Lessee Accounting Flashcards
(21 cards)
In a finance and operating lease how do you recognize a right of use asset?
PV of lease payments
In a finance lease, what rate is used to determine interest expense and PV of payments?
Lease’s implicit rate, if known. Otherwise the lessee’s incremental borrowing rate is used.
How is a guaranteed residual value treated in a finance lease?
PV is taken less any expected residual value at the end of the lease and added to the lease liability
5 ways a lease can be classified as a finance lease
Specialized lease property
Purchase option reasonably certain to be exercised
Transfers title at the end of the lease
Lease term major part of remaining economic life (greater than or equal to 75%)
PV of lease payments substantially all of leased item’s fair value (greater than or equal to 90%)
On January 2, Year 1, Marx Co. as lessee signed a 5-year noncancelable equipment lease with annual payments of $200,000 beginning December 31, Year 1. Marx treated this transaction as a finance lease. The five lease payments had a present value of $758,000 on January 2, Year 1, based on Marx’s incremental borrowing rate of 10%. In its year-end income statement dated June 30, Year 1, what amount of interest expense should Marx report?
A. $0
B. $37,900
C. $55,800
D. $75,800
B. $37,900
Remember to account for the portion of the year.
In a finance lease, the lessee recognizes a right-of-use asset and a lease liability at the present value (PV) of lease payments. The PV of payments and interest expense are calculated using the lease’s implicit rate, if known. Otherwise, the lessee’s incremental borrowing rate is used.
After the lease’s inception, the lessee reports interest expense on the lease liability for the time it has been outstanding during the year (Choice A). Interest expense equals the outstanding liability balance × the interest rate × the number of months outstanding during the year divided by 12 months.
In this scenario, Marx Co. signed a lease on January 2, Year 1. Because Marx has a June 30 year end, it will need to report 6 months of interest expense in the year-end income statement. At lease inception, the PV of lease payments is given as $758,000 using the lessee’s 10% incremental borrowing rate. Interest expense is $37,900 ($758,000 liability × 10% × 6/12 months).
Main, a pharmaceutical company, signed an operating lease agreement to use office space for 5 years. Main took possession and began to use the building on July 1, Year 1. Rent was due the first day of each month. Monthly lease payments escalated over the 5-year period of the lease as follows:
Period Lease payment
July 1, Year 1 – September 30, Year 1 $0 – rent abatement during move-in, construction
October 1, Year 1 – June 30, Year 2 $17,500
July 1 Year 2 – June 30, Year 3 $19,000
July 1, Year 3 – June 30, Year 4 $20,500
July 1, Year 4 – June 30, Year 5 $23,000
July 1 Year 5 – June 30, Year 6 $24,500
In its income statement for the year ended June 30, Year 2, what amount should Main report as lease expense?
A. $105,000
B. $157,500
C. $180,225
D. $240,300
D. $240,300
In an operating lease, a lessor permits the use, but does not transfer ownership of, an asset to a lessee. At lease inception, the lessee records a right-of-use asset and a corresponding lease liability at the present value of lease payments.
Lease payments (ie, rent) are expensed uniformly over the lease term on a straight-line (S/L) basis. Monthlylease expense equals the total lease payments divided by the months in the lease term.
In this scenario, Main has a 5-year (ie, 60-month) operating lease for office space with escalating lease payments each year. Monthly lease expense is $20,025, as calculated below:
July 1, Year 1–June 30, Year 2 ($17,500 × 9 months) $157,500
July 1, Year 2–June 30, Year 3 ($19,000 × 12 months) 228,000
July 1, Year 3–June 30, Year 4 ($20,500 × 12 months) 246,000
July 1, Year 4–June 30, Year 5 ($23,000 × 12 months) 276,000
July 1, Year 5–June 30, Year 6 ($24,500 × 12 months) 294,000
Total lease payments $1,201,500
Monthly lease expense ($1,201,500 / 60 months) $20,025
Main took possession of the space on July 1, Year 1. Therefore, Main should report $240,300 in lease expense on its income statement for the year ended June 30, Year 2 ($20,025 × 12 months).
