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Chapter 15Leases MULTIPLE CHOICE 1. Generally accepted accounting principles require that certain lease agreements be accounted for as purchases. The theoretical basis for this treatment is that a lease of this type a. effectively conveys all of the benefits and risks incident to the ownership of property. b. is an example of form over substance. c. provides the use of the leased asset to the lessee for a limited period of time. d. must be recorded in accordance with the concept of cause and effect. ANS: A DIF: Easy TOP: AICPA FN-Reporting OBJ: LO 2 MSC: AACSB Reflective Thinking 2. Which of the following statements characterizes an operating lease? a. The lessee records depreciation and interest. b. The lessee records the lease obligation related to the leased asset. c. The lessor transfers title of the leased property to the lessee for the duration of the lease term. d. The lessor records depreciation and lease revenue. ANS: D DIF: Easy TOP: AICPA FN-Reporting OBJ: LO 2 MSC: AACSB Reflective Thinking 3. One of the four general criteria for a capital lease is that the present value at the beginning of the lease term of the minimum lease payments equals or exceeds a. the property's fair market value. b. 90 percent of the property's fair market value. c. 75 percent of the property's fair market value. d. 50 percent of the property's fair market value. ANS: B DIF: Easy TOP: AICPA FN-Reporting OBJ: LO 4 MSC: AACSB Reflective Thinking 4. In a lease that is recorded as an operating lease by the lessee, the equal monthly rental payments should be a. allocated between interest expense and depreciation expense. b. allocated between a reduction in the liability for leased assets and interest expense. c. recorded as a reduction in the liability for leased assets. d. recorded as rental expense. ANS: D DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Reflective Thinking 5. One of the four general criteria for a capital lease specifies that the lease term be equal to or greater than a. the estimated economic life of the property. b. 90 percent of the estimated economic life of the property. c. 75 percent of the estimated economic life of the property. d. 50 percent of the estimated economic life of the property. ANS: C DIF: Easy TOP: AICPA FN-Reporting OBJ: LO 4 MSC: AACSB Reflective Thinking 1 2Chapter 15/Leases 6. For a capital lease, the amount recorded initially by the lessee as a liability should a. exceed the present value at the beginning of the lease term of minimum lease payments during the lease term. b. exceed the total of the minimum lease payments during the lease term. c. not exceed the fair value of the leased property at the inception of the lease. d. equal the total of the minimum lease payments during the lease term. ANS: C DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 7. Johnson Institute leased a new machine having an expected useful life of 12 years. The noncancelable lease term is 10 years, and Johnson may exercise a purchase option at the end of the noncancelable term. The machine should be capitalized by Johnson and depreciated over a. 9 years. b. 12 years. c. 10 years. d. 10 or 12 years at Johnson's option. ANS: C DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Reflective Thinking 8. The lessee's balance sheet liability for a capital lease would be periodically reduced by the a. minimum lease payment. b. minimum lease payment plus the amortization of the related asset. c. minimum lease payment less the amortization of the related asset. d. minimum lease payment less the portion of the minimum lease payment allocable to interest. ANS: D DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 9. What are the three types of period costs that a lessee experiences with capital leases? a. Interest expense, amortization expense, executory costs b. Amortization expense, executory costs, lease expense c. Executory costs, interest expense, lease expense d. Lease expense, executory costs, initial costs ANS: A DIF: Easy TOP: AICPA FN-Reporting OBJ: LO 5 MSC: AACSB Reflective Thinking 10. An eight-year capital lease specifies equal minimum annual lease payments. Part of this payment represents interest and part represents a reduction in the net lease liability. The portion of the minimum lease payment in the fourth year applicable to the reduction of the net lease liability should be a. the same as in the third year. b. less than in the third year. c. less than in the fifth year. d. more than in the fifth year. ANS: C DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 11. Which of the following statements concerning guaranteed residual values is appropriate for the lessee? a. The asset and related liability should be increased by the amount of the residual value. Chapter 15/Leases3 b. The asset and related liability should be decreased by the amount of the residual value. c. The asset and related liability should be decreased by the present value of the residual value. d. The asset and related liability should be increased by the present value of the residual value. ANS: D DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 12. Johntech Inc. leased a new machine having an expected useful life of 30 years from Carbide Co. Terms of the noncancelable 25-year lease were that Johntech would gain title to the property upon payment of a sum equal to the fair market value of the machine at the termination of the lease. Johntech accounted for the lease as a capital lease and recorded an asset and a liability in the financial records. The asset recorded under this lease should properly be amortized over a. 5 years (the period of actual ownership). b. 22.5 years (75 percent of the 30-year asset life). c. 25 years (the term of the lease). d. 30 years (the total asset life). ANS: C DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 13. Which one of the following items is not part of the minimum lease payments from the standpoint of the lessee? a. The minimum rental payments called for by the lease b. Any guarantee the lessee is required to make at the end of the lease term regarding any deficiency from a specified minimum c. Any estimated residual value at the end of the lease term d. Any payment the lessee must make at the end of the lease term to purchase the leased property under a bargain purchase option ANS: C DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 14. A lease contains a bargain purchase option. In determining the lessee's capitalizable cost at the beginning of the lease term, the payment called for by the bargain purchase option would be a. subtracted at its present value. b. added at its exercise value. c. added at its present value. d. subtracted at its exercise price. ANS: C DIF: Easy TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 15. Which of the following statements characterizes a sales-type lease? a. The lessor recognizes only interest revenue over the life of the asset. b. The lessor recognizes only interest revenue over the lease term. c. The lessor recognizes a dealer's profit at lease inception and interest revenue over the lease term. d. The lessor recognizes a dealer's profit at lease inception and interest revenue over the asset life. ANS: C DIF: Easy OBJ: LO 6 4Chapter 15/Leases TOP: AICPA FN-Measurement MSC: AACSB Analytic 16. Initial direct costs incurred by a lessor in consummating a sales-type lease are a. charged to unearned income in the first period of the lease term. b. charged to cost of sales in the first period of the lease term. c. deferred and allocated over the lease term in proportion to the recognition of rent revenue. d. deferred and allocated over the lease term on a straight-line basis. ANS: B DIF: Easy TOP: AICPA FN-Measurement OBJ: LO 6 MSC: AACSB Analytic 17. Equal monthly rental payments for a particular lease should be charged to Rental Expense by the lessee for which of the following? Capital Lease a. b. c. d. Operating Lease Yes Yes No No No Yes No Yes ANS: D DIF: Easy TOP: AICPA FN-Reporting OBJ: LO 5 MSC: AACSB Reflective Thinking 18. Lease Y does not contain