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Flashcards in Present Value Leases Deck (70):
1

Which of the following is a criterion for a lease to be classified as a capital lease in the books of a lessee?

  1. The lease contains a bargain purchase option.
  2. The lease does not transfer ownership of the property to the lessee.
  3. The lease term is equal to 65% or more of the estimated useful life of the leased property.
  4. The present value of the minimum lease payments is 70% or more of the fair market value of the leased property.

The lease contains a bargain purchase option.

According to ASC Topic 840, this answer is correct because if the lease contains a bargain purchase option, it must be classified as a capital lease.

When a lessor records a direct financing or sales-type lease, the lessee, in turn, must record a capital lease.  Capital leases reflect the transfer of risks and benefits associated with the asset to the lessee. A lease is considered to be a capital lease to the lessee if any one of the four criteria of ASC Topic 840 is satisfied.

  1. Transfer of title
  2. Bargain purchase
  3. 3.75% of useful life
  4. 4.90% of net FV

2

Bain Co. entered into a 10-year lease agreement for a new piece of equipment worth $500,000. At the end of the lease, Bain will have the option to purchase the equipment. Which of the following would require the lease to be accounted for as a capital lease?

  1. The lease includes an option to purchase stock in the company.
  2. The estimated useful life of the leased asset is 12 years.
  3. The present value of the minimum lease payments is $400,000.
  4. The purchase option at the end of the lease is at fair market value.

The estimated useful life of the leased asset is 12 years.

Remember only 1 needs to be met, and for Lessor only there must also be two additoinal requirements met (rent is collectible, etc.)There are four criteria for a capital lease. In summary, they are:

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

This answer meets item #3 above.

3

On January 1, year 1, Frost Co. entered into a 2-year lease agreement with Ananz Co. to lease 10 new computers. The lease term begins on January 1, year 1 and ends on December 31, year 2. The lease agreement requires Frost to pay Ananz two annual lease payments of $8,000. The present value of the minimum lease payments is $13,000. Which of the following circumstances would require Frost to classify and account for the arrangement as a capital lease?

  1. The economic life of the computers is 3 years.
  2. The fair value of the computers on January 1, year 1 is $14,000.
  3. Frost does not have the option of purchasing the computers at the end of the lease term.
  4. Ownership of the computers remains with Ananz throughout the lease term and after the lease ends.

The fair value of the computers on January 1, year 1 is $14,000.

There are four criteria for a capital lease. In summary, they are:

  • The lease agreement transfers ownership of the leased asset to the lessee at the conclusion of the lease term (Title transfer).
  • Bargain purchase option
  • Lease term is 75% or more of estimated economic life
  • Present value of minimum lease payments at least 90% of excess of fair value of leased property.

This answer meets item #4 above.

4

During January 2005 Yana Co. incurred landscaping costs of $120,000 to improve leased property.

The estimated useful life of the landscaping is fifteen years. The remaining term of the lease is eight years, with an option to renew for an additional four years. However, Yana has not reached a decision with regard to the renewal option.

In Yana's December 31, 2005 balance sheet, what should be the net carrying amount of landscaping costs?

  1. $0
  2. $105,000
  3. $110,000
  4. $112,000

$105,000

The leasehold improvements should be amortized over the shorter of the useful life of the improvements or the lease term. The lease term to use is 8 years because that is the best estimate of useful life at the time the improvement is made. If the firm decides to renew, then a change in estimate can be made at that time.

The book value at the end of the first year then is $120,000(7/8) = $105,000. This amount reflects one year of amortization.

5

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?

  1. $86,700
  2. $161,838
  3. $188,813
  4. $202,300

$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.

6

As an inducement to enter a lease, Graf Co., a lessor, granted Zep, Inc., a lessee, 12 months of free rent under a 5-year operating lease. The lease was effective on January 1, 2005, and provided for monthly rental payments to begin January 1, 2006. Zep made the first rental payment on December 30, 2005.

In its 2005 income statement, Graf should report rental revenue in an amount equal to

  1. Zero.
  2. Cash received during 2005.
  3. One-fourth of the total cash to be received over the life of the lease.
  4. One-fifth of the total cash to be received over the life of the lease.

One-fifth of the total cash to be received over the life of the lease.

In the absence of information to the contrary, revenue is recognized on a straight-line basis (the same amount each year) in an operating lease.

This principle is not affected by the schedule of cash payments, even if the cash flows are not the same each year of the lease term, as is the case here.

Thus, one-fifth of the total cash rentals over the term of the lease is recognized as revenue each year in this lease term.

7

On June 1, 2005, Oren Co. entered into a 5-year nonrenewable lease, commencing on that date, for office space and made the following payments to Cant Properties:

  • Bonus to obtain lease $30,000
  • First month's rent $10,000
  • Last month's rent $10,000

In its income statement for the year ending June 30, 2005, what amount should Oren report as rent expense?

  1. $10,000
  2. $10,500
  3. $40,000
  4. $50,000

$10,500

Rent expense is based on the straight-line method because it is assumed that the tenant will receive equal benefits each period. Therefore, the bonus is amortized into rent expense on the SL basis each year, resulting in a monthly rent expense of $10,500: $10,000 + $30,000/(60 months). The last month's rent is treated as prepaid rent until the last month of the contract, at which time it is expensed.

The income statement is dated 1 month after the rental contract commenced. Only 1 month's rent expense would be reported ($10,500).

8

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?

  1. $0
  2. $5,000
  3. $60,000
  4. $65,000

$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.

9

On April 1, year 1, Hall Fitness Center leased its gym to Dunn Fitness Center under a four-year operating lease. Hall normally charges $6,000 per month to lease its gym, but as an incentive, Hall gave Dunn half off the first year's rent, and one-quarter off the second year's rent. Dunn's rental payments were as follows:

  • Year 112 x $3,000 = $36,000
  • Year 212 x $4,500 = $54,000
  • Year 312 x $6,000 = $72,000
  • Year 412 x $6,000 = $72,000

Dunn's rent payments were due on the first day of the month, beginning on April 1, year 1. What amount should Dunn report as rent expense in its monthly income statement for April, year 3?

  1. $3,000
  2. $4,500
  3. $4,875
  4. $6,000

$4,875

In the absence of information to the contrary, the lessee is assumed to receive the same benefit from the asset each period. Therefore, rent expense for an operating lease is recognized evenly over the lease term, regardless of the pattern of payments. The sum of the lease payments is $234,000 (= $36,000 + $54,000 + $72,000 + $72,000). With four years or 48 months in the term, rent expense for each month in the term is $4,875 (= $234,000/48).

10

On December 1, 2004, Clark Co. leased office space for 5 years at a monthly rate of $60,000. On the same date, Clark paid the lessor the following amounts:

  • First month's rent $60,000
  • Last month's rent $60,000
  • Security deposit (refundable at lease expiration) $80,000

Installation of new walls and offices$360,000

What should be Clark's 2004 expense relating to utilization of the office space?

  1. $60,000
  2. $66,000
  3. $120,000
  4. $140,000

$66,000

Rent expense + amortization of leasehold improvements = total expense related to utilizing the office space. Rent expense ($60,000) + Amortization ($360,000/60) = $66,000.

Although the last month's rent was paid in 2004, that amount is a prepayment of rent to be recognized as rent expense in the last month of the lease.

11

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

  • 2005 revenues recognized - Interest
  • 2005 amount recognized compared to 2004 - 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).

