.33 x 7). The fact that the first four months require no lease payment does not mean the firm has no lease expense during those months.

2

Wall Co. leased office premises to Fox, Inc. for a 5-year term beginning January 2, 2005.
Under the terms of the operating lease, rent for the first year was $8,000 and rent for years 2 through 5 was $12,500 per annum. However, as an inducement to enter the lease, Wall granted Fox the first 6 months of the lease rent free.
In its December 31, 2005 income statement, what amount should Wall report as rental income?

$10,800 Rental income is recognized on the straight-line basis for operating leases. The schedule of rental receipts does not affect how annual rental income is recognized. Thus, annual rental income to be recognized is $10,800 = [($4000) + 4($12,500)]/5. The trick here is to remember to use only one-half the first year's rent because that is all that will be received the first year.

3

On January 1, 2003, JCK Co. signed a contract for an 8-year lease of its equipment with a 10-year life.
The present value of the 16 equal semiannual payments in advance equaled 85% of the equipment's fair value. The contract had no provision for JCK, the lessor, to give up legal ownership of the equipment.
Should JCK recognize rent or interest revenue in 2005, and should the revenue recognized in 2005 be the same as or smaller than the revenue recognized in 2004?
2005 revenues recognized
2005 amount recognized compared to 2004

Interest, Smaller
The lease is a capital lease to the lessor because the lease term (8 years) exceeds 75% of the useful life at inception (10 years). Only one of the criteria for lease capitalization need be met for a lease to be capitalized.
Thus, the lessor should recognize interest revenue rather than rent revenue (which would be recognized under an operating lease). Each lease payment includes principal and interest. Therefore, a lower principal balance exists at the beginning of 2005 than at the beginning of 2004 because more principal would have been paid off by the time the 2005 payments were made.
Thus, interest revenue is lower in 2005 than in 2004 (interest revenue as a percentage of the lease payment declines each year).

4

On July 1, 2004, Gee, Inc. leased a delivery truck from Marr Corp. under a 3-year operating lease. Total rent for the term of the lease was $36,000, payable as follows:
12 months at $500 = $6,000
12 months at $750 = 9,000
12 months at $1,750 = 21,000
All payments were made when due. In Marr's June 30, 2006 balance sheet, the accrued rent receivable should be reported as

$9,000 Assuming the payment schedule is in chronological order, rent revenue is recognized faster than cash is received because the required rent payments increase in amount over the term. The amount of rent revenue (expense) to be recognized each year is $12,000 ($36,000/3) - this is the straight-line basis.
As of 6/30/06, 2 years or two-thirds of the lease term has elapsed. Therefore, $24,000 of rent revenue has been recognized, but only $15,000 cash has been received to that point.
Therefore, the lessor has $9,000 in rent receivable for the revenue recognized but not yet received in cash. The lessor has provided two-thirds of the value of the rental period but has collected less than that amount.

5

A company enters into a three-year operating lease agreement effective January 1, year 1. The amounts due on the first day of each year are $25,000 in year 1, $30,000 in year 2, and $35,000 in year 3. What amount, if any, is the related liability on the first day of year 2?

$5,000 For operating leases, rent expense is recognized on a straight-line basis unless the lessee is receiving benefits from the leased asset in some other manner. This is true even if the payment schedule is uneven, as is the case here. Annual rent expense, therefore, is $30,000 [= ($25,000 + $30,000 + $35,000)/3]. As of 1/1/2, the lessee has recognized $30,000 of expense but paid only $25,000. Therefore, a liability of $5,000 is reported. The lessee owes $5,000 on this date because it has obtained $30,000 worth of use of the asset but paid only $25,000. This answer is correct assuming that the question is asking for the liability amount before the payment due 1/1/2 is made.

6

On January 1, 2005, Mollat Co. signed a 7-year lease for equipment having a 10-year economic life.
The present value of the monthly lease payments equaled 80% of the equipment's fair value. The lease agreement provides for neither a transfer of title to Mollat nor a bargain purchase option.
In its 2005 income statement, Mollat should report
A. Rent expense equal to the 2005 lease payments.
B. Rent expense equal to the 2005 lease payments less interest expense.
C. Lease amortization equal to one-tenth of the equipment's fair value.
D. Lease amortization equal to one-seventh of 80% of the equipment's fair value.

