FAR SU13

Green Co. was preparing its year-end financial statements. Green had a pending lawsuit against a competitor for $5,000,000 in damages. Green's attorneys indicate that obtaining a favorable judgment was probable and the amount of damages is reasonably estimated. Green incurred $100,000 in legal fees. The income tax rate was 30%. What amount, if any, should Green recognize as a contingency gain in its financial statements?

$0 Gain contingencies are recognized only when realized. A probable favorable judgment and reasonably estimated amount of damages may be disclosed in the notes to the financial statements, but no amount should be recognized as a contingency gain until realized.

As an inducement to enter a lease, Arts, Inc., a lessor, grants Hompson Corp., a lessee, 9 months of free rent under a 5-year operating lease. The lease is effective on July 1, Year 3, and provides for monthly rent payments of $1,000 to begin on April 1, Year 4. In Hompson's income statement for the year ended June 30, Year 4, lease expense should be reported as

$10,200 In an operating lease, a single (equal) lease expense is recognized each period. It is calculated so that the total undiscounted lease payments are allocated over the lease term on a straight-line basis. The total lease payments for this operating lease are $51,000 [$1,000 monthly rent × (60 total months in the lease term - 9 months' free rent)]. Allocating this $51,000 on the straight-line basis to the 5 years of the operating lease results in lease expense of $10,200 ($51,000 ÷ 5 years) per year.

Wall Co. leased office premises to Fox, Inc., for a 5-year term beginning January 2, Year 4. Under the terms of the operating lease, rent for the first year is $8,000 and rent for years 2 through 5 is $12,500 per annum. However, as an inducement to enter the lease, Wall granted Fox the first 6 months of the lease rent-free. In its December 31, Year 4, income statement, what amount should Wall report as rental income?

$10,800 For an operating lease, lease payments are recognized as rental income by the lessor. If rental payments vary from a straight-line basis, rental income should be recognized over the full lease term on a straight-line basis. Thus, an equal amount of rental income is recognized each period over the lease term. Wall therefore should report rental revenue of $10,800 {[$8,000 - ($8,000 × .5) + ($12,500 × 4)] ÷ 5 years}.

A company has an operating lease for its office space. The lease term is 120 months and requires monthly rent of $15,000. As an incentive for the company to enter into the lease, the lessor granted the first 8 months' lease at no cost. What amount of monthly lease expense should be recognized over the life of the lease?

$14,000 Under an operating lease, lease expense must be recognized on the straight-line basis. Thus, a single (equal) amount of lease expense is recognized in each period. It is calculated as total undiscounted lease payments divided by the lease term. In this situation, the total lease payment of $1,680,000 ($15,000 monthly lease payment × 112 months) must be expensed over the full lease term of 120 months. Thus, monthly lease expense is $14,000 ($1,680,000 ÷ 120).

Steam Co. acquired equipment under a finance lease for 6 years. Minimum lease payments were $60,000 payable annually at year end. The interest rate was 5% with an annuity factor for 6 years of 5.0757. The present value of the payments was equal to the fair market value of the equipment. What amount should Steam report as interest expense at the end of the first year of the lease?

$15,227 A lease payment has two components: interest expense and the portion applied to the reduction of the lease liability. The effective-interest method requires that the carrying amount of the liability at the beginning of each interest period be multiplied by the appropriate interest rate to determine the interest expense. The difference between the minimum lease payment and the interest expense is the amount of reduction in the carrying amount of the lease liability. The carrying amount at the beginning of the period was $304,542 ($60,000 × 5.0757 PV of an ordinary annuity for 6 periods at 5%). Under the effective-interest method, the lessee's interest expense at the end of the first year is $15,227 ($304,542 × 5%).

On December 30, Year 3, Ames Co. leased equipment under a finance lease for 10 years. It contracted to pay $40,000 annual rent on December 31, Year 3, and on December 31 of each of the next 9 years. The lease liability was recorded at $270,000 on December 30, Year 3, before the first payment. The equipment's useful life is 12 years, and the interest rate implicit in the lease is 10%. In recording the December 31, Year 4, payment, by what amount should Ames reduce the lease liability?

