Ch21a-Explain the accounting for operating leases

Allan Company leased equipment to Harlan Company on May 1, 2016. The lease expires on May 1, 2019 and qualifies as an operating lease for both the lessee and the lessor. During 2016, Harlan paid $1,080,000 in rentals to Allan for the 8-month period. Allan incurred maintenance and other related costs under the terms of the lease of $96,000 in 2016 as well as $540,000 in depreciation. Ignoring income taxes, the amount of expense incurred by Harlan from this lease for the year ended December 31, 2016, should be

$1,080,000.

Jane (lessor) and Sally (lessee) are entering into a lease agreement that does not meet any of the lease classification tests and will therefore be accounted for as an operating lease. Sally will be making 3 beginning-of-the-year payments of $88,100.40. The asset has an unguaranteed residual value of $60,000. The term of the lease is 3 years and Jane used a 6% rate to calculate the payments. Sally's incremental borrowing rate is 8% but Sally is aware of Jane's rate. What is the fair value of Jane's asset?

$300,000.00

Patsy Co. and Philip Inc. sign a lease agreement dated January 1, 2017. The lease agreement specifies that Patsy (lessor) will grant right-of-use to Philip (lessee) of one of its machines that is not of a specialized nature. The lease term is non-cancelable and has a 3 year term. On January 1, 2017, the machine has a cost and fair value of $240,000, an estimated economic life of five years, and a residual value at the end of the lease of $48,000 (unguaranteed). The machine reverts to Patsy at the end of the lease term and the lease contains no renewal options. Patsy used a 6 percent rate when calculating the lease payments, and Philip is aware of this rate. Philip's incremental rate is 8%. The payments are to be made at the beginning of the year with the first payment on January 1, 2017. Use the following PV factors: What is the annual payment Philip will make for the term of the lease?

$70,480.32

Which of the following is correct regarding an operating lease?

The lessee records a right-of-use asset and lease liability at the commencement of the lease.

Interest expense should be reported on the income statement by the lessee regardless of whether they have a finance lease or an operating lease.

False

The FASB indicates that reporting ______________ in the income statement more appropriately reflects the economics of a(n) ______________ lease than separate recognition of interest and amortization expense.

a single operating cost; operating

When a lessee records an operating lease

part of its annual lease expense is based on interest related to amortizing its lease liability.

In an operating lease, the lessor will depreciate the property over ________.

the asset's life

Allan Company leased equipment to Harlan Company on May 1, 2016. The lease expires on May 1, 2019 and qualifies as an operating lease for both the lessee and the lessor. During 2016, Harlan paid $1,080,000 in rentals to Allan for the 8-month period. Allan incurred maintenance and other related costs under the terms of the lease of $96,000 in 2016 as well as $540,000 in depreciation. Ignoring income taxes, the amount of income reported by Allan from this lease for the year ended December 31, 2016, should be

$444,000.

Patsy Co. and Philip Inc. sign a lease agreement dated January 1, 2017. The lease agreement specifies that Patsy (lessor) will grant right-of-use to Philip (lessee) of one of its machines that is not of a specialized nature. The lease term is non-cancelable and has a 3 year term. On January 1, 2017, the machine has a cost and fair value of $240,000, an estimated economic life of five years, and a residual value at the end of the lease of $48,000 (unguaranteed). The machine reverts to Patsy at the end of the lease term and the lease contains no renewal options. Patsy used a 6 percent rate when calculating the lease payments, and Philip is aware of this rate. Philip's incremental rate is 8%. The payments are to be made at the beginning of the year with the first payment on January 1, 2017. Use the following PV factors: What type of lease is this for Philip and why?

An operating lease because none of the finance lease tests are met.

When comparing a finance lease and an operating lease, the _________ lease has higher charges in the earlier years and lower charges in later years whereas the __________ lease reports the same amount of expense each period.

Finance; operating

When is the straight-line method for expense measurement used?

For an operating lease.

What should the lessor generally do when a lease does not qualify as a sales-type lease?

