13.3 Flashcards
On January 1 of the current year, Tell Co. leased equipment from Swill Co. under a 9-year sales-type lease. The equipment had a cost of $400,000 and an estimated useful life of 15 years. Semiannual lease payments of $44,000 are due every January 1 and July 1. The present value of lease payments at 12% was $505,000, which equals the sales price of the equipment. Using the straight-line method, what amount should Tell recognize as depreciation expense on the equipment in the current year?
$56,111
The lessee capitalizes the lease because the present value of the minimum lease payments (excluding executory costs) is at least equal to 90% of the excess of the fair value of the leased property to the lessor. The fair value to the lessor is presumably the sales price. Given that the sale price equals the present value of the minimum lease payments, the latter amount equals 100% of the lessor’s fair value. Thus, the lessee records an asset and an obligation for $505,000. The lessee should depreciate the asset in a manner consistent with its normal depreciation policy. Given straight-line depreciation, annual depreciation expense is $56,111 ($505,000 ÷ 9 years). The estimated useful life is used only if a bargain purchase option exists and most likely will be exercised.
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.
At January 1, Year 1, the lease would be reported on Neary’s books as a(n)
Asset & a liability.
The lessee must record a capital lease as an asset and as an obligation at an amount equal to the present value of the minimum lease payments.
On January 1, Year 4, Hook Oil Co. sold equipment with a carrying amount of $100,000 and a remaining useful life of 10 years to Maco Drilling for $150,000. Hook immediately leased the equipment back under a 10-year capital lease with a present value of $150,000. It will depreciate the equipment using the straight-line method. Hook made the first annual lease payment of $24,412 in December Year 4. In Hook’s December 31, Year 4, balance sheet, the unearned gain on the equipment sale should be
$45,000
A profit or loss on the sale in a sale-leaseback transaction is ordinarily deferred and amortized in proportion to the amortization of the leased asset if the leaseback is classified as a capital lease. At 12/31/Year 4, a gain proportionate to the lease amortization will be recognized [($150,000 – $100,000) ÷ 10 years = $5,000]. Hence, the deferred gain will be $45,000 ($50,000 – $5,000).
Douglas Co. leased machinery with an economic useful life of 6 years. For tax purposes, the depreciable life is 7 years. The lease is for 5 years, and Douglas can purchase the machinery at fair market value at the end of the lease. What is the depreciable life of the leased machinery for financial reporting purposes?
5 years.
If a lessee capitalizes a lease because the lease term is at least 75% of the expected remaining life, or the present value of the minimum lease payments is at least 90% of the fair value at the inception of the lease, the asset should be amortized over the lease term. These capitalization criteria do not apply when the beginning of the lease term is within the last 25% of the total estimated economic life. Douglas Co.’s lease is for a period that exceeds 75% of the expected remaining life (5 years ÷ 6 years = 83 1/3%). Thus, the depreciable life is the lease term of 5 years.
Which one of the following loss contingencies would be accrued as a liability rather than disclosed in the notes to the financial statement?
Liabilities for service or product warranties that cannot be purchased separately by the customers.
A warranty that cannot be purchased separately by the customer is an assurance-type warranty. An assurance-type warranty creates a loss contingency. Similarly to the guidelines for loss contingencies, a liability for future warranty costs should be accrued if (1) the incurrence of the expense is probable and (2) the amount can be reasonably estimated.
Wall Co. leased office premises to Fox, Inc., for a 5-year term beginning January 2, Year 4. Under the terms of the operating lease, rent for the first year is $8,000 and rent for years 2 through 5 is $12,500 per annum. However, as an inducement to enter the lease, Wall granted Fox the first 6 months of the lease rent-free. In its December 31, Year 4, income statement, what amount should Wall report as rental income?
$10,800
For an operating lease, rent is reported as income in accordance with the lease agreement. 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. No basis other than straight-line is more representative of the reduction in the use benefit of office space. Hence, Wall should report rental revenue of $10,800 {[$8,000 – ($8,000 × .5) + ($12,500 × 4)] ÷ 5 years}.
Glade Co. leases computer equipment to customers under direct-financing leases. The equipment has no residual value at the end of the lease, and the leases do not contain bargain purchase options. Glade wishes to earn 8% interest on a 5-year lease of equipment with a fair value of $323,400. The present value of an annuity due of $1 at 8% for 5 years is 4.312. What is the total amount of interest revenue that Glade will earn over the life of the lease?
$51,600
To earn 8% interest over the lease term, the annual payment must be $75,000 ($323,400 fair value at the inception of the lease ÷ 4.312 annuity factor). Given no residual value and no bargain purchase option, total lease payments will be $375,000 ($75,000 payment × 5 years). Because this is a direct-financing lease, the fair value is presumably equal to the carrying amount, so no dealer’s profit will be recognized. The entire difference between the gross lease payments received and their present value is treated as interest revenue ($375,000 – $323,400 = $51,600).
A company leases a machine from Leasing, Inc., on January 1, Year 1. The lease terms include a $100,000 annual payment beginning January 1, Year 1. The machine’s fair value is $500,000, and the residual value is estimated at $20,000. The company guarantees the residual value. The useful life of the machine is 6 years, and the lease term is 5 years. The implicit rate of interest is 6% and is known by the company. The following present value factors are provided:
5 years:
Present value of $1 at 6%: .7473
Present value of an annuity due at 6%: 4.4651
Present value of an ordinary annuity at 6%: 4.2124
6 years:
Present value of $1 at 6%: .7050
Present value of an annuity due at 6%: 5.2124
Present value of an ordinary annuity at 6%: 4.9173
What is the value of the machine in the company’s balance sheet at lease inception?
