13.5

Question 1

Main, a pharmaceutical company, leased office space from Ash. Main took possession and began to use the building on July 1, Year 1. Rent was due the first day of each month. Monthly lease payments escalated over the 5-year period of the lease as follows:

7/1/Year 1 - 9/30/Year 1
Lease payment: $0 - rent abatement during move-in, construction

10/1/Year 1 - 6/30/Year 2
Lease payment: 17,500

7/1/Year 2 - 6/30/Year 3
Lease payment: 19,000

7/1/Year 3 - 6/30/Year 4
Lease Payment: 20,500

7/1/Year 4 - 6/30/Year 5
Lease payment: 23,000

7/1/Year 5 - 6/30/Year 6
Lease payment: 24,500

What amount would Main show as deferred rent expense at December 31, Year 4?

Answer 1

$71,550

A lessee normally recognizes rent expense over the lease term as it becomes payable. If rental payments are not uniform, rent expense should be recognized on a straight-line basis (unless another systematic and rational basis is more representative of the consumption of the benefit from the property). The lessee under this operating lease with nonuniform payments must recognize a constant rent expense. The total rent to be paid is $1,201,500 [($17,500 × 9 months) + ($19,000 × 12 months) + ($20,500 × 12 months) + ($23,000 × 12 months) + ($24,500 × 12 months)]. The monthly rent expense is therefore $20,025 ($1,201,500 ÷ 60 months). The total rent expense recognized through December 31, Year 4, is $841,050 ($20,025 × 42 months of the 5-year lease term). However, the amount paid through December 31, Year 4, is $769,500 [($17,500 × 9 months) + ($19,000 × 12 months) + ($20,500 × 12 months) + ($23,000 × 6 months)]. Thus, the excess of the rent expense recognized through December 31, Year 4, over the rent paid is $71,550 ($841,050 – $769,500). This amount is the credit to deferred rent expense at December 31, Year 4.

Question 2

Crane Mfg. leases a machine from Frank Leasing. Ownership of the machine returns to Frank after the 15-year lease expires. The machine is expected to have an economic life of 17 years. At this time, Frank is unable to predict the collectibility of the lease payments to be received from Crane. The present value of the minimum lease payments exceeds 90% of the fair value of the machine. What is the appropriate classification of this lease for Crane?

Answer 2

Capital

A lease is classified as a capital lease by the 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. Because the lease is for 75% or more of the estimated economic life of the leased property, Crane must capitalize the lease. Note that payment collectibility is an issue only for the lessor.

Question 3

On July 1, Year 3, South Co. entered into a 10-year operating lease for a warehouse facility. The annual minimum lease payments are $100,000. In addition to the base rent, South pays a monthly allocation of the building’s operating expenses, which amounted to $20,000 for the year ended June 30, Year 4. In the notes to South’s June 30, Year 4, financial statements, what amounts of subsequent years’ lease payments should be disclosed?

Answer 3

$100,000 per annum for each of the next 5 years and $900,000 in the aggregate.

The future minimum lease payments as of the date of the latest balance sheet presented are 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. Thus, South should disclose that annual minimum lease payments are $100,000 for each of the next 5 years and that the aggregate of the remaining minimum lease payments is $900,000. The operating expenses are executory costs and are not included in the minimum lease payments.

Question 4

In a lease that is recorded as a sales-type lease by the lessor, interest revenue

Answer 4

Should be recognized over the period of the lease using the effective-interest method.

The difference between the gross investment in the lease and the sum of the present values of the components of the gross investment is recorded as unearned income. This unearned income is amortized to income over the lease term using the effective-interest method, which produces a constant periodic rate of return on the net investment.

Question 5

On January 1, Year 4, Babson, Inc., leased two automobiles for executive use. The lease requires Babson to make 5 annual payments of $13,000 beginning January 1, Year 4. At the end of the lease term, December 31, Year 8, Babson guarantees the residual value of the automobiles will total $10,000. The lease qualifies as a capital lease. The interest rate implicit in the lease is 9%. Present value factors for the 9% rate implicit in the lease are as follows:

For an annuity due with 5 payments: 4.240
For an ordinary annuity with 5 payments: 3.890
Present value of $1 for 5 periods: 0.650

Babson’s recorded capital lease liability immediately after the first required payment should be

Answer 5

$48,620

The lessee records a capital lease as an asset and a liability at the present value of the minimum lease payments. If no bargain purchase option exists, the minimum lease payments equal the sum of (1) the minimum rental payments, (2) the amount of residual value guaranteed by the lessee, and (3) any nonrenewal penalty imposed. Accordingly, the capital lease liability recorded at the inception of the lease was $61,620 [($13,000 annual payment × 4.240 PV of an annuity due at 9% for 5 periods) + ($10,000 guaranteed residual value × .650 PV of $1 at 9% for 5 periods)]. The first required payment reduced this amount to $48,620 ($61,620 - $13,000).

