Accounting for Leases

Question 1

What are the two ways a lease can be reported under US GAAP?

Answer 1

Operating lease

Capitalized Lease

Question 2

Who are the two parties to a lease?

Answer 2

lessor - has legal title to the property

lessee - given the right to use the property

Question 3

How many different ways can a capitalized lease be reported?

Answer 3

direct financing lease

sales-type lease

Question 4

For a lessor, when is a capitalized lease reported as a direct financing lease?

In a direct financing lease, when is the lessor’s profit recognized?

For a lessor, when is a capitalized lease reported as a sales-type lease?

In a sales-type lease, when is the lessor’s profit recognized?

Answer 4

if the lessor never sells the item being leased in the normal course of business, it is a direct financing lease. no manufacturers or dealers profit.

in a direct financing lease, no profit is recognized when the lease begins. All profit is recognized as interest over the life of the lease.

If a lessor sells the item being leased in the normal course of business, it is a sales-type lease. The lease is said to have a manufacturer or dealer’s profit.

In a sales-type lease, the profit is recognized as sales revenue immediately. Any remaining profit is recognized as interest over the life of the lease.

Question 5

What are the criteria that must be met for a lease to be classified as a capitalized lease?

Answer 5

title transfers to the lessee at the end of the lease

lessee has the option to buy the asset at the end of the lease for an amount significantly below expected market value (bargain option)

life of the lease is 75% or more of the economic life of the asset

the PV of the minimum lease payment is 90% or more of the FV of the leased item

Question 6

In a capitalized lease, both the lessor and the lessee must make use of an interest rate. For each party, how is that interest rate determined?

Answer 6

the lessor uses the imputed or implicit interest rate that is built into the cash flows of the contract. This is basically the profit rate added to the contract to compensate the lessor for the payments to be received over a period of time.

the lessee uses the incremental borrowing rate, which is the rate at which it could borrow additional money to buy the asset instead of leave it. However, the lessor’s imputed interest rate is used if the lessee knows the imputed rate, and that rate is less than the incremental borrowing rate.

Question 7

If none of the four capitalized lease criteria are met, how is the lease classified?

Answer 7

If not even one of the four criteria are met for capitalization, a lease is reported as an operating lease.

Question 8

If a lease has a bargain purchase option, it is viewed as a capitalized lease. What qualifies as a bargain purchase option?

Answer 8

A bargain purchase option means that the lessee has the right to buy the leased asset at a price that is significantly below the expected FV of the property at the time, so that it is reasonable to expect the lessee will exercise this option.

Question 9

A lease will often have a residual value. This residual value can be guaranteed or unguaranteed. What is a residual value for a lease? What is the difference in a guaranteed and unguaranteed residual value?

Answer 9

residual value is the expected worth of the asset at the end of the lease

a residual value is guaranteed if the lease has to compensate the lessor if the actual value is below the guaranteed amount

a residual value is unguaranteed if the lessee has no obligation to pay the lessor for any amount related to the residual value at the end of the lease term

Question 10

Capitalized leases are reported based on the amount of minimum lease payments that will be made by the lessee.

For the lessee, what is the amount of minimum lease payments?

For the lessor, what is the amount of minimum lease payments?

Answer 10

lessee -

the amount of payments to be made each year over the life of the lease

any bargain purchase option

any guaranteed residual value

lessor -

the amount of payments to be received each year over the life of the lease

any bargain purchase option

any expected residual value, whether guaranteed or not

Question 11

A lessee pays $2,000 on Dec 31, year 1, to lease an asset for one year. If this is an operating lease, what entries are made by the lessee? What entries are made by the lessor?

Answer 11

Year 1 (lessee)

Prepaid Rent 2,000
Cash 2,000

Year 2 (lessee)

Rent expense 2,000
Prepaid Rent 2,000

Year 1 (lessor)

Cash 2,000
unearned rent 2,000

Year 2 (lessor)

unearned rent 2,000
Rent Revenue 2,000

Question 12

An operating lease is signed on Jan 1, year 1. The lease is for two years and payments are $6,000 in year 1 and 10,000 in year 2. What expense does the lessee recognized in Year 1? What revenue doe the lessor recognize in Year 1?

Answer 12

Unless the years are expected to be different in some manner, the same revenue and expense should be recognized each period. Revenue of $8,000 and expense of $8,000 per year.

Question 13

On Jan 1, year 1, XYZ co. leases a large truck from a lessor for five years. Annual lease payments are $20,000 beginning on Jan 1, year 1. The PV of these minimum lease payments is $70,000 based on an incremental borrowing rate of 10%. What j/e is made by XYZ on Jan 1, year 1?

Answer 13

Leased Truck 70,000
Cash 20,000
Lease obligation 50,000

Question 14

On Jan 1, year 1, XYZ co. leases a large truck from a lessor for five years. Annual lease payments are $20,000 beginning on Jan 1, year 1. The PV of these minimum lease payments is $70,000 based on an incremental borrowing rate of 10%. What 2 j/e’s is made by XYZ on Dec 31, year 1?

