CH.21
LBJ Corp. agrees on January 1, 2020, to lease equipment from Cal-Auto Inc. for three years. The lease calls for annual lease payments of $23,000 at the beginning of each year. The lease does not transfer ownership, not does it contain a bargaining purchase option, and is not a specialized asset. In addition, the useful life of the equipment is 10 years and the present value of the lease payment is less than 90% of the fair value of the equipment. Assume that the implicit rate used by the lessor is unknown, and LBJ's incremental borrowing rate is 6%. 1)What is the Right-of-Use asset amount that LBJ Corp. should recognize at the commencement of the lease agreement? 2)What is the lease expense that LBJ Corp. should recognize for 2020 assuming that its fiscal year ends December 31? 3)What journal entry would LBJ Corp. make at December 31, 2020 to record lease expense?
1)Present value of the lease payment = $23,000 × PV factor [table VI] (n=3, i= 6%, Annuity Due) = $23,000 × 2.8334 = $65,168. 2)Explanation: For operating lease, the lessee continues to use the effective-interest method for amortizing the lease liability. However, instead of reporting interest expense, a lessee reports interest on the lease liability as part of Lease Expense. In addition, the lessee no longer reports amortization expense related to the right-of-use asset. Instead, it "plugs" in an amount for amortization that increases the Lease Expense account so that it is the same amount from period to period. Thus, lease expense is equal to the annual lease payment, $23,000. 3) Dr. Lease expense $23,000 Cr. Lease liability $2,530 Cr. ROU Asset $20,470
On January 1, 2021, Yancey, Inc. signs a 10-year noncancelable lease agreement to lease a storage building from Holt Warehouse Company. Collectibility of lease payments is reasonably predictable and no important uncertainties surround the amount of costs yet to be incurred by the lessor. The following information pertains to this lease agreement. (a) The agreement requires equal rental payments of $887,703 at the beginning each year. (b) The fair value of the building on January 1, 2021 is $6,000,000; however, the book value to Holt is $4,950,000. (c) The building has an estimated economic life of 10 years, with no residual value. Yancey depreciates similar buildings using the straight-line method. (d) At the termination of the lease, the title to the building will be transferred to the lessee. (e) Yancey's incremental borrowing rate is 11% per year. Holt Warehouse Co. set the annual rental to insure a 10% rate of return. The implicit rate of the lessor is known by Yancey, Inc. (f) Yancey's will pay $15,000 of the property taxes (executory costs) related to the leased asset directly to the taxing authority. 1)From the lessee's viewpoint, what type of lease in this? 2)From the lessor's viewpoint, what type of lease is involved? 3)What is the Right-of-Use asset amount that Yancey should recognize at the commencement of the lease agreement? 4)Yancey, Inc. would record amortization expense on this asset in 2021 of 5)If the lease was nonrenewable, there was no bargain purchase option, title to the building does not pass to the lessee at termination of the lease and the lease term was only for eight years, what type of lease would this be for the lessee?
1)Finance lease Explanation: For a lease to be recorded as a finance, the lease must be noncancelable and meet one of the following five criteria: 1. The lease transfers ownership of the property to the lessee at the end of the lease. 2. The lease contains a bargain-purchase option. 3. The lease term is equal to 75% or more of the estimated economic life of the leased property. 4. The present value of the lease payments (excluding executory costs) equals or exceeds 90% of the fair value of the leased property. 5. Underlying asset of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term. Since at the termination of the lease, the title to the building will be transferred to the lessee, it is a finance for lessees. 2)Sales-type lease At the termination of the lease, the title to the building will be transferred to the lessee and there is no involvement of an unrelated third party. Thus, it is a sales-type lease. 3)$6,000,000 Present value of the lease payment = $887,703 × PV factor (n=10, i= 10%, Annuity Due) = $887,703 × 6.7590 = $6,000,000. 4)$600,000 If the lease agreement transfers ownership of the leased asset, amortize the ROU asset over the economic life of the leased asset. Amortization expense = $6,000,000 ÷ 10 years = $600,000 5)Finance lease Explanation: Lease term = 8 years 75% of Economic life of leased asset = 75% x 10 years = 7.5 years ---The lease term is more than 75% of the estimated economic life of leased property --- the lease agreement meets one of five criteria for a finance lease
Krause Company on January 1, 2020, enters into a ten-year noncancelable lease for equipment having an estimated useful life of 12 years and a fair value to the lessor, Daly Corp., at the inception of the lease of $4,000,000. The following data are relevant to the lease agreement. a. Rental payments of $266,000, payable at the beginning of each six-month period. b. A guarantee by Krause Company that Daly Corp. will realize $200,000 from selling the asset at the expiration of the lease. However, the actual residual value is expected to be $120,000. c. Krause's incremental borrowing rate is 9%. However, Krause is aware that the lessor used an implicit rate of 8% in computing the lease payments. d. Krause uses the straight-line method to depreciate its assets. e. The equipment has a cost of $3,600,000 to Daly Corp. 1) The classifications of a lease by Krause Company (the lessee) and by Daly Corp (the lessor) are. 2) On January 1, 2020, Krause should record the lease liability at the inception of the lease agreement 3)Assuming the first payment is made on time, the amount that should be reported by Krause Company as the lease liability on its January 1, 2020 balance sheet is 4)Which is the appropriate entries for Krause Company to recognize the second rental payment (July 1, 2020)? 5)Krause company would record amortization expense on this asset in 2020 of 6)1. What amount would Daly Corp record as Lease Receivable at the inception of the lease? 7)At the end of the lease term (1/1/2030) the fair market value of the residual value is $100,000. What is the amount of gain or loss Krause should record when it transfers lease equipment to Daly Corp?