On January 1, Year 1, Eber Co. leased equipment under a 4-year finance lease. The present value of the lease payments is $348,680. The equipment had a 5-year economic life and a $20,000 guaranteed residual value. The equipment reverts to the lessor at the end of the lease. What amount should Eber report as amortization of the right-of-use asset on December 31, Year 1?
A. $65,736
B. $69,736
C. $82,170
D. $87,170
D. $87,170
In a finance lease, a lessee recognizes a right-of-use(ROU) asset and a lease liability at the present value (PV) of the lease payments. For leases containing a guaranteed residual value (GRV), the total lease payments include the probable amount that the lessee will owe to a lessor at the end of the lease.
The lessee amortizes the ROU asset on a straight-line basis over the shorter of the leased asset’s useful life or the lease term. However, if the title transfers or the lessee is likely to exercise a purchase option, the ROU asset is amortized over the asset’s useful life because the lessee will be the ultimate owner.
In this scenario, Eber Co. has a 4-year finance lease that includes a $20,000 GRV. Because the lease does not have a title transfer or purchase option, Eber will amortize the ROU asset over the 4-year lease term because it’s shorter than the 5-year useful life. The PV of the lease payments is given as $348,680, including the GRV. The Year 1 ROU asset amortization equals $87,170 ($348,680 / 4 years).
On January 1, Year 1, Babson, Inc. leased two automobiles for executive use. The lease requires Babson to make five annual payments of $13,000 beginning January 1, Year 1. At the end of the lease term, December 31, Year 5, Babson guarantees the residual value of the automobiles will total $12,000, and the expected residual value at the time will be $2,000. The lease qualifies as a finance lease. The interest rate implicit in the lease is 9%, which is known to Babson. Present value factors for 5 periods at the 9% rate are as follows:
Annuity due 4.240
Ordinary annuity 3.890
Present value of $1 0.650
Babson’s recorded lease liability immediately after the first required payment should be
A. $37,570
B. $42,120
C. $44,070
D. $48,620
D. $48,620
In this scenario, Babson, Inc. has a 5-year finance lease with a residual value guarantee of $12,000. The $13,000 annual payments are due at the beginning of each year (ie, annuity due). The automobiles’ expected residual value at the end of the lease is $2,000, and Babson has guaranteed a minimum value of $12,000. The $10,000 difference for the guarantee is included in the total lease payments ($12,000 − $2,000). After the first payment is made at lease inception, the lease liability equals $48,620.
PV of lease payments ($13,000 × 4.24 annuity due) $55,120
PV of guaranteed residual value ($10,000 × 0.65 PV of $1) 6,500
Initial lease liability $61,620
Less: Year 1 lease payment (applied to lease liability) (13,000)
Remaining lease liability $48,620
(Choices A and B) Liabilities of $37,570 and $42,120 exclude the residual value guarantee with the ordinary annuity and annuity due factors, respectively.
(Choice C) A $44,070 liability uses the ordinary annuity factor instead of the annuity due factor.
Things to remember:
A residual value guarantee in a lease is the probable amount a lessee will have to pay for a leased asset at the end of a lease. The lease liability equals the present value of lease payments, including the guaranteed residual value.
Neal Corp. entered into a nine-year finance lease on a warehouse on December 31, Year 1. Lease payments of $50,000, which include real estate taxes itemized in the contract at $2,000 per year, are due annually, beginning on December 31, Year 2, and every December 31 thereafter. Neal does not know the interest rate implicit in the lease; Neal’s incremental borrowing rate is 9%. The rounded present value of an ordinary annuity for nine years at 9% is 5.6. What amount should Neal report as finance lease liability at December 31, Year 1?
A. $268,800
B. $280,000
C. $291,200
D. $450,000
B. $280,000
Taxes are included
A company enters into a 5-year operating lease agreement effective January 1, Year 1. The rent due on the last day of each year is $10,000. As an inducement to enter into the lease, the company received half off the first year’s rent. The following information pertains to the company on January 1, Year 1:
Incremental borrowing rate 6%
Present value of $1 for 1 period at 6% 0.943
Present value of ordinary annuity for 5 periods at 6% 4.212
What amount will the company record as the right-of-use asset?
