13.1 Flashcards
Conlon Co. is the plaintiff in a patent-infringement case. Conlon has a high probability of a favorable outcome and can reasonably estimate the amount of the settlement. What is the proper accounting treatment of the patent infringement case?
Disclosure in the notes only.
Under the conservatism restraint, when alternative accounting methods are appropriate, the one having the less favorable effect on net income and total assets is preferable. Thus, a loss, not a gain, contingency may be recorded in the financial statements. If the probability of realization of a gain is high, the contingency is disclosed in the notes.
Linden Corporation is a defendant in a lawsuit in which the plaintiff is seeking $1,000,000 in damages. The company had terminated the plaintiff, George Russell, from his position with Linden after Russell allegedly sold specifications for one of Linden’s new products to a competitor. Linden’s attorney believes that it is quite possible Linden will lose the case and that, if so, damages could range from $100,000 to $200,000.
Regardless of the outcome of the case, Linden’s accountants estimate the company will incur an additional $5,000 in unemployment costs because of Russell’s termination. The amount that Linden should accrue because of the contingency in this situation is
$0
Loss contingencies are accrued when the loss is probable. The $5,000 in unemployment costs that will probably be incurred are a routine cost of doing business.
Able sold its headquarters building at a gain and simultaneously leased back the building. The lease was reported as a capital lease. At the time of sale, the gain should be reported as
An asset valuation allowance.
Able Co. leased equipment to Baker under a noncancelable lease with a transfer of title. After recognition of the lease, will Able record any depreciation expense on the leased asset and interest revenue related to the lease?
Depreciation expense:
Interest Revenue:
No
Yes
The lease provides for the transfer of ownership. Accordingly, the lease is recognized as a capital lease by the lessor and lessee. For capital leases, depreciation is recorded by the lessee, not the lessor, because substantially all of the benefits and risks of ownership have been transferred. Furthermore, the lessor records interest revenue (income) under a capital lease whether it is a sales-type lease or a direct-financing lease.
A manufacturer of household appliances may incur a loss due to the discovery of a defect in one of its products. The occurrence of the loss is reasonably possible and the resulting costs can be reasonably estimated. This possible loss should be
Accrued:
Disclosed in the Notes:
No
Yes
A contingent loss is accrued when two conditions are met: It is probable that at a balance sheet date an asset is overstated or a liability has been incurred, and the amount of the loss can be reasonably estimated. If both conditions are not met, but the probability of the loss is at least reasonably possible, the amount of the loss must be disclosed. This loss is reasonably possible and reasonably estimable, and it therefore should be disclosed but not accrued as a liability. The financial statements should disclose the nature of the loss contingency and the amount or range of the possible loss. If an estimate cannot be made, the notes should state this.
On January 1, Rosewater Company leased a computer for 4 years at a monthly rent of $80, payable at the end of each month. Due to the rate of technical change, the computer is expected to become obsolete within 5 years. At the inception of the lease, the computer was retailing for $3,450. Had Rosewater chosen to purchase the computer instead of leasing it, they could have borrowed the funds at 10%. At a 10% interest rate, the present value of the lease payments is $3,154. Rosewater does not know the rate implicit in the lease. For the month of January, Rosewater should report (to the closest dollar) interest expense of
$26 and depreciation expense of $66.
Interest expense will be recognized in the amount of $26 [$3,154 × 10% × (1 ÷ 12 months)]. Since Rosewater does not know the lessor’s implicit rate, it is appropriate to use Rosewater’s own incremental borrowing rate to determine whether the lease should be classified as a capital lease. Since the present value of the lease payments is greater than 90% of the fair value of the computer ($3,154 ÷ $3,450 = 91.4%), the lease is appropriately classified as a capital lease and Rosewater will recognize depreciation expense. Since the lease agreement neither provides for transfer of ownership nor contains a bargain purchase option, the computers are depreciated over the lease term (4 years). Monthly depreciation expense will be $66 ($3,154 ÷ 48 months).
On December 31, Year 1, Neal, Inc., leased machinery with a fair value of $105,000 from Frey Rentals Co. The agreement is a 6-year, noncancelable lease requiring annual payments of $20,000 beginning December 31, Year 1. The lease is appropriately accounted for by Neal as a capital lease. Neal’s incremental borrowing rate is 11%. Neal knows the interest rate implicit in the lease payments is 10%.
- The present value of an annuity due of 1 for 6 years at 10% is 4.7908.
- The present value of an annuity due of 1 for 6 years at 11% is 4.6959.
In its December 31, Year 1 balance sheet, Neal should report a lease liability of
$75,816
Given that the lease qualifies as a capital lease and that the 10% known implicit interest rate is lower than the 11% incremental borrowing rate, the lease liability should be recorded at the present value of the minimum lease payments minus the initial payment [($20,000 periodic payment × 4.7908 present value factor for an annuity due at 10%) – $20,000 = $75,816].
On January 1, Year 1, Frost Co. entered into a 2-year lease agreement with Ananz Co. to lease 10 new computers. The lease term begins on January 1, Year 1, and ends on December 31, Year 2. The lease agreement requires Frost to pay Ananz two annual lease payments of $8,000. The present value of the minimum lease payments is $13,000. Which of the following circumstances would require Frost to classify and account for the arrangement as a capital lease?
The fair value of the computers on January 1, Year 1, is $14,000.