Question 6

Green Co. was preparing its year-end financial statements. Green had a pending lawsuit against a competitor for $5,000,000 in damages. Green’s attorneys indicate that obtaining a favorable judgment was probable and the amount of damages is reasonably estimated. Green incurred $100,000 in legal fees. The income tax rate was 30%. What amount, if any, should Green recognize as a contingency gain in its financial statements?

Answer 6

$0

Gain contingencies are recognized only when realized. A probable favorable judgment and reasonably estimated amount of damages may be disclosed in the notes to the financial statements, but no amount should be recognized as a contingency gain until realized.

Question 7

On December 20, Year 6, an uninsured property damage loss was caused by a company car being driven on company business by a company sales agent. The company did not become aware of the loss until January 25, Year 7, but the amount of the loss was reasonably estimable before the financial statements were issued. The company’s December 31, Year 6, financial statements should report an estimated loss as

Answer 7

An accrual

A loss contingency is an existing condition, situation, or set of circumstances involving uncertainty as to the impairment of an asset’s value or the incurrence of a liability as of the balance sheet date. Resolution of the uncertainty depends on the occurrence or nonoccurence of one or more future events. A loss should be debited and either an asset valuation allowance or a liability credited when the loss contingency is both probable and reasonably estimable. The loss should be accrued even though the company was not aware of the contingency at the balance sheet date.

Question 8

In a sale-leaseback transaction, a gain resulting from the sale should be deferred at the time of the sale-leaseback and subsequently amortized when

I. The seller-lessee has transferred substantially all the risks of ownership.
II. The seller-lessee retains the right to substantially all of the remaining use of the property.

Answer 8

II only

In a sale-leaseback transaction, the gain or loss on the sale is normally deferred and amortized by the seller-lessee in proportion to (1) the amortization of the leased asset (if the lease is capitalized) or (2) the gross rental payments expensed (if the lease is an operating lease). Retention of substantially all the remaining use of the property signifies that the exceptions to deferral and amortization do not apply. 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.

Question 9

Trap Co. leased a new machine to Lake Co. on January 1, Year 4. The lease expires on January 1, Year 9. The annual rental is $90,000. Additionally, on January 1, Year 4, Lake paid $50,000 to Trap as a lease bonus and $25,000 as a security deposit to be refunded upon expiration of the lease. In Trap’s Year 4 income statement, the amount of rental revenue should be

Answer 9

$100,000

In the absence of a contrary indication, this lease should be classified as an operating lease. Whether or not the rental payments are made on the straight-line basis, rental income should be recognized on the straight-line basis unless another systematic and rational basis is more appropriate. The lessor should prorate the $50,000 bonus over the 5-year period of the lease. Consequently, rental revenue is equal to the total of the $90,000 rental payment plus the $10,000 ($50,000 ÷ 5) prorated portion of the bonus, or $100,000. The security deposit should be recorded as a liability.

Question 10

For a capital lease, the amount recorded initially by the lessee as a liability should normally

Answer 10

Equal the present value of the minimum lease payments at the beginning of the lease.

The lessee records a capital lease as an asset and a liability at the present value of the minimum lease payments. The discount rate is the lower of the lessor’s implicit interest rate (if known) or the lessee’s incremental borrowing rate of interest. The present value cannot exceed the fair value of the leased asset at the inception of the lease. Minimum lease payments include the minimum rental payments (excluding executory costs) required during the lease term and the amount of a bargain purchase option. If no such option exists, the minimum lease payments equal the sum of the minimum rental payments, the amount of residual value guaranteed by the lessee, and any nonrenewal penalty imposed.