12

During January 2005, Vail Co. made long-term improvements to a recently leased building.

The lease agreement provides for neither a transfer of title to Vail nor a bargain purchase option. The present value of the minimum lease payments equals 85% of the building's market value, and the lease term equals 70% of the building's economic life.

Should assets be recognized for the building and the leasehold improvements?

  • Building
  • Leasehold improvements

  • Building - NO
  • Leasehold improvements - YES

The lease is not a capital lease because title does not transfer to the lessee, there is no bargain purchase option, the lease term is not at least 75% of the useful life of the building, and the present value of the lease payments is not at least 90% of the fair value of the building. These are the four criteria for capitalizing a lease for the lessee and none are met.

The lease, therefore, is an operating lease. The improvements, therefore, are not capitalized to the building because there is no capitalized lease asset. The improvements are debited to leasehold improvements, an asset, and amortized over the remaining lease term or separate useful life, whichever is shorter.

13

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

  1. $0.
  2. $9,000.
  3. $12,000.
  4. $21,000.

$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.

14

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

  • Depreciation expense - NO
  • Interest revenue - 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.

15

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?

  1. $350,000
  2. $243,150
  3. $228,320
  4. $0

$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:

  • Lease liability $23,350
  • Interest expense .10($266,500) $26,650
    • Cash $50,000

The ending lease liability balance is $266,500 - $23,350 = $243,150.

16

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

  1. $102,500.
  2. $111,500.
  3. $112,500.
  4. $290,000.

$111,500.

The entry at December 31, 2005:

  • Interest expense ($112,500 x .08) $9,000
  • Lease liability $1,000
    • Cash $10,000

The ending lease liability for 2005 is $111,500 ($112,500 - $1,000 from entry).

17

Neal Corp. entered into a 9-year capital lease on a warehouse on December 31, 2003.

Lease payments of $52,000, which includes real estate taxes of $2,000, are due annually, beginning on December 31, 2004 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 9 years at 9% is 5.6.

What amount should Neal report as capitalized lease liability at December 31, 2003?

  1. $280,000
  2. $291,200
  3. $450,000
  4. $468,000

$280,000

The executory costs of $2,000 must be subtracted from the annual lease payment before capitalizing. Otherwise, the problem is straightforward. The capitalized amount is: $50,000(5.6) = $280,000.

18

Winn Co. manufactures equipment that is sold or leased. On December 31, 2005, Winn leased equipment to Bart for a 5-year period ending December 31, 2010, at which date ownership of the leased asset transferred to Bart. 
Equal payments under the lease were $22,000 (including $2,000 executory costs) and were due on December 31 of each year. 
The first payment was made on December 31, 2005. Collectability of the remaining lease payments was reasonably assured, and Winn had no material cost uncertainties. The normal sales price of the equipment was $77,000, and cost was $60,000.

For the year ending December 31, 2005, what amount of income should Winn realize from the lease transaction?

  1. $17,000
  2. $22,000
  3. $23,000
  4. $33,000

$17,000

This is a capital lease to the lessor because ownership is transferred to the lessee. There is no interest revenue in 2005 because the lease inception and the balance sheet date are the same. The first payment, thus, includes no interest.

The lease is a sales-type lease to the lessor because the normal selling price of $77,000 exceeds the cost of $60,000. The difference of $17,000 is the dealer profit to be recognized in 2005. There is no other income to be recognized in 2005.

19

At the inception of a capital lease, the guaranteed residual value should be

  1. Included as part of minimum lease payments at present value.
  2. Included as part of minimum lease payments at future value.
  3. Included as part of minimum lease payments only to the extent that guaranteed residual value is expected to exceed estimated residual value.
  4. Excluded from minimum lease payments.

Included as part of minimum lease payments at present value.

Only minimum lease payments are considered when evaluating the fourth criterion of capital leases: "Is the present value of minimum lease payments equal to or greater than 90% of the leased asset's market value?"

A guaranteed residual value is always included in the minimum lease payments of the lessor and also in the lessee's if the lessee guarantees it. It is so included because it is a collection or payment that is expected to be made under the terms of the lease.

20

For a capital lease, the amount recorded initially by the lessee as a liability should normally

  1. Exceed the total of the minimum lease payments.
  2. Exceed the present value of the minimum lease payments at the beginning of the lease.
  3. Equal the total of the minimum lease payments.
  4. Equal the present value of the minimum lease payments at the beginning of the lease.

Equal the present value of the minimum lease payments at the beginning of the lease.

In most cases, the initial recorded value of the lease liability is the present value of the minimum lease payments (the payments expected to be made by the lessee under the lease). 
Valuation at present value is required given the long-term nature of the lease liability. As payments are made over the lease term, the principal portion of each payment reduces the lease liability. At the end of the lease term the liability balance is zero.

21

Douglas Co. leased machinery with an economic useful life of 6 years. For tax purposes, the depreciable life is 7 years. The lease is for 5 years, and Douglas can purchase the machinery at fair market value at the end of the lease.

What is the depreciable life of the leased machinery for financial reporting?

  1. Zero
  2. 5 years
  3. 6 years
  4. 7 years

5 years

The lease will be treated as a capital lease for accounting purposes because the life of the lease (5 years) is at least 75% of the life of the asset (6 years)-5 years/6 years = 83%. 
Douglas will record the machinery as an asset (and related lease liability) and depreciate it over the periods benefited. Because Douglas neither obtains ownership of the machinery at the end of the lease nor has a written option to purchase the machinery at a bargain price, the equipment will be depreciated over the life of the lease, which is 5 years.

22

On December 30, 2003, Ames Co. leased equipment under a capital lease for 10 years.

It contracted to pay $40,000 annual rent on December 31, 2003 and on December 31 of each of the next 9 years. The capital lease liability was recorded at $270,000 on December 30, 2003 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, 2004 payment, by what amount should Ames reduce the capital lease liability?

  1. $27,000
  2. $23,000
  3. $22,500
  4. $17,000

$17,000

The lease liability balance at the beginning of 2004 is $230,000 ($270,000 - $40,000) because the first lease payment did not include any interest. It was paid at inception and thus consists completely of principal. The December 31, 2004 entry:

  • Lease liability $17,000
  • Interest expense .10($230,000) $23,000
    • Cash $40,000

The lease liability is reduced $17,000.

23

On January 1, 2005, Moul Mining Co. (lessee) entered into a 5-year lease for drilling equipment. Moul accounted for the acquisition as a capital lease for $120,000, which included a $5,000 bargain purchase option.

Moul expected to exercise the bargain purchase option at the end of the lease. Moul estimated that the equipment's fair value will be $10,000 at the end of its 8-year life. Moul regularly uses straight-line depreciation on similar equipment.

For the year ending December 31, 2005, what amount should Moul recognize as depreciation expense on the leased asset?

  1. $13,750
  2. $15,000
  3. $23,000
  4. $24,000

$13,750

Depreciation expense = $13,750 = ($120,000 - $10,000)/8.

The bargain purchase option is included in the capitalized asset value because it is expected to be paid. Given that the asset will be purchased, the 8-year total useful life is used by the lessee for depreciation. The salvage value at the end of the asset's useful life is used for depreciation.

24

Able sold its headquarters building at a gain and simultaneously leased back the building. The lease was reported as a capital lease.