A lease is classified as a capital lease by the lessee if, at its inception, any of the following four criteria is satisfied: (1) the lease provides for the transfer of ownership of the leased property, (2) the lease contains a bargain purchase option, (3) the lease term is 75% or more of the estimated economic life of the leased property, or (4) the present value of the minimum lease payments (excluding executory costs) is at least 90% of the fair value of the leased property to the lessor. This criterion is inapplicable if the beginning of the lease term falls within the last 25% of the total estimated economic life. Consequently, if the fair value of the computers on January 1, Year 1, is $14,000, the lease must be capitalized. The present value of the minimum lease payments is 92.86% ($13,000 ÷ $14,000) of the fair value at the lease’s inception.
If a company uses off-balance-sheet financing, assets have been acquired
With operating leases.
With an operating lease, no long-term liability need be reported on the face of the balance sheet.
In the long-term liabilities section of its balance sheet at December 31, Year 3, Mene Co. reported a capital lease obligation of $75,000, net of current portion of $1,364. Payments of $9,000 were made on both January 2, Year 4, and January 2, Year 5. Mene’s incremental borrowing rate on the date of the lease was 11%, and the lessor’s implicit rate, which was known to Mene, was 10%. In its December 31, Year 4, balance sheet, what amount should Mene report as capital lease obligation, net of current portion?
$73,500
The total lease obligation on 12/31/Yr 3 was $76,364 ($75,000 noncurrent portion + $1,364 current portion). After the Year 4 payment, which included the current portion, the lease obligation was $75,000. Consequently, the Year 5 payment included interest of $7,500 ($75,000 carrying amount during Year 4 × 10% lessor’s implicit rate, which is both known to the lessee and lower than the lessee’s incremental borrowing rate) and a principal component of $1,500 ($9,000 cash – $7,500 interest). The latter is the current portion of the lease obligation on 12/31/Year 4. The capital lease obligation at December 31, Year 4, net of current portion, is therefore $73,500 ($75,000 – $1,500).
Cott, Inc., prepared an interest amortization table for a 5-year lease payable with a bargain purchase option of $2,000, exercisable at the end of the lease. At the end of the 5 years, the balance in the leases payable column of the spreadsheet was zero. Cott has asked Grant, CPA, to review the spreadsheet to determine the error. Only one error was made on the spreadsheet. Which of the following statements represents the best explanation for this error?
The beginning present value of the lease did not include the present value of the payment called for by the bargain purchase option.
Cott must record a capital lease as an asset and an obligation equal to the present value of the minimum lease payments, which consist of the minimum rental payments (excluding executory costs) and the amount of the bargain purchase option. The effect of including the present value of the bargain purchase option is that, at the end of the 5-year amortization period, the lease obligation should equal that amount.
An issuer of bonds uses a sinking fund for the retirement of the bonds. Cash was transferred to the sinking fund and subsequently used to purchase investments. The sinking fund
I. Increases by revenue earned on the investments
II. Is not affected by revenue earned on the investments
III. Decreases when the investments are purchased
I only.
The bond sinking fund is a long-term investment. The objective of making payments into the fund is to segregate and accumulate sufficient assets to pay the bond liability. The amounts transferred to the fund plus the revenue earned provide the necessary monies.
On January 1, Year 4, Nori Mining Co. (lessee) entered into a 5-year lease for drilling equipment. Nori accounted for the acquisition as a capital lease for $240,000, which includes a $10,000 bargain purchase option. At the end of the lease, Nori expects to exercise the bargain purchase option. Nori estimates that the equipment’s fair value will be $20,000 at the end of its 8-year life. Nori regularly uses straight-line depreciation on similar equipment. For the year ended December 31, Year 4, what amount should Nori recognize as depreciation expense on the leased asset?
$27,500
When a lease is capitalized because title passes to the lessee at the end of the lease term or because the lease contains a bargain purchase option, the depreciation period is the estimated economic life of the asset. The asset should be depreciated in accordance with the lessee’s normal depreciation policy for owned assets. Nori regularly uses the straight-line method. Hence, depreciation expense is $27,500 [($240,000 leased asset – $20,000 salvage value) ÷ 8-year economic life].
On January 1, Emerald Co. entered into a 10-year noncancelable lease requiring year-end payments of $90,000. Emerald’s incremental borrowing rate is 12%, while the lessor’s implicit interest rate, known to Emerald, is 10%. Present value factors for an ordinary annuity for 10 periods are 6.145 at 10% and 5.650 at 12%. Ownership of the property remains with the lessor at expiration of the lease. There is no bargain purchase option. The leased property has an estimated economic life of 15 years. The fair value of the leased property is $1.2 million. What amount should Emerald capitalize for this leased property on January 1?
$0
This lease does not qualify as a capital lease because none of the capitalization criteria is met. It does not transfer ownership or contain a bargain purchase option. Furthermore, the lease term is not 75% of the economic life, and the present value of the minimum lease payments is not 90% of the fair value. Thus, the lease should be accounted for as an operating lease.
During Year 4, Smith Co. filed suit against West, Inc., seeking damages for patent infringement. At December 31, Year 4, Smith’s legal counsel believed that it was probable that Smith would be successful against West for an estimated amount in the range of $75,000 to $150,000, with all amounts in the range considered equally likely. In March Year 5, Smith was awarded $100,000 and received full payment thereof. In its Year 4 financial statements issued in February Year 5, how should this award be reported?
As a disclosure of a contingent gain of an undetermined amount in the range of $75,000 to $150,000.
Gain contingencies should not be recognized until they are realized. A gain contingency should be disclosed, but care should be taken to avoid misleading implications as to the likelihood of realization. The disclosure should reflect the estimated range of the gain.