$461,456
A lease is classified as a capital lease if the lease term is 75% or more of the estimated economic life of the leased asset [the lease term is 83.33% (5/6) of the useful life]. The lessee records a capital lease on the balance sheet as an asset and an obligation at an amount equal to the present value of the minimum lease payments. The amount of guaranteed residual value to be included in the lessee’s minimum lease payments is the maximum amount the lessee is obligated to pay. Thus, minimum lease payments for the lessee include periodic lease payments of $100,000 to be paid annually over a 5-year period starting from 1/1/Year 1 and a single amount of $20,000 for guaranteed residual value to be paid at the end of the lease term (after 5 years). The implicit rate of 6% is used in calculating the present value of the minimum lease payments. The first periodic lease payment is made at the inception of the lease. Accordingly, the present value factor of an annuity due is used to calculate the present value of periodic annual payments. The machine is recognized in the lessee’s balance sheet at $461,456 [($100,000 × 4.4651) + ($20,000 × 0.7473)].
On December 31, Year 4, Bain Corp. sold a machine to Ryan and simultaneously leased it back for 1 year. Pertinent information at this date follows:
Sales price: $360,000
Carrying amount: 330,000
Present value of reasonable lease rentals ($3,000 for 12 months at 12%): 34,100
Estimated remaining useful life: 12 years
In Bain’s December 31, Year 4, balance sheet, the deferred revenue from the sale of this machine should be
$0
The general rule is that profit or loss on the sale in a sale-leaseback transaction is deferred and amortized over the life of the lease. However, certain exceptions exist. One exception applies when the seller-lessee relinquishes the right to substantially all of the remaining use of the property sold and retains only a minor portion of such use. This exception is indicated if the present value of a reasonable amount of rentals for the leaseback represents 10% or less of the fair value of the asset sold. In this case, the seller-lessee should account for the sale and the leaseback as separate transactions based upon their respective terms. Because the $34,100 present value of the reasonable lease rentals is less than 10% of the $360,000 sales price (the fair value), Bain should recognize the entire $30,000 difference between the $360,000 sales price and the $330,000 carrying amount as a gain from the sale. The leaseback should then be accounted for as if it were unrelated to the sale because the leaseback is considered to be minor.
An entity introduced a new product that carries a standard 2-year warranty against defects. It estimates that warranty costs will be 2% of sales in the year of sale and 3% of those sales in the following year. Sales in Year 1 and Year 2 were $5 million and $7 million, respectively. Actual costs of servicing the warranty in Year 1 and Year 2 were $110,000 and $260,000, respectively. What warranty expense must the entity recognize for Year 2?
$350,000
A standard warranty against manufacturing defects is an assurance-type warranty. This warranty creates a loss contingency. A liability for warranty costs and warranty expenses is recognized on the date the product is sold. Thus, the expense related to Year 2 sales must be recognized in Year 2 even if actual expenditures will not occur until Year 3. The expense related to Year 2 sales equals $350,000 [$7,000,000 × (2% for the year of sale + 3% for the year after the year of sale)].
Which of the following is a criterion for a lease to be classified as a capital lease in the books of a lessee?
The lease contains a bargain purchase option.
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.
On December 1, Year 4, Clark Co. leased office space for 5 years at a monthly rental of $60,000. On the same date, Clark paid the lessor the following amounts:
First month’s rent: $60,000
Last month’s rent: 60,000
Security deposit (refundable at lease expiration): 80,000
Installation of new walls and offices: 360,000
What should be Clark’s Year 4 expense relating to utilization of the office space?
$66,000
During Year 4, this operating lease was effective only for the month of December. The Year 4 expenses therefore include the $60,000 monthly rent plus the $360,000 cost of the installation of the new walls and offices allocated over the 60 months of the rental agreement. Thus, the total December expense equals $66,000 [$60,000 + ($360,000 ÷ 60 months)].
When the occurrence of a gain contingency is reasonably possible and its amount can be reasonably estimated, the gain contingency should be
Disclosed but not included in net income.
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.
On January 1, Year 4, Wren Co. leased a building to Brill under an operating lease for 10 years at $50,000 per year, payable the first day of each lease year. Wren paid $15,000 to a real estate broker as a finder’s fee. The building is depreciated $12,000 per year. For Year 4, Wren incurred insurance and property tax expenses totaling $9,000. Wren’s net rental income for Year 4 should be
$27,500
The net rental income equals the annual payment minus expenses. The finder’s fee is an initial direct cost that should be deferred and allocated over the lease term in proportion to the recognition of rental income. It should therefore be recorded as a deferred charge and amortized using the straight-line method over the 10-year lease term. Accordingly, the net rental income for Year 4 is $27,500 [$50,000 annual rental – $12,000 depreciation – $9,000 insurance and taxes – ($15,000 ÷ 10 years) amortization of the finder’s fee].
Lease M does not contain a bargain purchase option, but the lease term is equal to 90% of the estimated economic life of the leased property. Lease P 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% of the estimated economic life of the leased property. How should the lessee classify these leases?
Lease M:
Lease P:
Capital Lease
Capital Lease
For a lease to be classified as a capital lease by the lessee, any one of four criteria must be met. One of these criteria is that the lease term equal 75% or more of the estimated remaining economic life of the leased property. Both leases meet the 75% criterion and should be properly classified as capital leases.