$17,000 A lease payment has two components: interest expense and the portion applied to the reduction of the lease liability. The effective-interest method requires that the carrying amount of the liability at the beginning of each interest period be multiplied by the appropriate interest rate to determine the interest expense. The difference between the lease payment and the interest expense is the amount of reduction in the carrying amount of the lease liability. The carrying amount at the beginning of the period was $230,000 ($270,000 - $40,000 annual rent), and the interest expense is $23,000 ($230,000 × 10%). Thus, the reduction in the lease liability is $17,000 ($40,000 - $23,000).

Winn Co. manufactures equipment that is sold or leased. On December 31, Year 4, Winn leased equipment to Bart for a 5-year period ending December 31, Year 9, at which date ownership of the leased asset will be transferred to Bart. Equal payments under the lease are $22,000 and are due on December 31 of each year. The first payment was made on December 31, Year 4. The normal sales price of the equipment is $77,000, and cost is $60,000. For the year ended December 31, Year 4, what amount of selling profit should Winn realize from the lease transaction?

$17,000 Ownership of the leased equipment transfers to the lessee at the end of the lease term. Accordingly, one of the five criteria to classify the lease as a sales-type lease by the lessor is satisfied. Given no residual value or initial direct costs, selling profit for a sales-type lease is recognized for the excess of the fair value of the leased equipment over its carrying amount. Thus, a selling profit of $17,000 ($77,000 - $60,000) is recognized by Winn.

Conn Corp. owns an office building and normally charges tenants $30 per square foot per year for office space. Because the occupancy rate is low, Conn agreed to lease 10,000 square feet to Hanson Co. at $12 per square foot for the first year of a 3-year operating lease. Rent for remaining years will be at the $30 rate. Hanson moved into the building on January 1, Year 1, and paid the first year's rent in advance. What amount of rental revenue should Conn report from Hanson in its income statement for the year ended September 30, Year 1?

$180,000 In an operating lease, when payments differ from year to year, revenue is recognized by allocating the total amount of revenue to be received evenly over the lease term. At 9/30/Year 1, the amount of revenue to be recognized is for 9 months. Thus, rent revenue is $180,000 {[$10,000 square feet × ($12 + $30 + $30)] × (9 ÷ 36)}.

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, the company must pay $28,900 per month for 56 months beginning October 1 of the current year. The lease term spans 5 years. The company has a calendar year end. What amount is the company's lease expense for the current calendar year?

$188,813 n an operating lease, a single (equal) lease expense is recognized by the lessee in each period. It is calculated so that the total undiscounted lease payments are allocated over the lease term on a straight-line basis. The total cost of the lease is $1,618,400 ($28,900 × 56 months), and the lease term is 60 months. Thus, the monthly expense is $26,973.33 ($1,618,400 ÷ 60 months). Because the lease begins on June 1, it is in effect for 7 months, and the lease expense for the current calendar year is $188,813 ($26,973.33 × 7 months).

Neary Company has entered into a contract to lease computers from Baldwin Company starting on January 1, Year 1. Relevant information pertaining to the lease is provided below . Lease term 4 Years Useful life of computers 5 Years Present value of future lease payments $100,000 Fair value of leased asset on date of lease 105,000 Baldwin's implicit rate (known to Neary) 10% At the end of the lease term, ownership of the asset transfers from Baldwin to Neary. What is the annual amortization expense that Neary will record on the right-of-use asset?

$20,000 This lease is classified as a finance lease because the leased asset is transferred to Neary at the end of the lease term. The lease liability and right-of-use (ROU) asset are initially recognized at the present value of the lease payments of $100,000. The lessee amortizes the ROU on a straight-line basis. When, at the end of the lease term, (1) the ownership of a leased asset is transferred to the lessee, or (2) the lessee is reasonably certain to exercise a purchase option, the amortization period is the useful life of the leased asset. Thus, annual amortization expense for the ROU asset is $20,000 ($100,000 ÷ 5 years).

Oak Co. leased equipment for 9 years, agreeing to pay $50,000 at the start of the lease term on December 31, Year 4, and $50,000 annually on each December 31 for the next 8 years. The present value on December 31, Year 4, of the nine lease payments over the lease term, using the rate implicit in the lease, was $316,500. Oak knows that this rate is 10%. The December 31, Year 4, present value of the lease payments using Oak's incremental borrowing rate of 12% was $298,500. Oak made a timely second lease payment. The lease was classified as an operating lease by Oak. What amount should Oak report as a lease liability in its December 31, Year 5, balance sheet?

