Leases

Answer this: On January 1 of the current year, Tell Co. leased equipment from Swill Co. under a nine-year sales-type lease. The equipment had a cost of $400,000, and an estimated useful life of 15 years. Semiannual lease payments of $44,000 are due every January 1 and July 1. The present value of lease payments at 12% was $505,000, which equals the sales price of the equipment. Using the straight-line method, what amount should Tell recognize as amortization expense on the equipment in the current year?

A sales-type lease is treated by the lessee as a finance lease. Because this is a finance lease with no title transfer and no bargain purchase option, the lessee must amortize the asset over the shorter of either the economic useful life (15 years) or lease term (9 years). The annual amortization is $56,111 (505,000 / 9 = 56,111).

How do you account for salvage value in finance lease payments? On January 1, 20X0, Moul Mining Co. (Lessee), entered into a 5-year lease for drilling equipment. Moul accounted for the acquisition as a finance lease for $120,000, which includes a $5,000 purchase option. At the end of the lease, Moul expects to exercise the purchase option. Moul estimates that the equipment's fair value will be $10,000 at the end of its 8-year life. Moul regularly uses straight-line depreciation on similar equipment. For the year ended December 31, 20X0, what amount would Moul recognize as amortization expense on the leased asset?

Answer: $13,750 subtracted from the PV of lease payments. Only because the purchase option is expected to be used. Therefore you essentially own the asset now. Since the lease contains a purchase option which Moul expects to exercise, the equipment will be amortized over its useful life of 8 years. The amount to amortize will be the capitalized amount of $120,000 minus the salvage value of $10,000 for a amortizable basis of $110,000. Amortization in 20X0 will be $110,000/8 years or $13,750.

Lessee Company enters into a lease on January 1, 20X2 that is accounted for as a finance lease. The lease calls for quarterly payments of $15,000, beginning on January 1, 20X2, and continuing for 5 years. The last payment is due on October 1, 20X6. The lease has an implicit annual interest rate of 8%. The present value of an annuity due: - At 8% per period for 5 periods is 4.312 - At 2% per period for 20 periods is 16.678 What amount will Lessee report as a lease obligation on its financial statements dated December 31, 20X2?

Answer: $203,657

Depreciation Question: On January 1 of the current year, Tree Co. enters into a five-year lease agreement for production equipment. The lease requires Tree to pay $12,500 per year in lease payments. At the end of the five-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 reasonably assure its exercise. Tree would normally depreciate equipment of this type using the straight-line method. What amount is the carrying value of the asset related to this lease at December 31, of the current year?

Answer: $63,000

Important question because it is a finance lease with no title transfer or purchase option: On January 1, year 1, Eber Co. leased equipment under a four-year finance lease. The present value of the lease payments is $348,680. The equipment had a five-year economic life and a $20,000 guaranteed residual value. The equipment reverts to the lessor at the end of the lease. What amount should Eber report as amortization of the lease at December 31, year 1?

Answer: $87,170 The general rule for finance leases is that the right-of-use asset, which is measured at the present value (PV) of lease payments, will be amortized on a straight-line basis (ie, evenly) over the shorter of the lease term or useful life. There is an exception, however, when the title transfers to the lessee at the end of the lease or there is a purchase option reasonably certain to be exercised. In either of these instances, the lessee will amortize the asset over its useful life, since the lessee will receive the benefit of the asset's full useful life, rather than only for the lease term. Because there is no title transfer or purchase option in Eber's finance lease, the right-of-use asset will be amortized evenly over the shorter of the lease term (4 years) or useful life (5 years). Thus, the amortization expense can be calculated for the year by dividing the $348,680 PV of the lease payments by the 4-year lease term: $348,680* / 4 = $87,170. *Note that the PV of lease payments would already include any amount expected to be owed as a result of the guaranteed residual value (GRV; guaranteed residual value). CP notes; You don't amortize the residual value b/c it is include in the lease liability Things to Remember:The right-of-use asset for a finance lease is generally amortized evenly over the shorter of the lease term or useful life. If title transfers at lease end or there is a purchase option likely to be exercised, the useful life is used instead.

