Chapter 15

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: Interest Expense Reduction of the Lease Liability a. No Yes b. Yes No c. Yes Yes d. No No Option a Option b Option c Option d

Option a Explanation In an annuity due, the first payment contains no interest component - the entire payment is applied to a reduction of the lease liability.

When the leaseback in a sale-leaseback transaction is an operating lease, the seller-lessee: a) Immediately recognizes any gain on the sale. b) Amortizes any gain over the lease term. c) Recognizes any gain on the sale immediately only if the asset leased is land. d) Does not record a gain.

a Explanation Since the leaseback qualifies as an operating lease, sale leaseback accounting is appropriate. Any gain on the sale is recognized immediately.

Which of the following is not required in order for a contract to contain a lease? a) The asset must be explicitly identified in the contract. b) The customer can derive substantially all of the potential economic benefits from using the asset. c) The customer can direct the use of the asset throughout the contract term. d) The provider cannot have the right to substitute alternative assets during the period of use and could benefit economically from such a substitution.

a Explanation The asset can be either explicitly or implicitly identified in the contract.

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

a Explanation The lessor, not the lessee accretes a residual asset.

Universal Leasing Corp. leases farm equipment to its customers. Typically, the equipment has no residual value at the end of leases and the contracts call for payments at the beginning of each year. Universal's target rate of return is 10%. On a five-year lease of equipment with a fair value of $485,100, Universal will earn interest revenue over the life of the lease of: a) $96,575 b) $114,900 c) $121,275 d) $194,040

a Explanation The present value factor for an annuity due for 5 periods at 10% is 4.16987. Thus, the annual payment is $116,334 ($485,100/4.16987), and the total receipts are $581,675 ($116,334 × 5). The interest revenue is total receipts minus fair value ($581,675 − $485,100).

Crawford Industries leased exercise equipment to Woodson Gyms on July 1, 2021. Crawford recorded the lease receivable at $810,000, the present value of lease payments discounted at 10% and fair value of the equipment. The lease called for ten annual lease payments of $120,000 due at the beginning of each year. The first payment was received on July 1, 2021. Crawford had manufactured the equipment at a cost of $750,000. With this lease agreement, control is considered to be transferred to the lessee at the beginning of the lease. The total increase in earnings (pretax) on Crawford's 2021 income statement would be: a) $81,000. b) $94,500. c) $100,500. d_ $120,000.

b Explanation $60 Profit: ($810 − $750) + $34.5 Interest revenue: ([10%/2] × [$810 − $120]) = $94.5.

Leasing has become the number one method of external financing by U.S. companies. Reasons include each of the following except: a) Tax advantages. b) Extended use of the asset. c) Protection against obsolescence. d) Lower upfront cash needed to use an asset.

b Explanation Advantages of leasing include: Leasing reduces the upfront cash needed to use an asset. Lease payments often are lower than installment payments. Leasing offers flexibility and a lower cost when disposing of the asset. Leasing might offer protection against the risk of declining asset values. Leasing might offer tax advantages. Leasing does not extend the lessee's use of the asset beyond that of the lease term.

Nichols Fruits leased farm equipment from King Machinery on January 1, 2021. The present value of the lease payments discounted at 10% was $40 million. Ten annual lease payments of $6 million are due at the beginning of each year beginning January 1, 2021. King had constructed the equipment recently for $33 million. With this lease agreement, control is considered to be transferred to the lessee at the beginning of the lease. What amount of selling profit did King record at the beginning of the lease? a) $6 million. b) $7 million. c) $33 million. d) $50 million.

b Explanation Control is transferred so this is considered a finance lease, and the lessor would debit lease receivable for the $40 million present value of the payments. The asset would be credited for its book value of $33 million. The difference of $7 million is profit on the "sale."

On January 1, 2021, Bentley Co. recorded a right-of-use asset of $135,180 in a finance 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: a) $115,180. b) $121,662. c) $126,698. d) $135,180.

b Explanation In a finance lease, the lessee amortizes its right of use asset on a straight-line basis. In this case, amortization is $135,180 / 10 years, or $13,518 per year. So, after one year, the balance will be $135,180 − $13,518 = $121,662.

Geron Co. recorded a right-of-use asset of $400,000 in a ten-year finance lease. The interest rate charged by the lessor was 10%. The balance in the right-of-use asset after two years will be: a) $324,000. b) $320,000. c) $440,000. d) $484,000.

b Explanation In a finance lease, the lessee amortizes its right of use asset on a straight-line basis. In this case, amortization is $400,000/10 years, or $40,000 per year. So, after 2 years, the balance will be $400,000 − $80,000 = $320,000.

