Chapter 15 Accounting Exam

Operating lease

-does not meet any of the criteria for a finance lease rights and responsibilities are retained by lessor -lessee merely uses the asset temporarily -a sale is not recorded by the lessor, the lessor records the lease revenue on a straight-line basis -Lessee records the right of use asset and lease payable at commencement based on present value of lease payments -lease payable is consider a non-debt liability

Leasing advantages

1. reduces the upfront cash needed to use an asset 2. Lease payments often are lower than installment payments 3. offers flexibility and a lower cost when disposing of the asset 4. might offer protection against the risk of declining asset values 5. might offer tax advantages.

The agreement specifies that ownership of the asset transfers to the lessee

1st criteria for a finance/sales lease

Finance lease or Operating lease

2 lessee leases

Sales-Type Lease (with or without profit) or and Operating Lease

2 lessor leases

The agreement contains a purchase option that the lease is reasonably certain to exercise (bargain to purchase option)

2nd criteria for a finance/sales lease

The lease term is for the "major part" of the remaining economic life of the underlying asset (75%)

3rd criteria for a finance/sales lease

The present value of the lease payments equal or exceeds "substantially all" (90%) of the fair. value of the underlying asset

4th criteria for a finance/sales lease

The underlying asset is such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

5th criteria for a finance/sales lease

Predicted cash payment

A lease agreement sometimes includes a guarantee by the lessee that the lessor will recover a specified residual value when custody of the asset reverts back to the lessor at the end of the lease term The lessee promises to return not only the property but also sufficient cash to provide the lessor with a minimum combined value A cash payment would be expected as of the beginning of a lease only if the guaranteed amount exceeds the estimated residual value of the asset

Short Term Lease Short cut method

A lease that has a maximum possible lease term of 12 months or less is a short term lease lessee can elect: to not to recognize the right of use asset or a lease liability, and instead recognize lease payments as expense over the lease term

guarantee (residual value)

A lessee sometimes will ________ that the lessor will recover a specified residual value when custody of the asset reverts back to the lessor The lessee promises to return not only the property, but possibly also sufficient cash to meet the guaranteed amount promised in the lease agreement This provides incentive for the lessee to exercise a higher degree of care in maintaining the leased asset to preserve the residual value However, if the lessor gets the asset back at the end of the lease, and the asset has commercial value then, the lessor has another source of return

True

A noteworthy benefit to lesses of operating lease accounting is that expenses are recognized straight line, rather than front-loaded as in the case of finance leases, for which interest expense and amortization are separately reported.

Accounting for uncertainty of payment amounts

Because the amounts of future lease payments are uncertain and often avoidable, we don't consider them as part of the lease payments used to calculate the lessee's lease liability and the lessor's lease receivable If and when lease payments increase, the change in the lease payments has no effect on balance sheet accounts and simply is reported as a separate lease expense (lessee) and lease revenue (lessor)

B

Harry Potter Barn (HPB) leased equipment from Sorcerer's Leasing Co. on July 1, 2021, in a sales type lease. The present value of the lease payments discounted at 10% was $80,000. Ten annual lease payments of $12,000 are due each July 1, beginning July 1, 2021. The total decrease in earnings (pretax) inHPB's Dec. 31, 2021, income statement would be: a. $5,000. b. $7,400. c. $8,400. d. $9,000

True (predicted cash payments)

If a cash payment under a lessee-guaranteed residual value is predicted: The PV of that payment is added to the PV of the periodic lease payments that the lessee records as both a right-of-use asset and a lease liability The lessor will include the expected cash payment as well as the residual value itself in the lease receivable (assuming a sales-type lease)

Termination Penalties

If a lease contract includes a penalty payment if the lessee chooses to terminate the lease at a time specified in the contract, we consider the termination penalty to be an additional cash payment if the lessee is "reasonably certain" to terminate the lease If termination is predicted, we consider the lease term to be from the beginning of the lease to the expected termination date

True

If a lessee has an estimated residual value, the lessee does not care about the value of the asset at all