How do you account for leasehold improvements? Green Co. incurred leasehold improvement costs for its leased property. The estimated useful life of the improvements was 15 years. The remaining term of the nonrenewable lease was 20 years. These costs should be

Answer: Capitalized and depreciated over 15 years. When a lessee (ie, tenant) pays for enhancements (eg, interior walls, electrical fixtures, plumbing) to a leased space, the changes are called leasehold improvements. Regardless of the type of lease (eg, operating, finance), leasehold improvements are capitalized and depreciated. The improvements' depreciation corresponds to the amount of time during which an asset contributes value to the company. For leased property, the tenant depreciates the leasehold improvements using the shorter of the remaining lease term or the asset's useful life on a straight-line basis (Choice C). This matches the cost of the improvements with the revenues they help to generate. In this scenario, Green Co.'s leasehold improvements have a useful life of 15 years and a remaining lease term of 20 years. Because the useful life is shorter than the remaining lease term, Green should capitalize and depreciate the improvements over 15 years. Things to remember:Leasehold improvements are enhancements to a leased space paid for by the tenant. They are capitalized and depreciated using the shorter of the remaining lease term or the asset's useful life on a straight-line basis.

Important question because it is a finance lease with no title transfer or purchase option: Douglas Co. leased machinery with an economic useful life of six years. For tax purposes, the depreciable life is seven years. The lease is for five years, and Douglas can purchase the machinery at fair market value at the end of the lease. What is the amortizable life of the leased machinery for financial reporting purposes?

Answer: Five years, not six years The lease is a finance lease because the lease term of 5 years is more than a "major part" i.e. 75% of the 6-year useful life. Because this is a finance lease with no title transfer and no purchase option likely to be exercised, for financial reporting the lessee must amortize the asset over the shorter of either the economic useful life (six years) or lease term (five years).

What interest rate do you use? Robbins, Inc. leased a machine from Ready Leasing Co. The lease qualifies as a finance lease and requires 10 annual payments of $10,000 beginning immediately. The lease specifies an interest rate of 12% and a purchase option of $10,000 at the end of the tenth year, even though the machine's estimated value on that date is $20,000. Robbins has a policy of exercising purchase options on leased equipment when fair market value exceeds option price. Robbins' 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 Robbins record as lease liability at the beginning of the lease term?

Answer: Interest rate stated, for an amount of $66,500 Choice C (Correct) and Choices A, B, D (Incorrect): Since the interest rate of 12% is specified in the lease, Robbins is apparently aware of the rate. As a result, Robbins will calculate the lease obligation using the 12% rate. The lease payments will consist of a 10-year annuity of $10,000 and a purchase option of $10,000, likely to be exercised based on Robbins's policy, at the end of 10 years. The resulting present value amounts are: $10,000 x 6.328 or $63,280 $10,000 x .322 or $3,220 The result is an initial lease obligation of $66,500.

When do you take control of an asset? 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 rental expense for the new offices should begin in which of the following months?

Answer: January A lease is a contract between the lessor (ie, owner) and lessee (ie, renter) that conveys the right to control the use of property for a period of time in exchange for consideration. Leases are generally classified as operating (ie, rental) or finance (ie, purchase or sale). The lessee reports the operating lease in its financial statements by recording a right-of-use asset and a corresponding lease liability (ie, present value of lease payments). The lease payments (ie, rent) are expensed uniformly over the lease term on a straight-line basis. Monthly rent expense equals the total amount of rental payments divided by the total number of months in the lease term. An operating lease takes effect when the lessee takes control of the property at the commencement of the lease. The date when the lessee makes leasehold improvements to the space (ie, March) or moves into the space (ie, May) does not determine control. Rent payments can begin at a later date, but rent expense begins when the lessee has control of the property. In this scenario, the lessee enters into the lease agreement in January. At that point, the lessee has control over the space, so the rent expense begins in January. Things to remember:The lessee in an operating lease records a right-of-use asset and a corresponding lease liability. The lease payments are expensed uniformly over the lease term on a straight-line basis. Rent expense begins when the lessee has control of the property at the commencement of the lease.

