International Accounting : Leases

16. On January 1, year 1, Nobb Corp. signed a twelve-year lease for warehouse space. Nobb has an option to renew the lease for an additional eight-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 fifteen 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 a. $486,000 b. $504,000 c. $510,000 d. $513,000

Correct Answer: B) $504,000 Notes (b) 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 eighteen years (12 years of original lease + 8 years in option period - 2 years gone by), and the useful life of the improvements is fifteen years. Therefore, amortization is based on a fifteen-year life ($540,000 ÷ 15 = $36,000). The 12/31/Y1 carrying amount is $504,000 ($540,000 - $36,000).

13. On December 1, year 1, 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 year 1 expense relating to utilization of the office space? a. $60,000 b. $66,000 c. $120,000 d. $140,000

Correct Answer: B) $66,000

28. Robbins, Inc. leased a machine from Ready Leasing Co. The lease qualifies as a capital lease and requires ten annual payments of $10,000 beginning immediately. The lease specifies an interest rate of 12% and a purchase option of $10,000 at the end of the tenth year, even though the machine's estimated value on that date is $20,000. Robbins' incremental borrowing rate is 14%. Present value of an annuity due of one for 10 years at: 12%: 6.328 14%: 5,946 Present value of one for 10 years at: 12%: 0.322 14%: 0.270 What amount should Robbins record as lease liability at the beginning of the lease term? a. $62,160 b. $64,860 c. $66,500 d. $69,720

Correct Answer: C) $66,500

29. Neal Corp. entered into a nine-year capital lease on a warehouse on December 31, year 1. Lease payments of $52,000, which includes real estate taxes of $2,000, are due annually, beginning on December 31, year 2, and every December 31 thereafter. Neal does not know the interest rate implicit in the lease; Neal's incremental borrowing rate is 9%. The rounded present value of an ordinary annuity for nine years at 9% is 5.6. What amount should Neal report as capitalized lease liability at December 31, year 1? a. $280,000 b. $291,200 c. $450,000 d. $468,000

Correct Answer: A) $280,000 Notes (a) The annua l executory costs (real estate taxes of $2,000) are not an expense or liability until incurred; therefore they are excluded from the minimum lease payments and are not reflected in the initial lease liability. The 12/31/Y1 capital lease liability is recorded at the PV of the minimum lease payments [5.6 × ($52,000 - $2,000) = $280,000].

11. On January 1, year 1, Mollat Co. signed a seven-year lease for equipment having a ten-year economic life. The present value of the monthly lease payments equaled 80% of the equipment's fair value. The lease agreement provides for neither a transfer of title to Mollat nor a bargain purchase option. In its year 1 income statement Mollat should report a. Rent expense equal to the year 1 lease payments. b. Rent expense equal to the year 1 lease payments less interest expense. c. Lease amortization equal to one-tenth of the equipment's fair value. d. Lease amortization equal to one-seventh of 80% of the equipment's fair value.

Correct Answer: A)

48. The following information pertains to a sale and leaseback of equipment by Mega Co. on December 31, year 1: Sales price: $400,000 Carrying amount: $300,000 Monthly lease payment: $3,250 Present value of lease payments: $36,900 Estimated remaining life: 25 years Lease term: 1 year Implicit rate: 12% What amount of deferred gain on the sale should Mega report at December 31, year 1? a. $0 b. $36,900 c. $63,100 d. $100,000

Correct Answer: A) $0 Notes (a) A sale-leaseback is generally treated as a single financing transaction in which any profit on the sale is deferred and amortized by the seller. However, there is an exception to this general rule when either only a minor part of the remaining use of the leased asset is retained (case one) or when more than a minor part but less than substantially all of the remaining use of the leased asset is retained (case two). Case one occurs when the PV of the lease payments is 10% or less of the FV of the sale-leaseback property. Case two occurs when the leaseback is more than minor but does not meet the criteria of a capital lease. This problem is an example of case one, because the PV of the lease payments ($36,900) is less than 10% of the FV of the asset (10% × $400,000 = $40,000). Under these circumstances, the full gain ($400,000 - $300,000 = $100,000) is recognized, and none is deferred.

8. As an inducement to enter a lease, Arts, Inc., a lessor, grants Hompson Corp., a lessee, nine months of free rent under a five-year operating lease. The lease is effective on July 1, year 1 and provides for monthly rental of $1,000 to begin April 1, year 2. In Hompson's income statement for the year ended June 30, year 2, rent expense should be reported as a. $10,200 b. $9,000 c. $3,000 d. $2,550

Correct Answer: A) $10,200 Notes (a) 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 $1,000 monthly for five years excluding the first nine months, or fifty-one months (60 - 9). Therefore, total rent expense for the five years is $51,000 (51 × $1,000). Recognizing rent expense on a straight-line basis, rent expense for the first year is $10,200 ($51,000 ÷ 5 years).