a bargain purchase option, but the lease term is equal to 90 percent of the estimated economic life of the leased property. Lease Z does not transfer ownership of the property to the lessee by the end of the lease term, but the lease term is equal to 75 percent of the estimated economic life of the leased property. How should the lessee classify these leases? Lease Y a. Capital lease b. Capital lease c. Operating lease d. Operating lease Lease Z Operating lease Capital lease Capital lease Operating lease ANS: B DIF: Medium TOP: AICPA FN-Reporting OBJ: LO 4 MSC: AACSB Reflective Thinking 19. Which of the following statements characterizes lessor accounting for residual values? a. Guaranteed residual values are included in the gross investment amount, but unguaranteed residual values are excluded from the gross investment. b. Unguaranteed residual values are included in the gross investment amount, but guaranteed residual values are excluded from the gross investment. c. Guaranteed residual values and unguaranteed residual values are excluded from the gross investment. d. Guaranteed residual values and unguaranteed residual values are included in the gross investment. ANS: D DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 6 MSC: AACSB Analytic Chapter 15/Leases5 20. Draper Corp. leased a new building and land from Baylor Leasing Inc. for 25 years. At the inception of the lease the building and land have fair market values of $200,000 and $25,000, respectively. The building has an expected economic life of 30 years. Which of the following statements is correct regarding Draper's treatment of the lease? a. Draper should treat the lease as a capital lease even though there is no bargain purchase option and no automatic transfer of ownership at the termination of the lease. b. Draper should treat the lease as a capital lease only if there is either a bargain purchase option or an automatic transfer of ownership at the termination of the lease. c. Draper should treat the lease as a capital lease provided that the land and building are recorded in separate asset accounts and accounted for separately. d. Draper should treat the lease as a capital lease only if Baylor treats the transaction as a leveraged lease. ANS: A DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 4 MSC: AACSB Analytic 21. Which of the following would be considered an executory cost? a. Minimum lease payments. b. Interest expense incurred. c. Bargain purchase option. d. Maintenance costs. ANS: D DIF: Easy TOP: AICPA FN-Reporting OBJ: LO 3 MSC: AACSB Reflective Thinking 22. If the residual value of a leased asset is greater than the amount guaranteed by the lessee a. the lessee pays the lessor for the difference. b. the lessee recognizes a gain at the end of the lease term. c. the lessee has no obligation related to the residual value. d. the lessee pays the lessor for the difference. ANS: C DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 3 MSC: AACSB Analytic 23. Which of the following is true regarding the lease term? a. The lease term does not include all periods covered by bargain renewal options. b. The lease term includes all periods for which failure to renew imposes a penalty sufficiently high that the lessee probably will renew. c. The lease term may extend beyond the date a bargain purchase option becomes exercisable. d. The lease term does not include all periods representing renewals or extensions of the lease at the lessor's option. ANS: B DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 3 MSC: AACSB Analytic 24. From the standpoint of the lessee, the minimum lease payment includes all of the following except a. the guaranteed residual value. b. the lessee's obligation to pay executory costs. c. the bargain purchase option. d. any payment that the lessee must make upon failure to extend or renew the lease. ANS: B DIF: Medium OBJ: LO 3 6Chapter 15/Leases TOP: AICPA FN-Measurement MSC: AACSB Analytic 25. Which of the following is (are) not correct regarding disclosure requirements lessees? I. For capital leases, future minimum lease payments in the aggregate and for each of the succeeding five years must be disclosed. II. For operating leases with initial or remaining lease terms in excess of one year, future minimum rental payments in the aggregate and for each of the five succeeding fiscal years must be disclosed. III. For capital leases, future minimum lease payments for each of the succeeding five years must be disclosed. IV. For operating leases with initial or remaining lease terms in excess of one year, future minimum lease payments for each of the five succeeding fiscal years must be disclosed. a. b. c. d. I only. II only. Both I and II. Both III and IV. ANS: D DIF: Medium TOP: AICPA FN-Reporting OBJ: LO 7 MSC: AACSB Reflective Thinking 26. Which of the following is not a required disclosure for lessors? a. Total of minimum sublease rentals to be received in the future under noncancelable subleases. b. Unearned interest revenue c. Unguaranteed residual values accruing to the benefit of the lessor. d. A general description of the lessor's leasing arrangements. ANS: A DIF: Medium TOP: AICPA FN-Reporting OBJ: LO 7 MSC: AACSB Reflective Thinking 27. In order for a lease to be considered a finance (or capital) lease, international accounting standards require that a lease agreement a. transfers substantially all risks and rewards incident to ownership of an asset to the lessee. b. contains a provision requiring transfer of title to the lessee by the end of the lease term. c. provides that the term of the lease contract be longer than one year. d. provides for a bargain purchase option. ANS: A DIF: Medium TOP: AICPA FN-Reporting OBJ: LO 8 MSC: AACSB Reflective Thinking 28. State Repairs acquires equipment under a noncancelable lease at an annual rental of $45,000, payable in advance for five years. After five years, there is a bargain purchase option of $75,000. The appropriate interest rate is 12 percent. What is the total present value of the lease and the first year's interest expense? a. $224,234 and $21,508 b. $224,234 and $26,908 c. $204,771 and $21,508 d. $204,771 and $19,173 ANS: A DIF: Medium OBJ: LO 5 Chapter 15/Leases7 TOP: AICPA FN-Measurement MSC: AACSB Analytic 29. Stockton, Inc. leased machinery with a fair value of $250,000 from Layton Machine Co. on December 31, 2008. The contract is a six-year noncancelable lease with an implicit interest rate of 10 percent. The lease requires annual payments of $50,000 beginning December 31, 2008. Stockton appropriately accounted for the lease as a capital lease. Stockton's incremental borrowing rate is 12 percent. Assuming the present value of an annuity due of 1 for 6 years at 10 percent is 4.7908 and the present value of an annuity due of 1 for 6 years at 12 percent is 4.6048, what is the lease liability that Stockton should report on the balance sheet at December 31, 2008? a. $189,540 b. $200,000 c. $230,240 d. $239,540 ANS: A DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 30. Baxter Company leased equipment to Fritz Inc. on January 1, 2008. The lease is for an eight-year period expiring December 31, 2015. The first of eight equal annual payments of $900,000 was made on January 1, 2005. Baxter had purchased the equipment on December 29, 2007, for $4,800,000. The lease is appropriately accounted for as a sales-type lease by Baxter. Assume that the present value at January 1, 2008, of all rent payments over the lease term discounted at a 10 percent interest rate was $5,280,000. What amount of interest revenue should Baxter record in 2009 (the second year of the lease period) as a result of the lease? a. $490,000 b. $480,000 c. $438,000 d. $391,800 ANS: D DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 6 MSC: AACSB Analytic 31. Jordan Co. leased a machine on December 31, 2008. Annual payments under the lease are $110,000 (which includes $10,000 annual executory costs) and are due on December 31 each year, for a ten-year period. The first payment was made on December 31, 2008, and the second payment was made on December 31, 2009. According