13.4 Flashcards
A lessee had a 10-year capital lease requiring equal annual payments. The reduction of the lease liability in Year 2 should equal
The current liability shown for the lease at the end of Year 1.
At the inception of a capital lease, a lessee should record a fixed asset and a lease obligation equal to the present value of the minimum lease payments. In a classified balance sheet, the lease liability must be allocated between the current and noncurrent portions. The current portion at a balance sheet date is the reduction of the lease liability (periodic payment – interest component) in the forthcoming year as determined in accordance with the interest method.
Warren Company is being sued in a wrongful discharge suit for $500,000. The company attorney has advised Warren that the probability of the plaintiff prevailing and receiving the full amount is about 80%. The attorney also indicated that the case would likely be tied up in the courts for 2 to 3 years. The most appropriate financial statement presentation for this loss contingency would be to
Record $500,000 as a loss contingency.
A liability arising from a loss contingency should be recorded if the contingent future event will probably occur and the amount of the loss can be reasonably estimated.
On January 1 of the current year, Tree Co. enters into a 5-year lease agreement for production equipment. The lease requires Tree to pay $12,500 per year in lease payments. At the end of the 5-year lease term, Tree can purchase the equipment for $30,000. The fair value of the equipment is $75,000. The estimated useful life of the equipment is 10 years. The present value of the lease payments is $50,000. The present value of the purchase option is $20,000. Tree’s controller believes the purchase option price is sufficiently below the expected fair value of the equipment at the date the option becomes exercisable to reasonably assure its exercise. Tree would normally depreciate equipment of this type using the straight-line method. What amount is the carrying value of the asset related to this lease at December 31 of the current year?
$63,000
Tree Co. can purchase the equipment at the end of the lease term. The purchase option price is sufficiently below the expected fair value of the equipment at the date the option becomes exercisable to reasonably assure its exercise. These conditions indicate a bargain purchase option (BPO). The existence of a BPO indicates that substantially all of the benefits and risks of ownership have been transferred. Therefore, Tree Co. enters into a capital lease agreement. On January 1, Tree Co. should record the capital lease as an asset and an obligation at the present value of the minimum lease payments, $70,000 ($50,000 + $20,000). When the lease is capitalized because the lease either transfers ownership to the lessee by the end of the lease term or contains a BPO, the depreciation of the asset is over its entire estimated economic life (i.e., 10 years). Using the straight-line depreciation method, the production asset will be depreciated $7,000 ($70,000 ÷ 10 years) per year. The carrying value of the asset related to this lease on December 31 of the current year should be $63,000 ($70,000 – $7,000).
As an inducement to enter a lease, Arts, Inc., a lessor, grants Hompson Corp., a lessee, 9 months of free rent under a 5-year operating lease. The lease is effective on July 1, Year 3, and provides for monthly rent payments of $1,000 to begin on April 1, Year 4. In Hompson’s income statement for the year ended June 30, Year 4, rent expense should be reported as
$10,200
Rent expense for an operating lease is recognized on a straight-line basis unless another systematic or rational basis is more appropriate. This requirement holds regardless of whether the lease payments are made on a straight-line basis. The total lease payments for this operating lease are $51,000 [$1,000 monthly rent × (60 total months in the lease term – 9 months’ free rent)]. Allocating this $51,000 on the straight-line basis to the 5 years of the operating lease results in rent expense of $10,200 ($51,000 ÷ 5 years) per year. The amount of $12,000 would be the rent expense if 9 months of free rent had not been granted.
On December 31, Year 4, Ruhl Corp. sold equipment to Dorr and simultaneously leased it back for 3 years. The following data pertain to the transaction at this date:
Sales price: $220,000
Carrying amount: 150,000
Present value of lease rentals ($2,000 for 36 months at 12%): 60,800
Estimated remaining useful life: 10 years
At December 31, Year 4, what amount should Ruhl report as deferred revenue from the sale of the equipment?
