CPA Exam - FAR - Area III - Leases
On January 2, 20X1, Cole Co. signed an 8-year noncancelable lease for a new machine, requiring $15,000 annual payments at the beginning of each year. The machine has a useful life of 12 years, with no salvage value. Title passes to Cole at the lease expiration date. Cole uses straight-line depreciation for all of its plant assets. Aggregate lease payments have a present value on January 2, 20X1, of $108,000, based on an appropriate rate of interest. For 20X1, Cole should record depreciation (amortization) expense for the leased machine at:
Depreciation (amortization) expense for 20X1 = ("Cost" - Salvage) / Useful life = $108,000 / 12 years = $9,000
Neal Corp. entered into a 9-year capital lease on a warehouse on December 31, 20X1. Lease payments of $52,000, which includes real estate taxes of $2,000, are due annually, beginning on December 31, 20X2, 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 factor for the present value of an ordinary annuity for nine years at 9% is 6. What amount should Neal report as capitalized lease liability at December 31, 20X1?
300k FASB ASC 840-30-30-1 requires capitalization of the present value of minimum lease payments. This does not include executory costs such as real estate taxes.
Annuity in arrears
= ordinary annuity
Recall the appropriate accounting treatment for residual value guarantees, bargain purchase options and variable lease payments included in leasing arrangements
BPO is included in the minimum lease payments. The residual value is either: If guaranteed by the lessee: both lessor and lessee include it in the min lease payments If guaranteed by a third party or unguaranteed: only lessor includes it
On January 1, 20X1, Bay Co. acquired a land lease for a 21-year period with no option to renew. The lease required Bay to construct a building in lieu of rent. The building, completed on January 1, 20X2, at a cost of $840,000, will be depreciated using the straight-line method. At the end of the lease, the building's estimated market value will be $420,000. What is the building's carrying amount in Bay's December 31, 20X2, balance sheet. This building is treated as a leasehold improvement. Although the land lease is for 21 years, the building will be in use for 20 years; thus, the depreciation period for the building is 20 years:
Cost / Life = $840,000 / 20 years = $42,000/year Building cost - Depreciation = Carrying Value of Building $840,000 - $42,000 = $798,000
How is depreciation recorded in a lease?
FASB states that "the asset recorded under a capital lease shall be amortized depending on the provisions of the lease. When a bargain purchase option exists or ownership of the leased asset reverts to the lessee, depreciation should be computed over the useful life of the assets using estimated salvage value at the end of that life." (In other cases, the lessee computes depreciation over the lease term using residual value at the end of the lease term.) Under a capital lease, the lease is depreciated using the life of the lease if the 75% or 90% of fair market value criteria are met. If the lease transfers ownership or has a bargain purchase, the life of the asset is used to determine depreciation.
What are the criteria for a capital lease?
Its capital if there's one of the following: a b.p.o. transfer of title, lease term is 75% of life, present value of payments is greater than or equal to 90% of fair value.
Identify the criteria for classifying a lease arrangement.
Its capital if there's one of the following: a bpo, transfer of title, lease term is 75% of life, pv of payments is greater than or equal to 90% of fv. An operating lease does not meet the criteria for a capital lease; "a true rental." If it both meets one of the capital criteria and both of the following additional criteria, then its either sales-type or direct financing. 1. Collectability is reasonably assured and 2. There are no significant uncertainties. A sales type lease is where the seller is a manufacturer or dealer of the asset and the lease is a way of selling the asset on an installment basis. A direct financing lease is financing the acquisition of an asset by the lessee but is not earning a profit. There is also sales-leaseback, which is when an owner sells the property then immediately leases all or part of it back from the new owner.
How are lease bonuses recognized?
Lease bonus = over the life of the lease
Star Co. leases a building for its product showroom. The 10-year nonrenewable lease will expire on December 31, 20X6. In January 20X1, Star redecorated its showroom and made leasehold improvements of $48,000. The estimated useful life of the improvements is eight years. Star uses the straight-line method of amortization. What amount of leasehold improvements (net of amortization) should Star report in its June 30, 20X1, balance sheet?
Leasehold improvements on January 1, 20X1 $48,000 Amortization of leasehold improvements January 1 to June 30, 20X1 ($48,000 / 6 years left on lease) x .5 years - 4,000 -------- Leasehold improvements on June 30, 20X1 $44,000 ========
The following information pertains to a sale and leaseback of equipment by Mega Co. on December 31 of the current year: When a sale of property is made and a gain is realized on the sale, if the seller immediately leases the property back from the new owner, that is sometimes a justification for deferring recognition of the gain on the sale. If the lease is for a term that is a small fraction of the asset's remaining useful life, then the gain is usually not deferred at all. On December 1, 20X1, Clark Co. leased office space for five years at a monthly rental 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 20X1 expense relating to utilization of the office space?