1)The classifications of a lease by Krause Company (the lessee) and by Daly Corp (the lessor) are. Finance lease and sales-type lease Krause Company: Lease term 10 years > 75% of the economic life of the equipment (12 years). Thus, it is a finance lease. Daly Corp: Since the lease classification tests for the lessor are identical to the tests used by the lessee and there is no involvement of an unrelated third party, it is a sales-type lease. 2)On January 1, 2020, Krause should record the lease liability at the inception of the lease agreement: The present value of the lease payments for measurement of lease liability and the ROU asset is : PV factor (table-VI- an annuity due, n=20, i=4% 14.13394 Semi-annual payments × $266,000 Present value of semi-annual payment $3,759,628 PV factor (table-II -a single payment n=20, i=4%) 0.45639 Guaranteed residual value less expected RV × $80,000* $36,511 Present value of lease payments $3,796,139 · Guaranteed R.V. $200,000 - Expected R. V. $120,000 = $80,000 (additional liability) 3)Assuming the first payment is made on time, the amount that should be reported by Krause Company as the lease liability on its January 1, 2020 balance sheet is: The lease liability at the inception of lease agreement, $3,796,139 - First payment $266,000 = $3,530,139 4)Which is the appropriate entries for Krause Company to recognize the second rental payment (July 1, 2020)? Dr. Lease Liability $124,794 Dr. Interest Expense $141,206 Cr. Cash $266,000 $3,530,139 × 4% = $141,206, The half year interest : 8% / 2 = 4%. 5)Krause company would record amortization expense on this asset in 2020 of: Recognize amortization expense in 2020 Dr. Amortization Expense $379,614* Cr. Accumulated Amortization $379,614 $3,796,135 ÷ 10 yrs = $379,614 6) What amount would Daly Corp record as Lease Receivable at the inception of the lease? The lease receivable for the lessor = PV of regular rental (lease) payment + PV of residual value (regardless of guarantees) = A + B = $3,850,906 PV factor (an annuity due, n=20, i=4% 14.13394 14.13394 × $266,000 $3,759,628 (A) PV factor (a single payment n=20, i=4%) 0.45639 Guaranteed residual value (RV) × $200,000 $91,278 (B) 7)At the end of the lease term (1/1/2030) the fair market value of the residual value is $100,000. What is the amount of gain or loss Krause should record when it transfers lease equipment to Daly Corp? Krause Company (Lessee) Dr. Loss on lease $20,000** Dr. Lease liability $80,000 Cr. Cash $100,000 · On January 1, 2030, since the fair value of the underlying asset ($100,000) is less than the expected residual value ($120,000), Krause has further to compensate Daly Corp. under the residual value guarantee. Thus, Krause must pay an additional $20,000 upon returning the equipment to Daly Corp. and recognize a loss of $20,000.
The lease receivable amount includes the present value of a. rental payments plus the present value of guaranteed and unguaranteed residual values. b. rental payments only. c. rental payments plus the present value of the unguaranteed residual value only. d.rental payments plus the present value of the guaranteed residual value only.
a. rental payments plus the present value of guaranteed and unguaranteed residual values.
