Accounting Seminar: Leases
On November 10, Year 4, a Garry Corp. truck was in an accident with an auto driven by Dacey. On January 10, Year 5, Garry received notice of a lawsuit seeking $800,000 in damages for personal injuries suffered by Dacey. Garry Corp.'s counsel believes it is reasonably possible that Dacey will be awarded an estimated amount in the range between $250,000 and $500,000, and that $400,000 is a better estimate of potential liability than any other amount. Garry's accounting year ends on December 31, and the Year 4 financial statements were issued on March 6, Year 5. What amount of loss should Garry accrue at December 31, Year 4? a. $0 b. $250,000 c. $400,000 d. $500,000
a. $0 A contingent loss is accrued when it is probable that, at a balance sheet date, an asset is overstated or a liability has been incurred and the amount of the loss can be reasonably estimated. If both conditions are not met but the probability of the loss is at least reasonably possible, the amount of the loss must be disclosed. This loss is reasonably possible and reasonably estimable. Hence, it should be disclosed but not accrued.
Arik Company is the plaintiff in two lawsuits. The first suit involves a competitor who has made an exact copy of one of Arik's products, and Arik is suing for patent infringement. The attorneys estimate a $5,000,000 award for Arik; however, it is anticipated that the case will be in litigation for 2 to 3 years before final resolution. The second case also involves patent infringement; however, in this instance, the attorneys do not believe Arik has a strong case. It is estimated that the company has a 50% chance of winning and the award, if any, would be in the $250,000 to $1,000,000 range. The most appropriate amount to be recorded as a gain contingency is a. $0 b. $5,000,000 c. $5,125,000 d. $5,250,000
a. $0 Gain contingencies are not recorded; they are recognized only when realized. A gain contingency must be adequately disclosed.
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? a. $0 b. $3,430,000 c. $3,500,000 d. $4,900,000
a. $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.
Thompson Corp. owned a machine that cost $80,000 and had accumulated depreciation of $50,000, an estimated salvage value of $5,000, and a fair value of $150,000. In January, the machine was damaged by Snow Corp. and became worthless. In October, a court awarded damages of $150,000 against Snow in favor of Thompson. On December 31, the final outcome of the case was awaiting appeal. Thompson's attorney believes Snow's appeal will be denied. What amount should Thompson accrue for this gain contingency on December 31? a. $0 b. $5,000 c. $125,000 d. $150,000
a. $0 Gain contingencies are recognized only when realized. An award of damages in a lawsuit is not realized if it is being appealed. Thus, no gain contingency should be recognized on December 31.
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? a. $14,000 b. $14,062 c. $15,000 d. $16,072
a. $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).
During Year 3, Manfred Corp. guaranteed a supplier's $500,000 loan from a bank. On October 1, Year 4, Manfred was notified that the supplier had defaulted on the loan and filed for bankruptcy protection. Counsel believes Manfred will probably have to pay between $250,000 and $450,000 under its guarantee. As a result of the supplier's bankruptcy, Manfred entered into a contract in December Year 4 to retool its machines so that Manfred could accept parts from other suppliers. Retooling costs are estimated to be $300,000. What amount should Manfred report as a liability in its December 31, Year 4, balance sheet? a. $250,000 b. $450,000 c. $550,000 d. $750,000
a. $250,000 A contingent loss is accrued when two conditions are met: It is probable that, at a balance sheet date, an asset is overstated or a liability has been incurred, and the amount of the loss can be reasonably estimated. If the estimate is stated within a given range and no amount within that range appears to be a better estimate than any other, the minimum of the range should be accrued. Hence, the minimum amount ($250,000) of the probable payment under the guarantee should be accrued as a liability. The retooling costs will be charged to the equipment account when incurred because they significantly improve the future service of the machines.
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? a. $261,200 b. $292,000 c. $320,000 d. $327,200
a. $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, Harrow Co., as lessee, signed a 5-year noncancelable equipment lease with annual payments of $100,000 beginning December 31, Year 4. Harrow treated this transaction as a finance lease. The five lease payments have a present value of $379,000 at January 1, Year 4, based on interest of 10%. What amount should Harrow report as interest expense for the year ended December 31, Year 4? a. $37,900 b. $27,900 c. $24,200 d. $0
a. $37,900 Under the effective-interest method, interest expense for the first year is $37,900 ($379,000 lease liability × 10% effective interest rate).