3. On January 1, year 1, Wren Co. leased a building to Brill under an operating lease for ten years at $50,000 per year, payable the first day of each lease year. Wren paid $15,000 to a real estate broker as a finder's fee. The building is depreciated $12,000 per year. For year 1, Wren incurred insurance and property tax expense totaling $9,000. Wren's net rental income for year 1 should be a. $27,500 b. $29,000 c. $35,000 d. $36,500

Correct Answer: A) $27,500

31. On January 1, year 1, Babson, Inc. leased two automobiles for executive use. The lease requires Babson to make five annual payments of $13,000 beginning January 1, year 1. At the end of the lease term, December 31, year 5, Babson guarantees the residual value of the automobiles will total $10,000. The lease qualifies as a capital lease. The interest rate implicit in the lease is 9%. Present value factors for the 9% rate implicit in the lease are as follows: For an annuity due with 5 payments: 4.240 For an ordinary annuity with 5 payments: 3.890 Present value of $1 for 5 periods: 0.650 Babson's recorded capital lease liability immediately after the first required payment should be a. $48,620 b. $44,070 c. $35,620 d. $31,070

Correct Answer: A) $48,620

19. Glade Co. leases computer equipment to customers under direct-financing leases. The equipment has no residual value at the end of the lease and the leases do not contain bargain purchase options. Glade wishes to earn 8% interest on a five-year lease of equipment with a fair value of $323,400. The present value of an annuity due of $1 at 8% for five years is 4.312. What is the total amount of interest revenue that Glade will earn over the life of the lease? a. $51,600 b. $75,000 c. $129,360 d. $139,450

Correct Answer: A) $51,600 Notes (a) The annual lease payment is $75,000 ($323,400 ÷ 4.312). After five years, total lease payments will be $375,000 (5 × $75,000). The total interest revenue over the life of the lease is the excess of total lease payments over the fair value of the leased asset ($375,000 - $323,400 = $51,600).

37. At the inception of a capital lease, the guaranteed residual value should be a. Included as part of minimum lease payments at present value. b. Included as part of minimum lease payments at future value. c. Included as part of minimum lease payments only to the extent that guaranteed residual value is expected to exceed estimated residual value. d. Excluded from minimum lease payments.

Correct Answer: A) Included as part of minimum lease payments at present value. Notes (a) At the inception of a capital lease, the lessee must record an asset and a liability based on the PV of the minimum lease payments. The minimum lease payments are the payments that lessee is required to make in connection with the leased property, including rent payments, bargain purchase option, and guaranteed residual value. Minimum lease payments (MLP) are recorded at present value. The whole guaranteed residual value is included in MLP.

54. On January 1, year 1, Goliath entered into a five-year operating lease for equipment. In January year 3, Goliath decided that it no longer needs the equipment and terminates the contract by paying a penalty of $3,000. How should Goliath account for the lease termination costs? a. Recognize $3,000 termination cost in year 3 as a loss from continuing operations. b. Recognize $1,000 termination cost each year for the remaining three years of the lease term. c. Recognize the $3,000 termination cost as an extraordinary item in year 3. d. Recognize the $3,000 termination cost as a discontinued operation in year 3.

Correct Answer: A) Recognize $3,000 termination cost in year 3 as a loss from continuing operations. Notes (a) A termination of an operating lease requires that the fair value of the termination costs be recognized as an expense or loss in calculating income from continuing operations in the year the lease was terminated.

40. A lessee had a ten-year capital lease requiring equal annual payments. The reduction of the lease liability in year two should equal a. The current liability shown for the lease at the end of year one. b. The current liability shown for the lease at the end of year two. c. The reduction of the lease obligation in year one. d. One-tenth of the original lease liability.

Correct Answer: A) The current liability shown for the lease at the end of year one. Notes (a) When a leasing agreement is accounted for as capital lease, the lessee recognizes a liability on its books equal to the present value of the minimum lease payments. The liability should be divided between current and noncurrent based upon when each lease payment is due. At the end of year one, the current lease liability should equal the principal portion of the lease payment due in year two. Therefore, when the lease payment is made in year two, the reduction of the lease liability will equal the current liability shown at the end of year one.

49. On December 31, year 1, Parke Corp. sold Edlow Corp. an airplane with an estimated remaining useful life of ten years. At the same time, Parke leased back the airplane for three years. Additional information is as follows: Sales price: $600,000 Carrying amount of airplane at date of sale: $100,000 Monthly rental under lease: $6,330 Interest rate implicit in the lease as computed by Edlow and known by Parke (this rate is lower than the lessee's incremental borrowing rate): 12% Present value of operating lease rentals ($6,330 for 36 months @ 12%): $190,581 The leaseback is considered an operating lease. In Parke's December 31, year 1 balance sheet, what amount should be included as deferred revenue on this transaction? a. $0 b. $190,581 c. $309,419 d. $500,000

Correct Answer: B) $190,581 Notes (b) A sale-leaseback is generally treated as a single financing transaction in which any profit on the sale is deferred and amortized by the seller. However, there is an exception to this general rule when either only a minor part of the remaining use of the leased asset is retained (case one) or when more than a minor part but less than substantially all of the remaining use of the leased asset is retained (case two). Case one occurs when the PV of the lease payments is 10% or less of the FV of the sale-leaseback property. Case two occurs when the leaseback is more than minor but does not meet the criteria of a capital lease. This is an example of case two because while the PV of the lease payments ($190,581) is more than 10% of the FV of the asset ($600,000), the lease falls into the operating lease category. Under these circumstances, the gain on sale ($600,000 - $100,000 = $500,000) is recognized to the extent that it exceeds the PV of the lease payments ($190,581). The gain reported would be $309,419 ($500,000 - $190,581). The portion of the gain represented by the $190,581 PV of the lease payments is deferred and amortized on a straight-line basis over the life of the lease.