In an operating lease in which the asset's economic life and lease term are different: a) The lessee amortizes the leased asset over the term of the lease at a straight-line amount. b)The lessee amortizes the leased asset at an amount that increases each period. c) The lessor amortizes the leased asset over the term of the lease. d) The lessee amortizes the asset over its economic life.

b Explanation In an operating lease, the lessee records a right-of-use asset and amortizes it, not on a straight-line basis, but by "plugging" the right-of-use asset amortization at whatever amount is needed to cause interest plus amortization to equal the straight-line lease payment amount. (over its economic life). Because the interest component of the straight-line lease expense decreases each period, the amortization component increases each period. In an operating lease, the lessor records no lease receivable and does not remove from its balance sheet the asset being leased.

Martius Company, a maker of high-tech gadgets, routinely leases equipment made by competitors in order to reverse-engineer design features Martius may want to incorporate in its own products. The reverse-engineering process is part of Martius's 9-month product development cycle and involves disassembling then later reassembling the equipment. LeaseCo. leases such equipment to Martius under a 12-month lease term. According to the terms of the lease, at the end of the lease term Martius will have the option to purchase the equipment for less than its expected fair value at that time. Martius Company is located in an area where commercial space is at a premium, there is no internal use for the competitor equipment at the end of Martius's product development cycle, and Martius's management wishes to focus solely on the manufacture and sale of its own equipment. Management also wishes to minimize liabilities reported on the balance sheet. In light of the above, as which type of lease is Martius most likely to record, correctly, its arrangement with LeaseCo.? a) As a finance lease. b) As a short-term lease. c) As an operating lease. d) Not enough information to decide.

b Explanation Since each lease is for 12 months and, with the lessee having no real use for the asset once it has been reverse engineered in the first 9 months of the lease, nor any interest in selling products that are not its own, it is unlikely that the lessee will either extend the lease or purchase the leased asset even at a bargain price. As a result, the lease qualifies as a short-term lease, which also allows Martius's management to minimize liabilities reported on the balance sheet.

Tucson Fruits leased farm equipment from Barr Machinery on July 1, 2021. The lease was recorded as a sales-type lease. The present value of the lease payments discounted at 10% was $40.5 million. Ten annual lease payments of $6 million are due at the beginning of each year beginning July 1, 2021. Barr had purchased the equipment for $33 million. What amount of interest revenue from the lease should Barr report in its 2021 income statement? a) $2,025,000 b) $1,725,000 c) $1,650,000 d) $0

b Explanation The interest is calculated based on the fair value of the asset, which in this case is the present value of the lease payments. (If the fair value was the purchase price, then there would have been no selling profit). Thus, the 2021 interest calculation is 10% × ($40,500,000 − $6,000,000) × 6/12.

We classify a lease as a finance lease if: a) the usual risks and rewards are retained by the lessor. b) the usual risks and rewards are transferred to the lessee. c) the present value of lease payments is less than the asset's book value. d) the present value of lease payments is less than the asset's fair value.

b Explanation We have a finance lease if the lease transfers substantially all the risks and rewards of ownership of the underlying asset.

A lessee is permitted to elect not to record a right-of-use asset and lease payable at the beginning of the lease term for a lease having a value of $5,000 or less, or that has a lease term of 12 months or less, when using: a) U.S. GAAP. b) IFRS. c) Either U.S. GAAP or IFRS. d) Neither U.S. GAAP nor IFRS.

c Explanation Both U.S. GAAP and IFRS allow the lessee to elect not to record a right-of-use asset and lease payable at the beginning of the lease term for a lease that has a lease term of 12 months or less. Only IFRS provides this option for "small ticket" leases having a value of $5,000 or less.

Which of the following is not a sufficient criterion for a lessor to classify a lease as a sales-type 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 present value of the lease payments is greater than the carrying value of the leased asset. d) The present value of the lease payments is substantially all of the fair value of the leased asset.

c Explanation For the lessor to consider the lease a sales-type lease, one of the five classification criteria (applicable to both the lessee and the lessor), must be met. The present value of the lease payments being greater than the carrying value of the leased asset means there is a selling profit if it's a sales-type lease.