1. Which of the following are reasons why a company is involved in leasing to other companies? 1)Interest revenue 2)High residual values 3)tax incentives 4)guaranteed bargain purchase options
1,2,3
Metcalf Company leases a machine from Vollmer Corp. under an agreement which meets the criteria to be a finance lease for Metcalf. The six-year lease requires payment of $170,000 at the beginning of each year, including $25,000 per year for maintenance, insurance, and taxes. The incremental borrowing rate for the lessee is 10%; the lessor's implicit rate is 8% and is known by the lessee. The present value of an annuity due of 1 for six years at 10% is 4.79079. The present value of an annuity due of 1 for six years at 8% is 4.99271. Metcalf should record the leased asset at
Because the lessee knows the implicit interest rate computed by the lessor, lessee must use the lessor's implicit rate (8%). PV of minimum lease payments = Annual payment x PV factor = $170,000 × 4.99271 = $848,761
Which of the following is not one of the lease classification tests? a. Transfer of ownership b. Purchase option c. Lease term d. Collectibility
Collectibility
Lease payments include: I. fixed payments. II. variable payments based on an index. III a bargain purchase option. IV. a guaranteed residual value.
I, II, III, and IV.
Which of the following would be included in the Lease Receivable account? I. Guaranteed residual value. II. Unguaranteed residual value. III. Executory costs IV. Rental payments.
I, II, and IV.
On January 1, 2021, Dean Corporation signed a ten-year noncancelable lease for certain machinery. The terms of the lease called for Dean to make annual payments of $220,000 at the end of each year for ten years with the title passing to Dean at the end of this period. The machinery has an estimated useful life of 15 years and no salvage value. Dean uses the straight-line method of depreciation for all of its fixed assets. Dean accordingly accounted for this lease transaction as a finance lease. The lease payments were determined to have a present value of $1,342,016 at an effective interest rate of 8%. With respect to this capitalized lease, Dean should record for 2021
Interest expense = Present value of $1,342,016 x effective interest rate of 8% = $107,361 Amortization Expense = $1,342,016 ÷ 15 years = $89,468 (because the lease agreement transfers ownership of the leased asset, amortize the ROU asset over the economic life of the asset.) interest expense of $107,361 and amortization expense of $89,468. December 31, 2021 Recognize interest expense on the lease liability Dr. Interest Expense $107,361 Cr. Interest Payable $107,361 Amortization expense on the leased asset Dr. Amortization Expense $89,468 Cr. ROU Assets - Finance Lease$89,468
In a finance lease, the lessee records a. amortization expense only. b. interest expense only. c. lease expense only. d. amortization expense and interest expense.
amortization expense and interest expense.
A lessee with a finance lease containing a bargain purchase option should depreciate the leased asset over the a. asset's remaining economic life. b. term of the lease. c. life of the asset or the term of the lease, whichever is shorter. d. life of the asset or the term of the lease, whichever is longer.
asset's remaining economic life.
In an operating lease, the lessee records a. amortization expense. b. interest expense. c. lease expense. d. amortization expense and lease expense.
lease expense.
In computing amortization of a leased asset where there is no bargain purchase option, the lessee should subtract a. no residual value and depreciate over the term of the lease. b. an unguaranteed residual value and depreciate over the term of the lease. c. a guaranteed residual value and depreciate over the life of the asset. d. an unguaranteed residual value and depreciate over the life of the asset.
no residual value and depreciate over the term of the lease.
The classifications of a lease by the lessee are a. operating and finance leases. b. operating, sales, and finance leases. c. operating and leveraged leases. d. None of these answers are correct.
operating and finance leases.
What impact does a bargain purchase option have on the present value of the minimum lease payments computed by the lessee? a. There is no impact as the option does not enter into the transaction until the end of the lease term. b. The lessee must increase the present value of the minimum lease payments by the present value of the option price. c. The lessee must decrease the present value of the minimum lease payments by the present value of the option price. d.The minimum lease payments would be increased by the option price.
The lessee must increase the present value of the minimum lease payments by the present value of the option price.
What payments are included in the lease liability?
The lessee should include variable lease payments in the value of the lease liability at the level of the index/rate at the commencement date.
