Chapter 21A

Stovall Industries leased equipment to Arnett Manufacturing on July 1, 2016, for a ten-year period expiring June 30, 2026. The lease is properly accounted for as a finance lease by the lessee and as a sales-type lease by the lessor. The terms of the lease agreement require equal annual payments of $50,000 on July 1 of each year, starting in 2016. The effective interest rate for the lease is 9%. The present value of the payments is $350,000 at the beginning of the new lease. The cost of the equipment on Stovall's accounting records was $310,000. What amount of profit on the sale and interest revenue would Stovall record for the year ended December 31, 2016?

$40,000 and $13,500. The profit is the difference between the sales price and the cost of goods sold, or $350,000 - $310,000 = $40,000. The lease receivable on July 1, 2016, will be $350,000 - $50,000 = $300,000. For the six months between July 1 and December 31, the accrued interest would be $300,000 x 9% x 6/12 = $13,500.

Which of the following is correct regarding executory costs? Select all that apply. A Executory costs included in the fixed payments required by the lessor are included in the measurement of the lease liability. B They include property insurance and property taxes. C Payments made by the lessee directly for executory costs are included in the measurement of the lease liability. D Gross leases require the lessee to make payments directly to a third party for executory costs.

A Executory costs included in the fixed payments required by the lessor are included in the measurement of the lease liability. B They include property insurance and property taxes.

Conceptual nature of a lease

A lease conveys the use of an asset from one party (the lessor) to another (the lessee) without transferring ownership. While there are various views, the FASB has recently adopted the requirement to: -Capitalize all long-term leases -Exception of leases that cover a term of less than one year.

THE LEASING ENVIRONMENT

A lease is a contractual agreement between a lessor and a lessee, that gives the lessee the right to use specific property, owned by the lessor, for a specified period of time. Largest group of leased equipment involves: Information technology equipment Transportation (trucks, aircraft, rail) Construction Agriculture

How is lease expense recorded for an operating lease?

By computing interest on the lease liability using the effective-interest method and then amortizing the right-of-use asset in a manner that results in equal amounts of lease expense each period.

In order to classify a transaction as a sales-type lease, a lessor must meet one of the lease classification tests. What other criterion must the lessor meet for lease capitalization?

The collectibility of the payments from the lessee must be probable.

How is the present value of the lease payments computed by the lessee impacted by a bargain-purchase option?

The lessee must increase the present value of the lease payments by the present value of the option price.

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. If the lease transfers control (or ownership) of the underlying asset to a lessee, then the lease is classified as a finance lease. -Must be non-cancelable -Meet at least one of the five tests:

Which of the following is an essential element of a lease agreement?

The lessor allows the lessee to use the leased property.

How is the lease receivable defined in a sales-type lease?

The present value of the rental payments + present value of guaranteed and unguaranteed residual values.

Margaret and Tim are studying the chapter on leasing for their Intermediate Accounting exam. Margaret believes that a common advantage of leasing is that it improves financial ratios by increasing assets without a corresponding increase in debt and a common disadvantage is that leasing permits 100% financing versus 60 to 80% when purchasing an asset. Tim believes that a common advantage of leasing is that it reduces the risk of obsolescence, consequently permitting rapid changes in equipment. Which of the following is correct?

Tim is correct about the risk of obsolescence, but Margaret is incorrect about both her advantage and disadvantage because leasing does not improve financial ratios by increasing assets without a corresponding increase in debt and the 100% financing is an advantage rather than a disadvantage of leasing.

The lease agreement that would most likely be classified as an operating lease is

a lease agreement in which the lessee may renew the two-year lease for an additional two years at the same rental.

When a ________ properly accounts for an operating lease, it ________ the amount of interest on the liability to/from the straight-line lease expense to arrive at the amount of ___________.

lessee; deducts; amortization on the right-to-use asset.

Jansen Company leased a machine with a cost and fair value of $250,000 to Naylor Company. The machine will have no residual value at the end of the 6-year lease. What will the six beginning-of-the-period lease payments be if the lessor's implicit interest rate is 12%? Assume that the present value of an annuity due for 6 periods at 12% is 4.60478, and the present value of an ordinary annuity for 6 periods at 12% is 4.11141

$54,291 The beginning-of-period payments are an annuity due, therefore, the annual lease payments will be $250,000/4.60478 = $54,291.

Companies classify lease arrangements as either _______ or __________.

Finance or Operating In either case, companies capitalize all leased assets and liabilities. That means the balance sheet is the same for either.

Which of the following are included in the lessee's calculation of the lease payments? I. The penalty for failure to renew or extend the lease that is reasonably certain of being exercised. II. The bargain purchase option. III. The fixed rental payments. IV. The present value of the cost of the leased asset.

I, II, and III.

Lessee Accounting for Operating Leases

If a lease does not meet any of the lease classification tests for a finance lease, a lessee should classify it as an operating lease. For leases classified as operating, the lessee records a right-of-use asset and lease liability at commencement of the lease, similar to the finance lease approach. However, unlike a finance lease, the lessee records the same amount for lease expense each period over the lease term.

For a finance lease, the portion of the lease liability due within one year or the operating cycle, whichever is longer, is

classified as a current liability.

Advantages of leasing

-100% financing at fixed rates. -Protection against obsolescence. -Flexibility. -Less costly financing.

Which of the following is included in the lease payments used for the present value test? Select all that apply. A unguaranteed residual values B renewal option at the expected fair rental value at the time the option becomes exercisable C Variable lease payments based on an index D Fixed lease payments

C Variable lease payments based on an index D Fixed lease payments

In which of the following situations could a lessee ignore the lease classification tests stating that a leased asset should be capitalized if the lease term is equal to 75% or more of the estimated remaining economic life of the leased asset?

If the inception of the lease occurs during the last 25% of the life of the asset.

Which of the following is a primary difference between a direct financing lease and a sales-type lease?

The involvement of a third party to guarantee a residual value.

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 lease expense is the same from period to period. 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.

Five tests:

Transfer of Ownership Test If the lease transfers ownership of the asset to the lessee, it is a finance lease. Purchase Option Test 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 (bargain purchase option). 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 (75% test). Lease term is generally considered to be the fixed, non-cancelable term of the lease. Bargain-renewal option can extend this period. 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. Present value test Present value of lease payments is reasonably close to the fair value of the asset - 90% test Lease Payments include the following: Fixed payments. Variable payments that are based on an index or a rate. Guaranteed residual value. Payments related to purchase or termination options that the lessee is reasonably certain to exercise. 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. The assumption is that the lessee uses all the benefits from the leased asset and therefore the lessee has essentially purchased the asset.

If at the end of the lease term the ________ does not have an alternative use for the leased asset, the ____________ classifies the lease as a(n) ____________ lease.

lessor; lessee; finance

When disclosing lease information in the notes to the financial statements, which of the following should only be reported by the lessor?

management approaches for risk associated with residual value of leased assets

If the fair value of the leased asset is less than the expected residual value, and if the lessee guaranteed the residual value,

the lessee will record a loss.

If a sales-type lease results in the lessor reporting a loss,

the lessor recognizes sales revenue and cost of goods sold.

In a sale-leaseback transaction, a failed sale is recorded

when any of the lease classification tests are met.