True

In a bargain purchase option the lease will control the asset for its ENTIRE USEFUL LIFE, therefore the amortization should be allocated over the life of an asset

a

In which of the following scenarios would the shortcut method be permissible? a. a lease term of 6 months with an option to renew for an additional 6 months. b. a lease term of 8 months with a bargain purchase option if the lease is extended to 24 months c. a lease term of 3 months with an option to extend for an additional 10 months. d. lease term of 24 months with a bargain purchase option exercisable at 18 months

Interest expense and amortization expense (separately)

Income statement reporting for an interest expense and amortization expense for financing lease

Lease expense (single)

Income statement reporting for an interest expense and amortization expense for operating lease

a

Karla Salons leased equipment from Smith Co. on January 1, 2021, in a operating lease. The present value of the lease payments discounted at 10% was $80,000. Ten annual lease payments of $12,000 are due each January 1, 2021, beginning January 1, 2021. The amortization of the rich of use asset in 2021 would be: a. $5,200 b. $6,800 c. $8000 d. $12,000

b

Knottworth Gedding Consulting leased machinery from Red Inc. on July 1, 2021. The lease was recorded as a finance lease. The present value of the lease payments discounted at 10% was $40.5 million. Ten annual lease payments of $6 million are due each July 1 beginning July 1, 2021. What amount of interest expense from the lease should Knottworth Gedding report in its December 31, 2021, income statement? a. $2,025,000 b. $1,725,000 c. $1,650,000 d. 0

Effect of Residual Value on Lease Classification

Leases are classified as a finance/sales-type lease, If the PV of the lease payments, including any lessee-guaranteed residual value constitutes "substantially all" of the fair value of the asset, it's a finance lease from the lessee's perspective and sales-type from the lessor's perspective

True

Lessors are not permitted to reassess the initial determination of the lease term/disc rate

c

On January 1, 2021, Hy Marx Tutoring leases non-specialized machinery under a 6-year lease. On January The machinery has a 9-year economic life. The present value of the monthly lease payments is determined to be 80% of the machinery's fair value. The lease contract includes neither a transfer of title to Marx nor a bargain purchase option. What amount should Marx report in its 2021 income statement? a. amortization expense equal to one-ninth of the equipments fair value b. amortization expense equal to one-sixth of the machinery's fair value c. Lease expense equal to the 2021 lease payments d. lease expense equal to the 2021 lease payments minus interest

c

On January 1, 2021, Super Sports Supply recorded a right-of-use asset of $135,180 in an operating lease. The lease calls for ten annual payments of $20,000 at the beginning of each year. The interest rate charged by the lessor was 10%. The balance in the right-of-use asset at December 31, 2021, will be: a. $115,180 b. $121,662 c. $126,698 d. $135,180

A (still uncertain even with 70% probability)

On January 1, Brighton Early Vineyard leased a truck for a five-year period, at which time possession of the truck will revert back to the lessor. Annual lease payments are $11,000 due on December 31 of each year, calculated by the lessor using a 4% discount rate. If Early's revenues exceed a specified amount during the lease term, Early will pay an additional $3,000 lease payment at the end of the lease. Early estimates a 70% probability of meeting the target revenue amount. What amount, if any, should be added to lease payments used to determine the right-of-use asset and lease liability as a result of the contingent rent agreement? A. $0 B. $3,000 C. present value of $3,000 D. present value of $14,000

b

Phil Wright Dental Services leased kitchen equipment under a 5-year lease with an option to renew for 3 years at the end of 5 years and an option to renew for an additional 3 years at the end of 8 years. The first 3-year renewal option can be exercised for one-half the original and usual rate. What is the length of the lease term that Wright should assume in recording the transactions related to the lease? a. 5 years b. 8 years c. 11 years d. cannot be determined

triggering event

Reassessment of the lease term requires a ____________ such that the lessee now has an economic initiative to exercise an option that extends or terminates the lease.

