FAR 12 Flashcards
Glade Co. leases computer equipment to customers under direct-financing leases.
The equipment has no residual value at the end of the lease, and the leases do not contain bargain purchase options. Glade wishes to earn 8% interest on a 5-year lease of equipment with a fair value of $323,400. The present value of an annuity due of $1 at 8% for 5 years is 4.312.
What is the total amount of interest revenue that Glade will earn over the life of the lease?
Total interest over the term equals the difference between total lease payments and the fair value of the property at inception. The lease payment is $75,000 ($323,400/4.312). Thus, total interest is 5($75,000) - $323,400 = $51,600.
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, 2004 and $50,000 annually on each December 31 for the next 8 years. The present value on December 31, 2004 of the nine lease payments over the lease term, using the rate implicit in the lease, which Oak knows to be 10%, was $316,500. The December 31, 2004 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, 2005 balance sheet?
The lessee uses 10% because it is the lower of the two rates and is known to the lessee. The lease liability balance immediately after the first payment (at inception) is $266,500 ($316,500 - $50,000). The first payment includes no interest because it is made immediately. The entry for the 12/31/05 payment is:
Lease liability 23,350
Interest expense .10($266,500) 26,650
Cash 50,000
The ending lease liability balance is $266,500 - $23,350 = $243,150.
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 7 years was 5.35 at the inception of the lease.
What amount should Koby capitalize as leased equipment?
The amount to be capitalized is the present value of the lease payments. This amount is $2,675,000 ($500,000 x 5.35) and should be equal to the market value of the equipment if the useful life is also 7 years.
Although $3,500,000 (7 x $500,000) will be paid by Koby over the lease term, the difference between that amount and $2,675,000 represents interest to be recognized over the term. The $2,675,000 amount is the current sacrifice required to obtain the use of the equipment and should be close to the purchase price if the equipment is available by purchase.
If Koby invested that amount at the interest rate implied in the lease, the investment would be sufficient to cover all seven payments.
Steam Co. acquired equipment under a capital lease for 6 years. Minimum lease payments were $60,000 payable annually at the year’s end. The interest rate was 5% with an annuity factor for 6 years of 5.0757. The present value of the payments was equal to the fair market value of the equipment. What amount should Steam report as interest expense at the end of the first year of the lease?
This lease is capitalized because the present value of the lease payments is 90% or more of the fair value of the asset (in this case, 100%). The capitalized lease liability at inception is $60,000 x 5.0757 = $304,542. Interest expense at the end of the first year is .05 x $304,542 = $15,227. A capitalized lease liability is much like a mortgage note with payments including both principal and interest. The principal portion of the first payment is $60,000 - $15,227, or $44,773.
On January 1, 2004, Harrow Co. as lessee signed a 5-year noncancelable equipment lease with annual payments of $100,000 beginning December 31, 2004.
Harrow treated this transaction as a capital lease. The five lease payments have a present value of $379,000 at January 1, 2004 based on interest of 10%.
What amount should Harrow report as interest expense for the year ending December 31, 2004?
The beginning lease liability balance at 1/1/04 is $379,000. That balance is unchanged the entire year because the first lease payment is made 1 year later. Therefore, the interest expense for the first year is $37,900 (.10 x $379,000).
Neal Corp. entered into a 9-year capital lease on a warehouse on December 31, 2003.
Lease payments of $52,000, which includes real estate taxes of $2,000, are due annually, beginning on December 31, 2004 and every December 31 thereafter. Neal does not know the interest rate implicit in the lease; Neal’s incremental borrowing rate is 9%. The rounded present value of an ordinary annuity for 9 years at 9% is 5.6.
What amount should Neal report as capitalized lease liability at December 31, 2003?
280,000
At the inception of a capital lease, the guaranteed residual value should be
Only minimum lease payments are considered when evaluating the fourth criterion of capital leases: “Is the present value of minimum lease payments equal to or greater than 90% of the leased asset’s market value?”
A guaranteed residual value is always included in the minimum lease payments of the lessor and also in the lessee’s if the lessee guarantees it. It is so included because it is a collection or payment that is expected to be made under the terms of the lease.
