13.2 Flashcards
Rent should be reported by the lessor as revenue over the lease term as it becomes receivable according to the provisions of the lease for a(n)
Direct-financing lease:
Operating lease:
Sales-type lease:
No
Yes
No
For capital leases (direct financing and sales-type leases), income is recognized in accordance with the interest method. Income equals the carrying amount for the period multiplied by an appropriate interest rate. For an operating lease, rent is ordinarily reported as income in accordance with the lease agreement, that is, as the rent becomes receivable. However, if rentals vary from a straight-line basis, the straight-line basis should be used unless another systematic and rational basis is more representative of the time pattern in which the use benefit from the property is reduced.
The excess of the fair value of leased property at the inception of the lease over its cost or carrying amount should be classified by the lessor as
Manufacturer’s or dealer’s profit from a sales-type lease.
In a sales-type lease, the cost, or carrying amount if different, plus any initial direct costs, minus the present value of any unguaranteed residual value, is charged against income in the same period that the sales price (present value of the minimum lease payments) is recognized. The result is the recognition of a net profit or loss on the sales-type lease. Thus, by definition, a sales-type lease is one that gives rise to a manufacturer’s or dealer’s profit (or loss) because the fair value of the leased property at the inception of the lease (the present value of the minimum lease payments) differs from its cost or carrying amount.
On January 1, Blaugh Co. signed a long-term lease for an office building. The terms of the lease required Blaugh to pay $10,000 annually, beginning December 30, and continuing each year for 30 years. The lease qualifies as a capital lease. On January 1, the present value of the lease payments is $112,500 at the 8% interest rate implicit in the lease. In Blaugh’s December 31 balance sheet, the capital lease liability should be
$111,500
A lease payment has two components: interest expense and the portion applied to the reduction of the lease obligation. The effective-interest method requires that the carrying amount of the obligation at the beginning of each interest period be multiplied by the appropriate interest rate to determine the interest expense. The difference between the minimum lease payment and the interest expense is the amount of reduction in the carrying amount of the lease obligation. Consequently, interest expense is $9,000 ($112,500 BOY liability balance × 8% implicit rate), and the reduction in the lease obligation is $1,000 ($10,000 cash – $9,000 interest expense). The new balance of the lease obligation is thus $111,500 ($112,500 – $1,000).
On April 1, Year 1, Hall Fitness Center leased its gym to Dunn Fitness Center under a 4-year operating lease. Hall normally charges $6,000 per month to lease its gym, but as an incentive, Hall gave Dunn half off the first year’s rent and one quarter off the second year’s rent. Dunn’s rental payments were as follows:
Year 1: 12 × $3,000 = $36,000
Year 2: 12 × $4,500 = $54,000
Year 3: 12 × $6,000 = $72,000
Year 4: 12 × $6,000 = $72,000
Dunn’s rent payments were due on the first day of the month, beginning on April 1, Year 1. What amount should Dunn report as rent expense in its monthly income statement for April, Year 3?
$4,875
Under an operating lease, rent is reported as an expense by the lessee in accordance with the lease agreement. If rental payments vary from a straight-line basis, rent expense must be recognized over the full lease term on the straight-line basis. However, another systematic and rational basis may be used if it is more representative of the time pattern in which the benefit of the property is reduced. The annual rent before incentives is $72,000 ($6,000 × 12 months), but the first year’s rent is $36,000 ($72,000 × 50%), and the second year’s rent is $54,000 ($72,000 × 75%). Consequently, the straight-line monthly rent expense over the 4-year term of the operating lease is $4,875 [($36,000 + $54,000 + $72,000 + $72,000) ÷ (12 months per year × 4 years)].
At its inception, the lease term of Lease G is 65% of the estimated remaining economic life of the leased property. This lease contains a bargain purchase option. The lessee should record Lease G as
An asset and a liability.
A lease must be classified as a capital lease by a lessee if, at its inception, any one of four criteria is satisfied. Each of these criteria indicates that a substantial transfer of the benefits and risks of ownership has occurred. One test is whether the lease contains a bargain purchase option, which is a provision that permits the lessee to purchase the leased property at a price significantly lower than the expected fair value of the property at the date the option becomes exercisable. A capital lease must be recorded by the lessee as both an asset and an obligation at an amount equal to the present value of the minimum lease payments, but this amount should not exceed the fair value at the inception of the lease.