Another good problem: On June 1, 20X3, Oren Co. entered into a five-year nonrenewable lease, commencing on that date, for office space and made the following payments to Cant Properties: Bonus to obtain lease $30,000First month's rent $10,000Last month's rent $10,000 In its income statement for the year ended June 30, 20X3, what amount should Oren report as rent expense?

As an operating lease, rent expense will be recognized uniformly over the 5-year term of the lease regardless of when the payments are made. The lease calls for a base rent of $10,000 per month plus a bonus of $30,000. The bonus will be allocated over the term of the lease at the rate of $6,000 per year or $500 per month. As a result, monthly rent expense will be $10,500. As of 6/30/X3, one month had elapsed resulting in rent expense of $10,500.

Not hard, but a little tricky: In the long-term liabilities section of its balance sheet at December 31, 20X2, Mene Co. reported a finance lease obligation of $75,000, net of current portion of $1,364. Payments of $9,000 were made on both January 2, 20X3, and January 2, 20X4. Mene's incremental borrowing rate on the date of the lease was 11% and the lessor's implicit rate, which was known to Mene, was 10%. In its December 31, 20X3, balance sheet, what amount should Mene report as finance lease obligation, net of current portion?

As of December 31, 20X2, the total lease liability was $75,000 + $1,364 or $76,364. The payment on 1/2/X3 would include interest at 10% of $7,636 and a reduction to the lease obligation of $1,364, resulting in an obligation of $75,000. When the payment is made on 1/2/X4, it will include interest at 10% of $7,500 and a principal reduction of $1,500. As of December 31, 20X3, the total lease obligation is $75,000. It will consist of a current portion of $1,500 and a noncurrent portion of $73,500.

Will a lease incentive bonus increase or decrease your lease payment for PV calculation purposes?

Decrease

In a finance lease, is the RT to use asset a plug (like for operating leases) or calculated evenly S/L?

Finance lease RT use Asset is S/L.

Will lease direct costs increase or decrease how your right of use asset is calculated?

Increase

How do executory costs affect the lease payments? See example: On December 31, 20X4, Red co. leased a machine from Green co. for a seven-year period. Equal annual payments under the lease are $112,500, including $7,500 annual executory costs, and are due on December 31 of each year. The first payment was made on December 31, 20X4, and the second payment was made on December 31, 20X5. The seven lease payments are discounted at 9% over the lease term. The present value of lease payments at the inception of the lease and before the first annual payment was $576,500. The lease is appropriately accounted for as a finance lease by Red Co. In its December 31, 20X5 balance sheet, Red Co. should report a lease liability of:

It decreases them from the lessee's perspective. The equal annual payments of $112,500 include executory costs of $7,500 per year, which are recognized as expense in the period incurred, resulting in net lease payments of $105,000 per year ($112,500 - $7,500), which are applied to interest expense and the lease obligation using the interest method. The initial lease obligation is $576,500. Since the first payment of $105,000 is made at the inception, before any interest has accrued, it is applied entirely to the obligation, reducing it to $471,500. The second payment will first be applied to interest with the remainder reducing the obligation. Interest is $471,500 x 9% or $42,435. The principal reduction is the difference of $62,565 ($105,000 - 42,435), reducing the obligation to $408,935 ($471,500 - 62,565).

Will accredited interest expense increase or decrease your lease liability?

It will increase

When should a lessor recognize in income a nonrefundable lease bonus paid by a lessee on signing an operating lease?

Over the life of the lease. A nonrefundable lease bonus paid by a lessee is treated as part of the lease payments and is recognized over the term of the lease.

When are profit and losses recognized for sale-lease back transactions?

Profits or losses are recognized immediately in a sales-leaseback transaction. When the shipping company sold the boat, its fair value was below its undepreciated cost, and the loss is recognized immediately.

How should an operating lease be recognized? What are the different journal entries to an operating lease? What is the plug?

Right to Use Journal Entry is considered the Plug, and therefore will be uneven.

There are 3 key steps in a finance lease. What should you use as the denominator for the RT Use Asset Amortization?

Shorter of the Lease Term or Useful Life (Unless there is a tittle transfer or purchase option, in which case you use the useful life). You don't subtract the FV at the end from the amortization, or residual value!