At the time of sale, the gain should be reported as

  1. Operating income.
  2. A gain, net of income tax.
  3. A separate component of stockholders' equity.
  4. An asset valuation allowance.

An asset valuation allowance.

When an asset is sold and then leased back, the lessee defers the gain (subject to certain exceptions, which do not apply in this question). The deferred gain is recorded as a contra account to the leased asset in a capital lease.

25

Rig Co. sold its factory at a gain and simultaneously leased it back for 10 years. The factory's remaining economic life is 20 years. The lease was reported as an operating lease.

At the time of sale, Rig should report the gain as

  1. Part of income from continuing operations.
  2. An asset valuation allowance.
  3. A separate component of stockholders' equity.
  4. A deferred credit.

A deferred credit.

The gain or loss on a sale-leaseback is deferred and amortized over the term of the lease for both operating and capital leases. There is no information about present value of lease payments or fair value of the asset.

Because this is an operating lease, the deferred gain is treated as a deferred credit. If it were a capital lease, it would be treated as an asset valuation allowance.

26

When equipment held under an operating lease is subleased by the original lessee, the original lessee would account for the sublease as a(n)

  1. Operating lease.
  2. Sales-type lease.
  3. Direct financing lease.
  4. Capital lease.

Operating lease.

A sublease arises when the lease agreement between the two original parties remains in effect, and the leased property is released to a third party by the original lessee. Per ASC Topic 840, when equipment held under an operating lease is subleased by the original lessee, the sublease is still considered to be an operating lease by the original lessee.

27

Arrow Company purchased a machine on January 1, year 1, for $1,440,000 for the purpose of leasing it. The machine is expected to have an 8-year life from date of purchase, no residual value, and be depreciated on the straight-line basis. On February 1, year 1, the machine was leased to Baxter Company for a 3-year period ending January 31, year 4, at a monthly rental of $30,000. Additionally, Baxter paid $72,000 to Arrow on February 1, year 1, as a lease bonus. What is the amount of income before income taxes that Arrow should report on this leased asset for the year ended December 31, year 1?

  1. $172,000
  2. $187,000
  3. $222,000
  4. $237,000

$172,000

Income from the lease is the monthly rental plus a proportionate fraction of the lease bonus less any depreciation expense.

  • Rental income = 11 months × $30,000 = $330,000
  • Lease bonus income = $72,000 × 11/36 = $22,000
  • Depreciation expense = $1,440,000/8 years = $(180,000)
  • Income from leased asset $172,000

Note that the lease bonus is recognized as income proportionately over the 36-month lease period.  The leased asset is depreciated for a full year since it has an 8-year life from the date of purchase (January 1).

28

Lease Y contains a bargain purchase option and the lease term is equal to 75% of the estimated economic life of the leased property. Lease Z contains a bargain purchase option and the lease term is equal to less than 75% of the estimated economic life of the leased property. How should the lessee classify these leases?

  • Lease Y
  • Lease Z

  • Lease Y - CAPITAL
  • Lease Z - CAPITAL

 ASC Topic 840 states that a lease shall be classified as a capital lease by the lessee if one or more of the four criteria are met. The four criteria are as follows:

  1. Lease transfers ownership to the lessee during lease term
  2. Lease contains a bargain purchase option
  3. Lease term is 75% or more of the economic useful life of the property
  4. Present value of the minimum lease payment equals 90% or more of FV of the leased property

Since both Lease Y and Lease Z meet at least one of the criteria, both are considered capital leases.

29

On January 1, year 1, Hooks Oil Co. sold equipment with a carrying amount of $100,000, and a remaining useful life of 10 years, to Maco Drilling for $150,000. Hooks immediately leased the equipment back under a 10-year capital lease with a present value of $150,000 and will depreciate the equipment using the straight-line method. Hooks made the first annual lease payment of $24,412 in December year 1. In Hooks’ December 31, year 1 balance sheet, the unearned gain on equipment sale should be

  1. $50,000
  2. $45,000
  3. $25,588
  4. $0

$45,000

According to ASC Topic 840, sale-leaseback transactions are treated as though two transactions were a single financing transaction, if the lease qualifies as a capital lease.  Any gain on the sale is deferred and amortized over the lease term (if possession reverts to the lessor) or the economic life (if ownership transfers to the lessee). Since this is a capital lease, the entire gain ($150,000 − $100,000 = $50,000) is deferred at 1/1/Y1.  At 12/31/Y1 an adjusting entry must be prepared to amortize 1/10 of the unearned gain (1/10 × $50,000 = $5,000), because the lease covers 10 years. Therefore, the unearned gain at 12/31/Y1 is $45,000 ($50,000 − $5,000).

30

Dahlia, Inc. signed a lease to rent equipment on July 1, year 1. On January 1, year 3, Dahlia decides that the equipment is no longer needed, and the company pays a $20,000 penalty to cancel the lease. How should the cancellation be reported on Dahlia’s financial statements?

  1. Recognize the cost of termination at the fair value at the date the agreement is terminated.
  2. Compare the termination costs to the present value of avoidable lease payments and recognize the difference as a loss at the date the equipment ceases to be used.
  3. Defer recognition of the loss until the end of the normal lease term.
  4. Amortize the loss over the remaining term of the lease.

Recognize the cost of termination at the fair value at the date the agreement is terminated.

Per ASC Topic 820, Dahlia should recognize the termination costs at fair value at the date the agreement is terminated, the entity no longer receives the rights to the assets, or the company ceases to use the asset (cease-use date).

31

On December 30, year 1, Ames Co. leased equipment under a capital lease for 10 years. It contracted to pay $40,000 annual rent on December 31, year 1, and on December 31 of each of the next 9 years. The capital lease liability was recorded at $270,000 on December 30, year 1, 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 2, payment, by what amount should Ames reduce the capital lease liability?

  1. $27,000
  2. $23,000
  3. $22,500
  4. $17,000

$17,000

The initial lease obligation at 12/31/Y1 was $270,000. The first payment was made the same day, and therefore consisted entirely of principal reduction. After the payment, the lease obligation was $230,000 ($270,000 − $40,000).  The next lease payment, on 12/31/Y2, consists of both principal and interest.  The interest portion is $23,000 ($230,000 × 10%), so the reduction in the lease liability is $17,000 ($40,000 − $23,000).

32

A lease contains a bargain purchase option. In determining the lessee’s capitalizable cost at the beginning of the lease term, the payment called for by the bargain purchase option would

  1. Not be capitalized.
  2. Be subtracted at its present value.
  3. Be added at its exercise price.
  4. Be added at its present value.

Be added at its present value.

Per ASC Topic 840, minimum lease payments include the rental payments plus the amount of the bargain purchase option if it exists. The amount to be capitalized is the present value of the minimum lease payments. Therefore, the present value of the bargain purchase option would be added to the present value of the rental payments (assumed to be previously calculated) in determining the lessee’s capitalizable cost.

33

The present value of the minimum lease payments should be used by the lessee in the determination of a(n)

  • Capital lease liability
  • Operating lease liability

  • Capital lease liability - YES
  • Operating lease liability - NO

Per ASC Topic 840, the present value of the minimum lease payments should be used to determine the liability under a capital lease. Under an operating lease, a liability arises when rent expense is recorded but has not been paid. Furthermore, it is recorded at the actual amount of cash to be paid, not its present value.

34

On January 1, year 1, 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 year 2, and should the revenue recognized in year 2 be the same or smaller than the revenue recognized in year 1?