On January 1, 2005, 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, 2005 balance sheet, the principal amount of the lease obligation was
The principal amount of the lease obligation on the date indicated in the question is the same as at the inception of the lease because no lease payment has been made as of the balance sheet date.
The lessee uses the lower of the implicit return to the lessor (10%) and its incremental borrowing rate (12%). The third-party guarantee does not affect the lessee. Therefore, the principal amount is 6.1446 x $10,000 = $61,446.
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 should report the gain as
The gain or loss on a sale-leaseback is deferred and amortized over the term of the lease for both operating and capital leases. There is no information about present value of lease payments or fair value of the asset.
Because this is an operating lease, the deferred gain is treated as a deferred credit. If it were a capital lease, it would be treated as an asset valuation allowance.
On December 31, 2005, Bain Corp. sold a machine to Ryan and simultaneously leased it back for 1 year. Pertinent information at this date follows:
Sales price $360,000
Carrying amount 330,000
Present value of reasonable lease rentals ($3,000 for 12 months @ 12%) 34,100
Estimated remaining useful life 12 years
In Bain’s December 31, 2005 balance sheet, the deferred revenue from the sale of this machine should be
This is a minor leaseback because the present value of the rentals is less than 10% of the fair value of the property; therefore, none of the gain is deferred. The conceptual basis for immediate recognition of the gain is that the sale is the dominant part of the transaction. The leaseback is a very minor part.
Renwood, Inc. contracted for services to be provided over a period of time in return for 2,000 shares of Renwood’s $5 par common stock when the service is completed. At the time, Renwood stock was selling for $10 per share. When the service was completed, Renwood’s stock price was $12 per share. Therefore, Renwood
The total owners’ equity increase of $20,000 (2,000 shares x $10) is recorded at signing. Of that amount, the common stock account will receive $10,000 (2,000 shares x $5 par). Therefore, the remainder ($10,000) is allocated to contributed capital in excess of par. Subsequent changes in stock price do not change the total amount of OE recorded.
Allam, Inc. contracted for services to be provided over a period of time with full payment in Allam’s $2 par common stock when the service is completed. At the time of the agreement, Allam stock was trading at $20 per share. The agreed-upon total value of the contract is $20,000. When the service was completed, Allam’s stock price was $25 per share. Therefore, Allam
The value of the stock to be issued is $20,000. At time of issuance, the stock price is $25. Therefore, 800 shares are issued ($20,000/$25). The par value of the stock is $2, requiring a credit of $1,600.
On January 1, Feld traded a delivery truck and paid $10,000 cash for a tow truck owned by Baker. The delivery truck had an original cost of $140,000, accumulated depreciation of $80,000, and an estimated fair value of $90,000. Feld estimated the fair value of Baker’s tow truck to be $100,000. The transaction had commercial substance. What amount of gain should be recognized by Feld?
The book value of the delivery truck is $60,000 ($140,000 - $80,000). Its fair value is $90,000. A gain of $30,000 is therefore implied. Cash was paid and the exchange had commercial substance. Therefore, the gain is fully recognized. If the exchange lacked commercial substance, no gain would be recognized.
During 2004, Beam Co. paid $1,000 cash and traded inventory, which had a carrying amount of $20,000 and a fair value of $21,000, for other inventory in the same line of business with a fair value of $22,000.
The exchange was made to facilitate sales to their respective customers.
What amount of gain (loss) should Beam record related to the inventory exchange?
There is a $1,000 gain inherent in the transfer of the old (Beam’s) inventory item (fair value of $21,000 - carrying amount of $20,000). If Beam’s item were sold, gross profit of $1,000 would result. However, under GAAP, exchanges of inventory made to facilitate sales are an exception to fair value measurement. Therefore, no gain or loss is recognized and the inventory received is valued at the book value of the inventory given up plus cash paid, for a total of $21,000. This amount is $1,000 less than the new inventory’s fair value because the $1,000 gain is disallowed.
Markson Co. traded a concrete-mixing truck with a book value of $10,000 to Pro Co. for a cement-mixing machine with a fair value of $11,000. Markson needs to know the answer to which of the following questions in order to determine whether the exchange has commercial substance?
The critical factor as to whether there is commercial substance in an exchange is when there is a significant change in the cash flows related to the asset exchanged.
