13.6 Flashcards
A lease is classified as a capital lease because it contains a bargain purchase option. Over what period of time should the lessee amortize the leased property?
The economic life of the asset.
An asset recorded under a capital lease by the lessee must be depreciated in a manner consistent with the lessee’s normal depreciation policy. If the lease is capitalized because the lease either (1) transfers ownership to the lessee by the end of the lease term (criterion 1) or (2) contains a bargain purchase option (criterion 2), the depreciation of the asset is over its entire estimated economic life.
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.
Hampton Co. has estimated the amount of loss that will occur if it is not able to collect its notes receivable. If it is probable these notes receivable will become uncollectible, a loss contingency should be
Disclosed and accrued as a liability.
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. Both of these conditions are met, so the loss should be disclosed and accrued as a liability.
At December 31 of the current year, Date Co. awaits judgment on a lawsuit for a competitor’s infringement of Date’s patent. Legal counsel believes it is probable that Date will win the suit and indicated the most likely award together with a range of possible awards. How should the lawsuit be reported in Date’s current-year financial statements?
In note disclosure only.
GAAP provide for recognition of contingent losses but not contingent gains if certain criteria are met. Gain contingencies are disclosed in a note but are not recognized until realized.
Grim Corporation operates a plant in a foreign country. It is probable that the plant will be expropriated. However, the foreign government has indicated that Grim will receive a definite amount of compensation for the plant. The amount of compensation is less than the fair market value but exceeds the carrying amount of the plant. The contingency should be reported in
The notes to the financial statements.
GAAP provide for recognition of loss but not gain contingencies if certain criteria are met. A loss contingency is an existing condition, situation, or set of circumstances involving uncertainty as to either the impairment of an asset’s value or the incurrence of a liability at a balance sheet date. Resolution of the uncertainty depends on the occurrence or nonoccurence of one or more future events. In the Grim Corporation case, an economic loss is expected because the amount of compensation is less than the fair market value of the plant expropriated. However, the amount of compensation exceeds the carrying amount of the plant. Thus, no accounting loss will result. The contingency should therefore be reported only in the notes to the financial statements.
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.
On January 1, Park Co. signed a 10-year operating lease for office space at $96,000 per year. The lease included a provision for additional rent of 5% of annual company sales in excess of $500,000. Park’s sales for the year ended December 31 were $600,000. Upon execution of the lease, Park paid $24,000 as a bonus for the lease. Park’s rent expense for the year ended December 31 is
$103,400
The rent expense for the year equals the annual rental, plus additional rent, plus a prorated amount of the bonus. Hence, rent expense is $103,400 {$96,000 + [($600,000 – $500,000) × 5%] + ($24,000 ÷ 10 years)}.
Le Chat Co. made the following entry at the inception of a lease:
Lease payments receivable $XXX
Asset $XXX
Unearned interest revenue XXX
This entry reflects recognition of
A direct-financing lease.
The lease is a capital lease recorded by a lessor (owner). Le Chat has removed an asset from the statement of financial position and replaced it with a receivable to reflect the transfer of substantially all the benefits and risks of ownership. Moreover, the lease is a direct-financing lease because no net profit or loss is recognized.
On January 1, Year 4, Day Corp. entered into a 10-year lease agreement with Ward, Inc., for industrial equipment. Annual lease payments of $10,000 are payable at the end of each year. Day knows that the lessor expects a 10% return on the lease. Day has a 12% incremental borrowing rate. The equipment is expected to have an estimated useful life of 10 years. In addition, a third party has guaranteed to pay Ward a residual value of $5,000 at the end of the lease.
The present value of an ordinary annuity of $1 at
12% for 10 years is 5.6502
10% for 10 years is 6.1446
The present value of $1 at
12% for 10 years is .3220
10% for 10 years is .3855
In Day’s October 31, Year 4, balance sheet, the principal amount of the lease obligation was
$61,446
This lease qualifies as a capital lease because the 10-year lease term is greater than 75% of the 10-year estimated useful life of the equipment. The lessee should record the present value of the minimum lease payments at the lower of the lessee’s incremental borrowing rate or the lessor’s implicit rate if known to the lessee. Because the 10% implicit rate (the lessor’s expected return on the lease) is less than the 12% incremental borrowing rate, the lease obligation should be recorded on 1/1/Year 4 at $61,446 ($10,000 periodic payment × 6.1446). The end of the fiscal year (10/31/Year 4) is 10 months after the inception of the lease, but the annual lease payments are payable at the end of the calendar year. Hence, the lease obligation recorded at the inception of the lease has not yet been reduced by the first payment. Moreover, given that the residual value of $5,000 is guaranteed by a third party, it is not included in the minimum lease payments by the lessee.