26. On December 31, year 1, Day Co. leased a new machine from Parr with the following pertinent information: Lease term: 6 years Annual rental payable at beginning of each year: $50,000 Useful life of machine: 8 years Day's incremental borrowing rate: 15% Implicit interest rate in lease (known by Day): 12% Present value of annuity of 1 in advance for 6 periods at 12%: 4.61 Present value of annuity of 1 in advance for 6 periods at 15%: 4.35 The lease is not renewable, and the machine reverts to Parr at the termination of the lease. The cost of the machine on Parr's accounting records is $375,500. At the beginning of the lease term, Day should record a lease liability of a. $375,500 b. $230,500 c. $217,500 d. $0

Correct Answer: B) $230,500 Notes (b) This is a capital lease for the lessee because the lease term is 75% of the useful life of the machine [6 years = (75% × 8 years)]. For a capital lease, the lessee records as a leased asset and a lease obligation the lower of the PV of the minimum lease payments or the FV of the leased asset (not given in this problem). The PV of the minimum lease payments is computed using the lower of the lessee's incremental borrowing rate (15%) or the implicit rate used by the lessor if known by the lessee (12%). Since the implicit rate is lower, and known by the lessee, it is used to compute the PV ($50,000 × 4.61 = $230,500). The cost of the asset on the lessor's books ($375,500) is irrelevant.

30. East Company leased a new machine from North Company on May 1, year 1, under a lease with the following information: Lease term: 10 years Annual rental payable at beginning of each lease year: $40,000 Useful life of machine: 12 years Implicit interest rate: 14% Present value of an annuity of one in advance for 10 periods at 14%: 5.95 Present value of one for 10 periods at 14%: 0.27 East has the option to purchase the machine on May 1, year 11 by paying $50,000, which approximates the expected fair value of the machine on the option exercise date. On May 1, year 1, East should record a capitalized lease asset of a. $251,500 b. $238,000 c. $224,500 d. $198,000

Correct Answer: B) $238,000 Notes (b) The requirement is to determine the amount to be recorded as a capitalized leased asset. This is a capital lease for the lessee because the lease term exceeds 75% of the economic life of the leased asset (10/12 > 75%). In a capital lease, the lessee records as an asset and liability the present value (PV) of the minimum lease payments (unless the PV exceeds the asset's FV, in which case the FV is recorded). The minimum lease payments include rentals, and a lessee-guaranteed residual value or a bargain purchase option. Only rentals apply in this case. Note that the $50,000 purchase option is not a bargain purchase option that the lessee would be compelled to exercise. A bargain purchase option is an option to purchase the leased asset at an amount less than its expected fair value. Therefore, the present value of the minimum lease payments is $238,000 ($40,000 × 5.95).

33. Oak Co. leased equipment for its entire nine-year useful life, agreeing to pay $50,000 at the start of the lease term on December 31, year 1, and $50,000 annually on each December 31 for the next eight years. The present value on December 31, year 1, 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, year 1 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, year 2 balance sheet? a. $350,000 b. $243,150 c. $228,320 d. $0

Correct Answer: B) $243,150 Notes (b) This is a capital lease for the lessee because the lease term (nine years) exceeds 75% of the useful life of the machine (also nine years). For a capital lease, the lessee records as a leased asset and a lease obligation at the lower of the PV of the minimum lease payments or the FV of the leased asset (not given in this problem). The PV of the minimum lease payments is computed using the lower of the lessee's incremental borrowing rate (12%) or the implicit rate used by the lessor if known by the lessee (10%). Since the implicit rate is lower, and known by the lessee, it is used to compute the PV ($316,500). The initial lease payment ($50,000) is entirely principal because it was made at the inception of the lease. Therefore, after the 12/31/Y1 payment, the lease liability is $266,500 ($316,500 - $50,000). The 12/31/Y2 payment consists of interest incurred during year 2 ($266,500 × 10% = $26,650) and principal reduction ($50,000 - $26,650 = $23,350). Therefore, the 12/31/Y2 capital lease liability is $243,150 ($266,500 - $23,350).

51. On January 1, year 1, Hooks Oil Co. sold equipment with a carrying amount of $100,000, and a remaining useful life of ten years, to Maco Drilling for $150,000. Hooks immediately leased the equipment back under a ten-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 a. $50,000 b. $45,000 c. $25,588 d. $0

Correct Answer: B) $45,000 Notes (b) 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); both are ten years in this case. 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 ten years. Therefore, the unearned gain at 12/31/Y1 is $45,000 ($50,000 - $5,000).

22. Howe Co. leased equipment to Kew Corp. on January 2, year 1, for an eight-year period expiring December 31, year 8. 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, year 1. 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 is $3,300,000. What amount of profit on the sale should Howe report for the year ended December 31, year 1? a. $720,000 b. $500,000 c. $90,000 d. $0

Correct Answer: B) $500,000 Notes (b) This is a sales-type lease, so at the inception of the lease, the lessor would recognize sales of $3,300,000 (the PV of the lease payments), and cost of goods sold of $2,800,000, resulting in profit on the sale of $500,000 ($3,300,000 - $2,800,000). Note that the list selling price of an asset ($3,520,000 in this case) is not always representative of its FV. An asset can often be purchased for less than its list price.