The present value of lease payments should be used by the lessee in determining the amount of a lease liability under a lease classified by the lessee as a(n) a. Finance Lease: Yes Operating Lease: Yes b. Finance Lease: Yes Operating Lease: No c. Finance Lease: No Operating Lease: No d. Finance Lease: No Operating Lease: Yes
a. Finance Lease: Yes Operating Lease: Yes For finance and operating leases, a lessee must recognize a lease liability and a right-of-use asset at the lease commencement date. A lease liability is measured initially at the present value of the lease payments to be made over the lease term.
On January 1, a company enters into an operating lease for office space and receives control of the property to make leasehold improvements. The company begins alterations to the property on March 1 and the company's staff moves into the property on May 1. The monthly rental payments begin on July 1. The recognition of lease expense for the new offices should begin in which of the following months? a. January. b. March. c. May. d. July.
a. January. The lease term began in January when the lessor made a leased asset available for use by a lessee. Lease expense therefore is recognized beginning in January.
True Co. did not record an accrual for a probable loss from a lawsuit in its financial statements. Which of the following explanations for True's not accruing the probable loss is in accordance with generally accepted accounting principles? a. No reasonable estimate of the loss can be made. b. An estimated range for the loss can be made but no amount in the range is more accurate than any other amount. c. Recognizing an amount in its financial statements would weaken the company's defense of the lawsuit. d. Accrual was not required because an estimated amount of the loss was disclosed in the notes to the financial statements.
a. No reasonable estimate of the loss can be made. A material contingent loss must be accrued when (1) it is probable that, at a balance sheet date, an asset has been impaired or a liability has been incurred, and (2) the amount of the loss can be reasonably estimated. If one or both conditions are not met, no loss is accrued.
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 a. Recognize the initial proceeds of $100,000 received from the buyer-lessor as a financial liability. b. Recognize the gain related to the rights transferred to the buyer-lessor. c. Derecognize the carrying amount of the asset and cease to depreciate it. d. Adjust the gain or loss on sale if the transaction is not at fair value.
a. 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 a. 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. b. Record $400,000 as a loss contingency. c. Disclose the loss contingency in the footnotes. d. Not record or footnote the loss contingency.
a. 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.
King Corp. (lessee) reports finance and operating leases at the end of the year. Cash payments were made during the year on all leases. What is the correct classification on the statement of cash flows of cash payments related to the leases? a. Repayment of the principal of a finance lease liability is a cash outflow from financing activities. b. Payment of the interest on an operating lease liability is a cash outflow from financing activities. c. Payments of the lease liability (principal and interest) for finance and operating leases are cash outflows from operating activities. d. Payment of a finance lease liability (principal and interest) is a cash outflow from operating activities.
a. Repayment of the principal of a finance lease liability is a cash outflow from financing activities. In the statement of cash flows, repayment of the principal portion of a finance lease liability is classified as a cash outflow from financing activities. Payment of interest on a finance lease liability is classified as a cash outflow from operating activities. Payments for operating lease liabilities (principal and interest) are cash outflows from operating activities.
Lessee entered into a 10-year equipment lease on January 1, Year 1. Annual lease payments of $40,000 are payable on January 1 each year beginning Year 1. The rate implicit in the lease is 5% and is known to the lessee. The lessee incurred $10,000 of initial direct costs. The lease is classified as an operating lease. 9 years: The present value of an ordinary annuity at 5% = 7.1078 10 years: The present value of an ordinary annuity at 5% = 7.7217 What are the amounts of the right-of-use asset and lease liability to be recorded at the commencement date? a. Right-of-Use Asset: $334,312 Liability: $324,312 b. Right-of-Use Asset: $324,312 Liability: $324,312 c. Right-of-Use Asset: $358,868 Liability: $348,868 d. Right-of-Use Asset: $308,868 Liability: $308,868
a. Right-of-Use Asset: $334,312 Liability: $324,312 The right-of-use asset of $334,312 [($40,000 × 7.1078) + $40,000 + $10,000] initially is measured at the present value of the lease payments discounted at 5% for 9 years, plus the first lease payment of $40,000 made at lease commencement, plus the initial direct costs of $10,000. The lease liability of $324,312 [($40,000 × 7.1078) + $40,000] initially is measured at the present value of the lease payments of $40,000 discounted at 5% for 9 years, plus the first lease payment of $40,000. Initial direct costs are not added to the lease liability.
