Chap 015 1ij

Chapter 15 Leases True/False Questions 1. At the inception of a lease agreement, the company's debt to equity ratio and rate of return on assets are both affected whether the lease is classified as a capital lease or as an operating lease. Answer: False

Learning Objective: 2

Level of Learning: 2

2. In ing for operating leases, the lessor, rather than the lessee, will recognize depreciation on the leased asset. Answer: True



3. Capital leases are agreements that are formulated outwardly as leases, but are installment purchases in substance. Answer: True



4. On a sale-leaseback transaction, any gain on the "sale" portion of the transaction is recognized immediately. Answer: False



5. A bargain purchase option is defined as the option of purchasing leased property at a price that is equal to the expected fair value of a leased asset. Answer: False



6. The criterion of 75% of economic life for classifying a lease as a capital lease is consistent with the basic premise that most of the risks and rewards of ownership occur during the first 75% of an asset's life. Answer: True



7. When the lessee guarantees an estimated residual value of $75,000, the amount the lessee records as a leased asset and lease liability is increased by $75,000. Answer: False



8. In addition to the criteria that must be met by the lessee, the lessor must meet additional conditions for classification as a nonoperating lease to satisfy the realization principle. Answer: True



9. If the lessee is expected to take ownership of a leased asset at the end of the lease term, the lessor must use an estimated residual value when calculating the lease payments necessary to achieve a desired rate of return. Answer: False



Spiceland/Sepe/Tomassini, Intermediate ing, Fourth Edition

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Chapter 15 Leases 10. When ing for a nonoperating lease, the lessee records the leased asset at the present value of the minimum lease payments or the asset's fair value, whichever is lower. Answer: True



Matching Pair Questions Use the following to answer questions 11-15: 11-15. Listed below are ten followed by a list of phrases that describe or characterize five of the . Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase. : A. Capital leases B. Depreciable assets C. Direct financing lease D. Executory costs E. Lease disclosure required F. Lessor's minimum lease receipts G. Lessor expenditures H. Loss to lessee I. Present value of minimum lease payments J. Sale-leaseback payments Phrases: 11. ____ ing for these is based on substance over form. 12. ____ Leasehold improvements. 13. ____ Amount capitalized by lessee. 14. ____ Capital lease expense. 15. ____ Both the gross and net amounts of lease. Answer: 11-A; 12-B; 13-I; 14-D; 15-E

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Chapter 15 Leases Use the following to answer questions 16-20: 16-20. Listed below are ten followed by a list of phrases that describe or characterize five of the . Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase. : A. Capital leases B. Depreciable assets C. Direct financing lease D. Executory costs E. Lease disclosure F. Lessor's minimum lease receipts G. Loss to lessee H. Present value of minimum lease payments I. Sale-leaseback payments J. Sales-type lease Phrases: 16. ____ Rent payments plus lessee-guaranteed and 3rd-party-guaranteed residual value. 17. ____ Cash paid to satisfy residual value guarantee. 18. ____ Tax payments. 19. ____ Amount paid to retain use of asset after sale. 20. ____ Marketing tool for lessor. Answer: 16-F; 17-G; 18-D; 19-I; 20-J Use the following to answer questions 21-25: 21-25. Listed below are ten followed by a list of phrases that describe or characterize five of the . Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase. : A. Additional lessor conditions B. Bargain purchase option C. Executory costs D. Depreciation period longer than lease term E. Operating method F. Gross method G. Lessee's minimum lease payments H. Lessor's net investment I. Net method J. PV of BPO price Phrases: 21. ____ Deducted in lessor's computation of rental payments. 22. ____ Lease payable equals PV of minimum lease payments. 23. ____ PV of minimum lease payments plus PV of unguaranteed residual value. 24. ____ Periodic rent payments plus lessee-guaranteed residual value. 25. ____ Lease receivable equals sum of minimum lease payments Answer: 21-J; 22-I; 23-H; 24-G; 25-F Spiceland/Sepe/Tomassini, Intermediate ing, Fourth Edition

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Chapter 15 Leases Use the following to answer questions 26-30: 26-30. Listed below are ten followed by a list of phrases that describe or characterize five of the . Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase. : A. Additional conditions for lessor in nonoperating leases B. Bargain purchase option C. Collectibility D. Contingency expense E. Depreciation period longer than lease term F. Requires disclosure only G. Gross method H. Lessee's minimum lease payments I. Lessor's net investment J. Net method Phrases: 26. ____ Contingent rentals. 27. ____ Title transfers to lessee. 28. ____ Typically used by lessor but not lessee 29. ____ Consistent with the realization principle. 30. ____ Purchase price sufficiently less than the expected fair market value when exercised. Answer: 26-F; 27-E; 28-G; 29-A; 30-B Use the following to answer questions 31-35: 31-35. Listed below are ten followed by a list of phrases that describe or characterize five of the . Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase. : A. 90% test B. Deferred gain on sale-leaseback C. Deferred loss on sale-leaseback D. Depreciation on leased assets E. Discount rate F. Interest expense G. Lessor's gross investment H. Lessor's net investment I. Leveraged lease J. Rate of return Phrases: 31. ____ Classified a contra asset . 32. ____ Based on term of lease or useful life depending on lease contract. 33. ____ Identified as the lower of implicit rate or lessee's incremental borrowing rate. 34. ____ Calculated as effective rate times balance. 35. ____ Calculated as minimum lease payments plus unguaranteed residual value. Answer: 31-B; 32-D; 33-E; 34-F; 35-G 92


Chapter 15 Leases Use the following to answer questions 36-40: 36-40. Listed below are ten followed by a list of phrases that describe or characterize five of the . Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase. : A. 75% test B. 90% test C. Bargain purchase option D. Capital lease E. Finance lease F. Lessor's gross investment G. Leveraged lease H. Operating lease I. Residual value J. Sales-type lease selling expense Phrases: 36. ____ Financed for lessor investment. 37. ____ Lessor reports rent revenue. 38. ____ Viewed as an additional payment when guaranteed by lessee. 39. ____ Included with initial direct costs. 40. ____ Considered the most decisive of the four capital lease criteria. Answer: 36-G; 37-H; 38-I; 39-J; 40-B ing: Multiple Choice Questions 41. GAAP requires that some lease agreements be ed for as purchases. The theoretical justification for this treatment is that a lease of this type: A) Complies with the concept of form over substance. B) Reflects the relationship of cause and effect. C) Satisfies the concept of historical cost. D) Conveys most of the risks and benefits of property ownership. Answer: D



42. Which of the following statements characterizes an operating lease? A) The lessee records depreciation and interest. B) The lessor records depreciation and lease revenue. C) The lessor transfers title at the end of the lease term. D) The lessee records a leased asset. Answer: B




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Chapter 15 Leases 43. The lessee's option to purchase a leased asset at a price that is sufficiently lower than the asset's expected fair value so that the exercise of the option appears reasonably assured is called a: A) Bargain purchase option. B) Lessee buy-out option. C) Lessor sell-out option. D) Guaranteed purchase option. Answer: A



44. From the perspective of the lessee, leases may be classified as either: A) Direct financing or sales-type. B) Capital or direct financing. C) Capital or operating. D) Direct financing or operating. Answer: C



45. From the perspective of the lessor, leases may be classified as either: A) Direct financing or sales-type. B) Operating, capital, or direct financing. C) Operating, sales-type, indirect financing. D) Operating, direct financing, or sales-type. Answer: D



46. Distinguishing between operating and non-operating leases is due in large part to the ing concept of: A) Conservatism. B) Materiality. C) Substance over form. D) Historical cost. Answer: C