  • Year 2 revenues recognized
  • Year 2 amount recognized compared to year 1

  • Year 2 revenues recognized = INTEREST
  • Year 2 amount recognized compared to year 1 = SMALLER

This lease qualifies as a direct financing lease; therefore interest revenue will be recognized rather than rent revenue. Had the lease qualified as an operating lease, rent revenue would have been recognized. The lessor’s criteria for direct financing classification is as follows:

  1. The lease transfers ownership to the lessee, at the end of the lease
  2. The lease contains a bargain purchase option
  3. The lease term is > 75% of an asset’s economic life
  4. The present value of the minimum lease payments is > 90% of the fair value of the leased asset.

In addition, collectibility of the minimum lease payments must be predictable and there may be no important uncertainties concerning costs yet to be incurred by the lessee. Since the question is silent in this regard, we will assume that the latter conditions are met. Recall that if one of the first four criteria are met, the lease is treated as a capital lease. In this case, since the lease term is for 80% of the asset’s economic life, test (3) is met, and the lease is properly treated as a capital lease. In addition, the amount of interest revenue will be smaller in year 2 than the revenue in year 1. This result occurs because the present value of the minimum lease payments or carrying value of the obligation decreases each year as lease payments are received. As this occurs, the amount of interest revenue on the outstanding amount of the investment will decrease as well. Over the course of time, the investment reduction portion of each level payment increases and the amount of interest declines.

35

On December 31, year 1, Bain Corp. sold a machine to Ryan and simultaneously leased it back for 1 year.  Pertinent information at this date follows:

  • Sales price $360,000
  • Carrying amount $330,000
  • Present value of reasonable rentals ($3,000 for 12 months @ 12%) $34,100
  • Estimated remaining useful life 12 years

In Bain’s December 31, year 1 balance sheet, the deferred revenue from the sale of this machine should be

  1. $34,100
  2. $30,000
  3. $ 4,100
  4. $0

$0

ASC Topic 840 generally treats a sale-leaseback as a single financing transaction in which any profit on the sale is deferred and amortized by the seller. However, ASC Topic 840 amends this general rule when either only a minor part of the remaining use of the leased asset is retained (case 1), or when more than a minor part but less than substantially all of the remaining use of the leased asset is retained (case 2).  Case 1 occurs when the PV of the lease payments is 10% or less of the FV of the sale-leaseback property. Case 2 occurs when the leaseback is more than minor but does not meet the criteria of a capital lease.  This is an example of case 1, because the PV of the lease payments ($34,100) is equal to or less than 10% of the FV of the asset ($360,000).  ASC Topic 840 specifies that under these circumstances, the full gain ($360,000 − $330,000 = $30,000) is recognized, and none is deferred.

36

The Morn Company leased equipment to the Lizard Company on May 1, year 1. At that time the collectibility of the minimum lease payments was not reasonably predictable. The lease expires on May 1, year 3. Lizard could have bought the equipment from Morn for $900,000 instead of leasing it. Morn’s accounting records showed a book value for the equipment on May 1, year 1, of $800,000. Morn’s depreciation on the equipment in year 1 was $200,000. During year 1 Lizard paid $240,000 in rentals to Morn. Morn incurred maintenance and other related costs under the terms of the lease of $18,000 in year 1. After the lease with Lizard expires, Morn will lease the equipment to the Cold Company for another 2 years. The income before income taxes derived by Morn from this lease for the year ended December 31, year 1, should be

  1. $22,000
  2. $100,000
  3. $122,000
  4. $240,000

$22,000

The lease shall be accounted for as an operating lease because none of the four requirements applicable to both lessees and lessors is met.  Even if one or more was met, the lease would still be classified as an operating lease as the payments are not reasonably predictable (ASC Topic 840). The calculation for lease income for year 1 would be as follows:

  • Rental income $240,000
  • Less: year 1 depreciation ($200,000)
  • Maintenance costs ($18,000)
  • Income from lease for year 1 $22,000

37

Beth Co. leased equipment to Wolf, Inc. on April 1, year 1. The lease is appropriately recorded as a direct financing lease by Beth. The lease is for an 8-year period expiring March 31, year 9. The first equal annual payment of $500,000 was made on April 1, year 1. Beth had purchased the equipment on January 1, year 1, for $2,800,000. The equipment has an estimated useful life of 8 years with no residual value expected. Beth uses straight-line depreciation and takes a full year’s depreciation in the year of purchase. The cash selling price of the equipment is $2,934,000. Assuming an interest rate of 10%, what amount of interest income should Beth record in year 1 as a result of the lease?

  1. $0
  2. $182,550
  3. $243,400
  4. $280,000

$182,550

The present value of the eight $500,000 lease payments is given to be $2,934,000 (cash selling price of the equipment). Since $500,000 is paid at the inception of the lease, the book value of the lease payments receivable (total minimum lease payments minus unearned interest income) outstanding for the last 9 months is $2,434,000. The 10% interest thereon is $243,400, but only 3/4 (9 months/12 months) of this amount, or $182,550, is associated with the period ending December 31, year 1.

38

Able Co. leased equipment to Baker under a noncancellable 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

  • Depreciation expense - NO
  • Interest revenue - YES

In a lease with a transfer of title (capital lease) the lessor (Able) records interest revenue whereas the lessee (Baker) records depreciation expense.

A direct financing lease arises when a consumer needs equipment but does not want to purchase the equipment outright, and/or is unable to obtain conventional financing.  In this situation, the consumer will turn to a leasing company (e.g., a bank) which will purchase the desired asset from a manufacturer (or dealer) and lease it to the consumer.  Direct financing leases apply to leasing companies, as opposed to manufacturers or dealers, because leasing companies purchase the assets solely for leasing, not for resale.  Leasing companies are usually involved in financing activities (e.g., banking and insurance), not in the sale of property of the type being leased.  The following situation shows when a direct financing lease would arise:

EXAMPLE:  ABC Company needs new equipment to expand its manufacturing operations but does not have enough capital to purchase the equipment at present.  ABC Company employs Universal Leasing Company to purchase the equipment.  ABC will lease the asset from Universal.  Universal records a direct financing lease. 

39

Hiller Company manufactures equipment which is sold or leased. On December 31, year 1, Hiller leased equipment to Drake Company for a 5-year period expiring December 31, year 6, at which date ownership of the leased asset is transferred to Drake. Equal payments under the lease are $20,000 and are due on December 31 of each year. The first payment was made on December 31, year 1. Collectibility of the remaining lease payments is reasonably assured, and Hiller has no material cost uncertainties. The normal sales price of the equipment is $77,000 and Hiller’s cost is $60,000. For the year ended December 31, year 1, how much income should Hiller recognize from the lease transactions?

  1. $0
  2. $17,000
  3. $20,000
  4. $23,000

$17,000

The lease is a sales-type lease because title to the leased asset transfers, collectibility is reasonably assured, there are no material cost uncertainties, and a manufacturer’s profit exists. Therefore, the lessor would recognize sales of $77,000 and cost of sales of $60,000, resulting in a profit of $17,000. There is no interest income in year 1 since the sale occurs on the last day of the year.

Sales-type leases, unlike direct financing leases, result in both (1) gross profit (loss) in the period of sales, and (2) interest revenue to be earned over the lease term using the effective interest method.  The diagram below compares and contrasts direct financing leases with sales-type leases.

