ACCT 400C Chapter 15 - Leases

Why do sellers use leases, economically?

They are arrangements that sellers can use to help customers buy their product.

What are the two types of lease classifications?

1.) Finance (lessee); Sales-type (lessor) 2.) Operating Lease

What is a Lease?

A lease is a contractual arrangement giving the lessee the right to use the lessor's asset in exchange for payments. Property, buildings and vehicles are common assets that are leased. A contract between two parties: the lessor and the lessee.

Finance Vs Operating Lease Graph

Int Exp = same for both Amortization Exp = constant (finance) increasing (operating) Total Exp = decreasing (finance) constant (operating)

******Need JEs

JE:

Match each lease with its description.

Operating: Rights and responsibilities of ownership are retained by the lessor. Finance or sales-type: Rights and responsibilities of ownership are transferred to the lessee.

Which method should normally be used to amortize the right-of-use asset?

Straight-line

Periods covered by renewal options

are not included in the lease term if a bargain purchase option is present.

Depending on the nature of the leasing arrangement, a lease is accounted for

as a rental or a purchase/sale.

Which of the following would a lessor not record in connection with a lease? a. Lease revenue. b. Lease receivable. c. Interest revenue. d. Right-of-use asset.

d. Right-of-use asset.

In a typical finance lease, the first lease payment at the beginning of the lease consists of

reduction in principal only

The journal entry to record the lessee's payment on a short-term lease under the shortcut method will include a debit to

rent expense. ***Full entry?

In an operating lease, the lessor

rents the asset to the lessee for a period of time.

What are the 5 reasons to lease?

1.) Less UPFRONT CASH to use asset. 2.) Lease payments are LOWER than installment payments. Ex: Installment payments to buy an asset are based on FULL FAIR VALUE. Lease payments only tied to PORTION of asset's fair value expected to decline over the lease period. 3.) Flexibility + LOWER COST when DISPOSING asset. 4.) Leasing PROTECTS the lessee against the risk of declining asset values. 5.) Leasing might offer TAX ADVANTAGES to lessee. Little to no taxable income that do not benefit from depreciation deductions but can still negotiate lower lease payments.

Leasing has become the number one method of external financing by U.S. Companies. Reasons Include each of the following EXCEPT: Tax advantages. Extended use of the asset. Protection against obsolescence. Lower upfront cash needed to use an asset.

Extended use of the asset.

What happens when a company (i.e., the lessee) reports a lease?

The right to use the asset for a period of time is recorded as a "RIGHT-OF-USE" asset in the BALANCE SHEET. The obligation to make PAYMENTS over the period is recorded as a LEASE LIABILITY.

The primary motivation for the new accounting guidance on leases was to

deter the use of off-balance-sheet financing.

If the lease payments have a total value that represents "substantially all" of the asset's fair value, it is logical to identify the contract as ____________.

equivalent to a sale.

The accounting for finance leases is similar to the purchase of an asset using an _____________note.

installment

After the first lease payment, each lease payment in a finance lease consists of an amount representing

interest and a reduction in the principal

In a(n) _____ lease, recording lease expense should reflect straight line rental of the asset during the lease term.

operating

The two basic lease classifications by a lessor are

operating and sales-type.

Selling profit exists in a sales-type lease when the

present value of the lease payments is greater than the cost of the asset.

Which of the following is not a sufficient criterion for a lessee to classify a lease as a finance lease? a. The lease transfers ownership of the leased asset to the lessee at the end of the lease term. b. The lessee has the option of acquiring the asset during or at the end of the lease term at a bargain price. c. The lease term is greater than two-thirds of the economic life of the asset. d. The present value of the lease payments is substantially all of the fair value of the leased asset.

c. The lease term is greater than two-thirds of the economic life of the asset.

Mill's Tread Industries leased exercise equipment to Jim's Gyms on July 1, 2021. The lease does not meet the criteria for classification as a finance lease. The lease agreement specifies four annual payments of $80,000 beginning on July 1, 2021. The present value of those payments at a discount rate of 10% is $278,948. Which of the following is true regarding the entries made on July 1, 2021? OPERATING LEASE ISSUE DATE JE: a. Jim's Gyms records a debit to rent expense for $278,948. b. Mill's Tread records a credit to exercise equipment for $278,948. c. Jim's Gyms records a credit to lease payable for $80,000. d. Mill's Tread records a debit to cash for $80,000.

d. Mill's Tread records a debit to cash for $80,000. July 1, 2021: LESSEE DR. Right-of-use asset $278,948 CR. Lease payable for $278,948. DR. Lease payable $80,000. CR. Cash $80,000 July 1, 2021: LESSOR DR. Cash $80,000. CR. Deferred lease revenue $80,000.