A. $37,405
B. $42,120
C. $45,000
D. $46,835
A. $37,405
In this scenario, the company needs to record the ROU asset for their operating lease. They determine the PV of lease payments by using the 6% incremental borrowing rate. Since they received half off the first year’s rent ($5,000), the total amount of payments equals $45,000 (Choice C). The ROU asset equals $37,405 (ie, PV of lease payments) as calculated below:
5-year ordinary annuity ($10,000 payments × 4.212) 42,120
Less: Year 1 rent reduction ($5,000 × 0.943) (4,715)
Total PV of lease payments $37,405
(Choice B) The ROU asset of $42,120 does not include the net reduction for free rent in Year 1.
(Choice D) The ROU asset of $46,835 adds the PV of 5 years of $10,000 payments to the PV of Year 1 reduced rent.
Things to remember:
At lease inception, the lessee records a right-of-use (ROU) asset and a corresponding lease liability. The ROU asset includes the present value of lease payments (ie, lease liability) plus any prepaid lease payments and initial direct costs (eg, legal fees) less any lease incentives received.
Cott, Inc. prepared an interest amortization table for a 5-year lease liability with a purchase option of $2,000, considered likely to be exercised at the end of the lease. At the end of the five years, the balance in the lease liability column of the spreadsheet was zero. Cott has asked Grant, CPA, to review the spreadsheet to determine the error. Only one error was made on the spreadsheet. Which of the following statements represents the best explanation for this error?
A. The beginning present value of the lease did not include the present value of the purchase option.
B. Cott subtracted the annual interest amount from the lease liability balance instead of adding it.
C. The present value of the purchase option was subtracted from the present value of the annual payments.
D. Cott discounted the annual payments as an ordinary annuity, when the payments actually occurred at the beginning of each period.
A. The beginning present value of the lease did not include the present value of the purchase option.
A finance lease is required to meet one of several criteria. It effectively transfers the rights and risks of ownership of the leased asset from the lessor to the lessee. The lessee recognizes a right-of-use asset and a lease liability at the present value of lease payments.
If a finance lease includes a purchase option that is likely to be exercised, the total lease payments include the recurring payments and the purchase option amount. At the end of the lease term, the unamortized lease liability will equal the purchase option amount because all the lease payments have been made.
The lease in this scenario has a purchase option that Cott, Inc. (ie, lessee) is likely to exercise, so it qualifies as a finance lease. Cott should include the purchase option amount in the lease liability (Choice C). Because Cott’s amortization table resulted in a zero balance after all payments were made, the initial amount recorded as a liability must have excluded the purchase option.
Robbins, Inc. leased a machine from Ready Leasing Co. The lease qualifies as a finance lease and requires 10 annual payments of $10,000 beginning immediately. The lease specifies an interest rate of 12% and a purchase option of $10,000 at the end of the 10th year, even though the machine’s estimated value on that date is $20,000. Robbins has a policy of exercising purchase options on leased equipment when fair market value exceeds option price. Robbins’ incremental borrowing rate is 14%.
The present value of an annuity due at:
12% for 10 years is 6.328.
14% for 10 years is 5.946.
The present value of $1 at:
12% for 10 years is 0.322.
14% for 10 years is 0.270.
What amount should Robbins record as lease liability at the beginning of the lease term?
A. $62,160
B. $64,860
C. $66,500
D. $69,720
C. $66,500
A finance lease must meet at least one of several criteria. It effectively transfers the rights and risks of ownership of the leased asset from the lessor to the lessee. The lessee recognizes a right-of-use asset and a lease liability at the present value (PV) of lease payments.
Lease payments include a purchase option amount if the option is likely to be exercised at the end of the lease. The PV of payments is calculated using the lessee’s incremental borrowing rate or the implicit rate in the lease, if known. Payments made at the beginning of each period use the annuity-due discount factor; a purchase option uses the single-sum discount factor.
In this scenario, Robbins, Inc. (ie, lessee) has a finance lease because it is likely to exercise the purchase option. A 12% rate is specified in the lease (ie, implicit rate), so the 12% factors are used to discount the PV of lease payments. The initial lease liability is $66,500.
PV of annual payments ($10,000 payment × 6.328 annuity-due factor at 12%) $63,280
PV of purchase option ($10,000 × 0.322 single-sum factor at 12%) 3,220
Initial lease liability $66,500
(Choice A) A liability of $62,160 uses the 14% factors to discount payments.