$243,150 For a finance or operating lease, a lessee initially must recognize a lease liability and a right-of-use asset. At the lease commencement date, a lease liability is measured at the present value of the lease payments to be made over the lease term. Subsequent to initial recognition, the lease liability is reduced for the excess of the periodic lease payment over the interest expense recognized during the period. Oak knows the implicit rate. Thus, the present value of the lease payments of this lease is $316,500, the amount based on the lessor's implicit rate. After the initial payment of $50,000, which contains no interest component, is deducted, the carrying amount during Year 5 is $266,500. Accordingly, the interest component of the next payment is $26,650 ($266,500 × 10% implicit rate), and the lease liability on December 31, Year 5, is $243,150 [$266,500 - ($50,000 - $26,650)].

Frisco Corp. (lessee) entered into a 7-year finance lease with Bovine Equipment (lessor) on January 1, Year 2. Lease payments of $47,500 are due annually beginning on December 31, Year 2. The interest rate implicit in the lease of 8% is known to Frisco. Frisco's incremental borrowing rate is 5%. The fair value of the leased asset on the date of the lease is $315,000. The useful life of the equipment is 8 years. 7 years 8 years The present value of an ordinary annuity at 5% 5.7864 6.4632 The present value of an ordinary annuity at 8% 5.2064 5.7466 What amount should Frisco Corp. record for the right-of-use asset on its balance sheet on the lease commencement date?

$247,304 At the lease commencement date, the right-of-use asset is measured at the sum of (1) initial direct costs incurred by the lessee and (2) the present value of the lease payments to be made over the lease term (the lease liability). The lease payments are discounted using the discount rate for the lease. The rate implicit in the lease is used because it is known to the lessee. Otherwise, the lessee's incremental borrowing rate is used. When no initial direct costs are incurred by the lessee, the right-of-use asset equals the lease liability recognized. Given no direct costs, the right-of-use asset equals $247,304 ($47,500 annual lease payment × 5.2064 PV of ordinary annuity at 8%).

On January 1, Rosewater Company leased a computer for 4 years at a monthly rent of $80, payable at the end of each month. Due to the rate of technical change, the computer is expected to become obsolete within 5 years. At the inception of the lease, the computer was retailing for $3,450. Had Rosewater chosen to purchase the computer instead of leasing it, they could have borrowed the funds at 10%. At a 10% interest rate, the present value of the lease payments is $3,154. Rosewater does not know the rate implicit in the lease. For the month of January, Rosewater should report (to the closest dollar) interest expense of

$26 and amortization expense of $66. On January 1, the lease liability and the right-of-use asset are recognized at the present value of lease payments of $3,154. Interest expense will be recognized in the amount of $26 [$3,154 × 10% × (1 ÷ 12 months)]. Rosewater does not know the lessor's implicit rate. Thus, it is appropriate to use Rosewater's incremental borrowing rate to determine whether the lease should be classified as a finance lease. Because the present value of the lease payments is greater than 90% of the fair value of the computer ($3,154 ÷ $3,450 = 91.4%), the lease is appropriately classified as a finance lease. The lease agreement neither provides for transfer of ownership nor contains a purchase option. Accordingly, the right-of-use asset is amortized over the lease term (4 years). Monthly amortization expense will be $66 ($3,154 ÷ 48 months).

Benedict Company leased equipment to Mark, Inc., on January 1, Year 2. The lease is for an 8-year period expiring December 31, Year 9. The first of 8 equal annual payments of $600,000 was made on January 1, Year 2. Benedict had purchased the equipment on December 29, Year 1, for $3,200,000. The lease is appropriately accounted for as a sales-type lease by Benedict. Assume that the present value at January 1, Year 2, of all rent payments over the lease term discounted at a 10% interest rate was $3,520,000. What amount of interest income should Benedict record in Year 3 (the second year of the lease period) as a result of the lease?