27. On January 1, year 1, Day Corp. entered into a ten-year lease agreement with Ward, Inc. for industrial equipment. Annual lease payments of $10,000 are payable at the end of each year. Day knows that the lessor expects a 10% return on the lease. Day has a 12% incremental borrowing rate. The equipment is expected to have an estimated useful life of ten years. In addition, a third party has guaranteed to pay Ward a residual value of $5,000 at the end of the lease. Present Value of an ordinary annuity of $1 for ten years at: 12%: 5.6502 10%: 6.1446 Present Value of $1 for ten years at: 12%: 0.3220 10%: 0.3855 In Day's October 31, year 1 balance sheet, the principal amount of the lease obligation was a. $63,374 b. $61,446 c. $58,112 d. $56,502

Correct Answer: B) $61,446 Notes (b) This is a capital lease since the lease term (ten years) is the same as the useful life of the leased asset. In a capital lease, the lessee records an asset and a liability based on the PV of the minimum lease payments. The minimum lease payments includes rentals and a guaranteed residual value, if guaranteed by the lessee. In this case the minimum lease payments include only the rentals, since the residual value is guaranteed by a third party. The minimum lease payments are discounted using the lower of the lessee's incremental borrowing rate or the implicit rate used by the lessor, if known. In this case, the lessee knows the implicit rate is 10%, which is lower than the incremental borrowing rate of 12%. Thus, the present value or principal amount of the lease obligation is $61,446 ($10,000 × 6.1446) through the first year. Although accrued interest would be recognized at 10/31/Y1, the principal amount does not change until 1/1/Y2.

35. In the long-term liabilities section of its balance sheet at December 31, year 1, 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, year 2, and January 2, year 3. Mene's incremental borrowing rate on the date of the lease was 11% and the lessor's implicit rate, which was known to Mene, was 10%. In its December 31, year 2 balance sheet, what amount should Mene report as capital lease obligation, net of current portion? a. $66,000 b. $73,500 c. $73,636 d. $74,250

Correct Answer: B) $73,500 Notes (b) On 1/2/Y2, Mene made a lease payment of $9,000, which included payment of the current portion of the lease obligation ($1,364) and interest ($9,000 - $1,364 = $7,636). After this payment, the total lease obligation was $75,000. The 1/2/Y3 payment would include interest of $7,500 ($75,000 × 10%), and principal of $1,500 ($9,000 - $7,500). This $1,500 amount would represent the current portion of the lease obligation at 12/31/Y2, so the long-term lease obligation net of the current portion at 12/31/Y2 is $73,500 ($75,000 - $1,500).

32. On December 30, year 1, Rafferty Corp. leased equipment under a capital lease. Annual lease payments of $20,000 are due December 31 for ten years. The equipment's useful life is ten years, and the interest rate implicit in the lease is 10%. The capital lease obligation was recorded on December 30, year 1, at $135,000, and the first lease payment was made on that date. What amount should Rafferty include in current liabilities for this capital lease in its December 31, year 1 balance sheet? a. $6,500 b. $8,500 c. $11,500 d. $20,000

Correct Answer: B) $8,500 Notes (b) The initial lease obligation at 12/30/Y1 was $135,000. The first lease payment was made the same day, and therefore consisted entirely of principal reduction. After the payment, the lease obligation was $115,000 ($135,000 - $20,000). This balance will be reported as current (for the portion to be paid in year 2) and long-term (for the portion to be paid beyond year 2). The next lease payment of $20,000 will be paid 12/31/Y2, and will consist of both interest ($115,000 × 10% = $11,500) and principal reduction ($20,000 - $11,500 = $8,500). Thus, the portion of the $115,000 lease obligation to be paid in the next year (and therefore reported as a current liability) is $8,500. Note that the interest to be paid next year ($11,500) is not a liability at 12/31/Y1 because it has not yet been incurred.

41. On January 2, year 1, Cole Co. signed an eight-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 twelve 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, year 1, of $108,000 based on an appropriate rate of interest. For year 1, Cole should record depreciation (amortization) expense for the leased machine at a. $0 b. $9,000 c. $13,500 d. $15,000

Correct Answer: B) $9,000 Notes (b) This is a capital lease since title passes to Cole, the lessee, at the end of the lease. At the inception of the lease on 1/2/Y1, the lessee records the PV of the lease payments ($108,000) as an asset and a liability. The asset is depreciated on a straight-line basis over its useful life of twelve years, resulting in a yearly depreciation charge of $9,000 ($108,000 ÷ 12). The asset is depreciated over its useful life rather than over the lease term (eight years) because title transfers to the lessee, allowing the lessee to use the asset for twelve years.

55. In January year 1, Hopper Corp. signed a capital lease for equipment with a term of twenty years. In year 3, Hopper negotiated a modification to a capital lease that resulted in the lease being reclassified as an operating lease. Hopper calculated the company had a gain of $8,000 on the lease modification. Hopper retains all rights to use the property during the remainder of the lease term. How should Hopper account for the lease modification? a. Recognize an $8,000 gain from lease modification during year 3. b. Defer the gain and recognize it over the life of the operating lease. c. Recognize the $8,000 gain as an extraordinary item in year 3. d. Recognize the $8,000 gain as a discontinued operation in year 3.