A necessary condition for a sales-type lease is: a) Legal title to the asset transfers to the lessee. b) The present value of lease payments exceeds the lessor's cost. c) The lessee considers the lease to be a finance lease. d) The lessor earns selling profit instead of interest revenue.

c Explanation For the lessor to consider the lease a sales-type lease, one of the five classification criteria must be met. The same criteria apply for the lessee to consider a lease to be a finance lease.

If a finance lease contains a bargain purchase option, the lessee should amortize the leased asset: a) Over the term of the lease. b) Without reference to the economic life of the asset. c) Over the economic life of the asset. d) Without reference to the term of the lease.

c Explanation If title of the asset transfers to the lessee at the end of the lease, or there is a bargain purchase option, the lessee depreciates the asset over its economic life. If neither of these are part of the finance lease agreement, the lessee depreciates the asset over the lease term.

Grant Industries leased exercise equipment to Silver Gyms on July 1, 2021. Grant 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 at the beginning of each year. The first payment was received on July 1, 2021. Grant had manufactured the equipment at a cost of $750,000. The total increase in earnings (pretax) on Grant's 2021 income statement would be: a) $0 b) $93,000 c) $94,500 d) $100,500

c Explanation In 2021, there are two components to pretax earnings: interest income and selling profit. The interest income (based on the fair value of the asset) is $34,500 [10% × ($810,000 − $120,000) × 6/12], and the dealer's profit is $60,000 ($810,000 − $750,000).

On January 1, 2021, Natick Co. 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 the lessor was 10%. The balance in the right-of-use asset at December 31, 2021, will be: a) $115,180. b) $121,662. c) $126,698. d) $135,180.

c Explanation In an operating lease, the lessee amortizes its right of use asset at an amount so that the total of interest expense and amortization will be a straight-line amount equal to the annual payments, $20,000 per year. Interest the first year will be 10% × ($135,180 − $20,000) = $11,518. So, amortization will be $20,000 − $11,518 = $8,482. The year-end balance, then, will be $135,180 − $8,482 = $126,698.

Nichols Fruits leased farm equipment from King Machinery on January 1, 2021. The present value of the lease payments discounted at 10% was $40 million. Ten annual lease payments of $6 million are due at the beginning of each year beginning January 1, 2021. King had constructed the equipment recently for $33 million. With this lease agreement, control is considered to be transferred to the lessee at the beginning of the lease. What amount of interest revenue from the lease should King report in its 2021 income statement? a) $4,000,000. b) $3,750,000. c) $3,400,000. d) $0.

c Explanation Interest revenue = 10% × [$40 − $6]) = $3.4 million.

Brown Properties entered into a sale-leaseback transaction. Brown retains the right to substantially all of the remaining use of the property. A gain resulting from the sale should: a) Not be reported. b) Be offset against losses from similar transactions. c) Be deferred at the time of the sale-leaseback and subsequently amortized. d) Be recognized in earnings at the time of the sale-leaseback.

c Explanation Since Brown Properties retains the right to substantially all of the remaining use of the property, economically, no sale has occurred. So, sale leaseback accounting is not permitted. Instead, the transaction is treated by both parties as a loan.

One criterion for an arrangement to constitute a lease is that we have an identified asset. Which of the following is required in order for a contract to contain an identified asset? a) The lease is classified as a finance/sales-type lease. b) The customer can derive substantially all of the potential economic benefits from using the asset. c) The property must be property, plant, or equipment (not inventory, intangibles, or natural resources). d) The provider cannot have the right to substitute alternative assets during the period of use and could benefit economically from such a substitution.

c Explanation The asset can be either explicitly or implicitly identified in the contract. The customer deriving substantially all of the benefits from the asset and the provider not having the right to substitute alternative assets are required for the second criterion for an arrangement to constitute a lease ― that the customer has the right to control the use of the asset. Also, the asset can be either explicitly or implicitly identified in the contract.

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 Explanation The five criteria for a lease to be categorized as a finance lease are: (1) Ownership transfers to the lessee at the end of the lease; (2) the lease contains a bargain purchase option; (3) The lease term is for the major part of the economic life of the asset; (4) the present value of the lease payments are substantially all of the fair value of the asset; (5) the underlying 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.

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 Explanation The five criteria for a lease to be categorized as a finance lease are: (1) Ownership transfers to the lessee at the end of the lease; (2) the lease contains a bargain purchase option; (3) The lease term is for the major part of the economic life of the asset; (4) the present value of the lease payments are substantially all of the fair value of the asset; (5) the underlying 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.