Additional guidelines unique to sales-type leases are:

  1. The lessor bases the lease payment schedule on the amount the lessee would have paid to purchase the asset outright (i.e., the sales price).  Therefore, sales are equal to the present value of the minimum lease payments.                                              
  2. The cost of goods sold to be charged against income is equal to the historic cost or carrying value of the leased asset (most likely inventory) less the present value of any unguaranteed residual value.
  3. The difference between the selling price and cost of goods sold is the gross profit (loss) recognized by the lessor at the inception of the lease.
  4. When accounting for sales-type leases, guaranteed residual value is considered part of sales revenue because the lessor knows the entire asset has been sold.  Unguaranteed residual value, however, is excluded from both sales and cost of sales at its present value because there is less certainty that unguaranteed residual value will be realized.

40

In a sale-leaseback transaction, a gain resulting from the sale should be deferred at the time of the sale-leaseback and subsequently amortized when

  • I. The seller has transferred substantially all the risks of ownership.
  • II. The seller retains the right to substantially all of the remaining use of the property.

I only.

II only.

Both I and II.

Neither I nor II.

  • I. The seller has transferred substantially all the risks of ownership. - NO
  • II. The seller retains the right to substantially all of the remaining use of the property. - YES

Per ASC Topic 840, in a sale-leaseback where the seller-lessee retains the right to substantially all of the remaining use of the property, a gain resulting from the sale should be deferred and subsequently amortized. On the other hand, when the seller-lessee has transferred substantially all the risks of ownership, any gain or loss on sale is recognized immediately.

41

Initial direct costs are

  1. Expensed currently for sales-type leases.
  2. Capitalized and amortized to expense over the lease term for all leases.
  3. Capitalized only if the related lease qualifies as a capital lease.
  4. Presented on the balance sheet as a contra account to capitalized leased assets.

Expensed currently for sales-type leases.

Initial direct costs are costs incurred in connection with the negotiation and consummation of leases, such as legal fees, commissions, etc. For sales-type leases, profit or loss is recognized upon inception of the lease. In keeping with the matching principle, the costs of consummating that lease should be taken into income at the same time as the resulting profit or loss. Therefore, initial direct costs for sales-type leases are expensed currently.

42

Star Company leased a new machine from Fox Company on December 31, year 1, under a lease with the following pertinent information:

  • Lease term 10 years
  • Annual rental payable at the beginning of each year $200,000
  • Useful life of the machine15 years
  • Implicit interest rate 10%
  • Present value of an annuity of $1 in advance for 10 periods at 10% 6.76
  • Present value of $1 for 10 periods at 10% 0.39

Star has the option to purchase the machine on December 31, year 11, by paying $250,000, which is significantly less than the $500,000 expected fair market value of the machine on the option exercise date.  Assume that, at the inception of the lease, the exercise of the option appears to be reasonably assured.  At the inception of the lease, Star should record a capitalized lease liability of

  1. $1,254,500
  2. $1,352,000
  3. $1,449,500
  4. $1,547,000

$1,449,500

Per ASC Topic 840, the lessee records as a liability the lower of the present value of the minimum lease payments (excluding executory costs), or the fair value of the leased asset. Minimum lease payments for the lessee include the minimum rental payments and the amount of any bargain purchase option if exercise of the option appears reasonably assured.  Since the fair value of the leased asset is not given, the leased asset and lease obligation are recorded as the present value of the minimum lease payments, as computed below.

  • Present value of annual rental $200,000 × 6.76 $1,352,000
  • Present value of bargain purchase option $250,000 × .39 $97,500
  • = Present value of minimum lease payments $1,449,500

43

On January 1, year 1, Nobb Corp. signed a 12-year lease for warehouse space. Nobb has an option to renew the lease for an additional 8-year period on or before January 1, year 5. During January year 3, Nobb made substantial improvements to the warehouse. The cost of these improvements was $540,000, with an estimated useful life of 15 years. At December 31, year 3, Nobb intended to exercise the renewal option. Nobb has taken a full year’s amortization on this leasehold. In Nobb’s December 31, year 3 balance sheet, the carrying amount of this leasehold improvement should be

  1. $486,000
  2. $504,000
  3. $510,000
  4. $513,000

$504,000

The cost of the leasehold improvements ($540,000) should be amortized over the remaining life of the lease, or over the useful life of the improvements, whichever is shorter.  The remaining life of the lease should include periods covered by a renewal option if it is probable that the option will be exercised.  In this case, the remaining life of the lease is 18 years (12 years of original lease + 8 years in option period − 2 years past), and the useful life of the improvements is 15 years.  Therefore, amortization is based on a 15-year life ($540,000 ÷ 15 = $36,000). The 12/31/Y3 carrying amount is $504,000 ($540,000 − $36,000).

44

On January 1, year 1, Frost Co. entered into a two-year lease agreement with Ananz Co. to lease 10 new computers. The lease term begins on January 1, year 1 and ends on December 31, year 2. The lease agreement requires Frost to pay Ananz two annual lease payments of $8,000. The present value of the minimum lease payments is $13,000. Which of the following circumstances would require Frost to classify and account for the arrangement as a capital lease?

  1. The economic life of the computers is three years.
  2. The fair value of the computers on January 1, year 1, is $14,000.
  3. Frost Co. does not have the option of purchasing the computers at the end of the lease term.
  4. Ownership of the computers remains with Ananz Co. throughout the lease term and after the lease ends.

The fair value of the computers on January 1, year 1, is $14,000.

The present value of the minimum lease payments ($13,000) is greater than 90% of the fair value of the leased asset.

When a lessor records a direct financing or sales-type lease, the lessee, in turn, must record a capital lease.  Capital leases reflect the transfer of risks and benefits associated with the asset to the lessee. A lease is considered to be a capital lease to the lessee if any one of the four criteria of ASC Topic 840 is satisfied.

  1. Transfer of title
  2. Bargain purchase
  3. 75% of useful life
  4. 90% of net FV

45

On 1/31/Y1, Clay Company leased a new machine from Saxe Corp.  The following data relate to the lease transaction at its inception:

  • Lease term 10 years
  • Annual rental payable at beginning of each lease year $50,000
  • Useful life of machine 15 years
  • Implicit interest rate 10%
  • Present value of an annuity of 1 in advance for 10 periods at 10% 6.76
  • Present value of annuity of 1 in arrears for 10 periods at 10% 6.15
  • Fair value of the machine $400,000

The lease has no renewal option, and the possession of the machine reverts to Saxe when the lease terminates.  At the inception of the lease, Clay should record a lease liability of

  1. $400,000
  2. $338,000
  3. $307,500
  4. $0

$0

At the inception of a lease, the lessee records a lease liability if the lease is considered to be a capital lease. To be considered a capital lease, a lease must satisfy any one of the four criteria specified in ASC Topic 840. This lease does not satisfy any of the four criteria. The lease has no bargain purchase option and does not transfer title. The lease term is not 75% or more of the useful life (10 years out of 15 years is 67%) and the PV of the lease payments is not 90% or more of the FV of the asset [(6.76 × $50,000) / $400,000 = 84.5%]. Therefore, this is an operating lease, not a capital lease, and no liability is recorded at the lease’s inception.

46

Green Co. incurred leasehold improvement costs for its leased property. The estimated useful life of the improvements was 15 years. The remaining term of the nonrenewable lease was 20 years. These costs should be

  1. Expensed as incurred.
  2. Capitalized and depreciated over 20 years.
  3. Capitalized and expensed in the year in which the lease expires.
  4. Capitalized and depreciated over 15 years.

