Solutions to Review Questions (Chapter 21-Accounting for Leases)
SOLUTIONS TO REVIEW QUESTIONS AND EXERCISES TRU E-FALSE
1. (F) A lease is a contractual agreement conveying the rights to use property from one party to another. A~ lease does not by definition transfer ownership. Such arrangements can be written into a lease agreement, but the transfer of ownership is not a part of all lease agreements. An operating lease refers to a lease arrangement that has all the characteristics of a rental agreement. When a lease is an operating lease, rent expense accrues day by day to the lessee as the property is used. The lessee assigns rent to the periods benefiting from the use of the asset and ignores any commitments to make future payments. A lessor accounts for an operating lease by recording each rental receipt as rental revenue for the use of the item which is still carried on its books as an asset. The size of rental payments depends on a number of issues that are determined by the lessee and lessor. The fact that a lease is accounted for as a capital lease or as an operating lease does not have an impact on the size of the annual rental payments.
(T) (T) (T) (F)
The leased asset recorded on the books of a lessee is recorded at the lower of (a) the present value of the minimum lease payments excluding any executory cost, or (b) the fair market value of the leased asset at the inception of the lease. Although the amount capitalized as an asset and the amount recorded as an obligation at the inception of the lease are computed at the same present value, the amortization of the asset and the discharge of the obligation are independent accounting processes during the term of the lease. They need not be written off over the same number of accounting periods. The distinction for the lessor between a direct financing lease and a sales-type lease is the presence or absence of a manufacturer’s or dealer’s profit (or loss). A sales-type lease involves manufacturer’s or dealer’s profit, and a direct financing lease does not. The lessor is not required to be a manufacturer or dealer to account for a lease as a sales-type lease. All leases that do not qualify as direct financing or sales-type leases are classified and accounted for by the lessors as operating leases.
(F) (T) (T) (F) (F)
Because the actual residual value cannot be known until the lease expires, the residual value is only an estimated amount. When the lessor accounts for the minimum lease payments, the lessor works on the assumption that the residual value will be realized at the end of the lease term whether guaranteed or unguaranteed.
21—30Student Study Guide for Intermediate Accounting. 12th Edition 19. 20. 21. (T) (T) (T)
22. (T) *23 (1) *24. (F)
Any profit or loss experienced by the seller-lessee from the sale of the assets that are leased back under a capital lease should be deferred and amortized over the lease term in proportion to the amortization of the leased asset. Leasebacks in which the present value of the rental payments are 10% or less of the fair market value of the asset are defined as minor leasebacks. Minor leasebacks are not considered financing transactions and the transaction is considered a sale (with full or loss recognition).
MULTIPLE CHOICE 1. (A) A lease is a contractual agreement between a lessor and a lessee that conveys to the lessee the right to use specific property (real or personal), owned by the lessor, for a specific period of time in return for stipulated and generally periodic cash payments. An essential element of the lease agreement is that the lessor conveys less than the total interest in the property. There are no sinking fund or lease term requirements that must be met for a lease to exist. Also, leased property need not be held for sale prior to the lease agreement. 2. (C) A lease arrangement does not improve financial ratios. When a capital lease is involved, an asset is recorded but so is a corresponding liability. This transaction will actually result in a negative impact on most ratios of the lessee. 3. (C) The lessee and the lessor treat the lease rental payments in a capital lease as consisting
of interest and principal.
4. (D) Alternative A meets the 75% of the economic life test. Alternative B meets the 90% of the fair value of the leased property test. Alternative C appears to be a bargain purchase option. Thus, these situations all describe a capital lease arrangement because they meet one of the four capital lease criteria. Alternative D has no relationship to the four capital lease criteria and is most likely an operating lease arrangement. The FASB takes the position that if the inception of the lease occurs during the last 25% of the life of the asset, the economic life test cannot be used as a basis to classify a lease as a capital lease. The length of the lease is not a consideration, nor is the intent to exercise any bargain purchase option. Even if the leased property is to revert to the lessor, the economic life test is invalid as long as the asset is in the last 25% of its economic life. The present value of the cost of the leased asset is not a part of the specific computation of the minimum lease payments. Minimum lease payments include the items identified in alternatives B, C. and D as well as the guaranteed residual value. The one exception to the lessee using its incremental borrowing rate is when the lessor’s implicit rate is known and it is less than the lessee’s incremental rate; then the implicit rate must be used. The purpose for this exception concerns the fact that the implicit rate is generally more realistic. Also, use of the implicit rate, when it is lower, will help ensure that the lessee does not use an artificially high incremental rate to avoid capitalization under the 90% rule. A bargain purchase option allows the lessee to purchase the leased property for a future price that is substantially lower than the property’s expected future price. If a bargain purchase option exists, the lessee must increase the present value of the minimum lease
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payments by the present value of the option price. The certainty of exercise at lease inception is not a necessary condition for increasing the present value of the minimum lease payments. The existence of a bargain purchase option is sufficient. The amount of interest expense would be calculated by multiplying the lease obligation (present value of minimum lease payments) by the effective interest rate of 10%, which is $7,582 ($75,816 X 10%). Because the lease agreement transfers ownership of the asset to the lessee, depreciation of the leased equipment is based on the economic life of the asset. Therefore, using the straight-line method, the depreciation expense for the year would be $10,831 (S75,8l6/7). After the 2007 payment, the new lease obligation is $63,398. This is calculated by subtracting the difference between the annual lease payment ($20,000) and the amount of interest expense ($7,582) of $12,418 from the previous lease obligation of $75,816. The 2008 interest expense is therefore $6,340 (10% of $63,398), and depreciation expense is again $10,831 ($75,8 16/7). The rent expense resulting from an operating lease is charged against income in a manner consistent with the matching concept. Thus, rent expense is charged against
income in the period(s) benefiting from the use of the leased asset.