47. The four criteria provided in FASB Statement No. 13 for distinguishing a capital lease from an operating lease do not include: A) The agreement specifies that ownership transfers at the end of the lease term. B) The collectibility of the lease payments must be reasonably predictable. C) The agreement contains a bargain purchase option. D) The noncancelable lease term is 75% or more of the useful life of the leased asset. Answer: B



48. If the lessee and lessor use different interest rates to for a capital lease, then: A) Total expenses for the lessee will be different from the lessor's total revenues. B) Total expenses for the lessee will equal the lessor's total revenues. C) GAAP has been violated by at least one party. D) The lessee will report more net income for the year. Answer: A 94




Chapter 15 Leases 49. Crystal Corporation recorded a lease payment as follows: Rent expense Cash

2,000 2,000

Crystal must have a(n) A) Operating lease. B) Leveraged lease. C) Capital lease. D) Direct financing lease. Answer: A



50. The appropriate asset value reported on the balance sheet by the lessee for an operating lease is: A) Present value of the minimum lease payments. B) Sum of the minimum lease payments. C) Fair value of the asset at the inception of the lease. D) Zero, unless a prepayment or accrual is involved. Answer: D



51. Of the four criteria for a capital lease, the one that most often is the decisive criteria is: A) The 75% of economic life test. B) The transfer of title. C) The 90% of fair value test. D) The bargain purchase option. Answer: C



52. Additional lessor conditions for classification as a nonoperating lease are consistent with the criteria of the: A) Matching principle. B) Cause and effect principle. C) Materiality concept. D) Realization principle. Answer: D



53. Of the four criteria for a capital lease, which two are not applied if the lease begins during the final quarter of the asset's useful life? A) The 75% test and the bargain purchase option. B) The 90% test and the 75% test. C) The 90 % test is the only one to which this applies. D) The bargain purchase and the age of title criteria. Answer: B




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Chapter 15 Leases 54. Which of the following statements characterizes a leveraged lease? A) The lessor borrows part of the acquisition price of the leased asset from a third party lender. B) The lessor treats the lease as an operating lease. C) The lessee makes lease payments to the lessor's lender. D) The lessor's interest rate is always higher because the lease is leveraged. Answer: A



55. One of the four criteria for a capital lease specifies that the lease term be equal to or greater than: A) 75% of the expected economic life of the leased property. B) 90% of the expected economic life of the leased property. C) 80% of the expected economic life of the leased property. D) 50% of the expected economic life of the leased property. Answer: A



56. One of the four criteria for a capital lease specifies that the present value of the minimum lease payments be equal to or greater than: A) 90% of the cost of the asset. B) 75% of the fair value of the asset. C) 90% of the fair value of the asset. D) 75% of the cost of the asset. Answer: C



57. If the lessor records unearned rent at the beginning of a lease term, the lease must: A) Be a direct financing lease. B) Be a sales-type lease. C) Contain a bargain renewal option. D) Be an operating lease. Answer: D



58. When a lease qualifies as a capital lease, what is the cost basis of the asset acquired? A) The present value of the minimum lease payments, exclusive of executory costs. B) The present value of the minimum lease payments plus executory costs. C) The sum of the gross minimum lease payments. D) The present value of the minimum lease payments plus the present value of executory costs. Answer: A



59. What are the three types of expenses that a lessee experiences with a capital lease? A) Lease expense, executory costs, interest expense. B) Depreciation expense, lease expense, interest expense. C) Executory costs, lease expense, depreciation expense. D) Depreciation expense, interest expense, executory costs. Answer: D 96




Chapter 15 Leases 60. When the total expenses over the life of an operating lease are compared to the total expenses over the life of a capital lease, one will find that: A) The expenses of a capital lease are greater than the expenses of the operating lease. B) The expenses of the capital lease and operating lease are equal. C) The expenses of an operating lease are greater than the expenses of a capital lease. D) No meaningful comparison can be made. Answer: B



61. Since the lease payments under a lease agreement are normally paid at the beginning of each period, the appropriate compound interest table to be used to determine the amount at which the leased asset should be recorded is the: A) Ordinary annuity table. B) Present value of $1 table. C) Present value of an annuity due table. D) Future value of an annuity due table. Answer: C



62. When a capital lease is first recorded at the inception of the lease, the lessee typically debits: A) Leased asset. B) Rent expense. C) Lease expense. D) Lease receivable. Answer: A



63. For the lessee to for a lease as a capital lease, the lease must meet: A) All four of the criteria specified by SFAS No. 13. B) Any one of the six criteria specified by SFAS No. 13. C) Any two of the criteria specified by SFAS No. 13. D) Any one of the four criteria specified by SFAS No. 13. Answer: D



64. For the lessor to for a lease as a capital lease, the lease must meet: A) Any one of first four classification criteria and both of the last two additional conditions specified by SFAS No. 13. B) Any one of the six criteria specified by SFAS No. 13. C) All four of the criteria specified by SFAS No. 13. D) Any one of the four criteria specified by SFAS No. 13. Answer: A



65. The lessee normally measures the lease liability to be recorded as the: A) The future value of the minimum lease payments. B) The sum of the cash payments over the term of the lease. C) Present value of the minimum lease payments. D) The fair market value of the leased asset. Answer: C




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Chapter 15 Leases 66. Prepayments made on an operating lease are considered to be: A) A lease expense. B) A depreciable asset. C) Executory costs. D) A prepayment of rent. Answer: D



67. For a capital lease, an amount equal to the present value of the minimum lease payments should be recorded by the lessee as a(n): A) Asset and a liability. B) Asset and a different amount should be recorded as a liability. C) Liability and a different amount should be recorded as an asset. D) Expense. Answer: A



68. Like other assets, the cost of a leasehold improvement is allocated as depreciation expense over its useful life to the lessee, which will be: A) The shorter of the physical life of the asset or the lease term. B) The physical life of the asset. C) The lease term. D) A time period determined by management. Answer: A



69. Leasehold improvements usually are classified on a balance sheet as: A) Property, plant and equipment. B) Other long-term assets. C) Investments. D) Expenses. Answer: A



70. Unearned interest revenue related to a direct financing lease is classified on the lessor's balance sheet as: A) An asset. B) A liability. C) A contra to lease receivable. D) A contra to lease liability. Answer: C



71. For a leased asset under a lease that qualifies as a capital lease, the depreciation period used by the lessee must be: A) The same period that was used by the lessor. B) The useful life to the lessee. C) The term of the lease regardless of the lease provisions. D) The remaining life of the asset at the time the lease agreement took effect. Answer: B 98




Chapter 15 Leases 72. A sales-type lease differs from a direct financing lease in only one respect: A) The lessor receives a manufacturer's or dealer's profit. B) The lessor receives more interest than on a direct financing lease. C) The lessor receives less interest than on a direct financing lease. D) The lessor uses a longer amortization period than on a direct financing lease. Answer: A



73. Recording a sales-type lease is similar to recording: A) A purchase on . B) An exchange of assets. C) A sale of a fixed asset. D) A sale of merchandise on . Answer: D



74. If the lessee expects to obtain title to leased property due to a bargain purchase option or age of title at the end of the lease term: A) The lessee ignores any residual value for the leased property. B) The lessor ignores any residual value for the leased property. C) The lessee adds the present value of the residual value to the amount recorded for the lease. D) The lessor will always charge a higher annual lease rate. Answer: B



75. If the lessor retains title to leased property under the of the lease: A) The amount to be recovered through periodic lease payments is reduced by the present value of the residual amount. B) The amount to be recovered through periodic lease payments is increased by the present value of the residual amount. C) The amount to be recovered will be the same as if there were no residual value. D) The lessor will record a greater amount of depreciation due to the residual value. Answer: A