Capitalized and depreciated over 15 years.

Leasehold improvements should be depreciated over the remaining useful life of the leasehold improvement or the remaining life of the lease, whichever is shorter. Therefore, the leasehold improvement should be capitalized and depreciated over 15 years. This answer is correct.

47

Conn Company purchased a new machine for $480,000 on January 1, year 1, and leased it to East the same day. The machine has an estimated 12-year life, and will be depreciated $40,000 per year. The lease is for a 3-year period expiring January 1, year 4, at an annual rental of $85,000. Additionally, East paid $30,000 to Conn as a lease bonus to obtain the 3-year lease. For year 1 Conn incurred insurance expense of $8,000 for the leased machine. What is Conn’s year 1 operating profit on this leased asset?

  1. $67,000
  2. $55,000
  3. $47,000
  4. $37,000

$47,000

This lease is an operating lease because it does not meet any of the four criteria to be a capital lease as described in ASC Topic 840. The lessor (Conn) should recognize as revenue the year 1 rental payment ($85,000) plus a proportionate fraction of the lease bonus ($30,000/ 3-year lease term = $10,000 per year). Therefore, total revenue for year 1 is $95,000 ($85,000 + $10,000). Year 1 expenses total $48,000 (depreciation of $40,000 and insurance of $8,000). Thus, operating profit on the leased asset is $47,000 ($95,000 revenues less $48,000 expenses).

48

On January 1, year 1, Glen Co. leased a building to Dix Corp. for a 10-year term at an annual rental of $50,000. At inception of the lease, Glen received the first 2 years’ rent of $100,000 and a security deposit of $100,000. This deposit will not be returned to Dix upon expiration of the lease but will be applied to payment of rent for the last 2 years of the lease. What portion of the $200,000 should be shown as a current and long-term liability, respectively, in Glen’s December 31, year 1 balance sheet?

  • Current Liability
  • Long-term liability

  • Current Liability - $50,000
  • Long-term liability - $100,000

At 1/1/Y1, Glen would record as a current liability unearned rent of $50,000, and as a long-term liability unearned rent of $150,000. During year 1, the current portion of unearned rent was earned and would be recognized as revenue. At 12/31/Y1, the portion of the long-term liability representing the second year’s rent ($50,000) would be reclassified as current, leaving as a long-term liability, the $100,000 representing the last 2 years’ rent.

49

Koby Co. entered into a capital lease with a vendor for equipment on January 2 for seven years. The equipment has no guaranteed residual value. The lease required Koby to pay $500,000 annually on January 2, beginning with the current year. The present value of an annuity due for seven years was 5.35 at the inception of the lease. What amount should Koby capitalize as leased equipment?

  1. $500,000
  2. $825,000
  3. $2,675,000
  4. $3,500,000

$2,675,000

The equipment should be capitalized as the present value of the minimum lease payments. The present value of the minimum lease payments at January 2 is calculated as the present value of the annuity due factor times the payment, or $2,675,000 (5.35 × $500,000).

50

The lessee’s balance sheet liability for a capital lease would be periodically reduced by the total

  1. Minimum lease payment plus the amortization of the related asset.
  2. Minimum lease payment less the amortization of the related asset.
  3. Minimum lease payment less the portion of the minimum lease payment allocable to interest.
  4. Minimum lease payment.

Minimum lease payment less the portion of the minimum lease payment allocable to interest.

During the lease term, each minimum lease payment consists of both interest and reduction of the lease obligation. Lease amortization produces a constant periodic rate of interest on the remaining balance of the obligation, known as the "effective interest" method.

51

Hines Company leased a new machine from Ashwood Company on December 31, year 1, under a lease with the following pertinent information:

  • Lease term 8 years
  • Annual rental payable at the beginning of each lease year $50,000
  • Useful life of the machine 10 years
  • Present value of the 8 lease payments at 12/31/Y1 $258,000

The machine reverts to Ashwood at lease expiration date and has a fair value of $280,000 at the inception of the lease.  Hines uses the straight-line method of depreciation. For the year ended December 31, year 2, how much depreciation (amortization) should Hines record for the capitalized leased machine?

  1. $35,000
  2. $32,250
  3. $28,000
  4. $25,800

$32,250

Per ASC Topic 840, the lessee records the asset at the lower of (1) the present value of the minimum lease payments or (2) the fair market value of the leased asset. In this case, the present value ($258,000) is less than the fair market value ($280,000); therefore, $258,000 is capitalized. Since the machine reverts to the lessor at the end of the lease, the lessee should depreciate it over the lease term (8 years) even though it is less than the useful life (10 years). Depreciation expense is $32,250 ($258,000/8 years).

52

On December 31, year 1, Neal, Inc. leased machinery with a fair value of $105,000 from Frey Rentals Co. The agreement is a 6-year noncancelable lease requiring annual payments of $20,000 beginning December 31, year 1. The lease is appropriately accounted for by Neal as a capital lease. Neal’s incremental borrowing rate is 11%. Neal knows the interest rate implicit in the lease payments is 10%.

  • The present value of an annuity due of 1 for 6 years at 10% is 4.7908.
  • The present value of an annuity due of 1 for 6 years at 11% is 4.6959.

In its December 31, year 1 balance sheet, Neal should report a lease liability of

  1. $75,816
  2. $85,000
  3. $93,918
  4. $95,816

$75,816

The initial lease liability at 12/31/Y1, before the 12/31/Y1 payment, is $95,816 ($20,000 × 4.7908). The liability is recorded at the lower of the FV of the leased asset ($105,000) or the PV of the minimum lease payments ($95,816).  The 10% rate is used to compute PV, rather than the 11% rate, because ASC Topic 840 states that the discount rate is to be the lessee’s incremental borrowing rate, unless the lessor’s implicit rate is known and is less than the lessee’s incremental borrowing rate.  The 12/31/Y1 payment consists entirely of principal, reducing the 12/31/Y1 liability to $75,816 (95,816 − $20,000).

53

On October 1, year 1, Dean Company leased office space at a monthly rental of $30,000 for 10 years expiring September 30, year 11. As an inducement for Dean to enter into the lease, the lessor permitted Dean to occupy the premises rent-free from October 1 to December 31, year 1. For the year ended December 31, year 1, Dean should record rent expense of

  1. $0
  2. $29,250
  3. $87,750
  4. $90,000

$90,000

ASC Topic 840 states that rent on operating leases should be expensed on a straight-line basis unless another method is better suited to the particular benefits and costs associated with the lease.  In this lease, the lessee must pay rent of $30,000 monthly for 10 years less the first 3 months, or 117 months (120 − 3).  Therefore, total rent expense for the 10 years is $3,510,000 (117 × $30,000).  Recognizing rent expense on a straight-line basis, year 1 rent expense is $87,750 ($3,510,000 × 3/120).

54

Wilburn Corp. signs an agreement to lease land and a building for 20 years. At the end of the lease, the property will not transfer to Wilburn. The life of the building is estimated to be 20 years. Wilburn prepares its financial statements in accordance with IFRS. How should Wilburn account for the lease?

  1. The lease is recorded as an operating lease.
  2. The lease is recorded as a finance lease.
  3. The land is recorded as an operating lease and the building is recorded as a finance lease.
  4. The land is recorded as a finance lease, and the building is recorded as an operating lease.