On June 1, Oren Co. entered into a 5-year nonrenewable operating lease, commencing on that date, for office space and made the following payments to Rose Properties: Bonus to obtain lease $30,000 First month's rent 10,000 Last month's rent 10,000 The lease term requires monthly rent payments of $10,000. In its income statement for the year ended June 30, what amount should Oren report as lease expense? a. $10,000 b. $10,500 c. $40,000 d. $50,000
b. $10,500 In an operating lease, a single lease expense is recognized 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 rent expense in June is $10,000, the amount to be paid each month. The bonus to obtain the lease is an initial direct cost incurred by Oren. Initial direct costs incurred by the lessee are included in the total undiscounted lease payments. Thus, they are recognized in the single periodic lease expense on a straight-line basis over the lease term. Lease expense for June is $10,500 {$10,000 for the month's rent + [($30,000 ÷ 5) ÷ 12 amortization of the bonus]}.
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? a. $0 b. $30,000 c. $90,000 d. $120,000
b. $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.
On December 1, Year 4, Clark Co. leased office space for 5 years at a monthly rental of $60,000. The lease was classified as an operating lease. 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 4 expense relating to utilization of the office space? a. $60,000 b. $66,000 c. $126,000 d. $200,000
b. $66,000 During Year 4, this operating lease was effective only for the month of December. The Year 4 expenses therefore include the $60,000 monthly rent plus the $360,000 cost of the installation of the new walls and offices allocated over the 60 months of the rental agreement. Thus, the total December expense equals $66,000 [$60,000 + ($360,000 ÷ 60 months)].
On January 1, Year 1, Gee, Inc., leased a delivery truck from Marr Corp. under a 3-year operating lease. Total rent for the term of the lease will be $36,000, payable as follows: $ 500 × 12 months = $ 6,000 $ 750 × 12 months = $ 9,000 $1,750 × 12 months = $21,000 All payments were made when due. In Marr's December 31, Year 2, balance sheet, the accrued rent receivable should be reported as a. $0 b. $9,000 c. $12,000 d. $21,000
b. $9,000 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. An equal amount of rental income therefore is recognized each period over the lease term. This monthly rent revenue recognized is $1,000 [($6,000 + $9,000 + $21,000) ÷ 36 months]. At December 31, Year 2, cumulative revenue recognized is $24,000 ($1,000 × 24 months). Because cumulative cash received is $15,000 ($6,000 + $9,000), an accrued receivable for the $9,000 ($24,000 - $15,000) difference should be recognized.
On December 20, Year 6, an uninsured property damage loss was caused by a company car being driven on company business by a company sales agent. The company did not become aware of the loss until January 25, Year 7, but the amount of the loss was reasonably estimable before the financial statements were issued. The company's December 31, Year 6, financial statements should report an estimated loss as a. A disclosure, but not an accrual. b. An accrual. c. Neither an accrual nor a disclosure. d. An appropriation of retained earnings.
b. An accrual. A loss contingency is an existing condition, situation, or set of circumstances involving uncertainty as to the impairment of an asset's value or the incurrence of a liability as of the balance sheet date. Resolution of the uncertainty depends on the occurrence or nonoccurence of one or more future events. A loss should be debited and either an asset valuation allowance or a liability credited when the loss contingency is both probable and reasonably estimable. The loss should be accrued even though the company was not aware of the contingency at the balance sheet date.
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? a. Disclosed: $ 500,000 loss; $1,000,000 gain Accrued: $1,500,000 loss; $ 700,000 gain b. Disclosed: $2,000,000 loss; $1,000,000 gain Accrued: $1,500,000 loss c. Disclosed: $1,000,000 gain Accrued: $1,500,000 loss; $ 500,000 loss d. Disclosed: $500,000 loss; $300,000 gain Accrued: $1,500,000 loss
b. 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.
