FAR 12.02 - ACCOUNTING FOR LEASES: CAPITAL LEASE Flashcards
FAR 12.02 - ACCOUNTING FOR LEASES: CAPITAL LEASE
Oak Co. leased equipment for its entire nine-year useful life, agreeing to pay $50,000 at the start of the lease term on December 31, 20X1, and $50,000 annually on each December 31 for the next eight years.
The present value on December 31, 20X1, 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, 20X1, 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, 20X2, balance sheet?
$0
$350,000
$228,320
$243,150
$243,150.
EXPLANATION:
Since the lease is for the entire 9 year life of the property, it is a capital lease.
The lease obligation will initially be determined using the rate implicit in the lease since it is known to the lessee and lower than the lessee’s incremental borrowing rate, resulting in an initial obligation of $316,500.
The first payment is made at the inception of the lease and does not include interest, resulting in a reduction of $50,000 to $266,500.
The second payment will be applied to interest first at 10% of $266,500 or $26,650, with the remaining $23,350 applied to the lease obligation, reducing it to $243,150.
FAR 12.02 - ACCOUNTING FOR LEASES: CAPITAL LEASE
Which of the following is a criterion for a lease to be classified as a capital lease in the books of a lessee?
The lease contains a bargain purchase option.
The lease term is equal to 65% or more of the estimated useful life of the leased property.
The present value of the minimum lease payments is 70% or more of the fair market value of the leased property.
The lease does not transfer ownership of the property to the lessee.
The lease contains a bargain purchase option.
EXPLANATION:
The four criteria for a capital lease are title transfer, bargain purchase option, lease term at least 75% of the estimated
economic life of the asset, and present value of minimum lease payments at least 90% of the fair market value of the asset
(Roger Mnemonic: TT/BPO/75/90). If any one of these criteria is met, the lessee classifies the lease as a capital lease.
FAR 12.02 - ACCOUNTING FOR LEASES: CAPITAL LEASE
Crane Mfg. leases a machine from Frank Leasing. Ownership of the machine returns to Frank after the 15-year lease expires. The machine is expected to have an economic life of 17 years. At this time,
Frank is unable to predict the collectability of the lease payments to be received from Crane.
The present value of the minimum
lease payments exceeds 90% of the fair value of the machine.
What is the appropriate classification
of this lease for Crane?
Capital
Operating.
Installment
Leveraged
Capital
EXPLANATION:
The lease is a capital lease both because the present value of the minimum lease payments is equal to or greater than
90% of the fair value of the machine and because the 15 year lease term exceeds 75% of the asset’s useful life
(Mnemonic: TT/BPO/75/90).
FAR 12.02 - ACCOUNTING FOR LEASES: CAPITAL LEASE
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.
The lease term or the economic life of the asset, whichever is shorter.
The term of the lease.
The economic life of the asset, not to exceed 40 years.
The economic life of the asset.
EXPLANATION:
When a lease contains a bargain purchase option, and when title transfers to the lessee at the end of the lease term, the lessee will ultimately own the property. As a result, the capitalized cost will be amortized over the life of the property.
FAR 12.02 - ACCOUNTING FOR LEASES: CAPITAL LEASE
On January 1, 20X0, JCK Co. signed a contract for an eight-year lease of its equipment with a 10-year life.
The present value of the 16 equal semiannual payments in advance equaled 85% of the equipment’s fair value.
The contract had no provision for JCK, the lessor, to give up legal ownership of the equipment.
Should JCK recognize rent or interest revenue in 20X2, and should the revenue recognized in 20X2 be the same or smaller than the revenue recognized in 20X1?
20X2 revenues recognized: Interest
20X2 amount recognized compared to 20X1: Smaller
20X2 revenues recognized: Rent
20X2 amount recognized compared to 20X1: Smaller
20X2 revenues recognized: Interest
20X2 amount recognized compared to 20X1: The same
20X2 revenues recognized: Rent
20X2 amount recognized compared to 20X1: The same
20X2 revenues recognized: Interest
20X2 amount recognized compared to 20X1: Smaller
EXPLANATION:
Since the 8-year lease term exceeds 75% of the equipment’s 10-year useful life, JCK will record the lease as a salestype
or direct financing lease.
As such, JCK will recognize an interest bearing receivable.
Each payment received will be allocated to interest first with the remainder allocated to reducing the principal balance of the receivable.
Since the principal balance is reduced each period, the amount allocated to interest will decrease each period.
As a result, JCK will recognize interest revenue and the amount will decrease each year.
FAR 12.02 - ACCOUNTING FOR LEASES: CAPITAL LEASE
A six-year capital lease that species
equal minimum annual lease payments expires on December 31st.
The payments being made represent both interest and a reduction in the net lease liability. The portion of the minimum lease payment in the fifth year applicable to the reduction of the net lease liability should be:
Less than in the fourth year.
The same as in the sixth year.
More than in the fourth year.
More than in the sixth year.
More than in the fourth year.
EXPLANATION:
Payments made on a capital lease are first applied to interest with the remainder reducing the lease obligation.
As the lease obligation declines each year, the amount recognized as interest expense also decreases.
When lease payments are equal, a the interest portion declines, the principal reduction increases.
As a result, the principal reduction in the fifth year would be greater than the fourth year and smaller than the reduction in the sixth year.