76. Which of the following statements regarding guaranteed residual values is true for the lessee? A) The asset and liability at the inception of the lease should be increased by the amount of the residual value. B) The asset and liability at the inception of the lease should be decreased by the amount of the residual value. C) The asset and liability at the inception of the lease should be increased by the present value of the residual value. D) The asset and liability at the inception of the lease should be decreased by the present value of the residual value. Answer: C




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Chapter 15 Leases 77. A noncancelable lease contains a bargain purchase option. The fair value of the asset exceeds the lessor's cost of the asset. Collectibility of the lease payments is assured and there are no material cost uncertainties surrounding the lease. Therefore, the lease will be ed for by the lessor as a(n): A) Sales-type lease. B) Direct financing lease. C) Operating lease. D) Guaranteed lease. Answer: A



78. If the residual value of a leased asset turns out to be more than the amount guaranteed by the lessee, the A) Lessor must compensate the lessee for the excess. B) Lessee must pay the lessor the amount of the excess. C) Lessee will reduce the last year's depreciation. D) Lessor is not obligated to compensate the lessee for the excess. Answer: D



79. In a sale-leaseback arrangement, the lessee is also: A) The new owner of the property. B) The buyer. C) A third party guarantor. D) The seller. Answer: D



80. Which of the following is not among the criteria for classifying a lease as a capital lease? A) The agreement specifies that ownership of the asset transfers to the lessee. B) The agreement contains a bargain purchase option. C) The noncancelable lease term is equal to 90% or more of the expected economic life of the asset. D) The present value of the minimum lease payments is equal to or greater than 90% of the fair value of the asset. Answer: C

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Chapter 15 Leases Use the following to answer questions 81-84: Technoid Inc. sells computer systems. Technoid leases computers to Lone Star Company on January 1, 2006. The manufacturing cost of the computers was $12 million. This non-cancelable lease had the following : • Lease payments: $2,466,754 at the beginning of each 6 mo. period, with the first payment being made at 1/1/06. • Lease term: 5 years (10 semi-annual payments) • No residual value; no bargain purchase option • Economic life of equipment: 5 years • Implicit interest rate and lessee's incremental borrowing rate: 5% semi-annually • Fair value of the computers at 1/1/06: $20 million Collectibility of the rental payments is reasonably assured, and there are no lessor costs yet to be incurred. 81. Technoid would for this as: A) A capital lease. B) A direct financing lease. C) A sales type lease. D) An operating lease. Answer: C



82. Lone Star Company would for this as: A) A capital lease. B) A direct financing lease. C) A sales type lease. D) An operating lease. Answer: A



83. What is the net carrying value of the lease liability on Lone Star's 6/30/06 balance sheet? Round your answer to the nearest dollar. A) $17,533,246 B) $18,409,908 C) $21,000,000 D) None of the above is correct. Answer: B Learning Objective: 5 Level of Learning: 3 Rationale: This is $20,000,000 - lease payment of $2,466,754 + interest accrued of $876,662.


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Chapter 15 Leases 84. What is the interest revenue that Technoid would report on this lease in its 2006 income statement? A) $0 B) $1,673,820 C) $876,882 D) None of the above is correct. Answer: B Learning Objective: 5 Level of Learning: 3 Rationale: This is the $876,662 interest from question 83, plus the following: ($18,409,908 $2,466,754) x .05. Use the following to answer questions 85-89: On December 31, 2005, Reagan Inc. signed a capital lease for some equipment with Silver Leasing Co. The lease payments are made by Reagan annually, beginning at g date. Title does not transfer to the lessee, so the equipment will be returned to the lessor on December 31, 2011. There is no bargain purchase option, and Reagan guarantees a residual value to the lessor on termination of the lease. Reagan's lease amortization schedule appears below: Dec. 31 2005 2005 2006 2007 2008 2009 2010 2011

Payments $90,000 $90,000 $90,000 $90,000 $90,000 $90,000 $36,000

Interest

Balance

$17,165 14,251 11,221 8,070 4,793 1,385

$90,000 72,835 75,749 78,779 81,930 85,207 34,615

Balance $519,115 429,115 356,280 280,531 201,752 119,822 34,615 0

85. In this situation, Reagan: A) Is the lessee in a sales type lease. B) Is the lessee in a capital lease. C) Is the lessor in a capital lease. D) Is the lessor in a sales type lease. Answer: B



86. At what amount would Reagan record the leased asset at inception of the agreement? A) $519,115 B) $429,115 C) $576,000 D) Cannot be determined from the given information. Answer: A

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Chapter 15 Leases 87. What is the effective annual interest rate charged to Reagan on this lease? A) 4% B) 6% C) 8% D) Cannot be determined from the given information. Answer: A Learning Objective: 5 Level of Learning: 3 Rationale: Effective rate = interest expense / outstanding liability balance. 88. What is the carrying value of the lease liability on Reagan's 12/31/07 balance sheet (after the third lease payment is made)? A) $280,531 B) $190,530 C) $266,280 D) $356,280 Answer: A



89. What is the amount of residual value guaranteed by Reagan to the lessee? A) $1,385 B) $34,615 C) $36,000 D) Cannot be determined from the given information. Answer: C



90. On September 1, 2006, Custom Shirts Inc. entered into a lease agreement appropriately classified as an operating lease. The lease term is 3 years. The annual payments are (a) $20,000 for year 1, (b) $24,000 for year 2, and (c) $284,000 for year 3. How much rent expense will Custom Shirts recognize for 2006? A) $28,000. B) $24,000. C) $20,000. D) $ 8,000. Answer: D Rationale: Year 1 Year 2 Year 3 Total



$20,000 $72,000/3 x 4/12 = $8,000 24,000 28,000 $72,000


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Chapter 15 Leases 91. On January 1, 2006, Gibson Corporation entered into a 4-year operating lease. The payments were as follows: $20,000 for 2006, $18,000 for 2007, $16,000 for 2008, and $14,000 for 2009. What is the correct amount of lease expense for 2007? A) $20,500. B) $19,000. C) $17,000. D) Cannot be determined from the information provided. Answer: C Rationale: 2006 2007 2008 2009 Total



$20,000 18,000 16,000 14,000 $68,000 $68,000/4 = $17,000

92. On January 1, 2006, Princess Corporation leased equipment to King Company. The lease is for 8 years. The first payment of $675,000 was made on January 1, 2006. The equipment cost Princess Corporation $3,600,000. The present value of the minimum lease payments is $3,960,000. The lease is appropriately classified as a sales-type lease. Assuming the interest rate for this lease is 10%, how much interest revenue will Princess record in 2007 on this lease? A) $261,000. B) $328,500. C) $325,350. D) $293,850. Answer: D Learning Objective: 6 Rationale: Step 1 PV, 1/1/06 $3,960,000 Payment 1/1/06 (675,000 ) $3,285,000 x 10% Interest, 2006 $ 328,500 Step 2 2nd Payment Interest Step3

Interest, 2007

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$ 675,000 (328,500 ) $ 346,500 $3,285,000 (346,500 ) $2,938,500 x 10% $ 293,850


Chapter 15 Leases 93. On January 1, 2006, Packard Corporation leased equipment to Hewlitt Company. The lease is for 8 years. The first payment of $450,000 was made on January 1, 2006. Remaining payments are made on December 31 each year, beginning with December 31, 2006. The equipment cost Packard Corporation $2,400,000. The present value of the minimum lease payments is $2,640,000. The lease is appropriately classified as a sales-type lease. Assuming the interest rate for this lease is 10%, what will be the balance reported as a liability by Hewlitt on the December 31, 2007, balance sheet? A) $1,950,000. B) $1,509,000. C) $1,959,000. D) $1,704,900. Answer: D Learning Objective: 6 Rationale: Step 1 PV, 1/1/06 $2,640,000 Payment 1/1/06 (450,000 ) $2,190,000 x 10% Interest, 2006 $ 219,000 Step 2 2nd Payment Interest Step3