Question is in the image

Since the interest rate of 12% is specified in the lease, Robbins is apparently aware of the rate. As a result, Robbins will calculate the lease obligation using the 12% rate. The lease payments will consist of a 10-year annuity of $10,000 and a purchase option of $10,000, likely to be exercised based on Robbins's policy, at the end of 10 years. The resulting present value amounts are: $10,000 x 6.328 or $63,280 $10,000 x .322 or $3,220 The result is an initial lease obligation of $66,500.

Good for your conceptual understanding: On July 1, 20X9, 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: 12 months at $ 500 = $ 6,000 12 months at $ 750 = 9,000 12 months at $1,750 = 21,000 All payments were made when due. In Marr's June 30, 20X11, balance sheet, the accrued rent receivable should be reported as

Since the lease is a 3-year operating lease, the $36,000 to be received over the term of the lease will be recognized uniformly at the rate of $12,000 per year. As of 6/30/X11, $24,000 in rent was earned but only $15,000 had been received. Marr would report rent receivable of $9,000.

On December 1, 20X0, Tell Co. leased office space for five years at a monthly rental of $60,000. On the same date, Tell 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 Tell's 20X0 expense relating to utilization of the office space should be...

Since the lease was executed on 12/1/X0, only one month's rent of $60,000 would be reported as rent expense. The $60,000 paid as last month's rent will be reported as an asset, prepaid rent, and the deposit of $80,000 will be reported as an asset, deposits. The new walls and offices costing $360,000 will be capitalized as leasehold improvements and amortized over the 5-year term of the lease. Amortization will be $72,000 per year or $6,000 per month. As a result, Tell will report expenses in 20X0 of $60,000 in rent and $6,000 in amortization for a total of $66,000.

Easy but tricky: On December 30, 20X1, Rafferty Corp. leased equipment under a finance lease. Annual lease payments of $20,000 are due December 31 for 10 years. The equipment's useful life is 10 years, and the interest rate implicit in the lease is 10%. The finance lease obligation was recorded on December 30, 20X1, at $135,000, and the first lease payment was made on that date. What amount should Rafferty include in current liabilities for this finance lease in its December 31, 20X1, balance sheet?

The lease obligation recorded at the inception of the lease was $135,000. This would have been reduced by the initial $20,000 payment, made at the inception of the lease, resulting in an obligation of $115,000 at 12/31/X1. The payment on 12/31/X2 will consist of interest at 10% of $115,000 or $11,500. The remaining $8,500 will reduce the lease obligation in 20X2. As a result, $8,500 will be reported as a current liability, current portion of long-term debt, and the remaining $106,500 will be reported as noncurrent.

Can you solve this? 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 eight months' rent at no cost. What amount of monthly rent expense should be recognized over the life of the lease?

The lease payments (ie, rent) are expensed uniformly over the lease term on a straight-line (S/L) basis. Reduced or waived rent payments benefit the entire lease term and are reflected in the total lease payments used to calculate the monthly lease expense. In this scenario, the lessor gives an incentive of 8 months' free rent in the 120-month lease resulting in 112 payments. The total amount of rent paid is $1,680,000 ($15,000 payment × 112 months). Therefore, the S/L amount of monthly rent expense equals $14,000 ($1,680,000 total payments / 120 months).

When you amortize a finance lease, should you use the lease term or useful life?

Useful life Since the lease contains a purchase option which Nori expects to exercise, the equipment will be amortized over its useful life of 8 years (but lease term was 5 years). The amount to amortize will be the capitalized amount of $240,000 minus the salvage value of $20,000 for a amortizable basis of $220,000. Amortization in 20X2 will be $220,000/8 years or $27,500.

Answer: Green Co. incurred leasehold improvement costs for its leased property. The estimated useful life of the improvements was 15 years. The remaining term of the nonrenewable lease was 20 years. These costs should be 1) Expensed as incurred. 2) Capitalized and depreciated over 20 years. 3) Capitalized and expensed in the year in which the lease expires 4) Capitalized and depreciated over 15 years.