12.(B) Because the capital lease treatment records the asset and the related debt on the lessee’s financial statements, these items will both increase as a result of a capital lease. However, with total assets being greater the return on assets will decrease as the leasing arrangement does not provide an additional source of revenue to the lessee. Fair market value of leased machine $250,000 Less present value of the residual value -0Amount to be recovered by lessor $250,000 Six beginning-of-the-year lease payments to yield 12% return (5250,000/4.60478 = $54,291.41) (Table 6-5) The two additional requirements for the lessor to account for a lease as a capital lease are there to be sure that the lessor has really transferred the risks and rewards of ownership. If collectibility of payments is not predictable or if performance by the lessor is incomplete, then it is inappropriate to remove the leased asset from the lessor’s books and accounting for the lease as an operating lease is more appropriate. The lease receivable is the present value of the minimum lease payments. Whether the estimated residual value is guaranteed or unguaranteed is of accounting
consequence to the lessee. The accounting difference is that the minimum lease
payments, the basis for capitalization, includes the guaranteed residual value but excludes the unguaranteed residual value. A guaranteed residual value affects the lessee’s computation of minimum lease payments and, therefore, the amounts capitalized as a leased asset and a lease obligation. The residual value is the estimated fair market value of a leased asset at the end of the lease term. A guaranteed residual value occurs when a lessee or another third party agrees to make up any deficiency below a stated amount that the lessor realizes at the end of the lease term. If the residual value is guaranteed by a third party, it is treated by the lessee as an additional payment and by the lessor as realized at the end of the lease term. (B) If, at the end of the lease, the fair market value of the residual value is less than $10,000, Davies Co. will have to record a loss. Because the fair market value was only $5,500, Davies Co. will record a $4,500 loss ($10,000- $5,500). (A) If, at the end of the lease, the fair market value of the residual value is greater $10,000, Davies Co. will have to record a gain. Because the fair market value was $10,500, Davies Co. will record a $500 gain ($10,500 -$10,000). (C) The manner in which rental receipts are recorded, the amount of depreciation and the allocation of initial direct costs are not primary differences in applying the
21—30Student Study Guide for Intermediate Accounting. 12th Edition financing method to a direct financing lease or a sales-type lease. The primary difference is in recognition of the manufacturer’s or dealer’s profit at the inception of
21. the profit is thus $40,000 ($350,000 $310,000). The amount of the interest income is
Under a sales-type lease, the amount of profit on the sale is the difference between the sales price of the asset and the cost of the asset. For Debbie Company the amount of
calculated by multiplying the net investment by the effective interest rate (and then pro
rating to the portion of the year). In this case, the net investment at December 31, 2007, was $aOO,000 ($350,000 $50,000) and the effective interest rate is 9% to obtain
$27,000. However, because only a half a year has passed, only half of the $27,000, or $13,500, should be considered earned. Any profit related to a sale-leaseback transaction in which the seller-lessee retains the right to substantially all of the remaining use of the equipment sold shall he deferred and amortized in proportion to the amortization of the leased asset, if a capital lease, or in proportion to the related gross rental charged to expense over the lease term, if an
operating lease. It is important to note that losses are recognized immediately for either a capital or operating lease. This lease is an operating lease to Cihla because there is no option to renew or repurchase the airplane, the lease term of 4 years is less than 75% of the estimated life of the aircraft (8 x 75 O/~ = 6) and the present value of the lease payments is less than 90% of the fair value of the airplane (the lease payments without calculating present value are $240,000 ($5,000 x 12 x 4), which is less than 90% of the fair value of the plane of $360,000 (90% x $400,000). Therefore, Cihia accounts for the transaction as a sale and the lease as an operating lease. The rent expense for the year is therefore $15,000 [($5,000 x 12) ÷ 4]. Profit or loss in a sale-leaseback situation should be deferred and amortized. If the lease is a capital lease the profit or loss should be deferred and amortized over the lease term in proportion to the amortization of the leased assets. In an operating lease, the profit or loss should be deferred and amortized in proportion to the rental payments over the period of time the assets are expected to be used by the lessee.