Seller-Guarantor sold an asset with a carrying amount at the time of sale of $500,000 to Buyer for $650,000 in cash. Seller also provided a guarantee to Guarantee Bank of the $600,000 loan that Guarantee made to Buyer to finance the sale. The probability that Seller will become liable under the guarantee is remote. In a stand-alone arm's-length transaction with an unrelated party, the premium required by Seller to provide the same guarantee would have been $40,000. The entry made by Seller at the time of the sale should include a a. Gain of $150,000. b. Noncontingent liability of $40,000. c. Contingent liability of $600,000. d. Loss of $450,000.
b. Noncontingent liability of $40,000. No contingent liability results because the likelihood of payment by the guarantor is remote. However, a noncontingent liability is recognized at the inception of the seller's obligation to stand ready to perform during the term of the guarantee. This liability is initially measured at fair value. In a multiple-element transaction with an unrelated party, the fair value is estimated, for example, as the premium required by the guarantor to provide the same guarantee in a stand-alone arm's-length transaction with an unrelated party. The amount of that premium is given as $40,000. Hence, Seller debits cash for the total received ($650,000), credits the asset sold for its carrying amount ($500,000), credits the noncontingent liability for its estimated fair value ($40,000), and credits a gain for $110,000 ($650,000 - $500,000 - $40,000).
The fair value of the leased asset differs from its carrying amount. What are the components of the lease receivable for a lessor involved in a sales-type lease? a. The lease payments plus unguaranteed residual value. b. The lease payments plus guaranteed residual value. c. The lease payments less guaranteed residual value. d. The lease payments less initial direct costs.
b. The lease payments plus guaranteed residual value. In a sales-type lease, the lease receivable recognized by the lessor at the commencement of the lease is measured at the present value of the lease payments plus the present value of residual value guaranteed by the lessee or any other third party. In sales-type leases, initial direct costs are expensed when the fair value of the leased asset differs from its carrying amount.
A seller-lessee and a buyer-lessor entered into a sale and leaseback transaction. The leaseback is classified as an operating lease, and the initial transfer meets the requirements for recognition of revenue from customers. When the transaction is not at fair value or based on market terms, a. The gain or loss on the initial transfer of the asset recognized by the seller-lessee is the difference between the selling price and the carrying amount of the asset. b. The seller-lessee recognizes a financial liability if the selling price exceeds the fair value of the asset. c. The initial transfer of the asset is not recognized as a sale by the parties. d. The buyer-lessor recognizes interest income over the lease term if the selling price is lower than the fair value of the asset.
b. The seller-lessee recognizes a financial liability if the selling price exceeds the fair value of the asset. If 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 if all the criteria for revenue recognition are met. When the sale and leaseback transaction is not at fair value or based on market terms, off-market adjustments are needed to recognize the sale at fair value. When the selling price of an asset (or leaseback payment) is greater than fair value (or market value), the difference is essentially additional financing received from the buyer-lessor. This additional financing should be accounted for separately from the lease liability. A financial liability is recognized by the seller-lessee for the off-market adjustment (e.g., the excess of the selling price of an asset over its fair value).
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? a. Overstatement of $25,300. b. Understatement of $74,676. c. Understatement of $24,676. d. Understatement of $24,700.
b. 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
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? a. $90,000 b. $120,000 c. $180,000 d. $240,000
c. $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)}.
A manufacturer of household appliances may incur a loss due to the discovery of a defect in one of its products. The occurrence of the loss is reasonably possible and the resulting costs can be reasonably estimated. This possible loss should be a. Accrued: Yes Disclosed in Notes; No b. Accrued: Yes Disclosed in Notes: Yes c. Accrued: No Disclosed in Notes: Yes d. Accrued: No Disclosed in Notes: No
c. Accrued: No Disclosed in Notes: Yes A contingent loss is accrued when two conditions are met: It is probable that at a balance sheet date an asset is overstated or a liability has been incurred, and the amount of the loss can be reasonably estimated. If both conditions are not met, but the probability of the loss is at least reasonably possible, the amount of the loss must be disclosed. This loss is reasonably possible and reasonably estimable, and it therefore should be disclosed but not accrued as a liability. The financial statements should disclose the nature of the loss contingency and the amount or range of the possible loss. If an estimate cannot be made, the notes should state this.