Other things being equal, the ADVANTAGE of a lease being classified as an OPERATING lease rather than as a finance lease is:

An operating lease results in a LOWER total lease EXPENSE in the EARLIER years of the lease term.

Which of the following type of leases follows the same accounting method as that of an installment purchase?

Finance lease

Which of the following are possible reasons for leasing an asset rather than purchasing an asset? (Select all that apply)

No additional fees Avoiding the risk of decreasing selling prices Tax benefits Lower periodic payments on the asset Higher debt to asset ratios

On January 1, 20X1, Tucker Company leases equipment from Franz Inc. over three years of the equipment's five-year estimated useful life. Franz acquired the asset for $431,213 and normally utilizes an 8% interest rate for these types of transactions. The present value of the lease payments is $357,710. The annual lease payment is $100,000; the first payment is due on January 1, 20X1. Tucker should recognize the first lease payment by (Select all that apply)

debiting lease payable for $100,000 crediting cash for $100,000

The lessee records an asset and liability for operating leases under

new GAAP only.

Norma Manufacturing Company leases an asset to Maren Inc in a sales-type lease. The present value of the lease payments is $200,000 and the cost of the leased asset is $160,000. At the beginning of the four-year lease term, Norma should recognize a profit of:

$40,000

What are the 5 criteria that make a Finance/Sales-Type Lease?

1.) OWNERSHIP of asset transfers to the lessee. 2.) Contains (BPO) that the lessee is reasonably certain to exercise. 3.) The lease TERM is for the "major part" (i.e., 75% or more) of the assets remaining economic life. 4.) The PRESENT VALUE of PAYMENTS equals or exceeds "substantially all" (i.e., 90% or more) of the FAIR VALUE. 5.) Asset has SPECIALIZED NATURE that has NO ALTERNATIVE USE to the lessor at the end of the lease term.

T or F: The implicit rate is the desired rate of return of the lessor.

True Implicit rate = The effective interest rate of return the lease payments provide the lessor

(START OF SB QUESTIONS) In which of the following ways can a lease be accounted for? (Select all that apply.) As a rental agreement. As a purchase/sale agreement with equity financing. As an estate gift. As a purchase/sale agreement with debt financing.

As a rental agreement. As a purchase/sale agreement with debt financing.

The beginning of a six-year finance lease is December 31, 2021. The agreement specifies equal annual lease payments on December 31 of each year. For the lessee, the first payment on December 31, 2021, includes:

No Interest Expense, Yes Reduction of Lease Liability

At the beginning of its fiscal year, Lakeside Inc. leased office space to LTT Corporation under a seven-year operating lease agreement. The contract calls for quarterly rent payments of $25,000 each. The office building was acquired by Lakeside at a cost of $2 million and was expected to have a useful life of 25 years with no residual value. What will be the effect of the lease on LTT's earnings for the first year (ignore taxes)?

Reduced by 100,000 (4 x 25k)

Corinth Co. leased non-specialized equipment to Athens Corporation for an eight-year period, at which time possession of the equipment will revert back to Corinth. The equipment cost Corinth $16 million and has an expected useful life of 12 years. Its normal sales price is $22.4 million. The present value of the lease payments for both the lessor and lessee is $20.6 million. The first payment was made at the beginning of the lease. What is the lease classified as?

Sales-Type with selling profit 1.) 20.6/22.4 = 90+% 2.) Payments (20.6) > COGS (16) = w/ Profit

True or false: When a bargain purchase option exists, a renewal option is considered irrelevant because it is assumed that the purchase option will be exercised.

True

OPERATING LEASE EXAMPLE Karla Salons leased equipment from SmithCo on January 1, 2021, in an 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, beginning January 1, 2021. The amortization of the right-of-use(EE) asset in 2021 would be: FIND OPERATING AMORTIZATION FOR LESSEE. a. $ 5,200. b. $ 6,800. c. $ 8,000. d. $12,000.

a. $ 5,200. 1.) Interest Expense = Discount% x PV-PMT x months left 10% x 80,000-12,000 x 1 = 6,800 2.) Amortization = PMT - Int Exp. 12,000 - 6,800 = 5,200

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. A lease term of 24 months with a bargain purchase option exercisable at 18 months.

a. A lease term of 6 months with an option to renew for an additional 6 months. To use the shortcut method, the following criteria must be met: 1) Has a lease term (including any options to renew or extend) of twelve months or less; AND 2) Does not contain a purchase option that the lessee is reasonably certain to exercise, which would extend the term beyond twelve months.