$261,200 The net investment in the lease to be recorded by the lessor at 1/1/Year 2 is given as $3,520,000, the present value of the lease payments discounted at 10%. The net investment is immediately reduced by the $600,000 lease payment on 1/1/Year 2, resulting in a carrying amount for Year 2 of $2,920,000. Interest earned for the Year 2 at a rate of 10% ($2,920,000 × 10%) is $292,000. Thus, the $600,000 1/1/Year 3 lease payment consists of the $292,000 interest component and a $308,000 reduction of the net investment. Because the Year 3 net investment balance is $2,612,000 ($2,920,000 - $308,000), interest income for Year 3 is $261,200 ($2,612,000 × 10%).

On January 1, Year 4, Nori Mining Co. (lessee) entered into a 5-year lease for drilling equipment. The present value of the lease payments is $240,000. It includes a $10,000 present value of an option to purchase the equipment at the end of the lease term that Nori is reasonably certain to exercise. Nori estimates that the equipment's fair value will be $20,000 at the end of its 8-year life. Nori regularly uses straight-line amortization for similar equipment. For the year ended December 31, Year 4, what amount should Nori recognize as amortization expense on the right-of-use asset?

$27,500 This lease is classified as a finance lease because it contains a purchase option that the lessee is reasonably certain to exercise. The lease liability and right-of-use (ROU) asset are initially recognized at the present value of the lease payments of $240,000. The lessee amortizes the ROU on a straight-line basis. When, at the end of the lease term, the ownership of the leased asset is transferred to the lessee or the lessee is reasonably certain to exercise the purchase option, the amortization period is the useful life of the leased asset. Thus, Year-4 amortization expense is $27,500 [($240,000 right-of-use asset - $20,000 salvage value) ÷ 8-year economic life].

On January 1, Year 1, Alla Co. sold a property to Mish Co. for $400,000 and simultaneously leased it back for 3 years. The carrying amount of the property was $280,000, and its fair value was $310,000. The leaseback was properly classified as an operating lease. What amount of gain on sale of the property was recognized by Alla on January 1, Year 1?

$30,000 When the leaseback is classified as an operating lease, the initial transfer of the asset to the buyer-lessor can be accounted for as a sale of an asset, assuming all the criteria for revenue recognition were met. When the transaction is at fair value, a gain or loss on sale recognized by the seller-lessee is the difference between the selling price and the carrying amount of the asset. However, this transaction is not at fair value because the sales price of the property is greater than its fair value. Thus, the gain or loss on sale is calculated as the difference between the fair value of the property and its carrying amount. Accordingly, a gain on sale of $30,000 ($310,000 fair value - $280,000 carrying amount) is recognized by Alla on January 1, Year 1.

Summer, Inc., (lessee) entered into an 8-year operating lease on January 1, Year 1. Annual lease payments begin December 31, Year 1. They are $55,000 for Years 1-7 with a final payment in Year 8 of $100,000. The rate implicit in the lease of 8% is known to Summer. The present value of 1 at 8% for 8 years is 0.540. The present value of an ordinary annuity at 8% for 8 years is 5.747. What is the amortization amount of the right-of-use asset in Year 1 for Summer, Inc.?

$33,394 At lease commencement, given no initial direct costs, the lease liability equals the right-of-use asset. Amortization of the right-of-use asset equals the single (equal) lease expense minus the interest expense on the lease liability. The lease expense equals the total undiscounted lease payments divided by the lease term. The lease expense is $60,625 {[($55,000 × 7) + $100,000] ÷ 8 years}. Interest expense equals the carrying amount of the lease liability at the beginning of the period (January 1, Year 1) times the rate implicit in the lease (known to the lessee). Given no initial direct costs, the amounts of the lease liability and right-of-use asset initially are recognized at the present value of the lease rental payments based on the rate implicit in the lease. This amount is $340,385 {($55,000 × 5.747) + [($100,000 - $55,000) × 0.540]}. Year 1 interest expense therefore is $27,231 ($340,385 × 8%), and amortization of the right-of-use asset in Year 1 is $33,394 ($60,625 annual lease expense - $27,231 interest expense).