Finance Lease Financing approach

Same amortization expense each year with more expenses up front and less on subsequent end

Operating Lease Straight Light Approach

Same total expense each period, with amortization expense gradually increasing to the total payment

Uncertainty of lease payments

Sometimes lease payments are scheduled to increase or decrease on a future date during the lease term depending on whether a specified event occurs Examples may include, but are not limited to, contingencies regarding revenues. Profitability, and asset usage

lessee

The _______ accounting is not impacted by whether or not the lessor recognizes a profit. The journal entries made are the same with or without selling a selling profit for the lessor.

Lease term is uncertain

The contractual lease term is adjusted for any periods covered by options to extend or terminate the lease for which exercise is deemed to be "reasonably certain" after considering relevant economic factors Factors that might create an economic incentive for the lessee include bargain renewal rates, penalty payments for cancellation or non-renewal, and economic penalties such as significant customization or installment costs

market interest rates

The discount rate for the new lease term is the incremental borrowing rate of the lessee using ____________ at the time of the reassessment rather that the rate used at the beginning of the lease. (reassessment)

Lease modification

The lessee and lessor may agree to modify the terms of a lease before the lease term ends. This creates two possibilities: The modification might grant the lessee an additional right of use The modification might alter the lessee's right to use the asset

True

The lessor gets the lease payments plus the residual value of the asset both need to be the recovery they are looking for

True (lease payment exceptions)

There are two exceptions to not including variable payments in the calculation of the lease liability recorded at the beginning of the lease: 1. When variable lease payments are "in-substance fixed payments" ex:Fixed payments in disguise such as fixed minimum increases 2. When variable lease payments depend on an index or rate ex: Such as CPI or current interest rate Only if the lease asset and liability are later remeasured for another reason, will a change in payments based on the index or rate affect the right-of-use asset and liability

classification

When there is a change in the lease term, lesses are requires to reassess the __________ of the lease.

c

Which of the following meets the criteria for classification as a finance lease? a. at the end of the lease term, the asset has an alternative future use b. the lessee has the option of acquiring the asset during or at the end of the lease term at a price of fair value plus 10% c. the lease term is 8 years and the asset's economic life is 9 years d. the present value of the minimum lease payments is approximately 70% of the fair value of the leased asset

Lease

a contractural arrangement where the lessor (the owner) grants right to control/use an asset to the lessee (user) lease makes periodic cash payments.

Purchase option

a provision of some lease contracts that gives the lessee the option to purchase the lease asset during, or at the end of the lease term at a specified exercise price If it is "reasonably certain" that the lessee will exercise the purchase option, the accounting for the lease is affected in three ways: The lease is classified as a finance/sales-type lease Both the lessee and the lessor consider the exercise price of the option to be an additional cash payment We assume the lease term ends on the date that the option is expected to be exercised

Financial lease

amortization reflects the right to use the asset and the financing of that right (interest expense)

total lease expense

interest plus amortization expense

Residual value

is an estimate of what a leased assets commercial value will be at end of the term It affects several aspects of lease accounting including: Size of periodic lease payments, classification, amounts recorded by lessee/lessor

Implicit rate

is used to consider the time value of money while calculating the present value its the desired rate of return that the lessor has in mind when deciding the size of the lease payments

Operating lease

lease expense is recorded in a manner designed to mirror straight-line rental of the asset during the lease term.

Criteria for finance/sales type lease

must meet one or more of five criteria: 1. The agreement specifies that ownership of the asset transfers to the lessee 2. The agreement contains a purchase option that the lessee is reasonably certain to exercise (Bargain to purchase option) 3. The lease term is for the "major part" of the remaining economic life of the underlying asset (75%) 4. The present value of the lease payments equal or exceeds "substantially all" (90%) of the fair. value of the underlying asset 5. The underlying asset is such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

Sales-Type Lease with a selling profit

occurs when the fair value of an asset exceeds the cost of the carrying value

lessor

when there is a selling profit all ________ entries, other that the entry at the beginning of the lease to include the selling profit are precisely the same as the entires for a sales type lease without selling profit.