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? FIND INTEREST EXPENSE a. $2,025,000 b. $1,725,000 c. $1,650,000 d. $0

b. $1,725,000 1.) Interest Expense = Discount% x PV-PMT x months left 10% x (40.5-6) x (6/12) = 1,725,000 2.) Amortization Expense: N/A 3.) Increase / Decrease Earnings: N/A

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) in HPB's Dec. 31, 2021, income statement would be: FIND DECREASE IN EARNINGS. (LESSEE = S/L for amortization). a. $5,000. b. $7,400. c. $8,400. d. $9,000.

b. $7,400. 1.) Interest Expense = Discount% x PV-PMT x months left 10% x 80,000-12,000 x (6/12) = 3400 2.) Amortization Expense (S/L) = (PV / # Payments) x (months left) (80000/10) x (6/12) = 4000 3.) Increase/Decrease Earnings = 3400 + 4000 = 7,400

Under a sales-type lease, the lessor reports cash receipts on the statement of cash flows as part of: a. Financing activities b. Operating activities c. Investing activities d. Noncash investing and financing activities

b. Operating activities Under a sales-type lease, we assume that the lessor is actually selling a product. Therefore, the receipts are included as part of operating activities.

LeaseCo Industries leased equipment to UserCorp. on July 1, 2021. LeaseCo recorded the lease as a sales-type lease at $810,000, the present value of lease payments discounted at 10%. The lease called for ten annual lease payments of $120,000 due each July 1. The first payment was received on July 1, 2021. LeaseCo had manufactured the equipment at a cost of $750,000. The total increase in earnings (pretax) on LeaseCo's December 31, 2021, income statement would be: FIND INCREASE IN EARNINGS. (LESSOR, FIND SELLING PROFIT). a. $ 0 b. $ 93,000 c. $ 94,500 d. $100,500

c. $ 94,500 1.) Interest Revenue = Discount% x PV-PMT x months left 10% x 810,000-120,000 x (6/12) = 34500 2.) Selling Profit = PV - COGS 810,000 - 750,000 = 60,000 3.) Increase/Decrease Earnings = 34500 + 60000 = 94500

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: BALANCE OF RIGHT-OF-USE ASSET: a. $115,180. b. $121,662. c. $126,698. d.$135,180.

c. $126,698. 1.) Interest Expense = Discount% x PV-PMT x months left 10% x 135,180-20000 x 1 = 11,518 2.) Amortization = PMT - Int Exp. (20,000-11,518) = 8,482 3.) Ending Balance = PV - Amortize 135,180 - 8,482 = 126,698

On January 1, 2021, Hy Marx Tutoring leased non-specialized machinery under a 6-year lease. As of January 1, 2021 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 equipment's 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. Lease expense equal to the 2021 lease payments This lease does not meet any of the five criteria necessary for treatment as a finance lease. Thus, the lessee amortizes the asset in the amount needed for the TOTAL LEASE EXPENSE

Which of the following leases would least likely be classified as an operating lease by the lessee? a. The lease term is 5 years and the economic life of the leased asset is 8 years. b. Ownership of the leased asset reverts to the lessor at the end of the lease term. c. The agreement permits the lessee to buy the leased asset for one dollar at the end of the lease term. d. The fair value of the leased asset is $20 million and the present value of the lease payments is $13 million.

c. The agreement permits the lessee to buy the leased asset for one dollar at the end of the lease term.

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.

c. The lease term is 8 years, and the asset's economic life is 9 years.

On January 1, 20X1, Tucker Company leases equipment from Franz Inc. over three years of the equipment's five-year estimated useful life. Franz acquired the asset for $431,213 and normally utilizes an 8% interest rate for these types of transactions. The present value of the lease payments is $357,710. The annual lease payment is $100,000; the first payment is due on January 1, 20X1. Tucker should recognize the second lease payment by debiting (round to the nearest whole dollar and select all that apply)

lease payable for $79,383 interest expense for $20,617 ***Full entry?