Monthly rent $60,000 Amortization of walls and offices ($360,000 / 60 months = $6,000/month) 6,000 ------- Total $66,000
A company enters into a 3-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?
Non-level lease payments must be expensed on a straight-line basis. Year 1 $25,000 Year 2 30,000 Year 3 35,000 ------- Total rent payments $90,000 Lease term 3 years Yearly rent $30,000 The entry for the first payment would be: Rent expense $30,000 Cash $25,000 Lease liability 5,000
Howe Co. leased equipment to Kew Corp. on January 2, 20X1, for an 8-year period expiring December 31, 20X8. Equal payments under the lease are $600,000 and are due on January 2 of each year. The first payment was made on January 2, 20X1. The list selling price of the equipment is $3,520,000 and its carrying cost on Howe's books is $2,800,000. The lease is appropriately accounted for as a sales-type lease. The present value of the lease payments at an imputed interest rate of 12% (Howe's incremental borrowing rate) is $3,300,000. What amount of profit on the sale should Howe report for the year ended December 31, 20X1
Present value of lease payments (i.e. sales price) $3,300,000 Less carrying value of leased property 2,800,000 ---------- Income to be reported for year ended December 31, 20X1 $ 500,000 ==========
On March 1, 20X1, Ila Co. modified the terms of a 4-year lease of equipment. Ila had leased the equipment on January 1, 20X1, and properly recorded it as a capital lease. Under the modified provisions, the lease would have been classified as an operating lease. How should Ila account for the modified lease?
Sale-leaseback
• On December 29, Year 1, Action Corp. signed a 7-year capital lease for an airplane to transport its sports team around the country. The airplane's fair value was $841,500. Action made the first annual lease payment of $153,000 on December 31, Year 1. Action's incremental borrowing rate was 12%, and the interest rate implicit in the lease, which was known by Action, was 9%. The following are the rounded present value factors for an annuity due: 9% for 7 years: 5.5 12% for 7 years: 5.1 What amount should Action report as capital lease liability in its December 31, Year 1, balance sheet?
The capital lease obligation that a lessee recognizes on their books is based on the present value of the minimum lease payments. The minimum lease payments are the annual lease payments made at the beginning of each year of $153,000. The discount rate to get the present value of the payments is the lower of the lessee's incremental borrowing rate, or the rate implicit in the lease, if known to the lessee. The lower of these two here is the implicit rate in the lease that is known to the lessee, which is 9%. Thus, the amount of the lease liability will be based here on the present value factor for an annuity due of 7 years based on 9% (5.5) multiplied by the annual rental of $153,000: 5.5 × $153,000 = $841,500 However, since the first payment was just made, lower that amount to get the remaining liability at the end of the year:$841,500 − $153,000 = $688,500
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?
The inception of a lease is the date of the lease agreement. Rental expense should be as of that date. When the lease payments begin later than the inception date, the lease payments must be spread evenly over the longer period of time, which includes the months between the inception date and the beginning of the lease payments. $28,900 × 56 months = $1,618,400 $1,618,400 ÷ 60 months = $26,973.33 $26,973.33 × 7 months (June through December) = $188,813
• A company leases a machine from Leasing, Inc. on January 1, year 1. The lease terms include a $100,000 annual payment beginning January 1, year 1. The machine's fair value is $500,000 and the residual value is estimated at $20,000. The company guarantees the residual value. The useful life of the machine is six years, and the lease term is five years. The implicit rate of interest is 6% and is known by the company. The following present value factors are provided: Five Years Six Years Present value of $1 at 6% 0.7473 0.7050 Present value of an annuity due at 6% 4.4651 5.2124 Present value of an ordinary annuity at 6% 4.2124 4.9173 What is the value of the machine in the company's balance sheet at lease inception?
The value of the machine from the capital lease is the present value of the minimum lease payments (using the annuity due factor) and the present value of the guaranteed residual value, over the five-year lease term, as follows: ($100,000 × 4.4651) + ($20,000 × 0.7473) = $461,456.
On July 1, 20X0, Gee, Inc., leased a delivery truck from Marr Corp. under a 3-year operating lease. Total rent for the term of the lease will be $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, 20X2, balance sheet, the accrued rent receivable should be reported as:
This problem tests the rule that straight-line recognition should be used to record the rent revenue, regardless of the payment schedule. At $1,000 per month (straight-line), total revenue recognized by the end of the second year should be $24,000. Since cash was actually received at that point in the amount of $15,000 ($9,000 + $6,000), a receivable of $9,000 remains in the rent receivable account for the difference ($24,000 - $15,000).