$60,800
In an ordinary sale and leaseback, any profit or loss on the sale is amortized over the life of the lease. One exception applies when a seller-lessee retains more than a minor part but less than substantially all of the use of the property through the leaseback. The “excess” profit on the sale is recognized at the date of the sale if the seller-lessee realizes a profit on the sale in excess of either (1) the present value of the minimum lease payments over the lease term if the leaseback is an operating lease or (2) the recorded amount of the leased asset if the leaseback is classified as a capital lease. “Substantially all” has essentially the same meaning as the “90% test” used in determining whether a lease is a capital or operating lease (the present value of the lease payments is 90% or more of the fair value of the leased property). “Minor” refers to a transfer of 10% or less of the use of the property in the lease. For Ruhl Corp., the $60,800 present value of the lease rentals is greater than 10% and less than 90% of the fair value of the leased property as measured by the sales price. Thus, the excess profit to be recognized is $9,200 ($220,000 sales price – $150,000 carrying amount – $60,800 PV of lease payments). The $60,800 remaining gain on the sale-leaseback should be amortized in proportion to the gross rentals expensed over the lease term because the leaseback is an operating lease (none of the criteria for a capital lease is met). At 12/31/Year 4, the date of the inception of the lease, the entire $60,800 should be reported in the balance sheet as deferred revenue.
An entity is currently being sued by a customer. A reliable estimate can be made of the costs that would result from a ruling unfavorable to the entity, and the amount involved is material. The entity’s managers, lawyers, and auditors agree that the likelihood of an unfavorable ruling is remote. This contingent liability
Need not be disclosed.
A contingent liability includes a present obligation for which an outflow of resources embodying economic benefits is not probable. A contingent liability is not recognized but is disclosed unless the possibility of the outflow is remote.
On January 1, Year 1, West Co. entered into a 10-year lease for a manufacturing plant. The annual minimum lease payments are $100,000. In the notes to the December 31, Year 2, financial statements, what amounts of subsequent years’ lease payments should be disclosed?
Amounts for Appropriate Required Periods:
Aggregate Amount for the Period Thereafter:
$500,000
$300,000
The future minimum lease payments as of the date of the latest balance sheet presented must be disclosed in the aggregate and for each of the 5 succeeding fiscal years. This disclosure is required whether the lease is classified as a capital lease or as an operating lease. Hence, the aggregate amount of the obligation is $800,000 ($100,000 × 8 years remaining), consisting of the future payments for the next 5 years in the amount of $500,000 ($100,000 × 5 years), and for the period thereafter in the amount of $300,000.
Which of the following is a criterion for classifying a lease as a capital lease by a lessee?
The lease term is equal to 75% or more of the estimated economic life of the leased property.
On December 31, Lane, Inc., sold equipment to Noll and simultaneously leased it back for 12 years. Pertinent information at this date is as follows:
Sales price: $480,000
Carrying amount: 360,000
Estimated remaining economic life: 15 years
At December 31, assuming that Lane has retained substantially all of the use of the property, how much should it report as deferred revenue from the sale of the equipment?
$120,000
This lease should be recorded as a capital lease because its 12-year term exceeds 75% of the 15-year estimated remaining economic life of the equipment. In a sale and leaseback transaction, any profit or loss on the sale is normally required to be deferred and amortized in proportion to the amortization of the leased asset if the lease is a capital lease. The amortization is in proportion to the gross rental payments expensed over the lease term if the lease is an operating lease. The exception to deferral and amortization [(1) retention of more than a minor part but less than substantially all of the use of the property or (2) relinquishment of substantially all use] do not apply to this transaction. Consequently, at the inception of the lease, the $120,000 gain ($480,000 sales price – $360,000 carrying amount) should be reported as deferred revenue and then amortized in proportion to the amortization of the leased asset over the 12-year term of the lease.
With respect to a pending litigation, which one of the following factors is least likely to indicate that a provision must be recognized?
The number of parties involved in the litigation.
The number of parties involved in the litigation is relevant to the amount of the liability, not whether it should be recognized. The following are the recognition criteria: (1) it is probable that, at the balance sheet date, a liability has been incurred, and (2) the amount of loss can be reasonably estimated. The number of parties is not itself a recognition criterion. For example, the same accounting treatment is applied whether a claim is brought by an individual or in a class action suit.