On January 1 of the current year, Tree Co. enters into a 5-year lease agreement for production equipment. The lease requires Tree to pay $12,500 per year in lease payments. At the end of the 5-year lease term, Tree can purchase the equipment for $30,000. The fair value of the equipment is $75,000. The estimated useful life of the equipment is 10 years. The present value of the lease payments is $50,000. The present value of the purchase option is $20,000. Tree's controller believes the purchase option price is sufficiently below the expected fair value of the equipment at the date the option becomes exercisable to make its exercise reasonably certain. What amount is the carrying value of the asset related to this lease at December 31 of the current year?

$63,000 Tree Co. can purchase the equipment at the end of the lease term. Because Tree is reasonably certain to exercise the purchase option, the lease is classified as a finance lease. On January 1, Tree Co. should record the finance lease as an asset and a liability at the present value of the lease payments, $70,000 ($50,000 + $20,000). When the lease either transfers ownership to the lessee by the end of the lease term or contains a purchase option that the lessee is reasonably certain to exercise, the amortization of the asset is over its entire estimated economic life (i.e., 10 years). Using the straight-line amortization method, the right-of-use asset will be amortized at $7,000 ($70,000 ÷ 10 years) per year. The carrying value of the right-of-use asset on December 31 of the current year should be $63,000 ($70,000 - $7,000).

Robbin, Inc., leased a machine from Ready Leasing Co. The lease requires 10 annual payments of $10,000 beginning immediately. The lease contract specifies the rate implicit in the lease 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. Robbin is reasonably certain to exercise the purchase option. Robbin's incremental borrowing rate is 14%. The present value of an annuity due of 1 at: 12% for 10 years is 6.328 14% for 10 years is 5.946 The present value of 1 at: 12% for 10 years is .322 14% for 10 years is .270 What amount should Robbin record as lease liability at the beginning of the lease term?

$66,500 For a finance or an operating lease, a lessee initially must recognize a lease liability and a right-of-use asset. At the lease commencement date, a lease liability is measured at the present value of the lease payments to be made over the lease term. When the lease includes a purchase option that the lessee is reasonably certain to exercise, the lease is a finance lease. The lease payments therefore consist of rental payments and the exercise price of the purchase option. The discount rate for the lease is the rate implicit in the lease of 12% because it is known by Robbin. Thus, the lease liability is equal to $66,500 [($10,000 × 6.328) + ($10,000 × .322)].

On December 29, Year 1, Action Corp. signed a 7-year lease for an airplane to transport its professional 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 a lease liability in its December 31, Year 1, balance sheet?

$688,500 The lease liability is recorded at the present value of the lease payments. The lease should be recorded at the present value of lease payments discounted at the implicit rate of 9% because this rate is known by the lessee. The amount is $841,500 ($153,000 × 5.5), which then must be reduced by the payment made at the inception of the lease of $153,000. The lease liability therefore should be $688,500 ($841,500 - $153,000) in the December 31, Year 1, balance sheet.

A liability arising from a loss contingency should be recorded if the

Contingent future events will probably occur and the amount of the loss can be reasonably estimated. A material contingent loss must be accrued when the following two conditions are met: It is probable that, at the balance sheet date, an asset has been impaired or a liability has been incurred. The amount of the loss can be reasonably estimated.

Able Co. leased equipment to Baker under a noncancelable lease with a transfer of title. After recognition of the lease, will Able record any depreciation expense on the leased asset and interest revenue related to the lease?

Depreciation Expense = No Interest Revenue = Yes The lease transfers ownership. Accordingly, the lease is recognized as a sales-type lease by the lessor. The leased equipment is derecognized at the lease commencement date. Thus, no depreciation expense on the leased equipment is recognized by Able. In a sales-type lease, subsequent to the lease commencement date, each periodic lease payment received by the lessor includes both interest income and a reduction of the net investment in the lease.

Potter Co. has the following contingencies, all resulting from lawsuits in progress during the current year: Probable loss contingency $1,500,000 Reasonably possible loss contingency 500,000 Probable gain contingency 700,000 Reasonably possible gain contingency 300,000 Potter's accountant believes the financial statements will be misleading if the probable loss contingency is not disclosed. How much should be disclosed, and how much should be accrued in Potter's financial statements for the current year?