Answer 14

Interest expense - liability carrying amount of $50,000, multiplied by 10% rate, equals an interest expense of $5,000

Interest expense 5,000
Lease obligation 5,000

Depreciation expense = 70,000/5 or 14,000

Depreciation expense 14,000
accumulated depreciation 14,000

Question 15

On Jan 1, year 1, the Thomas Corp leases an asset from a lessor for 5 years. Annual lease payments are $20,000 beginning on Jan 1, year 1.

The PV of these minimum lease payments was $70,000 based on an incremental borrowing rate of 10%. At the end of year 1, an interest exp was recognized by Thomas.

At the end of year 2, how much interest expense is recognized, and what liability is reported?

Answer 15

Interest expense - liability carrying amount of $35,000(70,000-20,000-20,000-5,000), multiplied by 10% rate, equals an interest expense of $3,500

Liability will be reported as 35,000 + 3,500 = 38,500

Question 16

At the end of year 1, the JKL co. has a lease liability of $47,000. During year 2, a $10,000 payment will be made, and interest of $4,000 will be recognized, so that the lease liability will be $41,000 at the end of year 2. On a balance sheet as of Dec 31, year 1, how much of the $47,000 lease liability will be shown as a current liability?

Answer 16

During year 2, a payment of $6,000 will be made. Therefore, a current liability of $6,000 will be shown at the end of Year 1, with the remaining $41,000 of the liability presented as a long-term liability.

Question 17

The Harrison Co obtains use of equipment through a capitalized lease of 8 years. However the equipment actually has a useful life of 10 years. In depreciating the equipment, when should Harrison us an 8 year life and when should Harrison use a 10 year life?

Answer 17

For depreciation purposes, the lessee will use the entire 10 year useful life of the asset if title transfers to the lessee or if there is a bargain purchase option. In those two cases, the assumption is made that the lessee will gain title to the asset and use it for its entire life

If title does not transfer to the lessee, or if there is not a bargain purchase option, the lessee should use the 8 year life of the lease for depreciating the asset. Therefore, if the lease is a capital lease due to the 75% rule or the 90% rule, but there is no BPO or title transfer, then the depreciation is allocated to the lease term rather than to the useful life.

Question 18

A lessee has obtained an asset through a capitalized lease. The minimum payments are known so that the asset should be reported at the PV of those minimum lease payments. When is the PV of an ordinary annuity used for this computation, and when is the PV of an annuity due appropriate?

Answer 18

if the first lease payment is made upon the signing of the lease, the PV should be computed based on the cash flows being an annuity due.

If the first lease payment is made at the end of the first period, the PV should be computed based on the cash flows being an ordinary annuity.

Question 19

B leases a car to C in a contract that is properly viewed as a sales-type lease. The car has a cost of $20,000 to B, and the normal sales price is $24,000. C is going to pay a total of $30,000 in minimum lease payments (6,000 per year, first payment due immediately) over the life of the lease. The payments were set to earn an implicit interest rate of 10%.

Present value of an annuity due at 10% for 5 periods. 4.16987

What is the immediate gain that should be recognized by B, and the interest that will be recognized over the life of the lease?

Answer 19

As a sales-type lease, the lessor should be recognized the sales revenue equal to the PV of the lease payments, $25,019 (4.16987 x $6,000)

The interest to be recognized over the life of the lease equals the gross investment (lease receivable) less the net investment (PV of gross investment), or $4,981.

Lease receivable 30,000
Sales revenue 25,019
Unearned int. rev. 4,981
COGS 20,000
Inventory- Cars 20,000

Question 20

On Jan 1, year 1, Able buys a car for $20,000 which normally sells for $24,000. The care is leased immediately to Baker for 5 year. Payments are $6,000 per year, with the first payment made immediately. The payments were set to earn an implicit interest rate of 10%. This is a sales-type lease.

PV of an annuity due at 10% for 5 period. 4.16987

What is the balance of the receivable during Year 1, and how much interest revenue should Able recognize during year 1?

Answer 20

As a sales-type lease, the receivable will initially be the gross investment of $30,000. However, the fist payment of $6,000 is paid immediately, bringing the receivable balance down to $24,000. The unearned interest revenue of $4,981(30,000 -(4.16987 x 6,000)) that was initially recorded is a contra receivable account. the net receivable would be 19,019 (30,000 - 4,981 - 6,000)

because the interest rate is 10%, interest revenue for the first year is 1,902. the income to be recognized during year 1 is a $5,019 (25,019 - 20,000) gain at the date of signing and 1,902 for interest revenue in the first year.

Question 21

On Jan 1, year 1, Able buys a car for $20,000 which normally sells for $24,000. The care is leased immediately to Baker for 5 year. Payments are $6,000 per year, with the first payment made immediately. The payments were set to earn an implicit interest rate of 10%. This is a sales-type lease. Interest revenue of $1,902 was recognized at the end of year 1. The second payment was received at the beginning of year 2.

PV of an annuity due at 10% for 5 period. 4.16987

How much interest revenue is recognized in year 2, and what is the reported balance of the receivable at the end of year 2.