A. The lease is an operating lease because title is not transferred to the lessee at the end of the lease term (this covers the first two lease capitalization criteria: title transfer and bargain purchase option), the lease term is not at least 75% of the useful life of the asset at inception, and the present value of the lease payments is not at least 90% of the fair value of the asset.
None of the four lease capitalization criteria are met. Therefore, the lessee records an operating lease and recognizes only rent expense for the lease term (no interest expense).

7

What are the 4 criteria for capitalizing a lease for the leasee?

1. Transfer of ownership
2. Bargain purchase option
3. Lease term is 75% or more of estimated economic life
4. Present value of minimum lease payments at least 90% of excess of fair value of leased property

Only one of four criteria must be met for a lessee to account for the lease as a capital lease.

8

T/F: An operating lease is the best example of reporting the economic substance over legal form of long-term noncancellable leases.

False
An operating lease does not present the FS as showing the overall financial reality of the lease over the legal form of the transactions on the lease.

9

T/F: A lessee records annual rent expense on a long-term lease. This lease is capital.

False
A lease is capitalized when it meets the lease capitalization criteria. We do not have enough info here to determine whether or not it is a capital lease.

10

T/F: If a lease is not a capital lease, it is an operating lease for the lessee.

TRUE

11

T/F: The schedule of rental payments varies by period, but the rent expense to be recognized each period should be constant.

TRUE

12

T/F: A refundable deposit paid by the lessee and held by the lessor is included in rent expense and rent revenue.

False.

13

T/F: A bonus to obtain a lease is amortized as rent expense over the term of the lease.

TRUE

14

T/F: A long-term operating lease is an example of the use of off-balance sheet financing.

TRUE

15

T/F: Only the lessor capitalizes a lease. Lessee depreciates the asset.

False
Only the lessee capitalizes a lease. Both parties depreciate the asset.

16

T/F: The lessor's implicit rate in the lease is the rate the lessor earns from all cash flows to be received under the lease.

TRUE

17

T/F: An asset leased to one lessee as a capital lease later could be leased to another lessee as an operating lease.

TRUE

18

T/F: The market value of an asset to be leased is $30,000. The present value of the lessee's minimum lease payments is $25,000, and for the lessor is $28,000. Criteria 5 and 6 are met. This lease is definitely a capital lease for the lessor.

True
For the lease to be accounted for as a capital lease, the lessor must meet at least one of the first four criteria and both criteria 5 and 6.

19

T/F: An operating lease is any lease involving the use of a leased asset used in operations.

False
An operating lease does not transfer the risks and rewards of ownership to the leasee.

20

T/F: It is possible for a lessor to have an operating lease even though the lessee capitalizes the same lease?

TRUE

21

T/F: If any one of the four lease capitalization criteria are met by the lessor, then the lessor must account for the lease as a capital lease.

False
For the lease to be accounted for as a capital lease, the lessor must meet at least one of the first four criteria and both criteria 5 and 6.

22

T/F: The criteria for capitalizing a lease are used to determine whether the lessee has acquired most of the rewards and risks of ownership for the leased asset.

TRUE

23

T/F: The lessor's implicit interest rate is 10%, and this rate is known or can be determined by a lessee that has an incremental borrowing rate of 8%. 8% is also used by the lessee to capitalize the lease.

True.
The lower interest rate available is what will be applied to a capitalized lease.

24

T/F: Both the lessor and lessee lease accounting are affected by lease capitalization criteria 5 and 6.

False.
Only the lessor is affected by criteria 5 and 6.
5. There are no material cost uncertainties that would require unreimbursable costs to be incurred by the lessor.
6. Collectibility of the minimum lease payments is reasonably assured.

25

T/F: If either of the first two criteria for lease capitalization are met, in substance an installment purchase has been made by the lessee.

TRUE

26

T/F: The lease term includes periods covered by a bargain renewal option.

TRUE

27

T/F: The minimum lease payments of the lessor include a third party guarantee of residual value.