Interest, 2007


$ 450,000 (219,000 ) $ 231,000 $2,190,000 (231,000 ) $1,959,000 x 10% $ 195,900

Step 4

$450,000 195,900 $254,100

Step 5

$1,959,000 (254,100 ) $1,704,900


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Chapter 15 Leases 94. On January 1, 2006, Wellburn Corporation leased an asset from Tabitha Company. The asset originally cost Tabitha $300,000. The lease agreement is an operating lease that calls for four annual payments beginning on January 1, 2006, in the amount of $36,000. The other three remaining payments will be made on January 1 of each subsequent year. Which of the following journal entries should be made on the books of Tabitha on January 1, 2006? A) Cash 36,000 Lease receivable 36,000 B) Cash 36,000 Unearned rent revenue 36,000 C) Cash 36,000 Rent revenue 36,000 D) Cash 36,000 Rent expense 36,000 Answer: B



95. On January 1, 2006, Calloway Company leased a machine to Zone Corporation. The lease qualifies as a direct financing lease. Calloway paid $240,000 for the machine and is leasing it to Zone for $34,000 per year, an amount that will return 10% to Calloway. The present value of the minimum lease payments is $240,000. The lease payments are due each January 1. What is the appropriate interest entry on December 31, 2006? A) Cash 24,000 Interest revenue 24,000 B) Cash 20,600 Interest receivable 20,600 C) Unearned interest revenue 20,600 Interest revenue 20,600 D) Unearned interest revenue 24,000 Interest revenue 24,000 Answer: C Learning Objective: 5 Rationale: $240,000 $206,000 (34,000 ) x 10% $206,000 $ 20,600


Unearned interest revenue was recorded on 1/1/06.

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Chapter 15 Leases 96. On December 31, 2006, Perry Corporation leased equipment to iral Company for a 5year period. The annual lease payment, excluding executory costs is $40,000. The interest rate for this lease is 10%. The payments are due on December 31 of each year. The first payment was made on December 31, 2006. The normal cash price for this type of equipment is $125,000 while the cost to Perry was $105,000. For the year ended December 31, 2006, by what amount will Perry's pretax earnings increase from this lease? A) $20,000. B) $24,000. C) $28,500. D) $40,000. Answer: A Rationale: Fair value Cost Profit

Learning Objective: 9 $125,000 (105,000 ) $ 20,000


Since the lease was signed on December 31, no interest is earned in 2006.

97. On February 1, 2006, Pearson Corporation became the lessee of equipment under a five-year, noncancelable lease. The estimated economic life of the equipment is 8 years. The fair market value of the equipment was $600,000. The lease does not meet the definition of a capital lease in of a bargain purchase option, transfer of title, or the lease term. However, Pearson must classify this as a capital lease if the present value of the minimum lease payments is at least A) $600,000. B) $540,000. C) $450,000. D) $405,000. Answer: B Learning Objective: 8 Level of Learning: 3 Rationale: $600,000 x 90% = $540,000 98. ABC Company leased equipment to Best Corporation under a lease agreement that qualifies as a direct financing lease. The cost of the asset is $120,000. The lease contains a bargain purchase option that is effective at the end of the fifth year. The expected economic life of the asset is ten years. The lease term is 5 years. The asset is expected to have a residual value of $2,000 at the end of ten years. Using the straight-line method, what would Best record as annual depreciation? A) $23,600. B) $12,200. C) $12,000. D) $11,800. Answer: D Learning Objective: 7 Level of Learning: 3 Rationale: Cost $120,000 $118,000/10 = $11,800 Residual (2,000 ) Depreciable $118,000


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Chapter 15 Leases 99. XYZ Company leased equipment to West Corporation under a lease agreement that qualifies as a direct financing lease. The cost of the asset is $600,000. The lease qualifies as a capital lease because of the 90% rule. The expected economic life of the asset is ten years. The lease term is 5 years. The asset is expected to have a residual value of $10,000 at the end of ten years. Using the straight-line method, what would West record as annual depreciation? A) $118,000. B) $61,000. C) $60,000. D) $59,000. Answer: A Learning Objective: 7 Level of Learning: 3 Rationale: Cost $600,000 $590,000/5 = $118,000 Residual (10,000 ) Depreciable $590,000 100. Francisco leased equipment from Julio on December 31, 2006. The lease is a 10-year lease with annual payments of $150,000 due on December 31 of each year. The present value of the lease (at a 10% implicit interest rate) is $1,020,000. Francisco's incremental borrowing rate is 12% for this type of lease. The implicit rate of 10% is known by the lessee. What should be the balance in Francisco lease liability at December 31, 2007? A) $824,400. B) $807,000. C) $806,400. D) $792,000. Answer: B Learning Objective: 5 Rationale: Initial liability $1,020,000 Payment 12/31/06 (150,000 ) Liability 12/31/06 $870,000 X 10% Interest, 2007 $ 87,000

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Payment Interest Reduced balance

$150,000 (87,000 ) $63,000

Liab. 12/31/06 Reduced balance Liab. 12/31/07

$870,000 63,000 $807,000



Chapter 15 Leases Use the following to answer questions 101-105: Refer to the following lease amortization schedule. The ten payments are made annually starting with the inception of the lease. Title does not transfer to the lessee and there is no bargain purchase option. The asset has an expected economic life of twelve years. The lease is noncancelable. Payment 1 2 3 4 5 6 7 8 9 10

Cash Payment

Effective Interest

Decrease in balance

10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000

6,394 5,961 5,477 4,934 4,326 3,645 2,882 ? ?

10,000 3,606 4,039 4,523 5,066 5,674 6,355 7,118 ? ?

Balance 63,282 53,282 49,676 45,638 41,114 36,048 30,373 24,018 16,901 ? ?

101. What is the effective annual interest rate? A) 9%. B) 10%. C) 11%. D) 12%. Answer: D Learning Objective: 5 Level of Learning: 3 Rationale: $6,394/$53,282 = 12% (from Payment #2) 102. What is the total interest over the term of the lease? A) $100,000. B) $ 36,718. C) $ 53,282. D) $ 63,282. Answer: B Learning Objective: 5 Level of Learning: 3 Rationale: $100,000 $63,282 = $36,718 103. What is the outstanding balance after payment #9? A) $8,929. B) $13,463. C) $5,000. D) $5,537. Answer: A Learning Objective: 5 Level of Learning: 3 Rationale: Step 1 Interest = 12% x $16,901 = $2,028 Step 2 Decrease in balance = $10,000 $2,028 = $7,972 Step 3 Ending balance = $16,901 $7,972 = $8,929


109

Chapter 15 Leases 104. What would the lessee record as annual depreciation on the asset using the straight-line method, assuming no residual value? A) $5,328. B) $6,328. C) $6,392. D) $10,000. Answer: B Learning Objective: 5 Level of Learning: 3 Rationale: Depreciation = $63,282/10 years = $6,328 105. What would be the outstanding balance after payment #10? A) $0. B) $2,028. C) $8,929. D) $10,000. Answer: A Learning Objective: 5 Level of Learning: 3 Rationale: Loan completely amortized at that point. Use the following to answer questions 106-110: Refer to the following lease amortization schedule. The five payments are made annually starting with the inception of the lease. A $2,000 bargain purchase option is exercisable at the end of the five-year lease. Title transfers to the lessee at the end of the lease term. The asset has an expected economic life of eight years. Lease Payment