Disclosed: $2,000,000 loss $1,000,000 gain Accrued: $1,500,000 loss A material contingent loss must be accrued (debit loss, credit liability) when it is probable that (1) an asset has been impaired or a liability has been incurred and (2) the amount of the loss can be reasonably estimated. Therefore, a probable loss contingency of $1.5 million must be accrued and disclosed (Potter believes that the financial statements will be misleading if it is not disclosed). If one or both conditions to accrue a contingent liability are not met but the probability of the loss is at least reasonably possible, the nature of the contingency must be described. Thus, a reasonably possible loss contingency of $500,000 must be disclosed. Gain contingencies are recognized only when realized. However, a gain contingency must be adequately disclosed in the notes to the financial statements. Therefore, both probable and reasonably possible gains must be disclosed but not accrued. Accordingly, a $2,000,000 ($1,500,000 + $500,000) loss and $1,000,000 ($700,000 + $300,000) gain must be disclosed.

Conlon Co. is the plaintiff in a patent-infringement case. Conlon has a high probability of a favorable outcome and can reasonably estimate the amount of the settlement. What is the proper accounting treatment of the patent infringement case?

Disclosure in the notes only. Under the conservatism restraint, when alternative accounting methods are appropriate, the one having the less favorable effect on net income and total assets is preferable. Thus, a loss, not a gain, contingency may be recorded in the financial statements. If the probability of realization of a gain is high, the contingency is disclosed in the notes.

Lease M does not contain a purchase option, but the present value of the lease payments is equal to 91% of the fair value of the leased asset. Lease P does not transfer ownership to the lessee by the end of the lease term, but the lease term is equal to 77% of the estimated economic life of the leased asset. How should the lessee classify these leases?

Lease M Lease P Finance lease Finance lease A lease is classified as a finance lease by the lessee and as a sales-type lease by the lessor if, at lease commencement, at least one of the following five criteria is met: (1) The ownership of the leased asset is transferred to the lessee by the end of the lease term, (2) the lease includes an option to purchase the leased asset that the lessee is reasonably certain to exercise, (3) the lease term is for the major part (generally considered as 75%) of the remaining economic life of the leased asset, (4) the present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value (generally considered as 90%) of the leased asset, and (5) the leased asset is so specialized that it is expected to have no alternative use to the lessor at the end of the lease term. When no classification criterion is met, the lease is classified as an operating lease by the lessee. Thus, both lease M (91% of the fair value of the leased asset) and lease P (77% of the economic life of the leased asset) are classified as finance leases.

Which one of the following loss contingencies would be accrued as a liability rather than disclosed in the notes to the financial statement? A guarantee of the indebtedness of another. Liabilities for service or product warranties that cannot be purchased separately by the customers. A pending lawsuit with an uncertain outcome. A dispute over additional income taxes assessed for prior years (now in litigation).

Liabilities for service or product warranties that cannot be purchased separately by the customers. A warranty that cannot be purchased separately by the customer is an assurance-type warranty. An assurance-type warranty creates a loss contingency. Similarly to the guidelines for loss contingencies, a liability for future warranty costs should be accrued if (1) the incurrence of the expense is probable and (2) the amount can be reasonably estimated.

Spring Corp. entered into a 5-year lease agreement with Fall Corp. Spring, the lessee, paid an additional $5,000 nonrefundable lease bonus to Fall upon signing the operating lease agreement. When would Fall recognize in income the nonrefundable lease bonus paid by Spring?

Over the life of the lease. Under an operating lease, the lessor recognizes an equal amount of rental income each period of the lease term. Accordingly, a nonrefundable lease bonus and other rental payments should be recognized as rental revenue on a straight-line basis over the lease term.

On January 1, Year 1, a seller-lessee (1) transferred an asset to a buyer-lessor for $100,000 and (2) simultaneously entered into a contract with the buyer-lessor to use the asset (a leaseback). If the leaseback is classified as a sales-type lease, the seller-lessee should

Recognize the initial proceeds of $100,000 received from the buyer-lessor as a financial liability. The initial transfer of the asset to the buyer-lessor is not a sale if the leaseback is classified as a finance lease or a sales-type lease. If the transfer of the asset is not a sale, the seller-lessee accounts for the transaction as a financing transaction. The seller-lessee will continue to report the transferred asset and depreciate it. The initial proceeds received from the buyer-lessor are recognized as a financial liability (e.g., loan payable).