Question 11

Rig Co. sold its factory at a gain, and simultaneously leased it back for 10 years. The factory’s remaining economic life is 20 years. The lease was reported as an operating lease. At the time of sale, Rig normally should report the gain as a(n)

Answer 11

Deferred credit.

A gain on the sale in a sale-leaseback normally should be deferred and amortized. When the seller-lessee classifies the lease arising from the sale-leaseback as an operating lease, no asset is shown on the balance sheet, and the deferral cannot be presented as a contra asset. Accordingly, the usual practice is to report the gain as a deferred credit.

Question 12

On December 30, Rafferty Corp. leased equipment under a capital lease. Annual lease payments of $20,000 are due December 31 for 10 years. The equipment’s useful life is 10 years, and the interest rate implicit in the lease is 10%. The capital lease obligation was recorded on December 30 at $135,000, and the first lease payment was made on that date. What amount should Rafferty include in current liabilities for this capital lease in its December 31 balance sheet?

Answer 12

$8,500

In a classified balance sheet, a capital lease obligation must be allocated between the current and noncurrent portions. The current portion at a balance sheet date is the reduction of the lease liability in the forthcoming year. The portion of the minimum lease payment that exceeds the amount of interest expense is the reduction of the liability in the forthcoming year. At the beginning of the following year, the lease obligation is $115,000 ($135,000 opening balance – $20,000 initial payment), and the following year’s interest expense will be $11,500 ($115,000 lease obligation × 10% effective rate). The reduction of the liability when the next payment is made will be $8,500 ($20,000 cash – $11,500 interest).

Question 13

On November 25, Year 4, an explosion occurred at a Rex Co. plant causing extensive property damage to area buildings. By March 10, Year 5, claims had been asserted against Rex. Rex’s management and counsel concluded that it is probable Rex will be responsible for damages, and that $3.5 million would be a reasonable estimate of its liability. Rex’s $10 million comprehensive public liability policy has a $500,000 deductible clause. Rex’s December 31, Year 4, financial statements, issued on March 25, Year 5, should report this item as

Answer 13

An accrued liability of $500,000

A loss contingency is accrued when information available prior to issuance of the statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the statements. Furthermore, the loss must be reasonably estimable. The explosion occurred prior to the balance sheet date, and Rex concluded that a loss is probable. Moreover, the amount can be reasonably estimated as the deductible provided for in the insurance contract, given that the policy is sufficient to cover the probable liability. Rex need not be aware that claims have been asserted if it determines that the loss is probable and can be reasonably estimated. Consequently, Rex should accrue a liability of $500,000.

Question 14

On December 29, Year 1, Action Corp. signed a 7-year capital lease for an airplane to transport its professional sports team around the country. The airplane’s fair value was $841,500. Action made the first annual lease payment of $153,000 on December 31, Year 1. Action’s incremental borrowing rate was 12%, and the interest rate implicit in the lease, which was known by Action, was 9%. The following are the rounded present value factors for an annuity due:

9% for 7 years: 5.5
12% for 7 years: 5.1

What amount should Action report as capital lease liability in its December 31, Year 1, balance sheet?

Answer 14

$688,500

The capital lease liability is recorded at the present value of the minimum lease payments. The lease payments due should be discounted at the lesser of the borrower’s incremental borrowing rate or the rate implicit in the lease, if known by the borrower. In this situation, the lease should be recorded at the present value of minimum lease payments discounted at the implicit rate of 9% because this rate is known by the lessee and is lower than the incremental rate. The amount is $841,500 ($153,000 × 5.5), which must then be reduced by the payment made at the inception of the lease of $153,000. The capital lease liability thus should be $688,500 ($841,500 – $153,000) in the December 31, Year 1, balance sheet.

Question 15

On January 2, Cole Co. signed an 8-year noncancelable lease for a new machine, requiring $15,000 annual payments at the beginning of each year. The machine has a useful life of 12 years with no salvage value. Title passes to Cole at the lease expiration date. Cole uses straight-line depreciation for all of its plant assets. Aggregate lease payments have a present value on January 2 of $108,000, based on an appropriate rate of interest. For the current year, Cole should record depreciation (amortization) expense for the leased machine at

Answer 15

$9,000

This lease qualifies as a capital lease because title passes to the lessee at the end of the lease term. 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 (amortization) period is the estimated economic life of the asset. The asset should be depreciated (amortized) in accordance with the lessee’s normal depreciation policy for owned assets. Cole normally uses the straight-line method. Thus, depreciation (amortization) expense is $9,000 [($108,000 leased asset – $0 salvage value) ÷ 12-year economic life].

