LEASES

On July 1, Year One, South Co. entered into a ten-year operating lease for a warehouse facility. The annual minimum lease payments are $100,000. In addition to the lease payment, South incurred building operating expenses of $20,000 for the year ended June 30, Year Two. In the notes to South's June 30, Year Two, financial statements, what amounts of subsequent years' lease payments should be disclosed?

$100,000 per annum for each of the next five years and $900,000 in the aggregate South Co. should disclose a description of the lease agreement, annual lease payment obligations of $100,000 per year for each of the next five years, and the $900,000 ($100,000 × 9 years) aggregate total future payments. The $20,000 paid for annual operating cost are period expenses and would not be disclosed as a part of the future lease obligations.

On January 1, 20X5, Blaugh Co. signed a lease for an office building. The terms of the lease required Blaugh to pay $10,000 annually, beginning December 30, 20X5, and continuing each year for 30 years. The lease qualifies as a finance lease. On January 1, 20X5, the present value of the lease payments is $112,578 at the 8% interest rate implicit in the lease. In Blaugh's December 31, 20X5, balance sheet, the finance lease liability should be:

$111,584. The finance lease liability is calculated below. Present value at 1/1/X5 $112,578 Payment made 12/30/X5 $10,000 Interest portion for 20X5 (8% × $112,578) $ 9,006 Portion applied to the liability $ 994 Finance lease liability 12/31/X5 $111,584

On January 1, Year 1, Harrow Co., as lessee, signed a five-year non-cancellable equipment lease with annual payments of $100,000 beginning December 31, Year 1. Harrow properly treated this transaction as a finance lease. The five lease payments have a present value of $379,000 at January 1, Year 1, based on the implicit interest rate of 10%. What amount should Harrow report as interest expense for the year ended December 31, Year 1?

$37,900 The interest expense for Year 1 is $37,900, the implicit interest rate (10%) multiplied by the January 1, Year 1, present value ($379,000).

On January 1, Year 1, Babson, Inc. leased two automobiles for executive use. The lease requires Babson to make five annual payments of $13,000 beginning January 1, Year 1. At the end of the lease term, December 31, Year 5, Babson has the option to buy the automobiles for $10,000, which is considered a bargain. The lease qualifies as a finance lease. The interest rate implicit in the lease is 9%. Present value factors for the 9% rate implicit in the lease are as follows: For an annuity due with five payments: 4.240 For an ordinary annuity with five payments: 3.890 Present value of $1 for five periods: 0.650 Babson's recorded finance lease liability immediately after the first required payment should be:

$48,620 $13,000 × 4.240 = $55,120 Less: Initial payment $13,000 $42,120 Present value of bargain purchase option $10,000 × .65 = $ 6,500 Finance lease liability at 1/1/Year 1 $48,620

Robbins, Inc., leased a machine from Ready Leasing Co. The lease qualifies as a finance lease and requires 10 annual payments of $10,000, with the first payment due at the end of the year. 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' incremental borrowing rate is 14%. What amount should Robbins record as lease liability at the beginning of the lease term?

$59,722 he present value of the lease payments: Calculator steps: Clear All Enter 10 in the N key Enter 12 in the I/YR key Enter 10,000 in the PMT key Hit PV: -56,502 is the present value of the lease payments. The present value of the bargain purchase option: Calculator steps: Clear All Enter 10 in the N key Enter 12 in the I/YR key Enter 10,000 in the FV key Hit PV: -3,220 is the present value of the bargain purchase option. The present value of the finance lease = $56,502 + $3,220 = $59,722. Since the 12% interest rate implicit in the lease is known, the implicit rate is used rather than the 14% incremental borrowing rate. The minimum lease payments include the option payment since it is a bargain purchase option. To calculate the present value of the lease payments with the Time Value Tables, select the Present Value of an Annuity table and look for the factor where 10 Payments and 12% intersect, which is 5.6502. Multiply $10,000 by 5.6502 to get $56,502. To calculate the present value of the bargain purchase option with the Time Value Tables, select the Present Value of $1 table and look for the factor where 10 Periods and 12% intersect, which is 0.3220. Multiply $10,000 by 0.3220 to get $3,220. The present value of the finance lease = $56,502 + $3,220 = $59,722.