On January 1, a company enters into an operating lease for office space and receives control of the property to make leasehold improvements. The company begins alterations to the property on March 1 and the company’s staff moves into the property on May 1. The monthly rental payments begin on July 1. The recognition of rental expense for the new offices should begin in which of the following months?
January
The lease term began in January when the company received control over the property. Rent expense must be recognized over the full lease term on a straight-line basis.
Koby Co. entered into a capital lease with a vendor for equipment on January 2 for 7 years. The equipment has no guaranteed residual value. The lease required Koby to pay $500,000 annually on January 2, beginning with the current year. The present value of an annuity due for seven years was 5.35 at the inception of the lease. What amount should Koby capitalize as leased equipment?
$2,675,000
The lessee records a capital lease as an asset and an obligation at the present value of the minimum lease payments. These payments include the initial payment at the inception of the lease. Thus, the annual payments constitute an annuity due. In the absence of a bargain purchase option, guaranteed residual value, or nonrenewal penalty, the amount capitalized as leased equipment is $2,675,000 ($500,000 annual payment × 5.35 present value of an annuity due for 7 years).
Winn Co. manufactures equipment that is sold or leased. On December 31, Year 4, Winn leased equipment to Bart for a 5-year period ending December 31, Year 9, at which date ownership of the leased asset will be transferred to Bart. Equal payments under the lease are $22,000 (including $2,000 of executory costs) and are due on December 31 of each year. The first payment was made on December 31, Year 4. Collectibility of the remaining lease payments is reasonably assured, and Winn has no material cost uncertainties. The normal sales price of the equipment is $77,000, and cost is $60,000. For the year ended December 31, Year 4, what amount of income should Winn realize from the lease transaction?
$17,000
For a lessor to treat a lease as a capital lease, it must first meet one of four criteria. Ownership of the leased equipment transfers to the lessee at the end of the lease term, so one of the four criteria is satisfied. In addition, the lessor cannot treat the lease as a capital lease unless collectibility of the remaining lease payments is reasonably assured and there are no material cost uncertainties. These conditions are met, and Winn should therefore record this lease as either a sales-type or a direct-financing lease. Because the $77,000 fair value is greater than the $60,000 recorded cost of the equipment on the lessor’s books, a manufacturer’s profit is present, and the lease should be accounted for as a sales-type lease. In a sales-type lease, two components of income are recognized: the profit on the sale and interest income. The profit on the sale recorded at the inception of the lease is $17,000 ($77,000 normal sales price – $60,000 cost). At the inception of the lease on December 31, Year 4, no interest income should be recorded. Thus, Winn should realize $17,000 of income from this lease transaction in Year 4.
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).
In a sale-leaseback transaction, the seller-lessee has retained the property. The gain on the sale should be recognized at the time of the sale-leaseback when the lease is classified as a(n)
Capital lease:
Operating lease:
No
No
A gain on the sale in a sale-leaseback transaction normally should be deferred and amortized in proportion to the amortization of the leased asset if the leaseback is classified as a capital lease. The amortization is in proportion to the gross rental payments expensed over the lease term if the leaseback is classified as an operating lease. The gain on the sale is normally not recognized at the time of the sale-leaseback.
During Year 3, Manfred Corp. guaranteed a supplier’s $500,000 loan from a bank. On October 1, Year 4, Manfred was notified that the supplier had defaulted on the loan and filed for bankruptcy protection. Counsel believes Manfred will probably have to pay between $250,000 and $450,000 under its guarantee. As a result of the supplier’s bankruptcy, Manfred entered into a contract in December Year 4 to retool its machines so that Manfred could accept parts from other suppliers. Retooling costs are estimated to be $300,000. What amount should Manfred report as a liability in its December 31, Year 4, balance sheet?
$250,000
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 the estimate is stated within a given range and no amount within that range appears to be a better estimate than any other, the minimum of the range should be accrued. Hence, the minimum amount ($250,000) of the probable payment under the guarantee should be accrued as a liability. The retooling costs will be charged to the equipment account when incurred because they significantly improve the future service of the machines.