to the agreement, the lease payments are discounted at 10 percent over the lease term. Assume the present value of minimum lease payments at the inception of the lease and before the first annual payment was $615,000 and Jordan appropriately classified the lease as a capital lease. What is the lease liability Jordan should report in its December 31, 2009, balance sheet? a. $466,500 b. $515,000 c. $534,150 d. $576,500 ANS: A DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 8Chapter 15/Leases 32. Aerotech Inc., a dealer in machinery and equipment, leased equipment to Quality Products on July 1, 2008. The lease is appropriately accounted for as a sale by Aerotech and as a purchase by Quality. The lease is for a ten-year period (the useful life of the asset) expiring June 30, 2018. The first of ten equal annual payments of $250,000 was made on July 1, 2008. Aerotech had purchased the equipment for $1,337,500 on January 1, 2008, and established a list selling price of $1,687,500 on the equipment. Assume that the present value at July 1, 2008, of the rent payments over the lease term discounted at 12 percent (the appropriate interest rate) was $1,582,500. What is the amount of profit on the sale and the amount of interest income that Aerotech should record for the year ended December 31, 2008? a. $245,000 and $94,950 b. $245,000 and $79,950 c. $350,000 and $79,950 d. $350,000 and $94,950 ANS: B DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 6 MSC: AACSB Analytic 33. On January 1, 2008, Shak, Inc. signed a noncancelable lease for a sneaker shining machine. The machine has an estimated useful life of nine years. The term of the lease is a six-year term with title passing to Shak at the end of the lease. The agreement called for annual payments of $40,000 starting at the end of the first year. Assume aggregate lease payments were determined to have a present value of $200,000, based on implicit interest of 12 percent. What amount of interest expense should Shak report in its 2008 income statement from this lease transaction? a. $0 b. $16,000 c. $24,000 d. $33,333 ANS: C DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 34. Epson Distributing leased a machine for a period of eight years, contracting to pay $200,000 at the beginning of the lease term on December 31, 2008, and $200,000 annually on December 31 for each of the next seven years. The present value of the eight rent payments over the lease term, appropriately discounted at 10 percent, is $1,174,000. On its December 31, 2009, balance sheet, Epson should report a liability under capital lease of a. $871,400. b. $876,600. c. $974,000. d. $1,091,400. ANS: A DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 35. Slice Company manufactures equipment that they sell or lease. On December 31, 2008, Slice leased equipment to Hook Company for a five-year period after which ownership of the leased asset will be transferred to Hook. The lease calls for equal annual payments of $50,000, due on December 31 of each year. The first payment was made on December 31, 2008. The normal sales price of the equipment is $220,000, and cost is $176,000. For the year ended December 31, 2008, what amount of income should Slice report from the lease transaction? a. $10,000 b. $30,000 c. $44,000 Chapter 15/Leases9 d. $74,000 ANS: C DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 6 MSC: AACSB Analytic 36. On March 1, 2008, Sturdy Corp. became the lessee of new equipment under a noncancelable six-year lease. The total estimated economic life of this equipment is ten years. The fair value of this equipment on March 1, 2008, was $100,000. The lease does not meet the criteria for classification as a capital lease with respect to transfer of ownership of the leased asset, or bargain purchase option, or lease term. Nevertheless, Sturdy must classify this lease as a capital lease if, at inception of the lease, the present value of the minimum lease payments (excluding executory costs) is equal to at least a. $67,500. b. $75,000. c. $90,000. d. $100,000. ANS: C DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 4 MSC: AACSB Analytic 37. On December 31, 2008, Gephardt Enterprises leased equipment from B & B Equipment Rental. Pertinent lease transaction data are as follows: The estimated seven-year useful equipment life coincides with the lease term. The first of the seven equal annual $200,000 lease payments was paid on December 31, 2008. B & B's implicit interest rate of 12 percent is known to Gephardt. Gephardt's incremental borrowing rate is 14 percent. Present values of an annuity of 1 in advance for seven periods are 5.11 at 12 percent and 4.89 at 14 percent. Gephardt should record the equipment on the books at a. $1,400,000. b. $1,022,000. c. $978,000. d. $0. ANS: B DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 38. On January 1, 2008, Collins Company leased a warehouse to Cuthbert under an operating lease for ten years at $80,000 per year, payable the first day of each lease year. Collins paid $36,000 to a real estate broker as a finder's fee. The warehouse is depreciated at $20,000 per year. During 2008, Collins incurred insurance and property tax expense totaling $15,000. Collins' net rental income for 2008 should be a. $9,000. b. $41,400. c. $44,000. d. $45,000. ANS: B DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 6 MSC: AACSB Analytic 10Chapter 15/Leases 39. On January 1, Twix Company as lessee signed a ten-year noncancelable lease for a machine with annual payments of $60,000. The first payment was also made on January 1. Twix appropriately treated this transaction as a capital lease. The ten lease payments have a present value of $405,000 at January 1, based on implicit interest of 10 percent. For the first year, Twix should record interest expense of a. $0. b. $6,000. c. $34,500. d. $40,500. ANS: C DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 40. Hazard Inc. manufactures equipment that is sold or leased. On December 31, 2008, Hazard leased equipment to Robards for a five-year period expiring December 31, 2013, at which date ownership of the leased asset will be transferred to Robards. Equal $40,000 payments under the lease are due on December 31 of each year. The first payment was made on December 31, 2008. Collectibility of the remaining lease payments is reasonably assured, and Hazard has no material cost uncertainties. The normal sales price of the equipment is $154,000 and cost is $120,000. For the year ended December 31, 2008, how much income should Hazard recognize from the lease transaction? a. $46,000 b. $40,000 c. $34,000 d. $28,000 ANS: C DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 6 MSC: AACSB Analytic 41. On January 1, Gregory Company signed a ten-year noncancelable lease for a new machine, requiring $40,000 annual payments at the beginning of each year. The machine has a useful life of 15 years, with no salvage value. Title passes to Gregory at the lease expiration date. Gregory uses straight-line depreciation for all of its plant assets. Aggregate lease payments have a present value on January 1 of $252,000, based on an appropriate rate of interest. For the first year, Gregory should record depreciation (amortization) expense for the leased machine at a. $40,000. b. $25,200. c. $16,800. d. $14,133. ANS: C DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 42. On December 1, 2008, Blake Inc. signed an operating lease for a warehouse for ten years at $24,000 per year. Upon execution of the lease, Blake paid $48,000 covering rent for the first two years. How much should be shown in Blake's income statement for the year ended December 31, 2008, as rent expense? a. $0 b. $2,000 c. $24,000 d. $48,000 ANS: B DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic Chapter 15/Leases11 43. On December 31, 2008, Cooke Company leased a machine under a capital lease for a period of ten years, contracting to pay $100,000 on signing the lease and $100,000 annually on December 31 of the next nine years. The present value at December 31, 2008, of the ten lease payments over the lease term discounted