13.8 Flashcards
Oak Co. leased equipment for its entire 9-year useful life, agreeing to pay $50,000 at the start of the lease term on December 31, Year 4, and $50,000 annually on each December 31 for the next 8 years. The present value on December 31, Year 4, of the nine lease payments over the lease term, using the rate implicit in the lease, was $316,500. Oak knows that this rate is 10%. The December 31, Year 4, present value of the lease payments using Oak’s incremental borrowing rate of 12% was $298,500. Oak made a timely second lease payment. What amount should Oak report as capital lease liability in its December 31, Year 5, balance sheet?
$243,150
The lease is a capital lease because the lease term is at least 75% of the estimated economic life of the property. The lessee uses the lower of the lessor’s implicit interest rate (if known) or the lessee’s incremental borrowing rate of interest. Oak knows the implicit rate; therefore, the present value of the minimum lease payments of this capital lease is $316,500, the amount based on the lessor’s implicit rate. After the initial payment of $50,000, which contains no interest component, is deducted, the carrying amount during Year 5 is $266,500. Accordingly, the interest component of the next payment is $26,650 ($266,500 × 10% implicit rate), and the capital lease liability on December 31, Year 5, is $243,150 [$266,500 – ($50,000 – $26,650)].
During Year 2, a former employee of Dane Co. began a suit against Dane for wrongful termination in November Year 1. After considering all of the facts, Dane’s legal counsel believes that the former employee will prevail and will probably receive damages of between $1,000,000 and $1,500,000, with $1,300,000 being the most likely amount. Dane’s financial statements for the year ended December 31, Year 1, will not be issued until February Year 2. In its December 31, Year 1, balance sheet, what amount should Dane report as a liability with respect to the suit?
$1,300,000
A contingent liability must be accrued when, based on the information available prior to the issuance of the financial statements, the loss is probable and the amount of the loss can be reasonably estimated. The most likely amount of the loss ($1,300,000) should be accrued if the estimate is stated within a range.
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.
When should a lessor recognize in income a nonrefundable lease bonus paid by a lessee on signing an operating lease?
Over the life of the lessee.
Given that the lease bonus is nonrefundable, it should be considered part of the rental payments. Regardless of when the rental payments are actually received, the lessor should recognize rental revenue on a straight-line basis over the lease term.
In May Year 1, Caso Co. filed suit against Wayne, Inc., seeking $1.9 million in damages for patent infringement. A court verdict in November Year 4 awarded Caso $1.5 million in damages, but Wayne’s appeal is not expected to be decided before Year 6. Caso’s counsel believes it is probable that Caso will be successful against Wayne for an estimated amount in the range between $800,000 and $1.1 million, with $1 million considered the most likely amount. What amount should Caso record as income from the lawsuit in the year ended December 31, Year 4?
$0
Gain contingencies are not recognized until they are realized. Because the appeal is not expected to be decided before Year 6, Caso should not record any revenue from the lawsuit in the Year 4 income statement. This gain contingency should be disclosed; however, care should be taken to avoid misleading implications as to the likelihood of realization.
The present value of minimum lease payments should be used by the lessee in determining the amount of a lease liability under a lease classified by the lessee as a(n)
Capital lease:
Operating lease:
Yes
No
The lessee must record a capital lease as an asset and an obligation at an amount equal to the present value of the minimum lease payments. Under an operating lease, the lessee records no liability except for rental expense accrued at the end of an accounting period. The accrual is at settlement value rather than present value.
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 July 1, Glen Corp. leased a new machine from Ryan Corp. The lease contains the following information:
Lease term: 10 years Useful life of the machine: 12 years Present value of the minimum lease payments: $120,000 Fair value of the machine: $200,000 Executory costs: $3,000
No bargain purchase option is provided, and the machine reverts to Ryan when the lease expires. What amount should Glen record as a capitalized leased asset at inception of the lease?
$120,000
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. The leased asset is 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. 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 guaranteed residual value, and any nonrenewal penalty imposed. Accordingly, the amount capitalized should equal the present value of the minimum lease payments ($120,000), which does not include executory costs.
Benedict Company leased equipment to Mark, Inc., on January 1, Year 2. The lease is for an 8-year period expiring December 31, Year 9. The first of 8 equal annual payments of $600,000 was made on January 1, Year 2. Benedict had purchased the equipment on December 29, Year 1, for $3,200,000. The lease is appropriately accounted for as a sales-type lease by Benedict. Assume that the present value at January 1, Year 2, of all rent payments over the lease term discounted at a 10% interest rate was $3,520,000. What amount of interest income should Benedict record in Year 3 (the second year of the lease period) as a result of the lease?
$261,200
The net investment to be recorded by the lessor at 1/1/Year 2 is given as $3,520,000, the present value of the minimum lease payments discounted at 10%. The net investment is immediately reduced by the $600,000 lease payment on 1/1/Year 2, resulting in a carrying amount for Year 2 of $2,920,000. Interest earned for the Year 2 at a rate of 10% ($2,920,000 × 10%) is $292,000. Thus, the $600,000 1/1/Year 3 lease payment consists of the $292,000 interest component and a $308,000 reduction of the net investment. Because the Year 3 net investment balance is $2,612,000 ($2,920,000 – $308,000), interest income for Year 3 is $261,200 ($2,612,000 × 10%).
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).
Which of the following information about threatened litigation should not be considered to determine whether an accrual is appropriate prior to an issuance of a company’s financial statements?
The period in which the threatened litigation became known to management.
A material contingent loss must be accrued (debit a loss and credit a liability) when (1) it is probable that an asset has been impaired or a liability has been incurred and (2) the amount of the loss can be reasonably estimated. Subsequent events are events or transactions that occur after the balance sheet date and prior to the issuance of the financial statements. The accrual is appropriate when the subsequent event provides additional evidence about conditions that existed at the date of the balance sheet. Thus, the period in which the underlying cause of the threatened litigation occurred is considered in determining whether to accrue a liability before the issuance of the financial statements. Therefore, the only information that is not considered is when threatened litigation became known to management.
Able sold its headquarters building at a gain and simultaneously leased back the building. The lease was reported as a capital lease. At the time of sale, the gain should be reported as
An asset valuation allowance.
In a sale-leaseback transaction, if the lease qualifies as a capital lease, the gain on the sale is normally deferred and amortized by the seller-lessee in proportion to the amortization of the leased asset, that is, at the same rate at which the leased asset is depreciated. Thus, the deferred gain may be reported as an asset valuation allowance (a contra asset with a credit balance).
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 Period:
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.
On February 5, Year 2, an employee filed a $2 million lawsuit against Steel Co. for damages suffered when one of Steel’s plants exploded on December 29, Year 1. Steel’s legal counsel expects the company will lose the lawsuit and estimates the loss to be between $500,000 and $1 million. The employee has offered to settle the lawsuit out of court for $900,000, but Steel will not agree to the settlement. In its December 31, Year 1, balance sheet, what amount should Steel report as liability from lawsuit?
$500,000
Because the loss is probable and can be reasonably estimated, it should be accrued if the amount is material. 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. Thus, Steel should report a $500,000 contingent liability.
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).