When a lessee (ie, tenant) pays for enhancements (eg, interior walls, electrical fixtures, plumbing) to a leased space, the changes are called leasehold improvements. Regardless of the type of lease (eg, operating, finance), leasehold improvements are capitalized and depreciated. The improvements' depreciation corresponds to the amount of time during which an asset contributes value to the company. For leased property, the tenant depreciates the leasehold improvements using the shorter of the remaining lease term or the asset's useful life on a straight-line basis (Choice C). This matches the cost of the improvements with the revenues they help to generate. In this scenario, Green Co.'s leasehold improvements have a useful life of 15 years and a remaining lease term of 20 years. Because the useful life is shorter than the remaining lease term, Green should capitalize and depreciate the improvements over 15 years. Things to remember:Leasehold improvements are enhancements to a leased space paid for by the tenant. They are capitalized and depreciated using the shorter of the remaining lease term or the asset's useful life on a straight-line basis.

You should use the implicit rate if it is known by who?

When it is known by the lessee. The implicit rate will always be known by the lessor, b/c they make it up, so the lessor will always use the implicit rate. If the rate is not known, then the lessee will use the incremental borrowing rate.

For operating leases, when do you start recognizing lease expense? 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 rental expense for the new offices should begin in which of the following months? 1) January 2) March 3) May 4) July

When the lessee has control over the asset. A lease is a contract between the lessor (ie, owner) and lessee (ie, renter) that conveys the right to control the use of property for a period of time in exchange for consideration. Leases are generally classified as operating (ie, rental) or finance (ie, purchase or sale). The lessee reports the operating lease in its financial statements by recording a right-of-use asset and a corresponding lease liability (ie, present value of lease payments). The lease payments (ie, rent) are expensed uniformly over the lease term on a straight-line basis. Monthly rent expense equals the total amount of rental payments divided by the total number of months in the lease term. An operating lease takes effect when the lessee takes control of the property at the commencement of the lease. The date when the lessee makes leasehold improvements to the space (ie, March) or moves into the space (ie, May) does not determine control. Rent payments can begin at a later date, but rent expense begins when the lessee has control of the property. In this scenario, the lessee enters into the lease agreement in January. At that point, the lessee has control over the space, so the rent expense begins in January. Things to remember:The lessee in an operating lease records a right-of-use asset and a corresponding lease liability. The lease payments are expensed uniformly over the lease term on a straight-line basis. Rent expense begins when the lessee has control of the property at the commencement of the lease.

Can tax and insurance costs be apart of the lease payment even though they are itemized separately? Example: On December 31, 20X4, Red co. leased a machine from Green co. for a seven-year period. Equal annual payments under the lease are $105,000, including $7,500 allocated annually for taxes and insurance, and are due on December 31 of each year. The first payment was made on December 31, 20X4, and the second payment was made on December 31, 20X5. The seven lease payments are discounted at 9% over the lease term. The present value of lease payments at the inception of the lease and before the first annual payment was $576,500. The lease is appropriately accounted for as a finance lease by Red Co. In its December 31, 20X5 balance sheet, Red Co. should report a lease liability of:

Yes The equal annual payments of $105,000 include tax and insurance costs of $7,500 per year, which are still considered part of the lease payment even though the tax + insurance portion of the payment is itemized separately. The initial lease obligation is $576,500. Since the first payment of $105,000 is made at the inception, before any interest has accrued, it is applied entirely to the obligation, reducing it to $471,500. The second payment will first be applied to interest with the remainder reducing the obligation. Interest is $471,500 x 9% or $42,435. The principle reduction is the difference of $62,565 ($105,000 - 42,435), reducing the obligation to $408,935 ($471,500 - 62,565).

When you are calculating the amortization expense on a leased asset, do you need to net the lease payments with the estimated salvage value?

Yes. Since the lease contains a purchase option which Nori expects to exercise, the equipment will be amortized over its useful life of 8 years. The amount to amortize will be the capitalized amount of $240,000 minus the salvage value of $20,000 for a amortizable basis of $220,000. Amortization in 20X2 will be $220,000/8 years or $27,500.

When reducing the lease liability in a finance lease, is this number a plug?

Yes. It will be the difference between the cash paid and the interest expense. In an operating lease the reduction of the RT to Use asset was the plug.

See example of operating lease

You need to back out the $10,000 for a lump sum and add the $5,000 in for a lump sum. The reason why you have to do this is because you are receiving the discount on the lease.