Correct Answer: B) Defer the gain and recognize it over the life of the operating lease. Notes (b) A modification to a capital lease that changes the classification of the lease to an operating lease requires the transaction be accounted for as a sales-leaseback transaction. Since Hopper retains substantially all rights to use the property (and the property is not within the last 25% of its useful life), the gain will be deferred and recognized over the remaining lease term.

5. On January 1, year 1, Glen Co. leased a building to Dix Corp. under an operating lease for a ten-year term at an annual rental of $50,000. At inception of the lease, Glen received $200,000 covering the first two 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 two 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? I. Current liability II. Long-term liability a. I. $0 ; II. $200,000 b. I. $50,000 ; II. $100,000 c. I. $100,000 ; II. $100,000 d. I. $100,000 ; II. $50,000

Correct Answer: B) I. $50,000 ; II. $100,000 Notes (b) 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 two years' rent.

21. Peg Co. leased equipment from Howe Corp. on July 1, year 1 for an eight-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 Peg and Howe is 10%. The cash selling price of the equipment is $3,520,000, and the cost of the equipment on Howe's accounting records is $2,800,000. The lease is appropriately recorded as a sales-type lease. What is the amount of profit on the sale and interest revenue that Howe should record for the year ended December 31, year 1? I. Profit on sale II. Interest revenue a. I. $720,000 ; II. $176,000 b. I. $720,000 ; II. $146,000 c. I. $45,000 ; II. $176,000 d. I. $45,000 ; II. $146,000

Correct Answer: B) I. $720,000 ; II. $146,000 Notes (b) This is a sales-type lease, so at the inception of the lease, the lessor would recognize sales of $3,520,000 and cost of goods sold of $2,800,000, resulting in a profit on sale of $720,000. In addition, interest revenue is recognized for the period July 1, year 1, to December 31, year 1. The initial net lease payments receivable on 7/1/Y1 is $3,520,000. The first rental payment received on 7/1/Y1 consists entirely of principal, reducing the net receivable to $2,920,000 ($3,520,000 - $600,000). Therefore, year 1 interest revenue for the six months from 7/1/Y1 to 12/31/Y1 is $146,000 ($2,920,000 × 10% × 6/12).

25. Lease M does not contain a bargain purchase option, but the lease term is equal to 90% of the estimated economic life of the leased property. Lease P does not transfer ownership of the property to the lessee at the end of the lease term, but the lease term is equal to 75% of the estimated economic life of the leased property. How should the lessee classify these leases? I. Lease M II. Lease P a. I. Capital lease ; II. Operating lease b. I. Capital lease ; II. Capital lease c. I. Operating lease ; II. Capital lease d. I. Operating lease ; II. Operating lease

Correct Answer: B) I. Capital lease ; II. Capital lease Notes (b) If any of the criteria for classification as a capital lease are met, the lease is classified as such. One of the capital lease criterion is that the lease term is equal to 75% or more of the estimated economic life of the leased property. Thus, both leases M and P should be classified as capital leases.

17. 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? I. Building II. Leasehold improvements a. Both I and II b. II only c. I only d. Neither I nor II

Correct Answer: B) II only Notes (b) A lease should be classified as a capital lease by the lessee if the lease terms meet any one of the following four criteria: (1) the lease transfers ownership of the property to the lessee by the end of the lease term, (2) the lease contains a bargain purchase option, (3) the lease term is greater than or equal to 75% of the economic life of the leased property, or (4) the present value of the minimum lease payments is greater than or equal to 90% of the fair market value of the leased property. In this question, the terms of Vail's lease do not meet any of the four criteria for treatment as a capital lease, so the lease should be accounted for as an operating lease. Vail should therefore not recognize the building as an asset. In an operating lease, the lessee should capitalize the cost of the leasehold improvements, recognizing them as assets, and amortize their cost over the shorter of their useful lives or the term of the lease.

39. A six-year capital lease expiring on December 31 specifies equal minimum annual lease payments. Part of this payment represents interest and part represents a reduction in the net lease liability. The portion of the minimum lease payment in the fifth year applicable to the reduction of the net lease liability should be a. Less than in the fourth year. b. More than in the fourth year. c. The same as in the sixth year. d. More than in the sixth year.

Correct Answer: B) More than in the fourth year. Notes (b) Each minimum lease payment shall be allocated between a reduction of the obligation and interest expense so as to produce a constant periodic rate of interest on the remaining balance of the obligation. Since the interest will be computed based upon a declining obligation balance, the interest component of each payment will also be declining. The result will be a relatively larger portion of the minimum lease payment allocated to the reduction of the lease obligation in the latter portion of the lease term.