at 10 percent was $676,000. At December 31, 2009, Cooke's total capital lease liability is a. $486,000. b. $518,000. c. $533,600. d. $607,960. ANS: C DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 44. In a lease that is recorded as an operating lease by the lessee, the equal monthly rental payments should be a. allocated between interest expense and depreciation expense. b. allocated between a reduction of the liability for leased assets and interest expense. c. recorded as a reduction in the liability for leased assets. d. recorded as a rental expense. ANS: D DIF: Easy TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 45. In a lease that is recorded as a direct financing lease by the lessor, unearned revenue a. should be amortized over the period of the lease using the interest method. b. should be amortized over the period of the lease using the straight-line method. c. does not arise. d. should be recognized in full at the inception of the lease. ANS: A DIF: Easy TOP: AICPA FN-Measurement OBJ: LO 6 MSC: AACSB Analytic 46. Generally accepted accounting principles require that certain lease agreements be accounted for as purchases. The theoretical basis for this treatment is that a lease of this type a. effectively conveys substantially all of the rights and risks incident to the ownership of the property. b. is an example of form over substance. c. provides the use of the lease asset to the lessee for a limited period of time. d. must be recorded in accordance with the concept of cause and effect. ANS: A DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 2 MSC: AACSB Analytic Marshall, Inc., leased equipment to Gadsby Company on January 1, 2008. The lease is for a five-year period ending January 1, 2013. The first equal annual payment of $1,200,000 was made on January 1, 2008. The cash selling price of the equipment is $5,174,552, which is equal to the present value of the lease payments at 8%. Marshall purchased the equipment for $4,300,000. 47. Marshall should account for this lease as a. an operating lease. b. a direct-financing lease. c. a sale-type lease. d. leveraged lease. 12Chapter 15/Leases ANS: C DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 6 MSC: AACSB Analytic 48. For 2008, Marshall should report interest revenue of a. $317,964. b. $344,000. c. $413,964. d. $517,455. ANS: A DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 6 MSC: AACSB Analytic 49. On January 1, 2008, Larsen Corporation sold a machine to Parson Corporation and simultaneously leased it back for ten years. The following information is available regarding the lease: Estimated remaining useful life at December 31, 2007 Sales price Carrying value at December 31, 2007 Annual rental under leaseback Interest rate implicit in the lease Present value of the lease rentals ($14,600 for 10 years at 10%) 10 years 90,000 52,500 14,600 10% $ 89,711 $ $ $ How much profit should Larsen recognize on January 1, 2008, on the sale of the machine? a. $0. b. $37,211 c. $90,000 d. $37,500 ANS: A DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 9 MSC: AACSB Analytic 50. On January 2, 2008, Boston Corporation entered into a 10-year noncancelable lease requiring year-end payments of $60,000. The incremental borrowing rate for Boston is 10%. The lessor's implicit rate (which is known by Boston) is 12%. The lease contains no transfer of title or bargain purchase option provisions. The leased property has an estimated economic life of 12 years. At what amount should the lease be capitalized by Boston? a. $0 b. $339,012 c. $368,676 d. $600,000 ANS: C DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 51. Barnum, Inc., leased equipment from Baily Supply on December 31, 2008. The lease term is for the 10-year period expiring December 30, 2018. The useful life of the leased asset is 10 years. Equal annual payments under the lease are $100,000 due on December 31 of each year. The first payment was made on December 31, 2008. Barnum's incremental borrowing rate was 12% at December 31, 2008. Baily's implicit rate for the lease is 10% and is known by Barnum. Barnum appropriately accounts for the lease as a capital lease. Chapter 15/Leases13 What is the balance in Barnum's \"Liability Under Lease Agreements\" account at December 31, 2009? a. $533,492 b. $545,010 c. $643,492 d. $800,000 ANS: A DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 52. Potter Corporation leased used equipment to Weasley, Inc. The equipment originally had a 10-year life and the lease to Weasley is for the last two of the ten-year life of the asset. The lease calls for four semiannual lease payments of $2,000 to be made at the end of each year in the life of the lease. The lease agreement contains no transfer of title or bargain purchase option provisions. What is the amount of the leased asset that should be recorded on Weasley's books at the beginning of the lease? a. $2,000 b. $7,092 c. $4,000 d. $-0ANS: D DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 53. Allied Package Express Service properly capitalized at $93,598 a large truck it had leased on January 1, 2008. The truck has a 14-year useful life. Title to the truck passes to Allied at the end of the 12-year lease term. Allied depreciates other similar trucks on the straight-line method with no salvage value. The lease agreement calls for annual payments of $11,500 at the beginning of each year of the lease term. The interest rate implicit in the lease (which is known by the lessee) is 8%. How much depreciation and interest expense should Allied record for 2009? a. b. c. d. Depreciation Expense $7,803 $6,686 $7,830 $6,686 Interest Expense $6,568 $6,568 $6,173 $6,173 ANS: D DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 54. Walker, Inc., leased a machine from Holden Company. The lease term was for a five-year period beginning January 1, 2008. Equal annual lease payments of $3,000 are due on December 31 of each year. The implicit rate of the lease is 10% and is known to Walker. Walker has properly applied the lease capitalization criteria and as a result, accounts for the lease as a capital lease. The first payment under the lease was made on December 31, 2008 as scheduled. How much should Walker classify as the current portion of the lease liability at December 31, 2008? a. $2,252 b. $2,727 c. $3,000 14Chapter 15/Leases d. $9,509 ANS: B DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 55. A lessee wants to lease an asset on a long-term noncancellable basis, but wants to avoid capitalizing the lease. The lessee is considering the following strategies to accomplish its objective: 1. 2. 3. 4. Use a lessee guarantee of residual value. Make it impossible for the lessee (which has a very low borrowing rate) to determine the lessor's implicit rate, which is much higher the lessee's borrowing rate. Include a bargain purchase option in the lease agreement. Include a transfer of title in the lease agreement. Which of the strategies above will provide the desired result? a. None b. 1 and 3 c. 1 and 4 d. only 2 ANS: A DIF: Challenging TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 56. The lessor capitalizes and amortizes initial direct costs for all types of leases except a. operating leases. b. sales-type leases. c. direct-financing leases. d. there are no exceptions. ANS: B DIF: Challenging TOP: AICPA FN-Measurement OBJ: LO 6 MSC: AACSB Analytic 57. A lease agreement included the following provisions: Inception of the lease: 1/1/2008 Annual lease payments of $6,000 are due 12/31/2008, 12/31/2009, 12/31/2010 Annual lease payments of $4,000 are due 12/31/2011, 12/31/2012, 12/31/2013 The lease calls for a total of six lease payments. The lessor's implicit rate of return is 12%. The lease is a capital lease to the lessor. How much interest revenue is recognized in 2008 by the lessor, assuming a calendar-year fiscal year? a. $3,600 b. $3,419 c. $2,550 d. $2,118 ANS: C DIF: Challenging TOP: AICPA FN-Measurement OBJ: LO 6 MSC: AACSB Analytic 58. An asset with a market value of $100,000 is leased on January 1, 2008. Five annual lease payments are due each January 1 beginning