The land is recorded as an operating lease and the building is recorded as a finance lease.

IFRS provides that because land has an indefinite life, if title is not expected to pass by the end of the lease term, then the substantial risks and rewards of ownership do not transfer. Thus, the lease should be separated into two components. The land should be recorded as an operating lease and the building should be recorded as a finance lease.

55

Farm Co. leased equipment to Union Co. on July 1, year 1, 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, year 1. Farm had purchased the equipment for $110,000. What amount of interest revenue from the lease should Farm report in its year 1 income statement?

  1. $0
  2. $5,500
  3. $5,750
  4. $6,750

$5,750

In this sales-type lease, the lessor would recognize a gross profit on the sale on 7/1/Y1 of $25,000 ($135,000 present value less $110,000 cost). In addition, interest revenue is recognized in year 1 for the period 7/1 through 12/31. The initial net lease payments receivable on 7/1/Y1 is $135,000. The first rental payment received on 7/3/Y1 consists entirely of principal, reducing the net receivable to $115,000 ($135,000 − $20,000). Therefore, year 1 interest revenue for the 6-month period is $5,750 ($115,000 × 10% × 6/12).

56

For a capital lease, the amount recorded initially by the lessee as a liability should

  1. Exceed the present value at the beginning of the lease term of minimum lease payments during the lease term.
  2. Exceed the total of the minimum lease payments during the lease term.
  3. Not exceed the fair value of the leased property at the inception of the lease.
  4. Equal the total of the minimum lease payments during the lease term.

Not exceed the fair value of the leased property at the inception of the lease.

Per ASC Topic 840, the lessee shall record a capital lease as a debit to an asset account and a credit to a liability account for an amount equal to the present value of the total of the minimum lease payments as of the beginning of the lease term. However, if the amount so determined exceeds the fair value of the leased property at the inception of the lease, the amount recorded as the asset and obligation shall be the fair value of the leased property.

57

On January 1, year 1, Vick Company as lessee signed a 10-year noncancelable lease for a machine stipulating annual payments of $20,000. The first payment was made on January 1, year 1. Vick appropriately treated this transaction as a capital lease. The 10 lease payments have a present value of $135,000 at January 1, year 1, based on implicit interest of 10%. For the year ended December 31, year 1, Vick should record interest expense of

  1. $0
  2. $6,500
  3. $11,500
  4. $13,500

$11,500

At the inception of the lease on 1/1/Y1, the capitalized lease liability was $135,000. The first payment, also on 1/1/Y1, consisted entirely of principal and reduced the liability to $115,000 ($135,000 − $20,000).  Therefore, year 1 interest expense is $11,500 ($115,000 × 10%).

58

The lessee’s net carrying value of an asset arising from the capitalization of a lease would be periodically reduced by the

  1. Total minimum lease payment.
  2. Portion of minimum lease payment allocable to interest.
  3. Portion of minimum lease payment allocable to reduction of principal.
  4. Depreciation/amortization of the asset.

Depreciation/amortization of the asset.

The solutions approach is to prepare the journal entry for the lease payment

  • Capital lease obligation (principal)xxx 
  • Interest expense xxx 
    • Cash xxx

and the journal entry for the lease amortization.

  • Amortization of leased asset xxx 
    • Accumulated amortization/depreciation xxx

Therefore, only the amortization of the leased asset results in a reduction of the carrying value of the asset.

59

On December 1, year 1, Branch Corporation leased office space for 10 years at a monthly rental of $15,000. On that date Branch paid the landlord the following amounts:
Rent deposit$  15,000

  • First month’s rent $15,000
  • Last month’s rent $15,000
  • Installation of new walls and offices $96,000
  • = $141,000

The entire amount of $141,000 was charged to rent expense in year 1. What amount should Branch have charged to expense for the year ended December 31, year 1?

  1. $15,000
  2. $15,800
  3. $30,800
  4. $96,000

$15,800

The leasehold improvement amortization is $9,600 a year ($96,000 ÷ 10 yrs.) or $800 per month ($9,600 ÷ 12 mos.).  Accordingly, December’s expenses should have been $15,800, and $95,200 of leasehold improvements should be deferred and amortized over the remainder of the lease.  The rent deposit of $15,000 and the last month’s rent of $15,000 should be set up as prepaid assets as shown in the following journal entry.

  • Leasehold improvements $96,000 
  • Rent expense $15,000 
  • Rent deposit $15,000 
  • Prepaid rent $15,000 
    • Cash $141,000
  • Leasehold imp. amort. 800 
    • Leasehold improv. 800

60

On January 1, year 1, Flip Corporation signed a 10-year noncancelable lease for certain machinery. The terms of the lease called for Flip to make annual payments of $30,000 for 10 years with title to pass to Flip at the end of this period. Accordingly, Flip accounted for this lease transaction as a capital lease of the machinery. The machinery has an estimated useful life of 15 years and no salvage value. Flip uses the straight-line method of depreciation for all of its fixed assets. The lease payments were determined to have a present value of $201,302 with an effective interest rate of 10%. With respect to this capitalized lease, Flip should record for year 1

  1. Lease expense of $30,000.
  2. Interest expense of $16,580 and depreciation expense of $13,420.
  3. Interest expense of $20,130 and depreciation expense of $13,420.
  4. Interest expense of $13,420 and depreciation expense of $16,580.

Interest expense of $20,130 and depreciation expense of $13,420.

Per ASC Topic 840, a lessee’s capital lease will incur interest expense. Interest expense, $20,130, is the carrying value of the lease obligation multiplied by the effective interest rate ($201,302 × 10%). Additionally, the cost of the equipment is depreciated over the life of the asset rather than the life of the lease since title automatically passes to the lessee at the end of 10 years and the lessee will own the asset.  Depreciation expense, $13,420, is the cost of the equipment depreciated over 15 years ($201,302/15 years).  One difficulty with this question is whether there was a $30,000 payment on January 1, year 1.  If so the interest expense would have been $17,130 [($201,302 − $30,000 × 10%)].  There is no interest expense given in that amount.  Therefore we must assume an ordinary annuity.

61

The lessee should amortize the capitalizable cost of the leased asset in a manner consistent with the lessee’s normal depreciation policy for owned assets for leases that

  • Contain a bargain purchase option
  • Transfer ownership of the property to the lessee by the end of the lease term

  • Contain a bargain purchase option - YES
  • Transfer ownership of the property to the lessee by the end of the lease term - YES

A lease that transfers ownership of the property to the lessee by the end of the lease term and a lease that contains a bargain purchase option are properly classified as capital leases. Per ASC Topic 840, if the lease meets either of the above criteria, the asset should be amortized in a manner consistent with the lessee’s normal depreciation policy for owned assets because the asset will be used by the lessee for its entire life.

62

When should a lessor recognize in income a nonrefundable lease bonus paid by a lessee on signing an operating lease?

  1. When received.
  2. At the inception of the lease.
  3. At the expiration of the lease.
  4. Over the life of the lease.

Over the life of the lease.

ASC Topic 840 specifies that, in an operating lease, the lesser should recognize rental revenues on a straight-line basis. This means that a lease bonus should be recorded as unearned revenue and recognized as rental revenue over the life of the lease.

63

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 fifteen 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?