2. Wall Co. leased office premises to Fox, Inc. for a five-year term beginning January 2, year 1. Under the terms of the operating lease, rent for the first year is $8,000 and rent for years two through five is $12,500 per annum. However, as an inducement to enter the lease, Wall granted Fox the first six months of the lease rent-free. In its December 31, year 1 income statement, what amount should Wall report as rental income? a. $12,000 b. $11,600 c. $10,800 d. $8,000

Correct Answer: C) $10,800 Notes (c) Rental revenue on operating leases should be recognized on a straight-line basis unless another method more reasonably reflects the pattern of use given by the lessor. When the pattern of cash flows under the lease agreement is other than straight-line, this will result in the recording of rent receivable or unearned rent. Wall's total rent revenue [(1/2 × $8,000) + (4 × $12,500) = $54,000] should be recognized on a straight-line basis over the five-year lease term ($54,000 × 1/5 = $10,800). Since cash collected in year 1 is only $4,000 (one-half of $8,000, since the first six months are rent-free), Wall would accrue rent receivable and rental revenue of $6,800 ($10,800 - $4,000) at year-end to bring the rental revenue up to $10,800.

1. Rapp Co. leased a new machine to Lake Co. on January 1, year 1. The lease is an operating lease and expires on January 1, year 6. The annual rental is $90,000. Additionally, on January 1, year 1, Lake paid $50,000 to Rapp as a lease bonus and $25,000 as a security deposit to be refunded upon expiration of the lease. In Rapp's year 1 income statement, the amount of rental revenue should be a. $140,000 b. $125,000 c. $100,000 d. $90,000

Correct Answer: C) $100,000 Notes (c) In an operating lease, the lessor should recognize rental revenue on a straight-line basis. This means that the lease bonus ($50,000) should be recorded as unearned revenue on 1/1/Y1, and recognized as rental revenue over the five-year lease term. Therefore, year 1 rental revenue should be $100,000 [$90,000 + ($50,000 ÷ 5)]. The security deposit ($25,000) does not affect rental revenue. Since it is to be refunded to the lessee upon expiration of the lease, it is recorded as a deposit, a long-term liability when received.

9. On January 1, year 1, Park Co. signed a ten-year operating lease for office space at $96,000 per year. The lease included a provision for additional rent of 5% of annual company sales in excess of $500,000. Park's sales for the year ended December 31, year 1, were $600,000. Upon execution of the lease, Park paid $24,000 as a bonus for the lease. Park's rent expense for the year ended December 31, year 1, is a. $98,400 b. $101,000 c. $103,400 d. $125,000

Correct Answer: C) $103,400

14. Star Co. leases a building for its product showroom. The ten-year nonrenewable lease will expire on December 31, year 11. In January year 6, 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, year 6 balance sheet? a. $45,600 b. $45,000 c. $44,000 d. $43,200

Correct Answer: C) $44,000 Notes (c) Leasehold improvements are capitalized and amortized over the shorter of the remaining life of the lease (six years from 1/1/Y6 to 12/31/Y11) or the useful life of the improvements (eight years). Therefore, the $48,000 cost is amortized over six years, resulting in annual amortization of $8,000 ($48,000 ÷ 6). For the period 1/1/Y6 to 6/30/Y6, amortization is $4,000 ($8,000 × 6/12), so the 6/30/Y6 net amount for leasehold improvements is $44,000 ($48,000 - $4,000).

45. On January 1, year 1, West Co. entered into a ten-year lease for a manufacturing plant. The annual minimum lease payments are $100,000. In the notes to the December 31, year 2 financial statements, what amounts of subsequent years' lease payments should be disclosed? I. Amount for appropriate required period II. Aggregate amount for the lease term a. I. $100,000 ; II. $0 b. I. $300,000 ; II. $500,000 c. I. $500,000 ; II. $800,000 d. I. $500,000 ; II. $0

Correct Answer: C) I. $500,000 ; II. $800,000 Notes (c) The future minimum lease payments (MLP) for each of the next five years and the aggregate amount of MLP for the lease term must be disclosed. At 12/31/Y2, eight annual payments of $100,000 each have not yet been paid. Therefore, future MLP are $800,000 (8 × $100,000). The amount for the appropriate required period (five years) is $500,000 ($100,000 per year for 5 years).

38. A six-year capital lease entered into on December 31, year 1, specified equal minimum annual lease payments due on December 31 of each year. The first minimum annual lease payment, paid on December 31, year 1, consists of which of the following? I. Interest expense II. Lease liability a. Both I and II b. I only c. II only d. Neither I nor II

Correct Answer: C) II only Notes (c) In a capital lease where the first annual lease payment is made immediately upon signing the lease (annuity due), the first payment consists solely of lease liability reduction, since no time has transpired during which interest expense could be incurred. Subsequent payments include both interest expense and reduction of the liability.

23. The excess of the fair value of leased property at the inception of the lease over its cost or carrying amount should be classified by the lessor as a. Unearned income from a sales-type lease. b. Unearned income from a direct-financing lease. c. Manufacturer's or dealer's profit from a sales-type lease. d. Manufacturer's or dealer's profit from a direct-financing lease.

Correct Answer: C) Manufacturer's or dealer's profit from a sales-type lease. Notes (c) The excess of the fair value of leased property at the inception of the lease over the lessor's cost is defined as the manufacturer's or dealer's profit. Answer (a) is incorrect because the unearned income from a sales-type lease is defined as the difference between the gross investment in the lease and the sum of the present values of the components of the gross investment. Answer (b) is incorrect because the unearned income from a direct-financing lease is defined as the excess of the gross investment over the cost (also the PV of lease payments) of the leased property. Answer (d) is incorrect because a sales-type lease involves a manufacturer's or dealer's profit while a direct financing lease does not.