A lease is recorded as a sales-type lease by the lessor. The difference between the gross investment in the lease and the sum of the present values of the two components of the gross investment (the net receivable) should be:
amortized over the period of the lease as interest revenue using the interest method.
FASB requires testing for impairment loss for certain long-lived assets. Which of the following types of leases is tested for impairment?
o Capital leases of lessees o Long-lived assets of lessors subject to operating leases
In the long-term liabilities section of its balance sheet at December 31, 20X1, Mene Co. reported a capital lease obligation of $75,000, net of current portion of $1,364. Payments of $9,000 were made on both January 2, 20X2, and January 2, 20X3. Mene's incremental borrowing rate on the date of the lease was 11% and the lessor's implicit rate, which was known to Mene, was 10%. In December 31, 20X2, balance sheet, what amount should Mene report as capital lease obligation, net of current portion?
• At December 31, 20X1, the total lease liability was $76,364 (the sum of the current portion of $1,364 and the long-term portion of $75,000). The $9,000 payment made on January 2, 20X2, was for the $1,364 current portion and the interest of $7,636 ($9,000 - $1,364). After the January 2, 20X2, payment, the total lease liability is $75,000. Interest for 20X2 is $7,500 ($75,000 × 10% implicit rate). Therefore, the reduction in principal that will be included in the January 2, 20X3, payment will be $1,500, which is the $9,000 payment minus $7,500 interest for 20X2. This $1,500 represents the current portion of the lease liability. Therefore, the long-term portion of the liability at December 31, 20X2, is the $75,000 total lease liability less the $1,500 current portion, or $73,500
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, 20X1, and $50,000 annually on each December 31 for the next eight years. The present value on December 31, 20X1, 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, 20X1, 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 the capital lease liability in its December 31, 20X2, balance sheet?
• FASB requires use of the interest rate implicit in the lease when: this rate can be determined and the implicit rate is less than lessee's incremental rate. Present value of NINE lease payments at December 31, 20X1 (at implicit rate) $316,500 Less December 31, 20X1 payment 50,000 -------- Present value of lease obligation at beginning of 20X2 $266,500 Add 20X2 interest at 10% (.10 x 266,500) 26,650 -------- Lease obligation prior to 12/31/X2 payment $293,150 Less December 31, 20X2, payment 50,000 -------- Capital lease liability on 12/31/X2 balance sheet $243,150 ========
Farm Co. leased equipment to Union Co. on July 1, 20X1, 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, 20X1. Farm had purchased the equipment for $110,000. What amount of interest revenue from the lease should Farm report in its 20X1 income statement?
• Initial amount of lease $135,000 Less first payment 20,000 -------- Lease amount applicable to last half of 20X1 $115,000 Times interest rate (10% x 6/12 year) x .05 -------- Interest revenue for 20X1 $ 5,750 ========
On December 30, 20X1, Rafferty Corp. leased equipment under a capital lease. Annual lease payments of $20,000 are due December 31 for 10 years. The equipment's useful life is 10 years, and the interest rate implicit in the lease is 10%. The capital lease obligation was recorded on December 30, 20X1, at $135,000, and the first lease payment was made on that date. What amount should Rafferty include in current liabilities for this capital lease in its December 31, 20X1, balance sheet?
• Initial lease obligation on December 31, 20X1 $135,000 Less payment made on December 31, 20X1 - 20,000 -------- Lease obligation during 20X2 $115,000 ======== Portion of December 31, 20X2, payment that is interest = rate x obligation x time = 10% x $115,000 x 1 = $11,500 Portion of December 31, 20X2, payment that is related to lease obligation = payment - interest portion = $20,000 - $11,500 = $8,500
On June 30 of the current year, Lang Co. sold equipment with an estimated useful life of 11 years and immediately leased it back for 10 years. The equipment's carrying amount was $450,000; the sales price was $430,000; and the present value of the lease payments, which is equal to the fair value of the equipment, was $465,000. In its June 30 current-year balance sheet, what amount should Lang report as deferred loss?
• When a sale of property is made and a gain is realized on the sale, if the seller immediately leases the property back from the new owner, that is sometimes a justification for deferring recognition of the gain on the sale. If the sale of the asset is for a realized loss, as here, of $20,000 (sales price of $430,000 less carrying amount of $450,000), then a loss is usually recognized immediately.