January 1, 2008. The lessee guarantees the $40,000 residual value of the asset as of the end of the lease term on December 31, 2012. The lessor's implicit interest rate is 8%. Chapter 15/Leases15 What is the annual lease payment? a. $18,227 b. $16,877 c. $23,191 d. $25,046 ANS: B DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 6 MSC: AACSB Analytic 59. The inception of a lease is January 1, 2008. A third party guarantees the residual value of the asset under the lease, estimated to be $12,000 at January 1, 2013, the end of the lease term. Annual lease payments are $10,000 due each December31, beginning December 31, 2008. The last payment is due December 31, 2012. Both the lessor and lessee use 10% as the interest rate. The remaining useful life of the asset was six years at the inception of the lease. What is the net asset balance for the lessor, and net liability balance for the lessee, at the date of the inception of the lease? a. b. c. d. Net Asset (Lessor) $45,359 $37,908 $45,359 $37,908 Net Liability (lessee) $45,359 $37,908 $37,908 $45,359 ANS: C DIF: Challenging TOP: AICPA FN-Measurement OBJ: LO 5 | LO 6 MSC: AACSB Analytic 60. Waters Company entered into a direct-financing lease with Toll Company for the use of an asset which cost Waters $240,000. The lease agreement contained a bargain purchase option effective immediately after the fifth rental, which provided that Toll could purchase the asset at that time. The estimated life of the asset was 10 years with an estimated residual value of $400. Assuming that Toll uses straightline depreciation, Toll's annual depreciation expense would be a. $22,200. b. $23,960. c. $44,400. d. $48,000. ANS: B DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 61. K Corporation agreed to lease a computer, at cost, to L Company for $36,000 payable each year-end for seven years without a bargain purchase option, or, as an equivalent alternative, for $33,000 per year with a bargain purchase option, after the seventh rental. If the lease is a direct financing lease, and K expects to earn a 12 percent return, the amount of cash L Company would need to pay for the bargain purchase option is a. $30,266. b. $26,340. c. $21,000. d. $9,948. ANS: A DIF: Challenging TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 16Chapter 15/Leases 62. Wallace Corporation entered into a direct financing lease (interest rate 12 percent) to lease Grommit an asset that cost Wallace $90,000. The lease specified annual year-end payments for seven years. The lease also specified that, along with the last payment, Grommit could purchase the asset for $8,000 cash. Under this lease agreement, Grommit will be required to pay annual payments of a. $11,714. b. $12,858. c. $17,966. d. $18,928. ANS: A DIF: Challenging TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 63. Rawlings Company entered into a direct-financing lease with Zubin Corporation, which called for seven annual rentals of $3,500 at an interest rate of 12 percent. The payments are to be paid and the end of each year. The lease also contained a bargain purchase option allowing Zubin to purchase the asset for $2,500 after making the seventh annual rental payment. What was the cost of the asset? a. $17,104 b. $18,473 c. $25,631 d. $27,000 ANS: A DIF: Challenging TOP: AICPA FN-Measurement OBJ: LO 6 MSC: AACSB Analytic 64. Lofgreen Company leased an asset for use in its factory. The lease agreement specifies that Lofgreen is to make annual payments of $2,818 payable at the end of each year. The lessor classified the lease as a direct-financing lease since Lofgreen was allowed to lease the asset at its cost of $14,000 (the present value of the lease payments). The lessor receives a 12 percent rate of return on the lease. The estimated residual value at the end of the lease term is zero. If the lease was classified as a capital lease by Lofgreen, how much annual depreciation would Lofgreen record using the straight-line method? a. $1,400 b. $1,750 c. $1,310 d. $2,818 ANS: B DIF: Challenging TOP: AICPA FN-Measurement OBJ: LO 5 MSC: AACSB Analytic 65. Johnson, Inc., leased an asset to Raymond Corporation. The cost of the asset to Johnson was $8,000. Terms of the lease specify four-year life for the lease, an annual interest rate of 15 percent, and four year-end rental payments. The lease qualifies as a capital lease and is classified as a direct-financing lease. The asset reverts to Johnson after the fourth year, when its residual value is estimated to be $1,000. The amount of each rental payment is a. $2,000. b. $2,335. c. $2,501. d. $2,602. Chapter 15/Leases17 ANS: D DIF: Challenging TOP: AICPA FN-Measurement OBJ: LO 6 MSC: AACSB Analytic 66. On January 1, 2008, Lessor Company leased a machine to Lessee Company. The machine had an original cost of $60,000. The lease term was five years and the implicit interest was on the lease was 15 percent. The lease is properly classified as a direct-financing lease. The annual lease payments of $17,306 are made each December 31. The machine reverts to Lessor at the end of the lease term, at which time the residual value of the machine will be $4,000. The residual value is not guaranteed. At the inception of the lease, the balance of Lessor's net receivable and Lessee's liability would be a. b. c. d. Lessor Receivable $60,000 $58,011 $60,000 $58,011 Lessee Liability $60,000 $58,011 $58,011 $60,000 ANS: C DIF: Challenging TOP: AICPA FN-Measurement OBJ: LO 5 | LO 6 MSC: AACSB Analytic 67. Garrison leased a special crane to Keillor that cost Garrison $40,000. The lease term was six years and the annual rentals were $10,000 per year, payable at the end of each year. The implicit interest rate was 10 percent. Garrison recognized a gross margin of a. $3,553. b. $4,000. c. $20,000. d. $24,000. ANS: A DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 6 MSC: AACSB Analytic 68. Roscoe Company entered into a lease of special equipment to Mac Company. The lease term was six years. The equipment cost Roscoe $40,000 and Roscoe plans to earn a $4,000 dealer profit. Roscoe's implicit rate on the lease is 12 percent. As a result of this agreement, Roscoe will receive year-end lease payments of a. $7,333. b. $8,213. c. $10,702. d. $12,090. ANS: D DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 6 MSC: AACSB Analytic 69. Alvin Company entered into a lease agreement with Theodore, Inc., to lease an asset that cost Alvin $120,000. The lease agreement requires five annual year-end rentals of $40,000 each. Alvin's implicit rate on the lease is 15 percent. Alvin's dealer profit on this lease would be a. $14,086 loss. b. $14,086 gain. c. $18,000 gain. 18Chapter 15/Leases d. $80,000 gain. ANS: B DIF: Medium TOP: AICPA FN-Measurement OBJ: LO 6 MSC: AACSB Analytic 70. If the lessee and the lessor use different interest rates to account for a capital lease, then a. the lease will never be accounted for as a capital lease by the lessee. b. total expenses (or revenues) will be equal for both lessee and lessor. c. total expenses (or revenues) will be different for the lessee and the lessor. d. GAAP has been violated since the lessor and the lessee are not allowed to use different interest rates in accounting for capital leases. ANS: C DIF: Challenging TOP: AICPA FN-Measurement OBJ: LO 4 MSC: AACSB Analytic PROBLEM 1. On July 1, 2005, Hawkeye Aviation leased two helicopters from Honnicutt Aircraft for an initial period of 12 months with a provision for a continuation on a month-to-month basis. The lease is properly classified as an operating lease. Lease payments are to be made as follows: First two months ............................... Second three months ............................ Third three months ............................. Last four months ............................... $15,000 12,000 10,000 8,000 per per per per month month month month After the first year, the rent continues at $6,000 per month. Provide the entries required to record the lease payments for the first year on the books of (1) (2) Hawkeye Aviation. Honnicutt Aircraft. ANS: (1) Hawkeye Aviation (Lessee) 2005 July, Aug. Sept., Oct., Nov. Prepaid Rent ............. Rent Expense ([2($15,000) + 3($12,000) + 3($10,000) + 4($8,000)] / 12) Cash ................... 