Cash Payment

Effective Interest

Decrease in Balance

1 2 3 4 5 6

8,000 8,000 8,000 8,000 8,000 2,000

?? 2,660 2,126 1,539 ?? 182

?? 5,340 5,874 6,461 ?? 1,818

Balance 34,600 26,600 21,260 15,386 8,925 ?? 0

106. What is the effective annual interest rate? A) 9%. B) 10%. C) 11%. D) 20%. Answer: B Learning Objective: 5 Level of Learning: 3 Rationale: $2,660/$26,600 = 10% (from Payment #2)

110


Chapter 15 Leases 107. What is the total interest over the term of the lease? A) $42,000. B) $8,200. C) $7,400. D) $3,460. Answer: C Learning Objective: 5 Level of Learning: 3 Rationale: Step 1 Interest rate = 2,660/$26,660 (from Payment #2) Step 2 Interest, Payment #1 =0 Interest, Payment #5 = $8,925 x 10% = $893 Step 3 Sum of interest = $7,400 Or $42,000 (sum of payment) $34,600 = $7,400 108. What is the ending balance after payment #5? A) $1,818. B) $2,000. C) $2,182. D) $3,818. Answer: A Learning Objective: 5 Level of Learning: 3 Rationale: Step 1 Interest rate = 2,660/$26,660 (from Payment #2) Step 2 Interest, Payment #1 =0 Interest, Payment #5 = $8,925 x 10% = $893 Step 3 Decrease in balance = $8,000 $893 = $7,107 Step 4 Ending balance = $8,925 $7,107 = $1,818 Or $1,818 Decrease in balance from payment #6 109. What would the lessee record as annual depreciation on the asset using the straight-line method, assuming no residual value? A) $3,325. B) $6,920. C) $4,325. D) $5,320. Answer: C Learning Objective: 5 Level of Learning: 3 Rationale: Deprecation = $34,600/8 years = $4,325 110. What would be the amount of interest expense recorded with payment #5? A) $2,000. B) $893. C) $7,107. D) $1,107. Answer: B Learning Objective: 5 Level of Learning: 3 Rationale: Interest rate = $2,660/$26,600 = 10% Interest, #5 = $8,925 x 10% = $893 Spiceland/Sepe/Tomassini, Intermediate ing, Fourth Edition

111

Chapter 15 Leases Problems 111. On January 1, 2006, Salvatore Company leased several machines from Nola Corporation under a 3-year operating lease agreement. The lease calls for semiannual payments of $15,000 each, payable on June 30 and December 31 of each year. The machines were acquired by Nola at a cost of $90,000 and are expected to have a useful life of 5 years with no expected residual value. Required: Prepare the appropriate journal entries for the lessee from the inception of the lease through the end of 2006. Answer: June 30, 2006: Rent expense Cash December 31, 2006: Rent expense Cash Learning Objective: 4

15,000 15,000 15,000 15,000 Level of Learning: 3

112. On January 1, 2006, Salvatore Company leased several machines from Nola Corporation under a 3-year operating lease agreement. The lease calls for semiannual payments of $15,000 each, payable on June 30 and December 31 of each year. The machines were acquired by Nola at a cost of $90,000 and are expected to have a useful life of 5 years with no expected residual value. Required: Prepare the appropriate journal entries for the lessor from the inception of the lease through the end of 2006. Answer: June 30, 2006: Cash Rent revenue December 31, 2006 Cash Rent revenue Depreciation expense Accumulated depreciation Learning Objective: 4

112

15,000 15,000 15,000 15,000 18,000 18,000 ($90,000/5 yrs. = $18,000)



Chapter 15 Leases 113. On January 1, 2006, Holbrook Company leased a building under a 3-year operating lease. The annual rental payments are $68,000 on January 1, 2006, the inception of the lease, and $50,000 January 1 of 2007 and 2008. Holbrook made structural modifications to the building costing $90,000 before occupying the building. The useful life of the building and the modifications is 30 years with no expected residual value. Required: Prepare the appropriate journal entries for Holbrook Company for 2006. Holbrook's fiscal year is the calendar year, and the company uses straight-line depreciation. Answer: January 1, 2006: Prepaid rent Cash Leasehold improvements Cash December 31, 2006: Rent expense Prepaid rent Depreciation expense Accumulated depreciation Learning Objective: 4

68,000 68,000 90,000 90,000 56,000

[($68,000 + $50,000 + $50,000)/3] 56,000

30,000

($90,000/3) 30,000


114. On January 1, 2006, Holbrook Company leased a building under a 3-year operating lease. The annual rental payments are $40,000 on January 1, 2006, $30,000 on January 1, 2007, and $20,000 on January 1, 2008. Required: Prepare the appropriate journal entries for Holbrook Company from the inception of the lease through the end of 2008. Answer: January 1, 2006: Prepaid rent Cash December 31, 2006: Rent expense Prepaid rent January 1, 2007: Prepaid rent Cash December 31, 2007: Rent expense Prepaid rent January 1, 2008: Prepaid rent Cash December 31, 2008: Rent expense Prepaid rent Learning Objective: 4

40,000 40,000 30,000

[($40,000 + $30,000 + $20,000) /3] 30,000

30,000 30,000 30,000 30,000 20,000 20,000 30,000 30,000 Level of Learning: 3


113

Chapter 15 Leases 115. Python Company leased equipment from Hope Leasing on January 1, 2006. Hope purchased the equipment at a cost of $222,666. Other information: Lease term Annual payments Life of asset Fair value of asset Implicit interest rate Incremental rate

3 years $80,000 on January 1 each year 3 years $222,666 8% 8%

There is no expected residual value. Required: Prepare appropriate journal entries for Python for 2006. Assume straight-line depreciation and a December 31 year-end. Answer: January 1, 2006: Leased asset Lease payable Lease payable Cash December 31, 2006: Interest expense Interest payable Depreciation expense Accumulated depreciation Learning Objective: 5

222,666 222,666 80,000 80,000 11,413

[($222,666 - 80,000) x 8%] 11,413

74,222

($222,666/3) 74,222


116. Southern Edison Company leased equipment from Hi-Tech Leasing on January 1, 2006. Other information: Lease term Annual payments Life of asset Implicit interest rate Incremental rate PV, annuity due, 3 periods, 8% PV, ordinary annuity, 3 periods, 8%

3 years $40,000 on January 1 each year 3 years 8% 8% 2.7833 2.5771

There is no expected residual value. Required: Prepare appropriate journal entries for Southern Edison for 2006 and 2007. Assume straightline depreciation and a December 31 year-end.

114


Chapter 15 Leases Answer: January 1, 2006: Leased asset Lease payable Lease payable Cash December 31, 2006: Interest expense Interest payable Depreciation expense Accumulated depreciation January 1, 2007: Interest payable Lease payable Cash December 31, 2007: Interest expense Interest payable Depreciation expense Accumulated depreciation Learning Objective: 5

111,332

($40,000 x 2.7833) 111,332

40,000 40,000 5,707

[($111,332 - $40,000) x 8%] 5,707

37,111

($111,332/3) 37,111

5,707 34,293 40,000 2,963

[($111,332 - $40,000 - $34,293) x 8%] 2,963

37,111

($111,332/3) 37,111


117. Eastern Edison Company leased equipment from Low-Tech Leasing on January 1, 2006. LowTech purchased the equipment at a cost of $111,332. Other information: Lease term Annual payments Life of asset Fair value of asset Implicit interest rate Incremental rate

3 years $80,000 on January 1 each year 3 years $222,666 8% 8%

There is no expected residual value. Required: Prepare appropriate journal entries for Low-Tech Leasing for 2006. Assume a December 31 year-end. Answer: January 1, 2006: Lease receivable Unearned interest revenue Equipment inventory Cash Lease receivable December 31, 2006: Unearned interest revenue Interest revenue Learning Objective: 5