It should classify and account for the lease as an operating lease.

What should the lessor do when a depreciable asset is leased under an operating lease?

It should record depreciation in the normal manner.

Patsy Co. and Philip Inc. sign a lease agreement dated January 1, 2017. The lease agreement specifies that Patsy (lessor) will grant right-of-use to Philip (lessee) of one of its machines that is not of a specialized nature. The lease term is non-cancelable and has a 3 year term. On January 1, 2017, the machine has a cost and fair value of $240,000, an estimated economic life of five years, and a residual value at the end of the lease of $48,000 (unguaranteed). The machine reverts to Patsy at the end of the lease term and the lease contains no renewal options. Patsy used a 6 percent rate when calculating the lease payments, and Philip is aware of this rate. Philip's incremental rate is 8%. The payments are to be made at the beginning of the year with the first payment on January 1, 2017. Use the following PV factors: On January 1, 2018, which of the following journal entries will Philip make?

Lease liability Cash

On July 1, 2017, Limon leased a piece of equipment to Wolford Industries for a three-year period expiring June 30, 2020, for $75,000 a month. Limon purchased the equipment on July 1, 2017 for $4,800,000. The equipment is being depreciated on a straight-line basis over an eight-year period with no salvage value. Assuming that both the lease to Dunaway and the lease to Wolford are recorded as operating leases for accounting purposes, what is the amount of income (expense) before income taxes that each would record as a result of the above facts for the year ended December 31, 2017?

Limon would report $150,000 in income and Wolford would report expenses of $450,000.

On January 1, 2018, Hickory Corporation signs a noncancelable contract in which it agrees to lease a piece of non-specialized manufacturing equipment to Penzey Products. Specific details related to the lease are as follows: • The lease has a 3-year term with no renewal option. • Penzey is required to make a payment of $287,432 to Hickory on January 1 of each year in the lease term, beginning January 1, 2018. • As of January 1, 2018, the machine's fair value is $950,000. The machine has an estimated economic life of 10 years and no expected salvage value. • Upon termination of the lease, the machine reverts to Hickory Corporation. • Penzey depreciates all of its machinery on a straight-line basis. • Penzey's incremental borrowing rate is 10% per year. The firm is not aware of the 8% implicit rate used by Hickory. From Hickory's point of view, this agreement would be classified as a(n)

Operating

Only a(n) ______lease will use the straight-line method for expense measurement.

Operating

Patsy Co. and Philip Inc. sign a lease agreement dated January 1, 2017. The lease agreement specifies that Patsy (lessor) will grant right-of-use to Philip (lessee) of one of its machines that is not of a specialized nature. The lease term is non-cancelable and has a 3 year term. On January 1, 2017, the machine has a cost and fair value of $240,000, an estimated economic life of five years, and a residual value at the end of the lease of $48,000 (unguaranteed). The machine reverts to Patsy at the end of the lease term and the lease contains no renewal options. Patsy used a 6 percent rate when calculating the lease payments, and Philip is aware of this rate. Philip's incremental rate is 8%. The payments are to be made at the beginning of the year with the first payment on January 1, 2017. Use the following PV factors: Which of the following is correct regarding the journal entry made by Philip on December 31, 2017?

Philip will credit Right-of-Use Asset for $62,727.24

Which of the following is correct regarding operating leases?

The lessee "plugs" the amount of the Right-to-Use Asset to amortize each period so that the asset is reduced to zero at the end of the lease.

Which of the following is correct regarding operating leases for lessors?

The lessor recognizes the asset on its balance sheet, depreciates the asset using its preferred method, and recognizes lease revenue.

Lessees record a right-of-use asset for operating leases.

True

Under an operating lease, the lessor records each rental receipt as rental revenue.

True

When a lessee properly accounts for an operating lease, it ________ the amount of interest on the liability to/from the ____________ to arrive at the amount of ___________.

deducts; straight-line lease expense; amortization on the right-to-use asset.

For leases accounted for as operating leases

the lessee continues to use the effective-interest method for amortizing the lease liability.