On January 1, Year 4, Jaffe Co. leased a machine to Pender Co. for 10 years, with $10,000 payments due at the beginning of each year effective at the inception of the lease. The machine cost Jaffe $55,000. The lease is appropriately accounted for as a sales-type lease by Jaffe. The present value of the 10 rent payments over the lease term discounted appropriately at 10% was $67,600. The estimated salvage value of the machine at the end of 10 years is equal to the disposal costs. How much interest revenue should Jaffe record from the lease for the year ended December 31, Year 4?
$5,760
In accordance with the effective-interest method, the interest income is equal to the carrying value of the net investment in the lease at the beginning of the interest period multiplied by the interest rate used to calculate the present value of the lease payments. The present value of $67,600 is reduced by the $10,000 payment made at the inception of the lease, leaving a carrying amount of $57,600. This balance multiplied by 10% yields $5,760 to be reflected as interest income for the first year of the lease.
Leases should be classified by the lessee as either operating leases or capital leases. Which of the following statements best characterizes operating leases?
The lessor records lease revenue, asset depreciation, maintenance, etc., and the lessee records lease payments as rental expense.
Operating leases are transactions in which lessees rent the right to use lessor assets without acquiring a substantial portion of the benefits and risks of ownership of those assets.
On December 31, Year 3, Roe Company leased a machine from Colt for a 5-year period. Equal annual payments under the lease are $105,000 (including $5,000 annual executory costs) and are due on December 31 of each year. The first payment was made on December 31, Year 3, and the second payment was made on December 31, Year 4. The five lease payments are discounted at 10% over the lease term. The present value of minimum lease payments at the inception of the lease and before the first annual payment was $417,000. The lease is appropriately accounted for as a capital lease by Roe. In its December 31, Year 4, balance sheet, Roe should report a lease liability of
At the inception of the lease, the lease obligation was recorded at the $417,000 present value of the minimum lease payments. Because the first payment was made at December 31, Year 3, the lease obligation should have been immediately reduced by $100,000 ($105,000 annual payment – $5,000 annual executory costs). Interest expense for Year 4 was $31,700, that is, the adjusted lease liability at the beginning of the year multiplied by the discount rate {[$417,000 – ($105,000 – $5,000)] × 10%}. The lease liability to be reported at the end of Year 4 is equal to the $317,000 beginning balance minus the amount of the annual payment for Year 4 not allocated to interest and the annual executory costs. The December 31, Year 4, balance of the lease liability is calculated as follows:
Balance 12/31/Year 3: $317,000
Minus:
Annual payment for Year 4: $105,000
Interest expense: (31,700)
Annual executory costs: (5,000)
(68,300)
Balance 12/31/Year 4
$248,700A company enters into a 3-year operating lease agreement effective January 1, Year 1. The amounts due on the first day of each year are $25,000 in Year 1, $30,000 in Year 2, and $35,000 in Year 3. What amount, if any, is the related liability on the first day of Year 2?
$5,000
An operating lease is a simple rental agreement, and no asset is recognized by the lessee. 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 total rent due is $90,000 ($25,000 + $30,000 + $35,000), and the annual straight-line expense is $30,000 ($90,000 ÷ 3 years). In Year 1, the entity recognized rent expense of $30,000, a cash payment of $25,000, and a liability of $5,000.
Keller Corporation signed a 3-year lease for an automobile on December 1. The automobile had a list price of $17,000 and an estimated useful life of 8 years. The lease called for payments of $500 per month for 36 months. The present value of the $500 payments was $15,054 at Keller’s incremental borrowing rate and $15,496 at the lessor’s implicit rate, which is known to the lessee. Based on the above information, Keller should record the lease as a(n)
Capital Lease
A lessee must report a lease as a capital lease if the present value of the minimum lease payments (MLP) is at least 90% of the fair value of the asset. If both the incremental borrowing rate and the implicit rate are known, the lesser of the two should be used to compute the PV. The lower interest rate is the one that will result in the highest PV. Dividing the present value of the MLP by the list price of the automobile yields a result > 90% ($15,496 ÷ $17,000 = 91.2%). Thus, this lease must be classified by Keller as a capital lease.