On December 30, 20X5, Haber Co. leased a typical new machine from Gregg Corp. The following data relate to the lease transaction at the inception of the lease: Lease term 10 years Annual payment at the end of each lease year $100,000 Useful life of machine 12 years Implicit interest rate 10% Present value of annuity due $1 for 10 periods at 10% 6.76 Present value ordinary annuity $1 for 10 periods at 10% 6.15 Fair value of the machine $700,000 The lease has no purchase option, and the possession of the machine reverts to Gregg when the lease terminates. At the inception of the lease, Haber should record a lease liability of:

$615,000. The lease is a finance lease since the lease term is for a major part of the remaining economic life of the underlying asset (greater than 75% of the expected useful life of the asset). Since the lease payments are made at the end of the period, the present value factor for an ordinary annuity is used: 6.15 × $100,000 = $615,000

On December 30, Year 5, Howard Co., leased a typical new machine from Gavin Corp. The following data relate to the lease transaction at the inception of the lease. Lease term 11 years Annual lease payment at the end of each lease year $120,000 Useful life of the machine 13 years Implicit interest rate 11% Present value of an annuity due of $1 for 11 periods at 11% 6.8892 Present value of an ordinary annuity of $1 for 11 periods at 11% 6.2065 Fair value of the machine $1,000,000 The lease has no purchase option, and the possession of the machine reverts to Gavin when the lease terminates. At the inception of the lease, Howard should record a lease liability of: $0.

$744,780. The lease is a finance lease since the lease term is for a major part of the remaining economic life of the underlying asset (greater than 75% of the expected useful life of the asset). Since the lease payments are made at the end of the period, the present value factor for an ordinary annuity is used: 6.2065 × $120,000 = $744,780.

Which of the following describes a major difference between a guaranteed residual value and an unguaranteed residual value?

A guaranteed residual value will cause the lessee to have a remaining lease liability at the end of the lease term before the leased asset is returned, but the lease liability will be zero at the end of the lease term if the residual value is unguaranteed. Residual value refers to the estimated fair value of an asset at the end of a lease. A guaranteed residual value means the lessee will "make up" any difference between actual residual value and the guaranteed value. The lessee includes this when calculating the present value of minimum lease payments. An unguaranteed residual value means the lessee will not "make up" any difference at the end of the lease. The lessee does not include any amount for residual value in minimum lease payments if it is unguaranteed. The result is that the lessee will have a remaining lease liability at the end of the lease term if the residual value is guaranteed and the liability will be zero at the end of the lease if the residual value is unguaranteed.

ABC Company wants its lease to be considered an operating lease instead of a finance lease. Which of these items should ABC ensure occurs?

Avoiding a transfer of ownership at the conclusion of the lease. If any of the conditions presented are met, the lease must be accounted for as a finance lease. The lease term is for a major part of the remaining economic life of the underlying asset (greater than 75% of the expected useful life of the asset). There is a transfer of ownership to the lessee at the end of the lease term. There is an option to purchase the asset at a "bargain price" at the end of the lease term. The present value of the minimum lease payments exceeds substantially all of the fair value of the underlying asset (greater than 90% of the fair market value of the asset). The underlying asset is so specialized for the lessee that it is expected to have no alternative future use to the lessor at the end of the lease term.

On January 1, Year 1, the Timble Corporation (Timble) leases a piece of typical equipment to use for eight years. The equipment has an expected life of ten years and no anticipated salvage value. Timble has an incremental borrowing rate of 5%. Annual payments for this asset are $9,000 with the first payment to be made immediately. At the end of the eight years, Timble has the right to buy the asset for $10,000 in cash. This amount is expected to be significantly below the expected fair value of the equipment on that date so it is reasonable to expect Timble to pay this amount. Timble records depreciation based on the straight-line method and interest based on the effective rate method. The present value of an annuity due of $1 at 5% for eight years is assumed to be 6.80. The present value of an ordinary annuity of $1 at 5% for eight years is assumed to be 6.50. The present value of a single amount of $1 at 5% in eight years is assumed to be 0.66. What amount of depreciation expense should Timble record for Year 1?