240,000

($80,000 x 3) 17,334 222,666

80,000 80,000 11,413

[($222,666 - $80,000) x 8%] 11,413



115

Chapter 15 Leases 118. Eastern Edison Company leased equipment from Low-Tech Leasing on January 1, 2006. Other information: Lease term Annual payments Life of asset Implicit interest rate Incremental rate PV, annuity due, 3 periods, 8% PV, ordinary annuity, 3 periods, 8% Hi-Tech's cost of the equipment

3 years $80,000 on January 1 each year 3 years 8% 8% 2.7833 2.5771 $222,666

There is no expected residual value. Required: Prepare appropriate journal entries for Low-Tech Leasing for 2006 and 2007. Assume a December 31 year-end. Answer: January 1, 2006: Lease receivable Unearned interest revenue Equipment inventory Cash Lease receivable December 31, 2006: Unearned interest revenue Interest revenue January 1, 2007: Cash Lease receivable December 31, 2007: Unearned interest revenue Interest revenue Learning Objective: 5

116

240,000

($80,000 x 3) 17,334 222,666

80,000 80,000 11,413

[($222,666 - $80,000) x 8%] 11,413

80,000 80,000 5,926

[($222,666 - $80,000 - $68,586) x 8%] 5,926



Chapter 15 Leases 119. Southwestern Edison Company leased equipment from Hi-Tech Leasing on January 1, 2006. Hi-Tech manufactured the equipment at a cost of $90,000. Other information: Lease term 3 years Annual payments $40,000 on January 1 each year Life of asset 3 years Fair value of asset $111,332 Implicit interest rate 8% Incremental rate 8% There is no expected residual value. Required: Prepare appropriate journal entries for Hi-Tech Leasing for 2006. Assume a December 31 year-end. Answer: January 1, 2006: Lease receivable Cost of goods sold Unearned interest revenue Sales revenue Equipment inventory Cash Lease receivable December 31, 2006: Unearned interest revenue Interest revenue Learning Objective: 6

120,000 90,000

($40,000 x 3) 8,668 111,332 90,000

40,000 40,000 5,707

[($111,332 - $40,000) x 8%] 5,707


120. Northwestern Edison Company leased equipment from Hi-Tech Leasing on January 1, 20063. Hi-Tech manufactured the equipment at a cost of $90,000. Other information: Lease term Annual payments Life of asset Implicit interest rate Incremental rate PV, annuity due, 3 periods, 8% PV, ordinary annuity, 3 periods, 8%

3 years $40,000 on January 1 each year 3 years 8% 8% 2.7833 2.5771

There is no expected residual value. Required: Prepare appropriate journal entries for Hi-Tech Leasing for 2006 and 2007. Assume a December 31 year-end.


117

Chapter 15 Leases Answer: January 1, 2006: Lease receivable Cost of goods sold Unearned interest revenue Sales revenue Inventory of equipment Cash Lease receivable December 31, 2006: Unearned interest revenue Interest revenue January 1, 2007: Cash Lease receivable December 31, 2007: Unearned interest revenue Interest revenue Learning Objective: 6

120,000 90,000

($40,000 x 3) 8,668 111,332 ($40,000 x 2.7833) 90,000

40,000 40,000 5,707

[($111,332 - $40,000) x 8%] 5,707

40,000 40,000 2,963

[($111,332 - $40,000 - $34,293) x 8%] 2,963


121. Diablo Company leased a machine from Juniper Corporation on January 1, 2006. The machine has a fair value of $20,000,000. The lease agreement calls for four equal payments at the end of each year in the amount of $6,309,410. The useful life of the machine was expected to be four years with no residual value. The appropriate interest rate for this lease is 10%. Required: (1.) Prepare the journal entry for Diablo Company at the inception of the lease. (2.) Prepare the journal entry for the first lease payment. (3.) Prepare the journal entry for the second lease payment. Answer: (1.) Leased asset Lease payable (2.) Interest expense Lease payable Cash (3.) Interest expense Lease payable Cash Learning Objective: 5

118

20,000,000 20,000,000 2,000,000 4,309,410

(10% x $20,000,000) 6,309,410

1,569,059 4,740,351

[10% x ($20,000,000 - $4,309,410)] 6,309,410



Chapter 15 Leases 122. Diablo Company leased a machine from Juniper Corporation on January 1, 2006. The machine has a fair value of $20,000,000. The lease agreement calls for four equal payments at the end of each year. The useful life of the machine was expected to be four years with no residual value. The appropriate interest rate for this lease is 10%. Other information: PV of an ordinary annuity @10% for 4 periods: 3.16987 PV of an annuity due @ 10% for 4 periods: 3.4869 Required: (1.) Determine the amount of each lease payment. (2.) Prepare the journal entry for Diablo Company at the inception of the lease. (3.) Prepare the journal entry for the first lease payment. (4.) Prepare the journal entry for the second lease payment. Answer: (1.) $20,000,000/3.16987 = $6,309,407 (2.) Leased asset 20,000,000 Lease payable (3.) Interest expense 2,000,000 Lease payable 4,309.407 Cash (4.) Interest expense 1,569,060 Lease payable Cash Learning Objective: 5

20,000,000 (10% x $20,000,000) 6,309,407 [10% x ($20,000,000 $4,309,4070)]

4,740,348 6,309,407 Level of Learning: 3


119

Chapter 15 Leases 123. Each of the independent situations below describes a nonoperating lease in which annual lease payments are payable at the beginning of each year. The lessee is aware of the lessor's implicit interest rate. Situation Lease term Lessor's desired rate of return Lessee's incremental borrowing rate Fair value of borrowing asset

1

2

10 yrs

20 yrs

10%

12%

12%

10%

$600,000

$400,000

For convenience, here are some table values: Periods; int. rate 10 periods, 10%

PV, ordinary annuity 6.1446

PV, annuity due 6.7590

10 periods, 12%

5.6502

6.3283

20 periods, 10%

8.5136

9.3649

20 periods, 12%

7.4694

8.3658

Required: For each situation determine the amount of the annual lease payment, as calculated by the lessor. Answer: Situation 1: $600,000/6.7590 = $88,771 PV of an annuity due of $1, n=10, i=10% Situation 2: $400,000/8.3658 = $47,814 PV of an annuity due of $1, n=20, i=12% Lessor uses implicit rate. Learning Objective: 1

120



Chapter 15 Leases 124. Each of the independent situations below describes a nonoperating lease in which annual lease payments are payable at the beginning of each year. The lessee is aware of the lessor's implicit interest rate. Situation Lease term Lessor's desired rate of return Lessee's incremental borrowing rate Fair value of borrowing asset

1

2

10 yrs

20 yrs

10%

12%

12%

10%

$600,000

$400,000

For convenience, here are some table values: Periods; int. rate 10 periods, 10%

PV, ordinary annuity 6.1446

PV, annuity due 6.7590

10 periods, 12%

5.6502

6.3283

20 periods, 10%

8.5136

9.3649

20 periods, 12%

7.4694

8.3658

Required: For each situation determine the amount recorded as a liability by lessee at the inception of the lease. Answer: Using implicit rate the lessor determines the amount of annual payments. Then, to calculate the liability, lessee uses the implicit rate or incremental rate, whichever is lower. Situation 1: Lessee PV of an annuity due of $1, n=10, i=10% $600,000/6.7590 = $88,770 (rounded down) $88,770 x 6.7590 = $600,000 (rounded up) Situation 2: PV of an annuity due of $1, n=20, i=12% $400,000/8.3658 = $47,814, which exceeds fair value of the asset. Asset and liability recorded at $400,000. Learning Objective: 5



121

Chapter 15 Leases 125. The Bobo Company leased equipment from Bolinger Industries on January 1, 2006. Bolinger purchased the equipment at a cost of $270,000. Other information: Lease term Annual payments Life of asset Implicit interest rate Lessee's incremental rate