4,333 10,667 Prepaid Rent ............. Rent Expense ............. Cash ................... 1,333 10,667 Rent Expense ............. Cash ................... Prepaid Rent ........... 10,667 15,000 12,000 2005 Dec. 2006 Jan., Feb. 2006 10,000 667 Chapter 15/Leases19 Mar., Apr. May, June Rent Expense ............. Cash ................... Prepaid Rent ........... 10,667 8,000 2,667 (2) Honnicutt Aircraft (Lessor) 2005 July, Aug. Sept., Oct. Nov. Cash ..................... Unearned Rent Revenue .. Rent Revenue ........... 15,000 Cash ..................... Unearned Rent Revenue .. Rent Revenue ........... 12,000 Cash ..................... Unearned Rent Revenue .... Rent Revenue ........... 10,000 667 Cash ..................... Unearned Rent Revenue .... Rent Revenue............ 8,000 2,667 4,333 10,667 1,333 10,667 2005 Dec. 2006 Jan., Feb. 10,667 2006 Mar., Apr. May, June DIF: Challenging OBJ: LO 5 | LO 6 MSC: AACSB Analytic 10,667 TOP: AICPA FN-Measurement 2. On January 2, 2005, the Wilcox Studios leased six computers for use in the engineering department. The lease period is for 13 years and the estimated economic life of the leased property is 15 years. The lease does not contain automatic title transfer or a bargain purchase option. Lease payments are $9,000 per year, payable each December 31. The incremental borrowing rate for Wilcox is 12 percent and the implicit interest rate (known by Wilcox) is 10 percent. The company uses straight-line depreciation for this type of equipment. Provide the necessary journal entries to record the transactions for Wilcox for the period January 2, 2005 through December 31, 2006. ANS: PVn = R(PVAFn/i) PVn = $9,000(Table IV 13/10%) PVn = $9,000(7.1034) PVn = $63,931 2005 Jan. 2 Dec. 31 Leased Equipment ................... Obligations under Capital Lease .. 63,931 Amortization Expense ($63,931/13) .. Accumulated Amortization ......... 4,918 Obligations under Capital Lease .... Interest Expense ($63,931 10%) ... 2,607 6,393 63,931 4,918 20Chapter 15/Leases Cash ............................. 9,000 2006 Dec. 31 Amortization Expense ............... Accumulated Amortization ......... 4,918 Obligations under Capital Lease .... Interest Expense [($63,931 - $2,607) 10%] ........ Cash ............................... 2,868 DIF: Medium OBJ: LO 5 MSC: AACSB Analytic 4,918 6,132 9,000 TOP: AICPA FN-Measurement 3. Washington Financing, Inc. purchased a packing machine to lease to Puyallup Fruits. The lease qualifies as a direct financing lease and requires lease payments of $58,860 per year, payable in advance, over a ten-year period. There is no expected residual value. The fair market value of the packing machine is $330,000--the same amount paid by Washington to purchase the asset. The lease term begins on January 1, 2005. Provide the journal entries required on Washington's books to (1) (2) record the lease transaction and the first lease payment. recognize interest revenue at the end of the first year. Washington uses a calendaryear accounting period. (Round all computations to the nearest dollar.) ANS: (1) 2005 Jan. 1 Lease Payments Receivable ........... Equipment Purchased for Lease ..... Unearned Interest Revenue ......... 588,600 Cash ................................ Lease Payments Receivable ......... 58,860 Unearned Interest Revenue ........... Interest Revenue................... [($588,600 - $58,860 - $258,600) 16%*] * Computation of implicit interest rate: $330,000/$58,860 = 5.6065 5.6065 - 1.0000 = 4.6065 for 9 periods From Table IV, the rate is 16% 43,382 330,000 258,600 58,860 (2) Dec. 31 DIF: Medium OBJ: LO 6 MSC: AACSB Analytic TOP: AICPA FN-Measurement 43,382 Chapter 15/Leases21 4. Jason Inc. uses leases as a means of selling its equipment. On January 1, 2005, the company leased a machine to Jeremy Manufacturing Inc. The cost of the machine to Jason was $78,450. The fair market value (which was the sales price) was $101,184 at the time of the lease. Annual lease payments are $13,500 and are payable in advance for 12 years. At the end of the lease term, title to the machine will pass to Jeremy Manufacturing. (1) (2) (3) Provide the entries required on Jason's books to record the lease and the first payment. Compute the manufacturer's profit to be recognized by Jason in the first year of the lease. Provide the entry required on Jason's books to recognize interest revenue at the end of the first year. (Round computations to the nearest dollar.) ANS: (1) 2005 Jan. 1 Lease Payments Receivable ($13,500 12) .................. Cost of Goods Sold ................ Finished Goods Inventory ........ Unearned Interest Revenue ....... Sales ........................... 162,000 Cash .............................. Lease Payments Receivable ....... 13,500 Sales price of machine ....................... Cost to manufacture .......................... Manufacturer's profit ........................ $101,184 78,450 $ 22,734 78,450 78,450 60,816 101,184 13,500 (2) (3) 2005 Dec. 31 Unearned Interest Revenue ......... Interest Revenue ................ [($162,000 - $13,500 - $60,816) . 10*] * Computation of implicit interest rate: $101,184/$13,500 = 7.4951 7.4951 - 1.0000 = 6.4951 for 11 periods. From Table IV, the rate is 10%. DIF: Medium OBJ: LO 6 MSC: AACSB Analytic 8,768 8,768 TOP: AICPA FN-Measurement 5. On January 1, 2005, Franklin Industries leased equipment on an eight-year term at $15,000 annual rental payments, paid in advance. There is a bargain purchase option on December 31, 2012 (end of lease), of $24,000. The economic life of the equipment is estimated to be 15 years. The interest rate is 12 percent. (1) Give the necessary entries for 2005 assuming all payments after the initial payment 22Chapter 15/Leases are made on December 31. (2) Give the entry at December 31, 2012, assuming the option is permitted to lapse and that there is no residual value because of obsolescence. Assume 2012 amortization entries have been made. ANS: (1) 2005 Jan. 1 93,151 Obligations under Capital Lease ...... Cash ............................... 15,000 Amortization Expense ($93,150/15) .... Accumulated Amortization ........... 6,210 Interest Expense ($78,150 12%) ..... Obligations under Capital Lease ...... Cash ............................... Dec. 31 Leased Equipment ..................... Obligations under Capital Lease .... [($15,000 5.5638) + ($24,000 .4039)] 9,378 5,622 93,151 15,000 6,210 15,000 (2) 2012 Dec. 31 Loss from Failure to Exercise Bargain Purchase Option ...................... Interest Expense Obligations under Capital Lease ...... Accumulated Amortization ($6,210 8) Leased Equipment ................... DIF: Challenging OBJ: LO 5 MSC: AACSB Analytic 19,476 2,571 21,424 49,680 93,151 TOP: AICPA FN-Measurement 6. Farewell Inc. leases equipment to its customers under noncancelable leases. On January 1, 2005, Farewell leased equipment costing $400,000 to Norman Co., for nine years. The rental cost was $44,000 payable in advance semiannually (January 1 and July 1), plus $2,000 semiannually for executory costs. The equipment had an estimated life of 15 years and sold for $533,025 with an estimated unguaranteed residual value of $80,000. The implicit interest rate is 12 percent. Prepare all journal entries for 2005 on Farewell's and Norman's books. Round all calculations to the nearest dollar. Use straight-line depreciation. ANS: Farewell's Books (Lessor) 2005 Jan. 1 Lease Payments Receivable [($44,000 18) + $80,000] ......... Cost of Goods Sold ($400,000 - 28,024) ................ Finished Goods Inventory .......... 872,000 371,976 400,000 Chapter 15/Leases23 Unearned Interest Revenue ......... Sales ............................. $44,000 11.4773 = $505,001 $80,000 .3503 = 28,024 $533,025 338,975 505,001 Cash ................................ Lease Payments Receivable ......... Executory Costs ................... 46,000 July 1 Cash ................................ Lease Payments Receivable ......... Executory Costs ................... 