TRUE

28

T/F: Only the lessee capitalizes a lease. Both parties depreciate the asset.

TRUE

29

T/F: The minimum lease payments of the lessee are the payments the lessee is reasonably expected to make over the lease term.

TRUE

30

T/F: A bargain purchase option ultimately saves the lessee money.

False
Essentially it is really just another lease payment.
The lessor structures all of the payments, including the BPO, to provide the required rate of return in expectation that it will be exercised.

31

On January 1, 2005, Blaugh Co. signed a long-term lease for an office building.
The terms of the lease required Blaugh to pay $10,000 annually, beginning December 30, 2005 and continuing each year for 30 years. The lease qualifies as a capital lease. On January 1, 2005, the present value of the lease payments is $112,500 at the 8% interest rate implicit in the lease.
In Blaugh's December 31, 2005 balance sheet, the capital lease liability should be:

$111,500
The entry at December 31, 2005:
Dr. Interest expense ($112,500 x .08) 9,000
Lease liability 1,000
Cr. Cash 10,000
The ending lease liability for 2005 is $111,500 ($112,500 - $1,000 from entry).

32

Jay's lease payments are made at the end of each period. Jay's liability for a capital lease would be reduced periodically by the
A. Minimum lease payment less the portion of the minimum lease payment allocable to interest.
B. Minimum lease payment plus the amortization of the related asset.
C. Minimum lease payment less the amortization of the related asset.
D. Minimum lease payment.

A. Each lease payment includes interest based on the lease liability at the beginning of the period. The amount of each payment exceeding the interest component is the amount of principal reduction. This amount reduces the lease liability used to compute the interest portion of the next payment.
Thus, the interest component decreases with each payment as more principal is paid off.

33

Glade Co. leases computer equipment to customers under direct-financing leases.
The equipment has no residual value at the end of the lease, and the leases do not contain bargain purchase options. Glade wishes to earn 8% interest on a 5-year lease of equipment with a fair value of $323,400. The present value of an annuity due of $1 at 8% for 5 years is 4.312.
What is the total amount of interest revenue that Glade will earn over the life of the lease?

$51,600
Total interest over the term equals the difference between total lease payments and the fair value of the property at inception. The lease payment is $75,000 ($323,400/4.312). Thus, total interest is 5($75,000) - $323,400 = $51,600.

34

What are the components of the lease receivable for a lessor involved in a direct-financing lease?
A. The minimum lease payments plus any executory costs
B. The minimum lease payments plus residual value
C. The minimum lease payments less residual value
D. The minimum lease payments less initial direct costs

B. The net lease receivable initial balance is the present value of the minimum lease payments (payments expected to be received under the lease) plus the present value of the residual at the end of the lease term. The value used for the residual (before discounting) is the estimated fair value of the asset at the end of the lease term, not the end of the asset's useful life.

35

Oak Co. leased equipment for its entire 9-year useful life, agreeing to pay $50,000 at the start of the lease term on December 31, 2004 and $50,000 annually on each December 31 for the next 8 years. The present value on December 31, 2004 of the nine lease payments over the lease term, using the rate implicit in the lease, which Oak knows to be 10%, was $316,500. The December 31, 2004 present value of the lease payments using Oak's incremental borrowing rate of 12% was $298,500. Oak made a timely second lease payment. What amount should Oak report as capital lease liability in its December 31, 2005 balance sheet?

$243,150 The lessee uses 10% because it is the lower of the two rates and is known to the lessee. The lease liability balance immediately after the first payment (at inception) is $266,500 ($316,500 - $50,000). The first payment includes no interest because it is made immediately. The entry for the 12/31/05 payment is:
Dr. Lease liability 23,350
Interest expense .10($266,500) 26,650
Cr. Cash 50,000
The ending lease liability balance is $266,500 - $23,350 = $243,150.

36

Able Co. leased equipment to Baker under a noncancelable lease with a transfer of title. Will Able record depreciation expense on the leased asset and interest revenue related to the lease?
Depreciation Expense
Interest Revenue

No, yes
Able is the lessor. In a capital lease, the physical asset is replaced with a financial asset on which interest revenue is recognized. Each payment includes principal and interest (with the exception of the first payment if due at signing). The lessor has no physical asset to depreciate. The lessee depreciates the asset if it is a capital lease to the lessee.