3 years $120,000 beginning Jan. 1, 2006 3 years 8% 8%

Required: (1.) Calculate the amount of dealer's profit that Bolinger would recognize in this sales-type lease. Round to nearest dollar. Show calculations. (2.) Prepare the appropriate entries for Bolinger on January 1, 2006. Round to nearest dollar. Show calculations. (3.) Prepare the appropriate entry for Bolinger on December 31, 2006. Round to nearest dollar. Answer: (1.) Sales revenue ($120,000 x 2.7833) Cost of goods sold Profit

$333,996 270,000 $ 63,996

(2.) January 1, 2006 Leased receivable ($120,000 x 3) Cost of goods sold Unearned interest revenue Sales revenue ($120,000 x 2.7833) Equipment inventory

360,000 270,000 26,004 333,996 270,000

Cash

120,000 Lease receivable

120,000

(3.) December 31, 2006 Unearned interest revenue ($333,996 - $120,000) x 8% Interest revenue Learning Objective: 6

17,120 17,120


Use the following to answer questions 126-127: Rumsfeld Corporation leased a machine on December 31, 2006, for a three-year period. The lease agreement calls for annual payments in the amount of $16,000 on December 31 of each year beginning on December 31, 2006. Rumsfeld has the option to purchase the machine on December 31, 2009, for $20,000 when its fair value is expected to be $30,000. The machine's estimated useful life is expected to be 5 years with no residual value. Rumsfeld uses straight-line depreciation for this type of machinery. The appropriate interest rate for this lease is 12%. n/i

PV of $1

1 period, 12% 2 periods, 12% 3 periods, 12%

0.89286 0.79719 0.71178

122

PV, ordinary annuity 0.89286 1.69005 2.40183

PV, annuity due 1.00000 1.89286 2.69005


Chapter 15 Leases 126. Required: (1.) Calculate the amount to be recorded as a leased asset and the associated lease liability. (2.) Prepare Rumsfeld's journal entries for this lease for 2006 and 2007. Answer: (1.) PV of $1, n=3, i=12% = .71178 PV of an annuity due of $1, n=3, i=12% = 2.69005 PV of payments $16,000 x 2.69005: PV of BPO $20,000 x.71178: (2.)

December 31, 2006: Leased asset Lease payable Lease payable Cash December 31, 2007: Interest expense Lease payable Cash Depreciation expense Accumulated depreciation


$43,041 14,236 $57,277

57,277 57,277 16,000 16,000 4,953 11,047

[($57,277 - $16,000) x 12%] 16,000

11,455

($57,277/5) 11,455


127. Required: (1.) Calculate the amount to be recorded as a leased asset and the associated lease liability. (2.) Prepare an amortization schedule for this lease. Answer: (1.) PV of $1, n=3, i=12% = .71178 PV of an annuity due of $1, n=3, i=12% = 2.69005 PV of payments $16,000 x 2.69005= PV of BPO $20,000 x.71178= (2.)

$43,041 14,236 $57,277

Amortization Schedule Dec. 31 2006 2007 2008 2009 *rounded


Payments Interest $57,277 $16,000 0 16,000 .12(41,277) = $4,953 16,000 .12(30,230) = 3,628 20,000 .12(17,858) = 2,142*

Decrease in Bal $16,000 11,047 12,372 17,858

Balance 41,277 30,230 17,858 0



123

Chapter 15 Leases 128. Merlin Co. leased equipment to Houdini Inc. The equipment cost the lessor $200,000. The appropriate interest rate for this lease is 15%. The annual rentals are paid at the end of each year. The lease term is 3 years. The residual value at the end of the lease term is expected to be $40,000. Assume this is a direct financing lease. n/I

PV of $1

1 period, 15% 2 periods, 15% 3 periods, 15%

.86957 .75614 .65752

PV, ordinary annuity .86957 1.62571 2.28323

PV, annuity due 1.00000 1.86957 2.62571

Required: (1.) If XYZ retains the equipment at the end of the lease term at a BPO cost of $20,000: (a.) The rental amount computed by the lessor is $_____________ (b.) The amount the lessee should capitalize is $____________ (2.) How much interest should be recognized at the end of year 1 by the: (a.) Lessor? $__________ (b.) Lessee? $_____ Answer: (1.) (a.)

Cost of leased asset Less PV of BPO Amount to be recovered through payments

$200,000 13,150 ($20,000 x .65752) $186,850

Payment = $186,850/2.28323 = $81,836 Rental amount

(2.)

(b.)

$200,000 Amount capitalized

(a) (b)

$200,000 x 15% = $30,000 $200,000 x 15% = $30,000


124



Chapter 15 Leases 129. Here is a lease amortization schedule for Jedi Corporation. Asset being leased: High-speed R2D2 unit Initial lease obligation Annual lease payments Annual interest rate Payments per year Number of years for lease Useful life of asset Bargain purchase option Lease Payment 1 2 3 4 5 6 7 8 9 10 11

Periodic Payment

Effective Interest

Decrease in Balance

30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000 ?? ??

?? 16,377 15,151 13,815 12,358 10,770 9,040 7,153 5,097 ?? 413

?? 13,623 14,849 16,185 17,642 19,230 20,960 22,847 24,903 ?? 4,587

?? 30,000 Payable at lease inception and at beginning of each subsequent year. ?? 1 10 12 years No expected residual value at the end of 12 years. 5,000 Exercisable at end of lease. Balance ?? 181,970 168,347 153,498 137,313 119,671 100,441 79,481 56,634 31,731 ?? ??

Total interest over term of lease. ?? Annual straight-line depreciation on the leased asset.

??

Required: (a) Calculate the effective interest and the decrease in balance for the first lease payment. (b) Calculate the initial lease obligation above. (c) Calculate the annual depreciation amount. (Round to the nearest dollar.) (d) Calculate the annual interest rate. (e) Calculate the missing amounts for rows for payments 10 & 11. (f) Calculate the total effective interest over the term of the lease. SHOW WELL LABELED ING COMPUTATIONS! Answer: a.

b. c. d. e.

f.

10 11

Effective interest = 0 for the first payment. The decrease in balance is $30,000. Initial lease obligation = $211,970 ($181,970 + $30,000) Annual straight-line depreciation on the leased asset = $17,664 ($211,970/12) Annual interest = 9.00% ($16,377/$181,970) 30,000 2,856 27,144 4,587 5,000 413 4,587 0 Total interest over term of lease = $93,030 ($305,000 - $211,970)


125

Chapter 15 Leases Learning Objective: 8

126



Chapter 15 Leases 130. To raise operating funds, Combs Corporation sold a piece of equipment on January 1, 2006, to a finance company for $600,000. Combs immediately leased the equipment back for a 10-year period. After that time ownership will transfer to Combs. The equipment has a fair value of $624,000. Its cost and its carrying value were $480,000. Its useful life is 12 years. The lease requires Combs to make payments of $80,000 to the finance company each January 1 beginning on the inception date of the lease. Combs depreciates similar assets on a straightline basis. The appropriate interest rate is 11%. Required: Prepare the journal entries for Combs on January 1, 2006, to record the sale-leaseback and the December 31, 2006, adjusting entries. Answer: January 1, 2006: Cash Equipment Deferred gain Leased equipment Lease payable Lease payable Cash

600,000 480,000 120,000 600,000 600,000 80,000 80,000

December 31, 2006: Interest expense Interest payable Depreciation expense Accumulated depreciation Deferred gain Depreciation expense Learning Objective: 10