46,000 July 1 Unearned Interest Revenue ........... Interest Revenue [($533,025 - $44,000) .06] ...... 29,342 Unearned Interest Revenue ........... Interest Revenue [($489,025 $44,000 + 29,342) .06] ......... 28,462 Dec. 31 44,000 2,000 44,000 2,000 29,342 28,462 Norman's Books (Lessee) 2005 Jan. 1 Dec. 31 505,001 Lease Expense ....................... Obligations under Capital Leases .... Cash .............................. July 1 Leased Equipment .................... Obligations under Capital Leases .. 2,000 44,000 Interest Expense [($505,001 - $44,000) 0.06] ..... Obligations under Capital Leases .... Lease Expense ....................... Cash .............................. 27,660 Amortization Expense ................ Accumulated Amortization ($505,001/9) ...................... Interest Expense .................... Interest Payable [($461,001 - $16,340) .06] ...... 56,111 DIF: Challenging OBJ: LO 5 | LO 6 MSC: AACSB Analytic 16,340 2,000 505,001 46,000 46,000 56,111 26,680 26,680 TOP: AICPA FN-Measurement 7. Henri Retail Stores is negotiating three leases for store locations. Henri's incremental borrowing rate is 12 percent. Each store will have an economic useful life of 30 years. Lease payments will be made at the end of each year. Based on the data below, properly classify each of the leases as an operating lease or a capital lease. The purchase price for each property is listed as an alternative to leasing. Location Lease Term Location A Lease Payment Purchase Price 26 years $1,500,000 $12,000,000 24Chapter 15/Leases Location B Location C 20 years 20 years 1,300,000 1,400,000 10,000,000 15,000,000 Determine whether each of the leases should be classified by Henri as an operating lease or a capital lease. Show computations and reasons to support your answers. (1) (2) (3) Location A Location B Location C ANS: (1) Location A: Capital lease Computations: 26 years/30 years = 86.7% of useful life, so the third criterion (75% of useful life) is met. $1,500,000 payment 7.8957 = $11,843,550 (present value of minimum lease payments). $11,843,550/$12,000,000 = 98.7% of F.V., so the fourth criterion (90% of F.V.) is also met. (2) Location B: Capital lease Computations: 20 years/30 years = 66.7% of useful life, so the third criterion (75% of useful life) is not met. $1,300,000 payment 7.4694 = $9,710,220 (present value of minimum lease payments). $9,710,220/$10,000,000 = 97.1% of F.V., so the fourth criterion (90% of F.V.) is met. (3) Location C: Operating lease Computations: 20 years/30 years = 66.7% of useful life, so the third criterion (75% of useful life) is not met. $1,400,000 payment 7.4694 = $10,457,160 (present value of minimum lease payments). $10,457,160/$15,000,000 = 69.7% of F.V., so the fourth criterion (90% of F.V.) is also not met. DIF: Challenging OBJ: LO 5 MSC: AACSB Analytic TOP: AICPA FN-Measurement 8. Standard Distributing entered into a leasing agreement with R & D Rental. The lease qualifies as a capital lease and calls for payments of $5,000 for 5 years with the first payment being made on January 1, 2005, and subsequent payments being made on December 31 of each year. Standard's incremental borrowing rate is 12 percent. Chapter 15/Leases25 Prepare a schedule amortizing Standard's lease obligation. ANS: Date 1/1/2005 1/1/2005 12/31/2005 12/31/2006 12/31/2007 12/31/2008 Payment $5,000 5,000 5,000 5,000 5,000 Interest Expense Principal Lease Obligation $1,822 1,441 1,014 536 $5,000 3,178 3,559 3,986 4,464 $20,187* 15,187 12,009 8,450 4,464 0 * $5,000 4.0373 = $20,187 DIF: Medium OBJ: LO 5 MSC: AACSB Analytic TOP: AICPA FN-Measurement 9. Johnson Manufacturing entered into a noncancelable lease for an office building on January 1, 2005. The lease calls for payments of $24,000 a year for eight years. The first payment is due on January 1, 2005, with the other payments due on December 31 of each year. Johnson has an incremental borrowing rate of 8 percent. The building is amortized by Johnson over eight years using the straightline method and assuming no salvage value. Prepare a partial balance sheet for Johnson for the year ending December 31, 2005, disclosing the asset and the liability related to the leased building. ANS: Asset: Cost: $24,000 6.2064 = $148,954 Annual amortization: $148,954 / 8 years = $18,619 Liability: ($148,954 - $24,000) .08 = $9,996 interest portion of 12/31/05 payment $24,000 - $9,996 = $14,004 principal portion of 12/31/05 payment $24,000 - ([$148,954 - $24,000 - $14,004] .08) = $15,124 principal portion of 12/31/2006 payment Johnson Manufacturing Balance Sheet (partial) December 31, 2005 Land, buildings, and equipment: Leased building ..................................... Less accumulated amortization ....................... Current liabilities: Obligations under capital lease--current portion .... Noncurrent liabilities: Obligations under capital lease--exclusive of amount included in current liabilities ..................... $148,954 18,619 $130,335 15,124 95,826 26Chapter 15/Leases DIF: Challenging OBJ: LO 7 MSC: AACSB Analytic TOP: AICPA FN-Measurement 10. George Harmon is the president of the Utah Western Railroad Company. The Utah Western is a bridge line that receives traffic from the Union Pacific Railroad and the Burlington Northern railroads at Salt Lake City, Utah, and hauls the freight to Denver, Colorado, for connections with other lines to points east. Recently, traffic on the Utah Western has increased dramatically and the railroad is in need of additional locomotives to haul its trains. Accordingly, George is considering leasing locomotives to meet the demands of this increase in traffic until new engines can be ordered if the surge subsides. As the controller of the railroad, George has asked you to advise him as to the disadvantages associated with leasing generally. ANS: Disadvantages of leasing for a lessee include the following: 1. Leases allow a lessee to obtain 100% financing at fixed interest rates. The larger amount financed means that the company will pay higher interest in terms of the total dollar outlay. 2. Leasing ready-to-use equipment rather than custom built equipment may result in lower quality product or services, which may result in lost sales for the lessee. In the case of the railroad, the company may wish to lease six-axle, 3,000 horsepower locomotives with the power and speed needed to meet existing customer schedules when such equipment is not available. Another possibility is that only older units may be available and older equipment may be subject to more downtime from breakdowns. Replacement parts for the older units may need to be purchased if the railroad does not carry anything comparable in its parts inventory. 3. No guarantee exists that the equipment the company (lessee) wants will be available when needed. Seasonal or other types of patterns that result in the need to lease may be common to all firms in an industry. The demand for equipment also may mean that leasing companies will increase interest rates charged. 4. Short-term leasing rates are generally higher than long-term rates in order to protect the lessor from obsolescence. 