On November 25, Year 4, an explosion occurred at a Rex Co. plant causing extensive property damage to area buildings. By March 10, Year 5, claims had been asserted against Rex. Rex's management and counsel concluded that it is probable Rex will be responsible for damages, and that $3.5 million would be a reasonable estimate of its liability. Rex's $10 million comprehensive public liability policy has a $500,000 deductible clause. Rex's December 31, Year 4, financial statements, issued on March 25, Year 5, should report this item as a. A disclosure in the notes to the financial statements indicating the probable loss of $3.5 million. b. An accrued liability of $3.5 million. c. An accrued liability of $500,000. d. A disclosure in the notes to the financial statements indicating the probable loss of $500,000.
c. An accrued liability of $500,000. A loss contingency is accrued when information available prior to issuance of the statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the statements. Furthermore, the loss must be reasonably estimable. The explosion occurred prior to the balance sheet date, and Rex concluded that a loss is probable. Moreover, the amount can be reasonably estimated as the deductible provided for in the insurance contract, given that the policy is sufficient to cover the probable liability. Rex need not be aware that claims have been asserted if it determines that the loss is probable and can be reasonably estimated. Consequently, Rex should accrue a liability of $500,000.
During Year 4, Leader Corp. sued Cape Co. for patent infringement. On December 31, Year 4, Leader was awarded a $500,000 favorable judgment in the suit. On that date, Cape offered to settle out of court for $300,000 and not appeal the judgment. In February Year 5, after the issuance of its Year 4 financial statements, Leader agreed to the out-of-court settlement and received a certified check for $300,000. In its Year 4 financial statements, how should Leader have reported these events? a. As a gain of $300,000. b. As a receivable and deferred credit of $300,000. c. As a disclosure in the notes to the financial statements only. d. It should not be reported in the financial statements.
c. As a disclosure in the notes to the financial statements only. Gain contingencies are not recognized until they are realized. Because the settlement did not occur until after the balance sheet date, and appeal was still possible, Leader should not record any revenue from the lawsuit in the Year 4 income statement. This gain contingency should be disclosed; however, care should be taken to avoid misleading implications as to the likelihood of realization.
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? a. A gain contingency for the minimum estimated amount of the settlement. b. A gain contingency for the estimated probable settlement. c. Disclosure in the notes only. d. No reporting is required at this time.
c. 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.
On January 1, Year 1, Lessee entered into a 4-year lease with Lessor that does not transfer ownership at the end of the lease term. It also includes a purchase option not reasonably expected to be exercised. The unspecialized leased asset has (1) a 5-year economic life, (2) no residual value, and (3) a present value of the annual lease payments equal to 75% of the leased asset's fair value. Moreover, Lessee incurred no initial direct costs. The lease therefore is classified as a(n) a. Operating lease by the lessor. b. Sales-type lease by the lessee. c. Finance lease by the lessee. d. Direct financing lease by the lessor.
c. Finance lease by the lessee. A lessee classifies a lease as a finance lease or an operating lease. A lease is classified as a finance lease if at least one of the classification criteria is met. One criterion is that the lease term is for the major part (at least 75%) of the remaining economic life of the leased asset. The lease term is 80% (4 years ÷ 5 years) of the remaining economic life. Accordingly, the lessee classifies the lease as a finance lease.
A 6-year finance lease entered into on December 31, Year 4, specified equal annual lease payments due on December 31 of each year. The first annual lease payment, paid on December 31, Year 4, consists of which of the following? a. Interest Expense: Yes Lease Liability: Yes b. Interest Expense: Yes Lease Liability: No c. Interest Expense: No Lease Liability: Yes d. Interest Expense: No Lease Liability: No
c. Interest Expense: No Lease Liability: Yes Under the effective-interest method, interest is recognized to account for a change in value due to the passage of time. Given that the first payment is made at the inception of the lease, no time has passed. Thus, the first payment reduces the lease liability, but no interest is recognized.
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 effective-interest method. d. Does not arise.
c. Should be recognized over the period of the lease using the effective-interest method. In a sales-type lease, each periodic lease payment received has two components: interest income and the reduction of the net investment in the lease. Interest income is calculated using the effective interest method. It equals the carrying amount of the net investment in the lease at the beginning of the period times the discount rate implicit in the lease.