Because the purchase option is expected to be paid, it is viewed as a bargain and is included as a cash flow as well as makes the classification of this lease a finance lease. Timble expects to pay the $10,000 and use the asset for its entire 10-year life and that is how the transaction should be recorded. Because the first payment is made immediately, the annual payments represent an annuity due. The present value of the cash flows is $9,000 × 6.80 ($61,200) + $10,000 × 0.66 ($6,600) for a total of $67,800. The entity plans to use the asset for all ten years so the depreciation expense each year is $6,780 ($67,800 ÷ 10)

What are the original accounting entries for recording a finance lease on the balance sheet?

Dr. ROU Asset, Cr. Lease Liability This entry records an asset and a liability consistent with a finance lease.

Lease A does not contain a bargain purchase option, but the lease term is for a major part of the remaining economic life of the underlying asset. Lease B does not transfer ownership of the property to the lessee by the end of the lease term, but the present value of the minimum lease payments exceeds substantially all of the fair value of the underlying asset. How should the lessee classify these leases? (Answers are in form of: Lease A, Lease B)

Finance lease, Finance lease Since each lease has either a lease term for a major part of the remaining economic life of the underlying asset or a present value of the minimum lease payments that exceeds substantially all of the fair value of the underlying asset, each is classified as a finance lease.

Compare and contrast the pattern of expense recognition under finance and operating leases

Finance lease: total expense will be greater in the early years of the lease as compared to the later years of the lease. Amortization of the ROU asset is straight-line and would not change each year. Interest on the Lease liability will be greater in the early years and then decline over time due to the balance in the Lease Liability account which declines as payments are made. Operating lease: total lease expense (interest on the lease liability and amortization on the ROU asset) will be the same from year to year.

The underlying asset for Lease A is so specialized for the lessee that it is expected to have no alternative future use to the lessor at the end of the lease term; however, Lease A does not contain a bargain purchase option. The lease term for Lease B is less than 75% of the estimated economic life of the leased property, but Lease B does transfer ownership of the property to the lessee by the end of the lease term. How should the lessee classify Lease A and Lease B, respectively?

Finance lease; Finance lease Because the underlying asset for Lease A is so specialized for the lessee that it is expected to have no alternative future use to the lessor at the end of the lease term, Lease A is classified as a finance lease. Because Lease B transfers ownership of the property to the lessee by the end of the lease term, Lease B is classified as a finance lease.

A firm has just signed an 8-year lease on a typical new machine. Fair value of the machine is $100,000. Lease payments are $18,000 per year, payable at the end of the year. The machine has an estimated salvage value of $5,000 at the end of the lease term. The machine has a 10-year useful life. The firm's incremental borrowing cost is 8%. This lease should be classified as:

Finance. The useful life of the machine is 10 years and the lease is for 8 years. Because the lease period is for a major part of the remaining economic life of the underlying asset (greater than 75% of the expected useful life of the asset), it must be classified as a finance lease.

On December 30, Year 1, 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, Year 1, 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, Year 1, balance sheet?

Since the first lease payment is on the first day of the lease, the total lease liability at December 31, Year 1, is $115,000, the total lease minus the first payment ($135,000 − $20,000). To divide the December 31 liability into its current versus noncurrent portions, it is helpful to look at the Year 2 journal entry: Interest Expense $11,500 Lease Liability $8,500 Cash $20,000 The interest expense ($11,500) is calculated as the total lease liability at December 31, Year 1 ($115,000), multiplied by the implicit interest rate (10%). The portion of the $20,000 lease payment used to reduce the lease liability ($8,500) in Year 2 would be considered a current liability at December 31, Year 1.

All of the following are criteria for a lease to be classified as a finance lease except:

The lease term is for a minor part of the remaining economic life of the asset. The correct criterion is if the lease term is for a major part of the remaining economic life of the underlying asset, not a minor part. While no bright line exists here, the FASB has given a guideline of 75% of the expected useful life of the asset when determining whether the lease term is for a "major" part of the asset's life.

Describe operating leases and their basic accounting.

The lessor transfers only the right to use the property to the lessee and the lessor/owner retains most of the risks and benefits of ownership. An ROU asset and a lease liability for the present value of the minimum lease payments are recorded at the lease signing. Lease expense is recorded on a straight-line basis over the life of the lease and includes both interest on the lease liability and the amortization of the ROU.