(Choices B and D) Liabilities of $64,860 and $69,720 are calculated using the estimated value of $20,000 for the purchase option at 14% and 12%, respectively. However, the lease liability should include a purchase option amount of $10,000.
Things to remember:
A lease with a purchase option that is likely to be exercised is a finance lease. The lease liability equals the present value of lease payments, including the purchase option. The rate implicit in the lease, if known, is used to discount the payments. Payments made at the beginning of each period use the annuity-due discount factor; a purchase option uses the single-sum discount factor.
On January 1 of the current year, Tell Co. leased equipment from Swill Co. under a nine-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 amortization expense on the equipment in the current year?
A. $26,667
B. $33,667
C. $44,444
D. $56,111
D. $56,111
In a sales-type lease, the lessor (ie, Swill Co.) transfers control of the leased asset to the lessee (ie, Tell Co.) to recognize revenue. The lessee accounts for a sales-type lease as a finance lease if it meets one of five criteria.
The lessee recognizes a right-of-use(ROU) asset and a lease liability at the present value (PV) of the lease payments.
Each lease period, the lessee recognizes lease expense by separately recording ROU asset amortization and interest expense.
Amortization is recorded on a straight-line basis over the shorter of the asset’s useful life or lease term.
In this scenario, Tell Co. has a finance lease since the PV of lease payments (ie, lease liability and ROU asset of $505,000) is 100% of the equipment’s sales price (ie, fair value). Because the lease term (9 years) is shorter than the equipment’s economic useful life (15 years), Tell will amortize the ROU asset over the lease term. The annual amortization expense is $56,111 ($505,000 ROU asset / 9 years).
In the long-term liabilities section of its balance sheet at December 31, Year 1, Mene Co. reported a finance lease obligation of $75,000, net of current portion of $1,364. Payments of $9,000 were made on both January 2, Year 2, and January 2, Year 3. Mene’s incremental borrowing rate on the date of the lease was 11% and the lessor’s implicit rate, which was known to Mene, was 10%. In its December 31, Year 2 balance sheet, what amount should Mene report as finance lease obligation, net of current portion?
A. $66,000
B. $73,500
C. $73,636
D. $74,250
B. $73,500
Liability is 75,000
Payment is 9,000
interest is 7,500
take net of payment and interest = 1,500
subtract current liability from total liability = 73,500
Smith Co. entered into a 5-year lease agreement for a new machine valued at $100,000 at lease inception. Which of the following would require the lease to be accounted for as a finance lease?
A. The present value of lease payments at lease inception equals $75,000.
B. The remaining economic life of the machine at lease inception is 6 years.
C. The machine reverts back to the lessor at the end of the lease.
D. There is an option to purchase the machine at the end of the lease for $20,000, when the estimated fair value will be $15,000.
B. The remaining economic life of the machine at lease inception is 6 years.
Lease term major part of remaining economic life is greater than or equal to 75%
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 a total of 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?
A. $86,700
B. $161,838
C. $188,813
D. $202,300
C. $188,813
In this scenario, the lessee has to pay rent for only 56 months of the 60-month lease (5 years × 12 months). The total amount of rent paid is $1,618,400 ($28,900 payment × 56 months). The S/L amount of monthly rent expense equals $26,973 ($1,618,400 total payments / 60 months). The lease expense for the current year (ie, June through December) is $188,813 ($26,973/month × 7 months).
On December 30, Year 1, Rafferty Corp. leased equipment under a finance lease. Annual lease payments of $20,000 are due December 31 for 10 years. The equipment’s useful life is 10 years, and the interest rate implicit in the lease is 10%. The finance lease obligation was recorded on December 30, Year 1, at $135,000, and the first lease payment was made on that date. What amount should Rafferty include in current liabilities for this finance lease in its December 31, Year 1, balance sheet for Year 2?