Linden Corporation is a defendant in a lawsuit in which the plaintiff is seeking $1,000,000 in damages. The company had terminated the plaintiff, George Russell, from his position with Linden after Russell allegedly sold specifications for one of Linden's new products to a competitor. Linden's attorney believes that it is quite possible Linden will lose the case and that, if so, damages could range from $100,000 to $200,000. Regardless of the outcome of the case, Linden's accountants estimate the company will incur an additional $5,000 in unemployment costs because of Russell's termination. The amount that Linden should accrue because of the contingency in this situation is a. $200,000 b. $100,000 c. $5,000 d. $0
d. $0 Loss contingencies are accrued when the loss is probable. The $5,000 in unemployment costs that will probably be incurred are a routine cost of doing business.
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? a. $27,000 b. $23,000 c. $22,500 d. $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).
d. $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).
On November 1, Year 4, Davis Co. discounted with recourse at 10% a 1-year, noninterest-bearing, $20,500 note receivable maturing on January 31, Year 5. What amount of contingent liability for this note must Davis disclose in its financial statements for the year ended December 31, Year 4? a. $0 b. $20,000 c. $20,333 d. $20,500
d. $20,500 When a note receivable is discounted, the receivable is removed from the accounts, a gain or loss is recognized, and a contingent liability is disclosed in a note. If the receivables are not paid, Davis Co. may be responsible for the full amount of the note $(20,500). Consequently, this amount should be disclosed in the notes.
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? a. Depreciation Expense: Yes Interest Revenue: Yes b. Depreciation Expense: Yes Interest Revenue: No c. Depreciation Expense: No Interest Revenue: No d. Depreciation Expense: No Interest Revenue: Yes
d. 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.
The amount recorded initially by the lessee as a lease liability should normally a. Exceed the total of the lease payments. b. Exceed the present value of the lease payments at the beginning of the lease. c. Equal the total of the lease payments. d. Equal the present value of the lease payments at the beginning of the lease. The lessee records a lease as an asset and a liability at the present value of the lease payments. The discount rate is the lessor's implicit interest rate (if known) or the lessee's incremental borrowing rate of interest. Lease payments include the rental payments required during the lease term and the amount of a purchase option if the lessee is reasonably certain to exercise it. If no such option exists, the lease payments equal the sum of (1) the rental payments, (2) the amount of residual value guaranteed by the lessee, and (3) any nonrenewal penalty imposed.
d. Equal the present value of the lease payments at the beginning of the lease. The lessee records a lease as an asset and a liability at the present value of the lease payments. The discount rate is the lessor's implicit interest rate (if known) or the lessee's incremental borrowing rate of interest. Lease payments include the rental payments required during the lease term and the amount of a purchase option if the lessee is reasonably certain to exercise it. If no such option exists, the lease payments equal the sum of (1) the rental payments, (2) the amount of residual value guaranteed by the lessee, and (3) any nonrenewal penalty imposed.
Which one of the following loss contingencies would be accrued as a liability rather than disclosed in the notes to the financial statement? a. A guarantee of the indebtedness of another. b. A dispute over additional income taxes assessed for prior years (now in litigation). c. A pending lawsuit with an uncertain outcome. d. Liabilities for service or product warranties that cannot be purchased separately by the customers.
d. 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.
On January 1, Year 1, JCK Co. signed a contract for an 8-year lease of its equipment with a 10-year life. The present value of the 16 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 3, and should the revenue recognized in Year 3 be the same or smaller than the revenue recognized in Year 2? a. Year 3 Revenues Recognized: Rent Year 3 Amount Recognized Compared with Year 2: The same b. Year 3 Revenues Recognized: Rent Year 3 Amount Recognized Compared with Year 2: Smaller c. Year 3 Revenues Recognized: Interest Year 3 Amount Recognized Compared with Year 2: The same d. Year 3 Revenues Recognized: Interest Year 3 Amount Recognized Compared with Year 2: Smaller
d. Year 3 Revenues Recognized: Interest Year 3 Amount Recognized Compared with Year 2: Smaller JCK classifies the lease as a sales-type lease because the lease term is for the major part (80% = 8 years ÷ 10 years) of the remaining economic life of the leased equipment. A lease term of 75% or more of the remaining economic life of the leased asset generally is considered to be a major part of its remaining economic life. In a sale-type lease, each periodic lease payment received has two components: interest income and the reduction of the net investment in the lease. Interest income is calculated using the effective interest method. It equals the carrying amount of the net investment in the lease at the beginning of the period times the discount rate implicit in the lease. The amount of interest income declines over the lease term. As the carrying amount of the investment in the lease decreases, the interest component of the periodic lease payment also decreases.