Warren Company is being sued in a wrongful discharge suit for $500,000. The company attorney has advised Warren that the probability of the plaintiff prevailing and receiving the full amount is about 80%. The attorney also indicated that the case would likely be tied up in the courts for 2 to 3 years. The most appropriate financial statement presentation for this loss contingency would be to

Record $500,000 as a loss contingency. A liability arising from a loss contingency should be recorded if the contingent future event will probably occur and the amount of the loss can be reasonably estimated.

Bain Co. entered into a 10-year lease agreement for a new piece of equipment worth $500,000. At the end of the lease, Bain will have the option to purchase the equipment. Which of the following would require the lease to be accounted for as a finance lease by Bain? The lease includes an option to purchase stock in the company. The present value of the minimum lease payments is $400,000. The estimated useful life of the leased asset is 12 years. Bain does not expect to exercise the purchase option.

The estimated useful life of the leased asset is 12 years. A lease is classified as a finance lease by the lessee if, at lease commencement date, any of the following five criteria is satisfied: (1) the lease transfers ownership of the leased asset to the lessee by the end of the lease term, (2) the lease includes an option to purchase the leased asset that the lessee is reasonably certain to exercise, (3) the lease term is for the major part (generally is considered to be at least 75%) of the remaining economic life of the leased asset, (4) the present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all (generally is considered to be at least 90%) of the fair value of the leased asset, or (5) the leased asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term. Because the lease is for 83% (10 years ÷ 12 years) of the economic life of the leased equipment, Bain classifies the lease as a finance lease.

On January 1, Year 1, Frost Co. entered into a 2-year lease agreement with Ananz Co. to lease a new computer. The lease term begins on January 1, Year 1, and ends on December 31, Year 2. The lease agreement requires Frost to pay Ananz two annual lease payments of $8,000. The present value of the minimum lease payments is $13,000. Which of the following circumstances would require Frost to classify and account for the arrangement as a finance lease?

The fair value of the computer on January 1, Year 1, is $14,000. A lease is classified as a finance lease by the lessee if, at lease commencement date, any of the following five criteria is satisfied: (1) the lease transfers ownership of the leased asset to the lessee by the end of the lease term, (2) the lease includes an option to purchase the leased asset that the lessee is reasonably certain to exercise, (3) the lease term is for the major part (generally is considered to be at least 75%) of the remaining economic life of the leased asset, (4) the present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all (generally is considered to be at least 90%) of the fair value of the leased asset, or (5) the leased asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term. Consequently, if the fair value of the computer on January 1, Year 1, is $14,000, the lease is a finance lease for Frost because the present value of the lease payments is 93% ($13,000 ÷ $14,000) of the fair value of the computer.

On the first day of its fiscal year, Lessor, Inc., leased certain property at an annual rental of $100,000 receivable at the beginning of each year for 10 years. The first payment was received immediately. The leased property is new, had cost $650,000, and has an estimated useful life of 13 years with no salvage value. The rate implicit in the lease is 8%. The present value of an annuity of $1 payable at the beginning of the period at 8% for 10 years is 7.247. Lessor had no other costs associated with this lease. Lessor should have accounted for this lease as a sales-type lease but mistakenly treated the lease as an operating lease. Lessor depreciates all of its properties using the straight-line depreciation method. Ignoring tax effects, what was the effect on net earnings during the first year of treating this lease as an operating lease rather than as a sale?

Understatement of $74,676. Accounting for the lease as an operating lease during the first year generated $50,000 of income, the $100,000 lease payment minus $50,000 of depreciation ($650,000 ÷ 13). In a sales-type lease, the lessor recognizes two income components: profit on the sale and interest income. Total income from accounting for the lease as a sale would have been $124,676 ($74,700 + $49,976). The effect of the error on net earnings was therefore an understatement of $74,676 ($124,676 - $50,000). Net investment ($100,000 × 7.247) $724,700 Carrying amount (650,000) Profit on sale $ 74,700 Net investment ($100,000 × 7.247) $724,700 First lease payment (100,000) Lease balance $624,700 Interest rate × .08 Interest income $ 49,976