Pyramid Properties entered a lease that contains a bargain purchase option. When calculating the amount to capitalize as a right-of-use asset at the beginning of the lease term, the payment called for by the bargain purchase option should be: a) Subtracted at its exercise price. b) Subtracted at its present value. c) Added at its present value. d) Excluded from the calculation.

c Explanation The lessee capitalizes the smaller of the present value of the lease payments or the fair value of the asset. The lease payments include both the annual payments and the amount of the exercise price of the bargain purchase option.

In a ten-year finance lease, the portion of the annual lease payment in the lease's third year that represents interest is: a) The same as in the fourth year. b) The same as in the first year. c) Less than in the second year. d) More than in the second year.

c Explanation The second year's lease payment comprises both interest and a reduction of the lease liability. Since interest is computed on the beginning balance of the liability account, as that balance is reduced, the interest component of subsequent payments is reduced (and the amount going to reduce the liability is increased).

On January 1, 2021, Jackson Properties leased a warehouse to Jensen Distributors. The operating lease provided for a nonrefundable bonus paid by Jensen. Jackson should recognize the bonus in earnings: a) At the beginning of the lease. b) When the bonus is received. c) Over the life of the lease. d) At the expiration of the lease.

c Explanation This bonus can be considered as additional rent, which is earned (and recognized) over the life of the lease.

On January 1, 2021, Walter Scott Co. leased non-specialized machinery under a 6-year lease. 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 Scott nor a bargain purchase option. What amount should Scott report in its 2021 income statement? a) Amortization expense equal to one-ninth of the machinery'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 Explanation 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 (interest plus amortization) to be equal to the periodic lease payment and reports the lease payment as lease expense in its income statement.

Nichols Fruits leased farm equipment from King Machinery on January 1, 2021. The present value of the lease payments discounted at 10% was $40 million. Ten annual lease payments of $6 million are due at the beginning of each year beginning January 1, 2021. King had constructed the equipment recently for $33 million. The total decrease in earnings (pretax) in Nichols' 2021 income statement would be: a) $3,400,000. b) $4,000,000. c) $6,066,667. d) $7,400,000.

d Explanation $3,400,000 Interest expense: (10% × [$40,000,000 − $6,000,000]) + $2,666,667 Amortization expense: ($40,000,000/10 years) = $4,000,000.

Nichols Fruits leased farm equipment from King Machinery on January 1, 2021. The present value of the lease payments discounted at 10% was $40 million. Ten annual lease payments of $6 million are due at the beginning of each year beginning January 1, 2021. King had constructed the equipment recently for $33 million. With this lease agreement, control is considered to be transferred to the lessee at the beginning of the lease. What amount did King record as a lease receivable? a) $6 million. b) $7 million. c) $33 million. d) $40 million.

d Explanation Control is transferred so the lessor is allowed to record revenue and would debit lease receivable for the $40 million present value of the payments. The asset would be credited for its book value of $33 million. The difference of $7 million is profit on the "sale."

Nichols Fruits leased farm equipment from King Machinery on January 1, 2021. The present value of the lease payments discounted at 10% was $40 million. Ten annual lease payments of $6 million are due at the beginning of each year beginning January 1, 2021. King had constructed the equipment recently for $33 million. With this lease agreement, control is considered to be transferred to the lessee at the beginning of the lease. The total increase in earnings (pretax) in King's 2021 income statement would be: a) $3.4 million. b) $6.0 million. c) $17.0 million. d) $10.4 million.

d Explanation Control is transferred so the lessor is allowed to record revenue, and would debit lease receivable for the $40 million present value of the payments. The asset would be credited for its book value of $33 million. The difference of $7 million is profit on the "sale." Interest revenue is (10% × [$40 − $6]) = $3.4 million. The total increase in earnings is $7 + $3.4 = $10.4 million.

If it is "reasonably certain" that the lessee will exercise a purchase option: a) The lease is classified as a finance/sales-type lease. b) Both the lessee and the lessor consider the exercise price of the option to be an additional cash payment. c) It's assumed that the lease term ends on the date that the option is expected to be exercised. d) All of these answer choices are correct.

d Explanation If it's "reasonably certain" that the lessee will exercise a purchase option, the lease is classified as a finance/sales-type lease, both the lessee and the lessor consider the exercise price of the option to be an additional cash payment, and we assume that the lease term ends on the date that the option is expected to be exercised.

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 Explanation The lessee, not the lessor records a right-of-use asset.