Describe finance leases and their basic accounting.

The lessor transfers some of the rights and benefits of ownership to the lessee. The arrangement is treated as a borrowing and a purchase. Borrowing: The lessee records a liability for the present value of the minimum lease payments and amortizes the liability as payments are made, similar to a mortgage loan. Purchase: The lessee records the property as an ROU asset and recognizes amortization expense, similar to depreciation on owned assets.

Which of the following conditions is not part of a finance lease?

The owner is responsible for all insurance on the property. Under a finance lease, the lessee (person receiving the lease) assumes the risks and benefits of ownership. This would include paying for insurance and maintenance. If the owner is responsible for paying all insurance, then the lease is an operating lease and not a finance lease.

Neal Corp. entered into a nine-year finance lease on a warehouse on December 31, Year 1. Lease payments of $50,000 are due annually, beginning on December 31, Year 2, and every December 31 thereafter. Neal does not know the interest rate implicit in the lease; Neal's incremental borrowing rate is 9%. What amount should Neal report as a finance lease liability at December 31, Year 1?

The present value of the finance lease: Calculator steps: Clear All Enter 9 in the N key Enter 9 in the I/YR key Enter 50,000 in the PMT key Hit PV: -299,762 is the present value of the finance lease. To calculate the present value of the lease payments with the Time Value Tables, select the Present Value of an Annuity table and look for the factor where 9 Payments and 9% intersect, which is 5.9952. Multiply $50,000 by 5.9952 to get $299,760. The reason the two answers don't match exactly is because the PV factor is rounded.

Which of the following statements that classify a lease as a finance lease is least accurate?

The present value of the minimum lease payments exceeds substantially all of the fair value of the underlying asset (greater than 80% of the fair market value of the asset). For a lease to be classified as a finance lease the present value of the minimum lease payments must exceed substantially all of the fair value of the underlying asset, but the FASB has given a guideline of greater than 90% of the fair market value of the asset, not 80%.

lease is considered a finance lease if any of five specific conditions are true. Which of the following is not one of those conditions?

The present value of the minimum lease payments exceeds substantially half of the fair value of the underlying asset. The correct criterion is if the present value of the minimum lease payments exceeds substantially all of the fair value of the underlying asset. While no bright line exists here, the FASB has given a guideline of 90% of the fair market value of the asset when determining whether the minimum lease payments are for "substantially all" of the asset's value.

List the five criteria to determine if a lease should be recorded as a finance lease. Note: Only one of these criteria must be met to classify a lease as finance.

There is a transfer of ownership to the lessee at the end of the lease term. There is a bargain purchase option—an option to purchase the asset significantly below expected market value at the end of the lease term. The lease term exceeds a major part (75% guideline) of the remaining useful life of the asset. The present value of the minimum lease payments exceeds substantially all (90% guideline) of the fair value of the asset. The leased asset is so specialized that it has no alternative future use to the lessor.

A firm has just signed a 10-year lease on a new machine. Fair value of the machine is $450,000. Lease payments are $55,000 per year, payable at the end of the year. The machine has an estimated salvage value of $15,000 at the end of the lease term. The machine has an 11-year useful life. The firm's incremental borrowing cost is 9%. This lease should be classified as:

finance. The useful life of the machine is 11 years and the lease is for 10 years. Because the lease period is more than 75% (10 ÷ 11 = 90.9%) of its useful life, it must be classified as a finance lease. The lease term is for a major part of the remaining economic life of the underlying asset. While no bright line exists here, the FASB has given a guideline of 75% of the expected useful life of the asset when determining whether the lease term is for a "major" part of the asset's life.

On January 1, XYZ Company (lessee) entered into a finance lease with ABC Company (lessor). XYZ Company will make an annual payment of $25,000 for five years as part of the lease, with the first payment due at the end of the year. The assumed interest rate on the lease is 8% and the lease liability is $99,818. How much of the first payment is interest expense and how much is a reduction of the lease liability?

the assumed interest rate is 8%, then the interest expense for the first payment is $7,985 ($99,818 × 8%). The remainder of the lease payment ($17,015) is a reduction of the lease liability.