Bell Co. is a defendant in a lawsuit that could result in a large payment to the plaintiff. Bell’s attorney believes that there is a 90% chance that Bell will lose the suit and estimates that the loss will be anywhere from $5,000,000 to $20,000,000 and possibly as much as $30,000,000. None of the estimates are better than the others. What amount of liability should Bell report on its balance sheet related to the lawsuit?
$5,000,000
A loss contingency is accrued by a debit to expense and a credit to a liability if it is probable that a loss will occur and the loss can be reasonably estimated. The $5,000,000 estimated loss is reported on the balance sheet, and the range of the contingent loss is disclosed in the notes. The loss is probable (likely to occur) given expert opinion that the chance of loss is 90%. When no amount within a reasonable estimated range is a better estimate than any other, the minimum is accrued.
On November 1, Year 4, Davis Co. discounted with recourse at 10% a 1-year, noninterest-bearing, $20,500 note receivable maturing on January 31, Year 5. What amount of contingent liability for this note must Davis disclose in its financial statements for the year ended December 31, Year 4?
$20,500
When a note receivable is discounted, the receivable is removed from the accounts, a gain or loss is recognized, and a contingent liability is disclosed in a note. If the receivables are not paid, Davis Co. may be responsible for the full amount of the note $(20,500). Consequently, this amount should be disclosed in the notes.
During January Year 4, Vail Co. made long-term improvements to a recently leased building. The lease agreement provides for neither a transfer of title to Vail nor a bargain purchase option. The present value of the minimum lease payments equals 85% of the building’s fair value, and the lease term equals 70% of the building’s economic life. Should assets be recognized for the building and the leasehold improvements?
Building:
Leasehold improvements:
No
Yes
A lease must be classified as a capital lease by a lessee if, at its inception, any of the following four criteria are met: (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. Because none of the criteria are satisfied, the lessee should not recognize a leased asset for the building. However, general improvements to leased property should be capitalized as leasehold improvements and amortized in accordance with the straight-line method over the shorter of their expected useful life or the lease term. If the useful life of the asset extends beyond the lease term and renewal of the lease is likely, the amortization period may include all or part of the renewal period.
On January 2, Ashe Company entered into a 10-year, noncancelable lease requiring year-end payments of $100,000. Ashe’s incremental borrowing rate is 12%, while the lessor’s implicit interest rate, known to Ashe, 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 12 years. What amount should Ashe capitalize for this leased property on January 2?
$614,500
The 10-year lease term exceeds 75% of the 12-year estimated economic life of the equipment. Consequently, one of the lease capitalization criteria is met, and the lease should be treated as a capital lease. GAAP require that the leased asset be recorded at the present value of the minimum lease payments using the lower of the lessor’s implicit rate (if known by the lessee) or the lessee’s incremental borrowing rate. The 10% implicit rate is lower than the 12% incremental borrowing rate, so the leased asset should be recorded at $614,500 ($100,000 periodic payment × 6.145 present value factor for 10 periods at 10% for an ordinary annuity).
On January 1, Year 4, Mollat Co. signed a 7-year lease for equipment having a 10-year economic life. The present value of the monthly lease payments equaled 80% of the equipment’s fair value. The lease agreement provides for neither a transfer of title to Mollat nor a bargain purchase option. In its Year 4 income statement, Mollat should report
Rent expense equal to the Year 4 lease payments.
A lease must be classified as a capital lease by a lessee if, at its inception, any of the following four criteria are 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. None of these criteria are satisfied, and the lease can therefore be treated as an operating lease. Under an operating lease, the lessee recognizes periodic rental expense but records neither an asset nor a liability (except for accrued rental expense at the end of a period). Mollat should not recognize interest expense on an operating lease.
Neary Company has entered into a contract to lease computers from Baldwin Company starting on January 1, Year 1. Relevant information pertaining to the lease is provided below.
Lease term: 4 Years
Useful life of computers: 5 Years
Present value of future lease payments: $100,000
Fair value of leased asset on date of lease: 105,000
Baldwin’s implicit rate: 10%
At the end of the lease term, ownership of the asset transfers from Baldwin to Neary. Neary has properly classified this lease as a capital lease on its financial statements and uses straight-line depreciation on comparable assets.
