ACCT 3200: Chapter 15 Flashcards
Which of the following leases would least likely be classified as an operating lease by the lessee?
Ownership of the leased asset reverts to the lessor at the end of the lease term.
The agreement permits the lessee to buy the leased asset for one dollar at the end of the lease term.
The lease term is 5 years, and the economic life of the leased asset is 8 years.
The fair value of the leased asset is $20 million, and the present value of the lease payments is $13 million.
The agreement permits the lessee to buy the leased asset for one dollar at the end of the lease term.
Explanation
The five criteria for a lease to be categorized as a finance lease are: (1) Ownership transfers to the lessee at the end of the lease; (2) the lease contains a bargain purchase option; (3) The lease term is for the major part of the economic life of the asset; (4) the present value of the lease payments are substantially all of the fair value of the asset; (5) the underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
In an operating lease in which the asset’s economic life and lease term are different:
The lessor amortizes the leased asset over the term of the lease.
The lessee amortizes the leased asset over the term of the lease at a straight-line amount.
The lessee amortizes the asset over its economic life.
The lessee amortizes the leased asset at an amount that increases each period.
The lessee amortizes the leased asset at an amount that increases each period.
Explanation
In an operating lease, the lessee records a right-of-use asset and amortizes it, not on a straight-line basis, but by “plugging” the right-of-use asset amortization at whatever amount is needed to cause interest plus amortization to equal the straight-line lease payment amount. (over its economic life). Because the interest component of the straight-line lease expense decreases each period, the amortization component increases each period. In an operating lease, the lessor records no lease receivable and does not remove from its balance sheet the asset being leased.
Universal Leasing Corporation leases farm equipment to its customers. Typically, the equipment has no residual value at the end of leases and the contracts call for payments at the beginning of each year. Universal’s target rate of return is 10%. On a five-year lease of equipment with a fair value of $485,100, Universal will earn interest revenue over the life of the lease of:
$96,575
$114,900
$194,040
$121,275
$96,575
Explanation
The present value factor for an annuity due for 5 periods at 10% is 4.16987. Thus, the annual payment is $116,334 ($485,100 ÷ 4.16987), and the total receipts are $581,675 ($116,334 × 5). The interest revenue is total receipts minus fair value ($581,675 − $485,100).
Pyramid Properties entered a lease that contains a bargain purchase option. When calculating the amount to capitalize as a right-of-use asset at the beginning of the lease term, the payment called for by the bargain purchase option should be:
Subtracted at its present value.
Excluded from the calculation.
Added at its present value.
Subtracted at its exercise price.
Added at its present value.
Explanation
The lessee capitalizes the smaller of the present value of the lease payments or the fair value of the asset. The lease payments include both the annual payments and the amount of the exercise price of the bargain purchase option.
Brown Properties entered into a sale-leaseback transaction. Brown retains the right to substantially all of the remaining use of the property. A gain resulting from the sale should:
Not be reported.
Be deferred at the time of the sale-leaseback and subsequently amortized.
Be recognized in earnings at the time of the sale-leaseback.
Be offset against losses from similar transactions.
Be deferred at the time of the sale-leaseback and subsequently amortized.
Explanation
Since Brown Properties retains the right to substantially all of the remaining use of the property, economically, no sale has occurred. So, sale leaseback accounting is not permitted. Instead, the transaction is treated by both parties as a loan.
When the leaseback in a sale-leaseback transaction is an operating lease, the seller-lessee:
Recognizes any gain on the sale immediately only if the asset leased is land.
Does not record a gain.
Immediately recognizes any gain on the sale.
Amortizes any gain over the lease term.
Immediately recognizes any gain on the sale.
Explanation
Since the leaseback qualifies as an operating lease, sale leaseback accounting is appropriate. Any gain on the sale is recognized immediately.
Which of the following would a lessee not record in connection with a lease?
Interest expense.
Lease revenue.
Right-of-use asset.
Amortization expense.
Lease revenue.
Explanation
The lessor, not the lessee records lease revenue.
Which of the following would a lessor not record in connection with a lease?
Lease receivable.
Interest revenue.
Right-of-use asset.
Lease revenue.
Right-of-use asset.
Explanation
The lessee, not the lessor records a right-of-use asset.
We classify a lease as a finance lease if:
the present value of lease payments is less than the asset’s book value.
the present value of lease payments is less than the asset’s fair value.
the usual risks and rewards are transferred to the lessee.
the usual risks and rewards are retained by the lessor.
the usual risks and rewards are transferred to the lessee.
Explanation
We have a finance lease if the lease transfers substantially all the risks and rewards of ownership of the underlying asset.
Under IFRS, a lessee will reassess variable lease payments that depend on an index or a rate:
only when the lessee remeasures the right-of-use asset and lease liability for other reasons.
whenever the lessee reassesses the variable lease payments.
only when the lessor also reassesses the variable lease payments.
never.
only when the lessee remeasures the right-of-use asset and lease liability for other reasons.
Explanation
Under IFRS, a lessee will reassess variable lease payments that depend on an index or a rate not just when the lessee remeasures the right-of-use asset and lease liability for other reasons, but also whenever there is a change in the cash flows resulting from a change in the reference index or rate.
Corinth Company leased non-specialized equipment to Athens Corporation for an eight-year period, at which time possession of the equipment will revert back to Corinth. The equipment cost Corinth $16 million and has an expected useful life of 12 years. Its normal sales price is $22.4 million. The present value of the lease payments for both the lessor and lessee is $20.6 million. The first payment was made at the beginning of the lease.
How should Corinth classify this lease?
Sales-type lease with selling profit
Explanation
The present value of the lease payments is greater than “substantially all” of the fair value of the asset ($20.6 ÷ $22.4 = 92%). The criteria indicate it is a sales-type lease to Corinth. Furthermore, it’s a sales-type lease with a selling profit because the present value of the lease payments ($20.6 million) exceeds the lessor’s cost ($16 million).
King Cones leased ice cream-making equipment from Ace Leasing. Ace earns interest under such arrangements at a 6% annual rate. The lease term is eight months with monthly payments of $10,000 due at the end of each month. King Cones elected the short-term lease option.
What is the effect (decrease in earnings) of the lease on King Cones’ earnings during the eight-month term (ignore taxes)?
$80,000
Explanation
A lease that has a lease term (including options to terminate or renew that are reasonably certain) of twelve months or less is considered a “short-term lease.”
A lessee that has a short-term lease has the option to not record the right-of-use asset and the liability to make lease payments and instead to simply record lease expense for the amount of each lease payment.
King Cone’s earnings will be reduced by the $10,000 per month lease expense, $80,000 for the eight-month term, ignoring taxes.
Java Hut leased a specialty expresso machine for a 10-year non-cancelable term. At the end of the 10-year term, Java Hut has four consecutive one-year renewal options. A replacement machine can be acquired, but due to an expensive installation process and Java Hut’s lease term for its store, Java Hut expects to lease the machine for 12 years.
What is the lease term (in years)?
12
Explanation
The lease term consists of ten years plus two renewal years, or 12 years, because the expensive installation now means that Java Hut is reasonably certain to exercise two of its one-year renewal options.