5. Tax benefits associated with leases are subject to changes in the tax law and thus could be reduced or eliminated. DIF: Challenging OBJ: LO 1 MSC: AACSB Communication TOP: AICPA FN-Reporting 11. Business leasing has become a large market. Banks, other lending institutions, and commercial leasing companies represent the largest share of the business leasing market with the remainder consisting of manufacturers, dealers, and distributors. Identify the advantages and disadvantages to lessors of leasing rather than selling property. ANS: Chapter 15/Leases27 Leasing has several advantages over sales for lessors. Customers may be unwilling or unable to purchase property. The use of leasing offers the lessor a means of servicing these customers and thus preserving a sale that otherwise might be lost. The lessor sees leasing as one component of a fullservice, selling strategy. Leasing also may afford the lessor with the opportunity of maintaining a business relationship with the lessee. In a purchase, the relationship between the buyer and seller may be limited to the time of the negotiation and consummation of the sale. A leasing transaction, on the other hand, may result in the lessee and lessor maintaining contact over an extended period of time. Such contracts may develop into long-term business relationships that prove useful both to the lessee and the lessor. Many lease agreements are structured such that the title to the leased property remains with the lessor. The lessor thus stands to benefit from the residual value of the asset at the end of the lease term. The asset may be leased to another lessee or sold. Large increases in residual values can result in significant gains to lessors when the assets are sold. This can be a two-edged sword, however. The lessor also can be saddled with an obsolete asset if he or she is not astute in structuring lease rates to encourage maximum use of the asset prior to its becoming obsolete. This accomplished by charging higher leasing rates for short-term leases over long-term leases in order to compensate the lessor for assuming the risk of obsolescence. A major disadvantage of leasing to lessors results from fixed rates on long-term leases. Such fixed rates expose the lessor to the risk of opportunity losses if interest rates advance. DIF: Challenging OBJ: LO 1 MSC: AACSB Communication TOP: AICPA FN-Reporting 12. Spartan Corporation has entered into a debt agreement that restricts its debt-to-equity ratio to less than two-to-one. The corporation is planning to expand its facilities, creating a need for additional financing. The board of directors is considering leasing the additional facilities but is concerned that leasing may violate its existing debt agreement. A violation of the debt agreement would place the corporation in default. The potential lessor insists that the lease be structured in such a way that it can be accounted for as a capital lease by the lessor (the lessor is a dealer and wants to recognized the dealer's gross profit on the transaction immediately). In addition, the lessor requires that the residual value of the leased asset be guaranteed when it reverts to the lessor at the end of the lease term. Spartan's board has asked you to analyze the following alternative: Alternative 1--Spartan would enter into a lease that qualifies as a capital lease (to Spartan). If this alternative is selected, Spartan's reported debt-to-owners'-equity ratio would be 1.9, and its ability to issue debt in the future would be seriously constrained. Alternative 2--Spartan would enter into a lease and pay a third party to guarantee the residual value of the leased property. The lease would be structured in such a way as to qualify as an operating lease to Spartan and as a capital lease to the lessor. In this case, Spartan's reported debt-to-equity ratio would be unaffected by the lease contract. Required: Explain the consequences of each of these alternatives, including any ethical considerations that might exist. ANS: 28Chapter 15/Leases The relative merits of the two alternatives depend on the likelihood that Spartan will require debt financing in the immediate future, and the cost of securing a third party guarantor of the residual value of the leased property. If Spartan is unlikely to need additional financing immediately, the risk of default on the existing debt agreement may be minimal since the lease liability will be reduced annually by the principal portion of the lease payment. Spartan also may be able to obtain capital through the issuance of stock, which would improve its debt-to-owners' equity ratio. Paying a third party to act as guarantor the lessor's residual value on the leased asset is costly. This cost must be compared to the benefits of the reduced risk of default on existing debt. Assumption of the residual value guarantee by the lessee requires no out-of-pocket expenditures until the end of the lease term unless the appraised residual value is less than the guaranteed residual value. The ethical issue centers around the use of a third party to guarantee the residual value to avoid including a capital lease obligation on the balance sheet. If the acquisition is intended to be permanent and the use of the third party is simply designed to effect an off-balance financing, then Alternative 2 poses some significant ethical questions. DIF: Challenging OBJ: LO 6 MSC: AACSB Analytic TOP: AICPA FN-Measurement 13. GW Company operates a large regional railway system. The following is an excerpt from the company's 2007 annual report: 6. Lease Commitments GW is committed under long-term lease agreements, which expire on various dates through 2079, for equipment, rail lines, and other property. Future minimum lease payments are as follows: Years 2008 2009 2010 2011 2012 2013 and subsequent years Total Less: Imputed interest on capital leases at an average rate of 8.4% Present value of minimum lease payments included in debt Operating $ 56.6 53.8 45.5 33.4 31.8 583.3 $ 804.9 Capital $ 15.0 14.9 14.9 14.9 14.8 80.5 $ 155.0 $ 100.9 Required: Given that lease payments occur evenly throughout the year, estimate the decline in the capital lease liability in 2007. ANS: Chapter 15/Leases29 The decline in the capital lease liability is the current portion of future lease payments, or the principal amount of next year' payments. Since payments occur evenly throughout the year, an average should be taken between payments occurring at the beginning of the year, and payments occurring at the end of the year. In the following calculations X represents the current portion of the lease payments. 1. Assuming year-end payments: (Outstanding Liability)(Interest Rate) + Principal = (100.9 + X)(.084) + X = 15.0 (2008 payment) 2. Assuming payments at the beginning of the year: (Outstanding Liability)(.084) + X = 15.0 = 15.0 (2008 payment) Average 1 and 2 {[(100.9 + X).084 + X] + [(100.9).084 + X]]/2 = 15.0 X = 6.26 DIF: Challenging OBJ: LO 7 MSC: AACSB Analytic TOP: AICPA FN-Measurement 14. Current generally accepted accounting principles do not require operating leases to be shown on the balance sheet. Consider the case of Company A. If the operating leases of A Company were added to the company's liabilities at December 31, 2008, the company's current ratio would decline from 0.69 to 0.57 and total debt would increase from $239 million to $1,105 million. Significant changes would also occur in the return on assets since assets would be increased and the related increase in depreciation and interest expense would exceed the rent expense currently included in the company's income statement. Required: 1. Discuss this situation described above as regards economic reality and the usefulness of information provided to decision makers. 2. Should operating leases be capitalized? Explain. ANS: 1. The company's operating leases likely contain the same commitments as capitalized leases. The company's commitments to the lessor are ignored as a result of not recording these operating leases. Although the yearly payments required by the operating leases are disclosed in the notes to the financial statements, the present value of these payments is not disclosed. Additionally, the assets under lease are not shown on the balance sheet. Rental payments are expensed on the income statement, but the amount of these rental payments is less than the depreciation on the asset if it were shown on the balance sheet plus the interest expense on the lease. Return on assets and return on equity are also altered as a result. 2. FASB Statement 13 on leasing is one of the most amended statements the Board has ever issued. Company managers have spent much time and money seeking loopholes in 30Chapter 15/Leases the leasing rules in order to achieve off-balance-sheet financing as a result of not recording the leased assets and related expenses. The FASB has responded by amending the original leasing pronouncement to close these loopholes. Some have suggested that all leases be capitalized. Although this solution would undoubtedly capture many capital leases disguised as operating leases, it would also igno