What is the annual depreciation expense that Neary will record on the leased computers?
$20,000
Under a capital lease, the lessee recognizes a leased asset at an amount equal to the present value of the minimum lease payments ($100,000). Since the lease provides for the transfer of ownership, Neary should depreciate the computers using the straight-line method over their estimated useful life (5 years). Annual depreciation expense on the computers is $20,000 ($100,000 ÷ 5 years).
On June 1, Oren Co. entered into a 5-year nonrenewable lease, commencing on that date, for office space and made the following payments to Rose Properties:
Bonus to obtain lease: $30,000
First month’s rent: 10,000
Last month’s rent: 10,000
In its income statement for the year ended June 30, what amount should Oren report as rent expense?
$10,500
Rent expense is recognized as services are used. Payments that benefit the entire lease term should be amortized over the lease period. Accordingly, the rent expense will include the rent payment for June and the amount of the bonus amortized for that period. Rent expense for June is thus $10,500 {$10,000 for the month’s rent + [($30,000 ÷ 5) ÷ 12 amortization of the bonus]}.
On December 31, Year 4, Mith Co. was a defendant in a pending lawsuit. The suit arose from the alleged defect of a product that Mith sold in Year 1. In the opinion of Mith’s attorney, it is probable that Mith will have to pay $50,000, and it is reasonably possible that Mith will have to pay $60,000 as a result of this lawsuit. In its Year 4 financial statements, Mith should report
An accrued liability of $50,000 and would disclose a contingent liability for an additional $10,000.
A contingent loss is accrued when it is probable that, at a balance sheet date, an asset is overstated or a liability is understated and the amount of the loss can be reasonably estimated. Because it is probable that Mith will have to pay $50,000, this amount should be accrued as a contingent liability. If a contingent loss is not both probable and reasonably estimable but the loss is at least reasonably possible, the amount of the loss must be disclosed. It is reasonably possible that Mith will have to pay an additional $10,000 ($60,000 – $50,000). Thus, it should also disclose a contingent liability for an additional $10,000.
On December 30, Year 3, Ames Co. leased equipment under a capital lease for 10 years. It contracted to pay $40,000 annual rent on December 31, Year 3, and on December 31 of each of the next 9 years. The capital lease liability was recorded at $270,000 on December 30, Year 3, before the first payment. The equipment’s useful life is 12 years, and the interest rate implicit in the lease is 10%. Ames uses the straight-line method to depreciate all equipment. In recording the December 31, Year 4, payment, by what amount should Ames reduce the capital lease liability?
$17,000
A lease payment has two components: interest expense and the portion applied to the reduction of the lease obligation. The effective-interest method requires that the carrying amount of the obligation at the beginning of each interest period be multiplied by the appropriate interest rate to determine the interest expense. The difference between the minimum lease payment and the interest expense is the amount of reduction in the carrying amount of the lease obligation. The carrying amount at the beginning of the period was $230,000 ($270,000 – $40,000 annual rent), and the interest expense is $23,000. Hence, the reduction in the lease liability is $17,000 ($40,000 – $23,000).
The following information pertains to a sale and leaseback of equipment by Mega Co. on December 31:
Sales price: $400,000 Carrying amount: 300,000 Monthly lease payment: 3,250 Present value of lease payments: 36,900 Estimated remaining life: 25 years Lease term: 1 year Implicit rate: 12%
What amount of deferred gain on the sale should Mega report at December 31?
$0
In a sale-leaseback transaction, a seller will defer all gains and losses, recognize all gains and losses, or recognize only excess gains. The rules for these recognition principles are based on the rights the seller retains in the property. If the seller-lessee retains substantially all rights in the property (present value of the minimum lease payments is 90% or more of the fair value of the leased asset), all gains and losses are deferred. If minor rights are retained (present value of the minimum lease payments is 10% or less of the fair value of the leased asset), all gains and losses are recognized. If the rights retained are between these two thresholds, only excess gains are recognized. In this situation, minor rights are retained, so the entire gain of $100,000 ($400,000 sales price – $300,000 carrying amount) is recognized, and none is deferred.