Answer 21

25,019 - 6,000 + 1,902 - 6,000 = 14,921

14,921 x .10 = 1,492 interest expense

14,921 + 1,492 = 16,413 receivable balance

Question 22

On Jan 1, year 1, Able buys a truck for $50,000 and leases it to Stu for $12,000 per year for five years, with the first payment made immediately. The second payment will be on Jan 1, year 2. This capitalized lease qualifies as a direct financing lease. The implicit interest rate for this contract is 10%.

What amounts of income are recognized on Jan 1, year 1, and at the end of year 1?

Answer 22

Jan 1, year 1 - as a direct financing lease, no income at the origination of the lease. An immediate gain is only appropriate in a sales-type lease. Unearned interest revenue is recorded for the difference between the cost of the asset (50,000_ and the receivable and any immediate payments (60,000) or $10,000 in this case.

Dec 31, year 1 - at the end of year 1, interest revenue must be recognized. Interest revenue equals the implicit interest rate times net lease receivable. Thus the lessor has a receivable $48,000 after one payment is made immediately, so the net receivable for the first year is reduced to $38,000 (48,000 - 10,000). The interest rate is 10% therefore the interest revenue recognized for the first year is $3,800.

Question 23

On Jan 1, year 1, Able buys a truck for $50,000 and leases it to Stu for $12,000 per year for five years, with the first payment made immediately. This capitalized lease qualifies as a direct financing lease. The implicit interest rate for this contract is 10%.

What is the net receivable balance reported on the balance sheet at Dec 31, year 1?

Answer 23

On Dec 31, year 1, $3,800 interest revenue is recorded, bringing the unearned revenue account balance down to $6,200. This account is a contra lease receivable account. The lease receivable balance at year end is 48,000 (60,000 - 12,000). Therefore, the net receivable balance on Dec 31, year 1 is $41,800 ( 48,000 - 6,200)

Question 24

On Jan 1, year 1, Able buys a truck for $50,000 and leases it to Stu for $12,000 per year for five years, with the first payment made immediately and the second payment made on Jan 1 year 2. This capitalized lease qualifies as a direct financing lease. The implicit interest rate for this contract is 10%. Interest revenue recognized for Year 1 was $3,800.

What amount of income is recognized for Year 2, and what is the amount of the receivable reported on the Dec 31, year 2 balance sheet?

Answer 24

interest income in year 2 is 2,980 ((60,000 - 12,000 - 12,000) - (10,000 - 3,800)) during the second year. The lease receivable balance on Dec 31, year 2 is $36,000 and the unearned interest receivable balance is 3,220(10,000 - 3,800 - 2,980)

net receivable is 36,000 - 3,220 = 32,780

Question 25

Ace leases a truck for $20,000 per year for five years, with he first payment made immediately. In 5 years, Ace can buy the ruck for $10,000, which is viewed as significantly below the expected FV. Ace incremental borrowing rate is 12% and the implicit interest rate (known by Ace) built into the contract is 10%.

                                          10%      12% PV of an annuity due for 5 period                                 4.17          4.04

PV of a single amount for
5 periods 0.62 0.57

at what value does Ace report the leased asset?

Answer 25

Ace must use the 10% implicit rate, because it is known by Ace and it is less than the incremental borrowing rate.

20,000 x 4.17 = 83,400
10,000 x .062 = 6,200

the leased asset is the sum of these figures or 89,600

Question 26

Ace buys a building for $300,000 and sells it to Zack for $400,000. Zack then leases the building back to ace for substantially its entire life. What happens to the $100,000 gain on the sale?

Answer 26

In a sale-leaseback such as this, the original owner’s gain is deferred if the leaseback is for a major portion of the asset’s life. Thus the $100,000 is reported as a deferred gain by Ace.

Question 27

On Jan 1, year 1, Ace buys a building for $300,000 and sells it to Zack for $400,000. Zack then leases the building back to Ace for ten years, a major portion of the building’s life. At the end of year 1, what amount is reported as a deferred gain by Ace?

Answer 27

Because the asset is being leased back for a major portion of this remaining life, the $100,000 is reported as a deferred gain. This deferred gain is then written off over the life of the lease. Over ten years, the deferred gain will be amortized at the rate of $10,000 per year ($100,000/10). After one year, the deferred gain will be reduced from $100,000 to $90,000.

Question 28

On Jan 1, year 1, Ace buys a building for $300,000 and sells it to Zack for $400,000. The building has a 30-year remaining life. Zack then leases the building back to Ace for two years, a minor portion of the building’s life. How is the $100,000 gain reported?

Answer 28

Because the leaseback is for only a minor portion of the leased asset’s remaining life, the entire $100,000 is recognized as gain. No portion is reported as a deferred gain when the leaseback is for a minor portion of the asset’s life.

Question 29

Ace leases equipment to Hall for $10,000 per year for 7 years. Of the annual payments $1,000 per year is assumed to be for executory costs, such as maintenance and taxes. The lease is a capitalize lease. What is the amount of the minimum lease payments?

Answer 29

Executory costs are not considered to be part of contract’s minimum lease payments. therefore, in this example, the minimum lease payments are $9,000 per year for seven years.