On December 31, 2021, Burton, Inc. leased machinery with a fair value of $1,575,000 from Cey Rentals Co. The agreement is a six-year noncancelable lease requiring annual payments of $300,000 beginning December 31, 2021. The lease is appropriately accounted for by Burton as a finance lease. Burton's incremental borrowing rate is 11%. Burton knows the interest rate implicit in the lease payments is 10%. The present value of an annuity due of 1 for 6 years at 10% is 4.7908. The present value of an annuity due of 1 for 6 years at 11% is 4.6959. In its December 31, 2021 balance sheet, Burton should report a lease liability of
$1,437,240 Explanation: Because the lessee knows the implicit interest rate computed by the lessor, the lessee must use the lessor's implicit rate (10%). PV of lease payments = Annual payment x PV factor annuity due = $300,000 × 4.7908 = $1,437,240 Capitalize lease asset and liability Dr. ROU Asset $1,437,240 Cr. Lease Liability $1,437,240 First lease payment Dr. Lease liability $300,000 Cr. Cash $300,000 Thus, the balance of lease liability as of 12/31/2021 is $1,137,240 (= $1,437,240 - $300,000)
1. Alt Corporation enters into an agreement with Yates Rentals Co. on January 1, 2021 for the purpose of leasing a machine to be used in its manufacturing operations. The following data pertain to the agreement: (a) The term of the noncancelable lease is 3 years with no renewal option. Payments of $574,864 are due on January 1 of each year. (b) The fair value of the machine on January 1, 2021, is $1,600,000. The machine has a remaining economic life of 5 years, with no salvage value. The machine reverts to the lessor upon the termination of the lease. (c) Alt depreciates all machinery it owns on a straight-line basis. (d) The machine is not of a specialized nature and is expected to have use to Yates when returned at the end of the lease. (e) Alt's incremental borrowing rate is 10% per year. Alt does not have knowledge of the 8% implicit rate used by Yates. What type of lease is this from Alt Corporation's viewpoint?
Finance lease This is a finance lease because the present value of lease payments is greater than 90% of the fair value of leasing property. The PV of lease payments = annual lease payment, $574,864 x 2.7355(table VI,n=3,i=10%) = $1,572,540 The discount rate is Alt's incremental borrowing rate of 10% because Alt does not have knowledge of the 8% implicit rate used by Yates. The PV of lease payment, $1,572,540 is greater than 90% of $1,600,000 (=$1,440,000)
From a lessee perspective, distinguish between a finance lease and an operating lease.
For a finance lease, the lessee recognizes interest expense on the lease liability over the life of the lease using the effective-interest method and records amortization expense on the right-of-use asset generally on a straight-line basis. A lessee therefore reports both interest expense and amortization of the right-of-use asset on the income statement. As a result, the total expense for the lease transaction is generally higher in the earlier years of the lease arrangement under a finance lease arrangement. In an operating lease, the lessee also measures interest expense using the effective-interest method. However, the lessee amortizes the right-of-use asset such that the total reported lease expense is the same from period to period. In other words, for operating leases, only a single lease expense (comprised of interest on the liability and amortization of the right-of-use asset) is recognized on the income statement, typically on a straight-line basis. If the lease transfers control (or ownership) of the underlying asset to a lessee, then the lease is classified as a finance lease. In this situation, the lessee takes ownership or consumes the substantial portion of the underlying asset over the lease term. All leases that do not meet any of the finance lease tests are classified as operating leases. In an operating lease, a lessee obtains the right to use the underlying asset but not ownership of the asset itself.
Identify the lease classification tests and how they are applied.
For a lease to be a finance lease, it must be non-cancelable and meet at least one of the 5 tests. Otherwise, the lease is an operating lease. 1) Transfer of Ownership Test If the lease transfers ownership of the asset to the lessee, it is a finance lease. This test is not controversial and easily implemented in practice. 2) Purchase Option Test A purchase option test is met if it is reasonably certain that the lessee will exercise the option. In other words, the lease purchase option allows the lessee to purchase the property for a price that is significantly lower than the underlying asset's expected fair value at the date the option becomes exercisable (hereafter referred to as a bargain purchase option). (For example, assume that Brett's Delivery Service leases a Honda Accord for $499 per month for 40 months, with an option to purchase the Accord for $100 at that end of the lease. If the estimated fair value of the Honda Accord is $3,000 at the end of the 40 months, the $100 option is clearly a bargain purchase option. Therefore, Brett's accounts for this lease as a finance lease.) 3) Lease Term Test If the lease term is 75 percent or greater of the economic life of the leased asset, the lease meets the lease term test and finance lease treatment is appropriate (often referred to as the 75% test. (a bargain renewal option allows the lessee to renew the lease for a rental that is lower than the expected fair rental at the time the option becomes exercisable. At the commencement of the lease, the difference between the renewal rental and the expected fair rental must be great enough to make exercise of the option to renew reasonably certain). 4) Present Value Test If the present value of the lease payments is reasonably close to the fair value of the asset, a company is effectively purchasing the asset and should therefore use the finance method to account for the lease. 5)Alternative Use Test If at the end of the lease term the lessor does not have an alternative use for the asset, the lessee classifies the lease as a finance lease. In this situation, the assumption is that the lessee uses all the benefits from the leased asset and therefore the lessee has essentially purchased the asset.