A. $6,500
B. $8,500
C. $11,500
D. $20,000
B. $8,500
Current liability is the amount that lowers the total liability
On 1/01/Y5, Zeus Company leased a new machine from Thor Corp. The following data relate to the lease transaction at its inception:
Lease term 5 years
Annual rental payable at beginning of each lease year $30,000
Useful life of machine 10 years
Implicit interest rate 8%
Present value of an annuity of 1 in advance for 5 periods at 8% 4.3121
Present value of annuity of 1 in arrears for 5 periods at 8% 3.9927
Fair value of the machine $200,000
The lease has no renewal option, the possession of the machine reverts to Thor when the lease terminates, and the machine does have alternative uses. The first lease payment of $30,000 is paid at the inception of the lease. What is the amount of the first year’s lease expense attributable to the interest component?
A. $0. It is an operating lease so there is no interest component.
B. $7,949
C. $7,183
D. $30,000
C. $7,183
This one is kind of dumb, but annuity in advance is the same as annuity due.
Correct! The lessee recorded the lease liability at the inception of the lease at $129,363 ($30,000 × 4.3121). The first lease payment is applied entirely to the lease liability so the outstanding lease liability for Year 1 is $99,363 ($129,363 – 30,000). The interest component is calculated by multiplying the outstanding lease liability by the interest rate (99,363 × .08). The result of $7,949 is the amount of the first year’s lease expense attributed to the interest component.
When accounting for an initial direct cost, the lessee will
A. Calculate the present value of the initial direct cost using the present value factor of a single sum associated with the lease term and include this amount in the lease liability.
B. Include the initial direct cost at its cost in the calculation of the right-of-use asset.
C. Include the initial direct cost at its cost in the calculation of the lease liability.
D. Calculate the present value of the initial direct cost using the present value factor of a single sum associated with the lease term and include this amount in the right-of-use asset.
B. Include the initial direct cost at its cost in the calculation of the right-of-use asset.
Correct! A cost that qualifies as an initial direct cost will be included in the lessee’s calculation of the right-of-use asset at its costs because these costs occur around the time of execution of the lease. Because the costs are included in the right-of-use asset amount, they are effectively amortized over the lease term as the right-of-use asset is amortized.
On 1/31/Y5, Zeus Company leased a new machine from Thor Corp. The following data relate to the lease transaction at its inception:
Lease term 5 years
Annual rental payable at beginning of each lease year $30,000
Useful life of machine 10 years
Implicit interest rate 8%
Present value of an annuity of 1 in advance for 5 periods at 8% 4.3121
Present value of annuity of 1 in arrears for 5 periods at 8% 3.9927
Fair value of the machine $200,000
The lease has no renewal option, the possession of the machine reverts to Thor when the lease terminates, and the machine does have alternative uses. The first lease payment of $30,000 is paid at the inception of the lease. What is the amount of lease liability recorded by Zeus at the inception of the lease?
A. $200,000
B. $129,363
C. $119,789
D. $0, because it does not meet the lease criteria for a finance lease.
B. $129,363
Not sure why this one doesn’t subtract the initial lease payment
Correct! The lease is an operating lease because it does not meet the finance lease criteria and it is longer than 12 months. The lease liability is measured using the annual rental payment of $30,000 multiplied by the present value of an annuity due factor of 4.3121.
Sorel Co. enters a lease for machinery from Sherman Co. Sorel appropriately accounts for the lease as a finance lease. The lease contains a bargain purchase option of $3,000 exercisable at the end of the three-year lease term. Sorel agrees to an annual lease payment of $11,000 due at the beginning of each period. Sorel knows the implicit interest rate is 4%. The present value factor of a single sum for three periods at 4% is .88900, the present value factor of an ordinary annuity for three periods at 4% is 2.77509, and the present value factor of an annuity due for three periods at 4% is 2.88609. What amount will Sorel record as the lease liability at the inception of the lease?
A. $31,747
B. $34,414
C. $33,193
D. $37,000
B. $34,414
Don’t forget the bargain purchase option
Correct! The lease liability is measured using the present value (PV) of the bargain purchase option (PV of a single sum) and the PV of the annual lease payments occurring at the beginning of each period (PV of an annuity due). The calculation of the lease liability is the sum of the PV of the bargain purchase option $2,667 ($3,000 × .88900) and the PV of the annual lease payments $31,747 (11,000 × 2.88609) totaling $34,414 (2,667 + 31,747).