37

T/F: The inception of a capital lease is January 1. The lease payments form an ordinary annuity. On December 31, the lessor computes interest based on the net lease receivable at inception.

TRUE

38

T/F: A lessor has only one kind of income from a direct financing lease: interest.

TRUE

39

T/F: Only the lessor is concerned with the classification of capital leases as direct financing or sales-type

TRUE

40

T/F: The lessee and lessor typically use the net recording method for capital leases.

False
Lessor typically uses the gross method.
Lessee typically uses the net method.

41

T/F: In a direct financing lease, the market and book values of the asset leased are the same at inception.

TRUE

42

Farm Co. leased equipment to Union Co. on July 1, 2005 and properly recorded the sales-type lease at $135,000, the present value of the lease payments discounted at 10%.
The first of eight annual lease payments of $20,000 due at the beginning of each year was received and recorded on July 3, 2005. Farm had purchased the equipment for $110,000.
What amount of interest revenue from the lease should Farm report in its 2005 income statement?

$5,750
The interest for the first 6 months of the lease term is (1/2).10($135,000 - $20,000) = $5,750.
The first lease payment reduces the principal by the full amount of the payment because no time has elapsed since inception (it was paid essentially at the inception of the lease). When the fiscal year is not specified, the student should assume a calendar fiscal year. Therefore, as of 12/31/05, only 6 months of the term had elapsed.

43

In a lease that is recorded as a sales-type lease by the lessor, interest revenue
A. Should be recognized in full as revenue at the lease's inception.
B. Should be recognized over the period of the lease using the straight-line method.
C. Should be recognized over the period of the lease using the effective interest method.
D. Does not arise.

C. For all capital leases, the lessor uses the effective interest method to compute interest over the period of the lease. The interest revenue recognized each period equals the interest rate implicit in the lease multiplied by the beginning net lease receivable.
The straight-line method is not used because each payment includes interest and principal. The distortion resulting from application of the straight-line method would be considerable.

44

A 6-year capital lease entered into on December 31, 2005 specified equal minimum annual lease payments due on December 31 of each year. The first minimum annual lease payment, paid on December 31, 2005, consists of which of the following?
Interest expense
Lease Liability

No, yes
The first payment, which is made at inception, is completely a principal payment because no time has elapsed in the lease term. Thus, the entire payment is applied to principal and reduces the lease liability by the amount of the payment.

45

T/F: The lessor multiplies the implicit interest rate by the beginning gross lease receivable balance in computing interest revenue for the period.

False,
multiples the implicit interest rate by the begining net lease receivable

46

T/F: In a sales-type lease, the lease payments are based on the book value of the asset leased.

False
lease payments are based on the market value of the asset.

47

T/F: The net lease receivable balance at a balance sheet date equals gross lease receivable balance less unearned interest balance and present value of remaining lease payments.

TRUE

48

T/F: The cost of goods sold to be recognized in a sales-type lease is the book value of the asset leased.

TRUE

49

T/F: A lessor has only one kind of income from a sales-type lease.

False
* Interest income or revenue
* dealer's gross profit, which is recognized at the inception of the lease agreement

50

T/F: The sales to be recognized in a sales-type lease are the market value or normal sales price of the asset leased.

TRUE

51

T/F: For capital lease 1, the market value of the asset is $50,000, and the book value is $40,000 to the lessor. In capital lease 2, the market value of the asset is $50,000, and the book value is $50,000. The same party is the lessee for both leases. This lessee will record and account for both leases in exactly the same way.

TRUE

52

T/F: The inception of a capital lease is January 1. The lease payments form an annuity due. On December 31, the lessor must accrue interest revenue and reduce unearned interest even though no payment is due that day.

TRUE

53

T/F: In a sales-type lease, the lessor immediately recognizes the full gross margin that would otherwise be recognized if the transaction were an outright sale.

TRUE

54

T/F: In a sales-type lease, the market and book values of the asset leased are the same at inception.

False
They are not the same and a gross profit (or loss) is recorded at inception.

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