On January 1, 2021, Ogleby Corporation signed a five-year noncancelable lease for equipment. The terms of the lease called for Ogleby to make annual payments of $180,000 at the beginning of each year for five years with title passing to Ogleby at the end of this period. The equipment has an estimated useful life of 7 years and no salvage value. Ogleby uses the straight-line method of depreciation for all of its fixed assets. Ogleby accordingly accounts for this lease transaction as a finance lease. The lease payments were determined to have a present value of $750,578 at an effective interest rate of 10%. With respect to this lease, for 2021 Ogleby should record
Interest expense = [$750,578 - $180,000 (First payment)] × 10% = $57,058 Amortization expense = $750,578 ÷ 7 years = $107,225 interest expense of $57,058 and amortization expense of $107,225. If the ROU asset will be transferred to the lessee at the end of the lease term (ownership transfer) or it is reasonably certain that the lessee will exercise a bargaining purchase option (BPO) for the ROU asset, then the ROU asset should be amortized over the useful life of the ROU asset. Otherwise it is amortized over the lease term.
1. On January 1, 2021, Eubank Company, as lessee, enters into a lease agreement for equipment. The following data are relevant to the lease agreement. a. The lease is noncancelable and does not contain automatic title transfer or a bargain purchase option. b. The lease term is 4 years. c. The lease agreement specifies annual payments of $140,000 beginning January 1, 2021, the inception of the lease, and at each January 1 through 2024. d. All of the executory costs are included in annual lease payments and required the lessor. e. Eubank's incremental borrowing rate is 10% per year. The lessee is aware that the lessor used an implicit rate of 8% in computing the lease. f. The fair value of the equipment on January 1, 2021 is $540,000. g. The equipment has an economic life of 6 years. Eubank Company uses the straight-line method for this type of equipment. On January 1, 2021, Eubank Company should record the lease liability at the inception of the lease agreement
Since the lessee is aware of lessor's implicit rate and it is less than lessee's incremental borrowing rate, Eubank should use 8% to compute the present value. The PV of lease payments = annual lease payment, $140,000 x 3.5771 (table VI,n=4,i=8%) = $500,794
Pisa, Inc. leased equipment from Tower Company under a four-year lease requiring equal annual payments of $344,152, with the first payment due at lease inception. The lease does not transfer ownership, nor is there a bargain purchase option. The equipment has a 4-year useful life and no salvage value. Pisa, Inc.'s incremental borrowing rate is 10% and the rate implicit in the lease (which is known by Pisa, Inc.) is 8%. Pisa, Inc. uses the straight-line method to amortize similar assets. What is the amount of amortization expense recorded by Pisa, Inc. in the first year of the asset's life? PV annuity due PV ordinary annuity 8%,4periods: 3.57710 3.31213 10%,4periods: 3.48685 3.16986
This is a finance lease since the lease term (4 years) is greater than 75% of the useful life (4 years). Thus, Pisa, Inc. (a lessee) should amortize the lease property (ROU assets) ROU Asset = $344,152 × 3.57710 = $1,231,066 Amortization expense = $1,231,066 / 4yrs = $307,767.
When lessors account for residual values related to leased assets, they a. include the residual value in the receivable measurement because it is assumed the residual value will be realized. b. include the unguaranteed residual value in sales revenue. c. recognize more gross profit on a sales-type lease with a guaranteed residual value than on a sales-type lease with an unguaranteed residual value. d. reduce the residual value by the executory costs.
include the residual value in the receivable measurement because it is assumed the residual value will be realized.
For a sales-type lease, a. the sales price includes the present value of the unguaranteed residual value. b. the present value of the guaranteed residual value is deducted to determine the cost of goods sold. c. the gross profit will be the same whether the residual value is guaranteed or unguaranteed. d. assets are depreciated by the lessor.
the gross profit will be the same whether the residual value is guaranteed or unguaranteed.
In computing the present value of the lease payments, the lessee should a. use its incremental borrowing rate in all cases. b. use both its incremental borrowing rate and the implicit rate of the lessor, assuming that the implicit rate is known to the lessee. c. use the implicit rate of the lessor, assuming that the implicit rate is known to the lessee. d.use the implicit rate in all cases.
use the implicit rate of the lessor, assuming that the implicit rate is known to the lessee.