  1. $26,667
  2. $33,667
  3. $44,444
  4. $56,111

$56,111

The leased asset should be recorded at the present value of the future lease payments because it is less than or equal to the fair value of the leased asset. Since the facts do not indicate that title is transferred to the lessee or a bargain purchase or lease option exists, the leased asset should be depreciated over the lesser of the lease term or the asset’s useful life; $56,111 (= $505,000 ÷ 9 years).

64

During January year 1, Vail Co. made long-term improvements to a recently leased building. The lease agreement provides for neither a transfer of title to Vail nor a bargain purchase option. The present value of the minimum lease payments equals 85% of the building’s market value, and the lease term equals 70% of the building’s economic life. Should assets be recognized for the building and the leasehold improvements?

  • Building
  • Leasehold improvements

  • Building - NO
  • Leasehold improvements - YES

Per ASC Topic 840, a lease is classified as a capital lease by the lessee if the lease terms meet any one of the following criteria: (1) transfer of ownership to the lessee by the end of the lease term; (2) bargain purchase option; (3) lease term greater than or equal to 75% of the economic life of the property; or (4) the present value of the minimum lease payments is greater than or equal to 90% of the property’s fair market value. Since the terms of Vail’s lease do not meet any of the criteria, the lease should be accounted for as an operating lease. Thus, Vail should not recognize the building as an asset. However, Vail should recognize the cost of leasehold improvements as asse

65

Melville Company leased equipment from Rice Corporation on July 1, year 1, for an 8-year period expiring June 30, year 9. Equal payments under the lease are $600,000 and are due on July 1 of each year. The first payment was made on July 1, year 1. The rate of interest contemplated by Melville and Rice is 10%. The cash selling price of the equipment is $3,520,000 and the cost of the equipment on Rice’s accounting records is $2,800,000. Assuming that the lease is appropriately recorded as a sales-type lease, what is the amount of profit on the sale and interest income that Rice should record for the year ended December 31, year 1?

  1. $0 and $0.
  2. $0 and $146,000.
  3. $720,000 and $146,000.
  4. $720,000 and $160,000.

$720,000 and $146,000.

Melville’s gross profit is the difference between the present value of the lease payments, $3,520,000 (which is also the cash selling price of the equipment), and the cost of goods sold ($2,800,000), or $720,000.  Interest income is found by multiplying the book value of the receivable from the lessee (total lease payments receivable minus unearned interest) outstanding during year 1 ($3,520,000 initial balance less $600,000 payment made on 7/1/Y1) times the implicit interest rate (10%) for 1/2 of a year. Therefore, interest income is $146,000 ($2,920,000 × 10% × 1/2).

66

Steam Co. acquired equipment under a capital lease for six years. Minimum lease payments were $60,000 payable annually at year-end. The interest rate was 5% with an annuity factor for six years of 5.0757. The present value of the payments was equal to the fair market value of the equipment. What amount should Steam report as interest expense at the end of the first year of the lease?

  1. $0
  2. $3,000
  3. $15,227
  4. $18,000

$15,227

This problem requires you to calculate the present value of the minimum lease payments, which is the present value of the ordinary annuity of $60,000 at 5% for 6 periods, or $304,542 (5.0757 × $60,000). This is the correct answer because interest expense for Year 1 is calculated as 5% of the carrying value of $304,542, or $15,227.

67

What are the three types of period costs that a lessee experiences with capital leases?

  1. Lease expense, interest expense, amortization expense.
  2. Interest expense, amortization expense, executory costs.
  3. Amortization expense, executory costs, lease expense.
  4. Executory costs, interest expense, lease expense.

Interest expense, amortization expense, executory costs.

The three costs incurred by a lessee with respect to capital leases are interest expense, amortization expense, and executory costs. Each payment consists of principal reduction and interest expense. The amount capitalized must be amortized over the useful life of the asset. Executory costs, such as insurance, maintenance, etc., are borne by the lessee. The basic premise in capital leases is the risks and responsibilities of ownership are transferred from lessor to lessee.

68

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

  1. 8%
  2. 10%
  3. 12%
  4. 14%

10%

ASC Topic 840 states that the lessee should compute the PV of the minimum lease payments using the lesser of the lessee’s incremental borrowing rate (14% in this case) or the implicit rate used by the lessor if known (10% in this case). The PV of the minimum lease payments should be computed using the implicit rate of 10% because it is known by the lessee and is lower than the incremental rate.

69

Barker Company leased a new machine from Bell Company on July 1, year 1, under a lease with the following pertinent information:

  • Lease term 10 years
  • Annual rental payable at the beginning of each lease year $30,000
  • Useful life of the machine 12 years
  • Implicit interest rate 14%      
  • Present value of an annuity of $1 in advance for 10 periods at 14% 5.95      
  • Present value of $1 for 10 periods at 14% 0.27      

Barker has the option to purchase the machine on July 1, year 11, by paying $40,000, which approximates the expected fair value of the machine on the option exercise date.  The cost of the machine on Bell’s accounting records is $150,000.  On July 1, year 1, Barker should record a capitalized leased asset of

  1. $150,000
  2. $178,500
  3. $189,300
  4. $190,000

$178,500

In a capital lease, the lessee records as an asset the lower of (1) the present value (PV) of the minimum lease payments, or (2) the FV of the leased asset. Since the FV is not given, we must assume that the asset is to be recorded at the PV of the minimum lease payments. The minimum lease payments must include any bargain purchase options (BPO). However, the $40,000 purchase option in this problem is not a BPO, since $40,000 approximates the expected fair value of the machine on the option exercise date. Therefore, the PV of the minimum lease payments is $178,500 (5.95 × $30,000). Note that the cost of the asset to the lessor ($150,000) is not relevant to the lessee.

70

Connor Corporation signed a lease on January 1, year 1, to rent equipment for 10 years. The lease was appropriately treated as a capital lease. On January 1, year 4 Connor renegotiated the lease terms. The new lease agreement does not contain a bargain purchase option, nor transfer of title. The new lease terms are for a shorter length of time, which is not greater than 75% of the economic useful life of the asset. The present value of the minimum lease payments under the new agreement is less than 90% of the fair market value of the leased asset. How should Connor account for the change in the lease agreement?

  1. Reduce the leased asset account by the gross value in the reduction of payments.
  2. Remove the leased asset from the books and treat the lease as an operating lease.
  3. Make no change until the end of the lease term at which time a gain or loss will be recognized for the reduction in payments.
  4. Treat the new lease as a sales-leaseback.

Treat the new lease as a sales-leaseback.

ASC Topic 840 requires that capital leases that are modified so that the resulting lease agreement is classified as an operating lease be accounted for under sale-leaseback provisions.

ASC 840-10-35-4 and 840-30-40-1 address modifications and terminations to capital leases. A company may modify a capital lease in such a way that it changes the lease to an operating lease. If a capital lease is modified as such, it is treated as a sales-leaseback transaction. If a company terminates a capital lease, the accounting for the termination depends on whether the lease was a capital lease for real estate or for an asset other than real estate. If the capital lease was for real estate, the criteria for recognition of gains in ASC Topic 605 must be met in order for the company to recognize a gain on termination of the lease. However, any loss on the transaction is recognized immediately. If the lease was for assets other than real estate, then the rules of ASC 840-30-40-1 apply and the asset and obligation of the lease are removed from the accounts and a gain or loss is recognized for the difference. If the original lessee remains secondarily liable, the guarantee obligation is recognized in accordance with ASC Topic 860.