Question 16

Which of the following is a characteristic of a capital lease?

Answer 16

The lease contains a bargain-purchase option.

A lessee capitalizes a lease that contains a BPO. A lessor capitalizes a lease that contains a BPO if (1) collectibility of the remaining payments is reasonably predictable and (2) no material uncertainties exist regarding unreimbursable costs to be incurred by the lessor.

Question 17

Martin Pharmaceutical Co. is currently involved in two lawsuits. One is a class-action suit in which consumers claim that one of Martin’s best selling drugs caused severe health problems. It is reasonably possible that Martin will lose the suit and have to pay $20 million in damages. Martin is suing another company for false advertising and false claims against Martin. It is probable that Martin will win the suit and be awarded $5 million in damages. What amount should Martin report on its financial statements as a result of these two lawsuits?

Answer 17

$0

Loss contingencies must be accrued when (1) it is probable that, at the balance sheet date, an asset has been impaired or a liability has been incurred, and (2) the amount of the loss can be reasonably estimated. Because the loss contingency is only reasonably possible, it is not accrued. Gain contingencies are recognized only when realized.

Question 18

Potter Co. has the following contingencies, all resulting from lawsuits in progress during the current year:

Probable loss contingency: $1,500,000
Reasonably possible loss contingency: 500,000
Probable gain contingency: 700,000
Reasonably possible gain contingency: 300,000

Potter’s accountant believes the financial statements will be misleading if the probable loss contingency is not disclosed. How much should be disclosed, and how much should be accrued in Potter’s financial statements for the current year?

Answer 18

Disclosed:
$2,00,000 loss
$1,00,000 gain 
Accrued
$1,500,000 loss 

A material contingent loss must be accrued (debit loss, credit liability) when it is probable that (1) an asset has been impaired or a liability has been incurred and (2) the amount of the loss can be reasonably estimated. Therefore, a probable loss contingency of $1.5 million must be accrued and disclosed (Potter believes that the financial statements will be misleading if it is not disclosed). If one or both conditions to accrue a contingent liability are not met but the probability of the loss is at least reasonably possible, the nature of the contingency must be described. Thus, a reasonably possible loss contingency of $500,000 must be disclosed. Gain contingencies are recognized only when realized. However, a gain contingency must be adequately disclosed in the notes to the financial statements. Therefore, both probable and reasonably possible gains must be disclosed but not accrued. Accordingly, a $2,000,000 ($1,500,000 + $500,000) loss and $1,000,000 ($700,000 + $300,000) gain must be disclosed.

Question 19

On January 1, Year 1, JCK Co. signed a contract for an 8-year lease of its equipment with a 10-year life. The present value of the 16 equal semiannual payments in advance equaled 85% of the equipment’s fair value. The contract had no provision for JCK, the lessor, to give up legal ownership of the equipment. Should JCK recognize rent or interest revenue in Year 3, and should the revenue recognized in Year 3 be the same or smaller than the revenue recognized in Year 2?

Year 3 Revenues Recognized:
Year 3 Amount Recognized Compared with Year 2:

Answer 19

Interest
Smaller

A lease must be classified as a capital lease by a lessor if, at its inception, any one of four criteria is satisfied and, in addition, collectibility of the minimum lease payments is reasonably predictable and no important uncertainties surround the unreimbursable costs yet to be incurred by the lessor. One of the criteria is that the lease term be 75% or more of the estimated economic life of the leased property. Because the lease term is 80% (8 years ÷ 10 years) of the estimated life of the equipment, the lease is a capital lease. Whether the lessor treats the capital lease as a direct-financing or sales-type lease, it will recognize interest revenue. The amount declines over the lease term because the effective-interest method is used. As the carrying amount decreases, the interest component (carrying amount × applicable interest rate) of the periodic lease payment also decreases.

Question 20

A liability arising from a loss contingency should be recorded if the

Answer 20

Contingent future events will probably occur and the amount of the loss can be reasonably estimated.

A material contingent loss must be accrued when the following two conditions are met:

I. It is probable that, at the balance sheet date, an asset has been impaired or a liability has been incurred.
II. The amount of the loss can be reasonably estimated.