57,200

[11% x ($600,000- $80,000)] 57,200

50,000

($600,000/12 yrs) 50,000

10,000

($120,000/12) 10,000



127

Chapter 15 Leases 131. Phelps Dodge Corporation is the world's second largest copper producer. In its 2001 annual report to shareholders, Phelps Dodge disclosed the following; Phelps Dodge leases mineral interests and various other types of properties, including shovels, offices and miscellaneous equipment. Certain of the mineral leases require minimum annual royalty payments, and others provide for royalties based on production. Summarized below at December 31, 2001, are future minimum rentals and royalties under non-cancelable leases (amounts in millions):

2002 2003 2004 2005 2006 After 2006 Total payments Present value of lease payments Less current portion Present value of long-term payments

Operating Leases $15.3 13.71.2 12.11.2 10.1 9.7 45.2 $ 106.1

Mineral Royalties 1.2 5.0 4.1 1.2 1.2 14.3 20.3

Capital Leases 4.9 4.0 18.0 $ 13.7 (3.2 $ 10.5

Required: Assume that the operating lease payments disclosed are from a single contract that lasts though 2009. How much rent expense on these leases will be charged in 2002 and 2003? Explain. What amount would the Phelps Dodge December 31, 2001, balance sheet report as long-term lease liabilities? Explain. What amount of the 2002 capital lease payment by Phelps Dodge would represent interest expense? Explain. Answer: The rent expense in 2002 and 2003 would be identical; namely, $13.26 million per year. This is based on the premise that one operating lease has unequal payments over the remaining nine years. In such situations, the expense is based on a straight-line allocation of the payments (i.e., $106.1 million/8 years). $10.5 million. The carrying value of the capital leases totals $13.7 million, but $3.2 million of that total represents a current liability at 12/31/01. $1.7 million ($4.9 million cash payment, less present value of the current liability at 12/31/01, which is $3.2 million). Learning Objective: 4

128



Chapter 15 Leases Essay Instructions: The following answers point out the key phrases that should appear in students' answers. They are not intended to be examples of complete student responses. It might be helpful to provide detailed instructions to students on how brief or in-depth you want their answers to be. 132. Discuss the economic advantages of leasing. Answer: The lessor may find some benefits to leasing an asset rather than selling it. One advantage is that the residual value is retained if title never es to the lessee. When the lease term is complete, the lessor still owns the asset. The lessor may lease it again or sell the property for an immediate gain. Another advantage to the lessor is the ongoing business relationship with the lessee. Often, the lessee will lease or buy more assets from the same dealer/lessor. Another advantage is increased sales. Leasing is a way to offer special financing to increase sales. The lessee may also find advantages in leasing. An important advantage for firms with little capital is avoiding down payment requirements. Leases frequently finance 100% of the value of an asset. This permits the lessee to use funds for other purposes. A second advantage to the lessee is reduced risk. The risks of ownership include obsolescence, physical deterioration of the asset, or casualty loss. The risks of ownership can be completely or partially avoided through leasing. Learning Objective: 2


133. What is a bargain purchase option and when do the parties to a lease know if it exists? Answer: A bargain purchase option gives the lessee the right to purchase leased property at a bargain price at some future date. If the specified price is sufficiently lower than the expected fair value at the date the option may be exercised, so that exercise of the option is reasonably assured, a bargain purchased option is said to exist. To determine if a bargain purchase option exists, the lessor and lessee must be able to reasonably predict what the market value of the leased asset will be on the option date. Learning Objective: 8


134. Differentiate between guaranteed and unguaranteed residual value of leased property. Answer: If a lease contains a guaranteed residual value, then the lessee, or some third party, guarantees that the lessor will recover a specified value at the end of the lease term. If the fair value of the asset is below this guaranteed minimum at the end of the lease term, then the lessee or the designated third party must pay the difference to the lessor. If, on the other hand, the residual is not guaranteed, then the lessor reacquires the property at the end of the lease term, and lessee has no further obligation. Learning Objective: 7



129

Chapter 15 Leases 135. What is meant by the term "minimum lease payments"? Answer: Minimum lease payments include the periodic lease payments required over the term of the lease plus any amount to be paid for residual value through either a bargain purchase option or a guarantee of residual value. Learning Objective: 1


136. Discuss the interest rates used by the lessee and the lessor for determining the present value of a capital lease. Answer: Since the minimum lease payments required under a capital lease are to be made in the future, the present value of these payments must be used to for capital leases. The incremental borrowing rate is the rate the lessee would have to pay to borrow the funds to purchase the leased assets if a purchase occurred instead of a lease. The implicit interest rate is the rate the lessor used to determine the lease payments. That is, it is the rate that will discount the lease payments and the residual value to the fair market value of the leased asset. The lessor uses the implicit interest rate to determine the present value of the minimum lease payments. The lessee uses the incremental borrowing rate or the implicit rate, whichever is lower. Learning Objective: 9


137. Describe the use of depreciation for an asset leased under a capital lease. Include a discussion of the depreciation period. Answer: The value of the leased asset (present value of the minimum lease payments) is amortized by the lessee using the lessee's normal depreciation method. The depreciation period depends on the criterion that qualified the lease as a capital lease. If the lease qualifies as a capital lease due to the existence of a bargain purchase option or the transfer of title, the depreciation period is the economic life of the asset. However, when the lease qualifies as a capital lease under the 75% or 90% rules, the lease term is used as the depreciation period. Learning Objective: 3


138. Discuss the three major types of leases that may apply to the lessor. Answer: From the lessor's point of view a lease may generally be one of three types: operating, direct financing, or sales-type. The operating lease is ed for as a rental. Periodic lease payments are recorded as rent revenue. Direct financing leases are capital leases where the lessor is primarily engaged in financing activities. The lessor views the lease as an investment and the revenue on such a lease is in the form of interest. The sales-type lease is typically used by a manufacturer or dealer in equipment. The lease is viewed as a marketing tool. The lessor receives income from two sources: profit on the "sale" of the leased equipment and interest on the financing portion of the contract. The distinguishing feature of the sales-type lease compared to the direct financing lease is the existence of the dealer profit or markup. Learning Objective: 1

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Chapter 15 Leases 139. Discuss the financial statement disclosure requirements for all leases entered into by the lessee. Answer: The lessee must reveal numerous items of information concerning all leases to which the organization is a party including: (1.) The future minimum lease payments required as of the balance sheet date for the next five years. These should be separated by operating and capital leases. (2.) The gross amount of assets recorded under capital leases and the related accumulated depreciation. (3.) The amount of rent expense for each period for which an income statement is presented. (4.) The general description of each lease contract. (5.) The amount of imputed interest for capital leases. Learning Objective: 1


140. In its 2001 annual report to shareholders, Navistar International Corporation disclosed the following: In 2001, the company entered into three sale-leaseback arrangements with various financial institutions. Under the first arrangement, truck cab assembly machinery with a net book value of $58 million, was sold for $60 million and leased back under an 8-year operating lease agreement. Under the second arrangement, tooling and related engine manufacturing equipment with a net book value of $261 million, was sold for $260 million and leased back under an 11.5-year operating lease agreement. The third arrangement consisted of additional engine manufacturing equipment with a net book value of $62 million that was sold for $65 million and leased back under a 10-year operating lease agreement. The gain on these transactions was deferred and is being amortized over the of the lease agreements. Discuss the most likely reasons for these three transactions, and explain the basis for the last sentence of the disclosure. Answer: There are two likely reasons for the transactions. First, they provide cash resources to Navistar that they can leverage into profit-making operations or investments. Second, this provides Navistar the ability to refinance debt owed on the assets into lower interest lease financing. The sale of these assets generates a total profit of $4 million. Because these are sales more in form than in substance, the $4 million gain is really a reduction in the cost of holding the leased property. Therefore, it is deferred and recognized as such over the remaining lives of the newly leased assets. Learning Objective: 10



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