56. On January 1, year 1, Belkor entered into a 10-year capital lease for equipment. On December 1, year 4, Belkor terminates the capital lease and incurs a $20,000 loss. How should Belkor recognize the lease termination on their financial statements? a. Recognize a $20,000 loss in year 4 as a discontinued operation. b. Recognize a $20,000 loss in year 4 as an extraordinary item. c. Recognize a $20,000 loss from continuing operations in year 4. d. Defer recognition of the loss and recognize pro rata over the life of the lease term.

Correct Answer: C) Recognize a $20,000 loss from continuing operations in year 4. Notes (c) A loss on a capital lease termination is recognized immediately as a loss from continuing operations.

24. In a lease that is recorded as a sales-type lease by the lessor, interest revenue a. Should be recognized in full as revenue at the lease's inception. b. Should be recognized over the period of the lease using the straight-line method. c. Should be recognized over the period of the lease using the interest method. d. Does not arise.

Correct Answer: C) Should be recognized over the period of the lease using the interest method. Notes (c) Revenue is to be recognized for a sales-type lease over the lease term so as to produce a constant rate of return on the net investment in the lease. This requires the use of the interest method. Interest revenue does arise in a salestype lease. Answer (a) is incorrect because the interest is to be earned over the life of the lease, not in full at the lease's inception.

58. Santiago 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 Santiago. The life of the building is estimated to be 20 years. Santiago prepares its financial statements in accordance with IFRS. How should Santiago account for the lease? a. The lease is recorded as a finance lease. b. The lease is recorded as an operating lease. c. The land is recorded as an operating lease, and the building is recorded as a finance lease. d. The land is recorded as a finance lease, and the building is recorded as an operating lease.

Correct Answer: C) The land is recorded as an operating lease, and the building is recorded as a finance lease. Notes (c) The requirement is to identify how Santiago should account for the lease. Answer (c) is correct because 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.

15. On January 2, year 1, Ral Co. leased land and building from an unrelated lessor for a ten-year term. The lease has a renewal option for an additional ten years, but Ral has not reached a decision with regard to the renewal option. In early January of year 1, Ral completed the following improvements to the property: Sales Office Estimated Life: 10 Years Cost: $47,000 Warehouse Estimated Life: 25 Years Cost: $75,000 Parking Lot Estimated Life: 15 Years Cost: $18,000 Amortization of leasehold improvements for year 1 should be a. $7,000 b. $8,900 c. $12,200 d. $14,000

Correct Answer: D) $14,000 Notes (d) Leasehold improvements are properly capitalized and amortized over the shorter of the remaining life of the lease or the useful life of the improvement. If the lease contains an option to renew and the likelihood of renewal is uncertain (as it is in this case), then the remaining life of the lease is based on the initial lease term. In this case, the remaining life of the lease is therefore ten years. Since the estimated lives of all improvements in this case are greater than or equal to ten years, the appropriate amortization period is ten years. The year 1 amortization is thus computed as the total cost of $140,000 ($47,000 + $75,000 + $18,000 = $140,000), divided by ten years, or $14,000. There is no salvage value for leasehold improvements, because the assets revert to the lessor at the end of the lease term. Note that if the renewal of the lease for an additional ten years were considered a certainty, the amortization periods would be as follows: ten years for the sales office (estimated life); twenty years for the warehouse (lease term); and fifteen years for the parking lot (estimated life).

34. On December 31, year 1, Roe Co. leased a machine from Colt for a five-year period. Equal annual payments under the lease are $105,000 (including $5,000 annual executory costs) and are due on December 31 of each year. The first payment was made on December 31, year 1, and the second payment was made on December 31, year 2. The five lease payments are discounted at 10% over the lease term. The present value of minimum lease payments at the inception of the lease and before the first annual payment was $417,000. The lease is appropriately accounted for as a capital lease by Roe. In its December 31, year 2 balance sheet, Roe should report a lease liability of a. $317,000 b. $315,000 c. $285,300 d. $248,700

Correct Answer: D) $248,700 Notes (d) The initial lease liability at 12/31/Y1 is $417,000 (the PV of the minimum lease payments). The annual executory costs ($5,000) are not an expense or liability until incurred; therefore, they are excluded from the minimum lease payments and are not reflected in the initial lease liability. The 12/31/Y1 payment of $105,000 includes $5,000 of executory costs; the remainder ($100,000) is entirely principal since the payment was made at the inception of the lease. Therefore, after the 12/31/Y1 payment, the lease liability is $317,000 ($417,000 - $100,000). The 12/31/Y2 payment consists of executory costs ($5,000), interest incurred during year 2 ($317,000 × 10% = $31,700), and reduction of principal ($105,000 - $5,000 - $31,700 = $68,300). Therefore, the 12/31/Y2 balance sheet should include a lease liability of $248,700 ($317,000 - $68,300).

42. On January 2, year 1, Nori Mining Co. (lessee) entered into a five-year lease for drilling equipment. Nori accounted for the acquisition as a capital lease for $240,000, which includes a $10,000 bargain purchase option. At the end of the lease, Nori expects to exercise the bargain purchase option. Nori estimates that the equipment's fair value will be $20,000 at the end of its eight-year life. Nori regularly uses straightline depreciation on similar equipment. For the year ended December 31, year 1, what amount should Nori recognize as depreciation expense on the leased asset? a. $48,000 b. $46,000 c. $30,000 d. $27,500

Correct Answer: D) $27,500 Notes (d) A leased asset acquired in a capital lease should be depreciated over the period of time the lessee expects to use the asset (either the lease term or the useful life, depending on the situation). In this case, Nori expects to use the leased asset for its entire eight-year useful life, due to the expected exercise of the bargain purchase option at the end of the five-year lease term. Therefore, Nori's year 1 depreciation expense is $27,500

53. 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 a. Operating income. b. An extraordinary item, net of income tax. c. A separate component of stockholders' equity. d. An asset valuation allowance.

Correct Answer: D) An asset valuation allowance. Notes (d) In a sale-leaseback transaction, if the leaseback is recorded as a capital lease and the lessee has retained substantially all of the rights to use the property, then any gain on the sale must be deferred and amortized over the life of the property in proportion to the amortization of the leased asset. This deferred gain acts as an asset valuation allowance resulting in the net amount shown for the leased asset being equal to the same carrying value as if the sale and leaseback transaction had not occurred.

36. For a capital lease, the amount recorded initially by the lessee as a liability should normally a. Exceed the total of the minimum lease payments. b. Exceed the present value of the minimum lease payments at the beginning of the lease. c. Equal the total of the minimum lease payments. d. Equal the present value of the minimum lease payments at the beginning of the lease.

Correct Answer: D) Equal the present value of the minimum lease payments at the beginning of the lease. Notes (d) If a lease is classified as a capital lease, the lessee must record an asset and a liability, each for an amount equal to the present value of the minimum lease payments at the beginning of the lease.

20. On January 1, year 1, JCK Co. signed a contract for an eight-year lease of its equipment with a ten-year life. The present value of the sixteen 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? I. Year 2 revenues recognized II. Year 2 amount recognized compared to year 1 a. I. Rent ; II. The same b. I. Rent ; II. Smaller c. I. Interest ; II. The same d. I. Interest ; II. Smaller

Correct Answer: D) I. Interest ; II. Smaller Notes (d) 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:

59. Which of the following is not true regarding lease accounting under IFRS? a. Lease payments under operating leases are recognized on a straight-line basis over the life of the lease. b. Leases are classified as either operating or finance leases by both the lessee and the lessor. c. For a finance lease, the asset is removed from the lessor's balance sheet. d. IFRS uses the same thresholds as US GAAP to determine if a lease is an operating lease or a finance lease.

Correct Answer: D) IFRS uses the same thresholds as US GAAP to determine if a lease is an operating lease or a finance lease. Notes (d) The requirement is to identify the incorrect statement regarding lease accounting under IFRS. Answer (d) is correct because IFRS does not use the same thresholds as US GAAP. IFRS standards require more judgment.

12. A twenty-year property lease, classified as an operating lease, provides for a 10% increase in annual payments every five years. In the sixth year compared to the fifth year, the lease will cause the following expenses to increase I. Rent II. Interest a. II only b. I only c. Both I and II d. Neither I nor II

Correct Answer: D) Neither I nor II Notes (d) When a leasing agreement is accounted for as an operating lease, the lessor and the lessee recognize rental revenue and rental expense respectively on a straight-line basis unless another systematic and rational basis more clearly reflects the time pattern in which use benefit is given (received) by the respective parties. The straight-lining of uneven lease payments includes scheduled rent increases. Even though the amount of the annual lease payment increases in year six, rental expense would not change. Interest is not an element of revenue (expense) in operating leases.

6. As an inducement to enter a lease, Graf Co., a lessor, granted Zep, Inc., a lessee, twelve months of free rent under a five-year operating lease. The lease was effective on January 1, year 1, and provides for monthly rental payments to begin January 1, year 2. Zep made the first rental payment on December 30, year 1. In its year 1 income statement, Graf should report rental revenue in an amount equal to a. Zero. b. Cash received during year 1. c. One-fourth of the total cash to be received over the life of the lease. d. One-fifth of the total cash to be received over the life of the lease.

Correct Answer: D) One-fifth of the total cash to be received over the life of the lease. Notes (d) Rental revenue on operating leases should be recognized on a straight-line basis unless another method more reasonably reflects the pattern of use given by the lessor. When the pattern of cash flows under the lease agreement is other than straight-line, this will result in the recording of rent receivable or unearned rent. Therefore, even though Graf received only one monthly payment in year 1 (1/48 of the total rent to received over the life of the lease), they would accrue as rent receivable and rent revenue an amount sufficient to increase the rent revenue account to a balance equal to one-fifth of the total cash to be received over the five-year life of the lease.

60. Under IFRS what is the interest rate used by lessees to capitalize a finance lease when the implicit rate cannot be determined? a. The prime rate. b. The lessor's published rate. c. The lessee's average borrowing rate. d. The lessee's incremental borrowing rate.

Correct Answer: D) The lessee's incremental borrowing rate. Notes (d) The requirement is to identify the rate used to capitalize a finance lease when the implicit rate cannot be determined. Answer (d) is correct because the lessee's incremental borrowing rate is used.