module4 Flashcards

1
Q

2

MCQ-00445
Application
In its Year 2 financial statements, Cris Co. reported interest expense of $85,000 in its income statement and cash paid for interest of $68,000 in its cash flow statement. There was no prepaid interest or interest capitalization either at the beginning or end of Year 2. Accrued interest at December 31, Year 1, was $15,000. What amount should Cris report as accrued interest payable in its December 31, Year 2 balance sheet?

A.	 $15,000

B.	 $17,000

C.	 $32,000

D.	 $2,000
A

Accrued
Interest
Payable
Beg bal 12/31/Year 1

15,000

Add: interest expense

85,000

Subtotal

100,000

Less: interest paid

(68,000)

Ending balance 12/31/Year 2

32,000

Choice “C” is correct, $32,000 accrued interest payable at Dec. 31, Year 2.

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2
Q

Black Corp.’s accounts payable at December 31 Year 1, totaled $900,000 before any necessary year-end adjustments relating to the following transactions:

On December 27, Year 1, Black wrote and recorded checks to creditors totaling $400,000 causing an overdraft of $100,000 in Black’s bank account at December 31, Year 1. The checks were mailed out on January 10, Year 2.
On December 28, Year 1, Black purchased and received goods for $153,061, terms 2/10, n/30. Black records purchases and accounts payable at net amounts. The invoice was recorded and paid January 3, Year 2.
Goods shipped F.O.B. destination on December 20, Year 1 from a vendor to Black were received January 2, Year 2. The invoice cost was $65,000.
At December 31, Year 1, what amount should Black report as total accounts payable?

A.	 $1,153,061

B.	 $1,450,000

C.	 $1,515,000

D.	 $1,053,061
A

Choice “B” is correct. $1,450,000 accounts payable at 12/31/Year 1.

Accounts
Payable
Balance per books before y/e adjustments

900,000

Add: Checks written on 12/27/Year 1 (which
reduced A/P) but not mailed until 1/10/Year 2

400,000

Add: Goods received 12/28/Year 1 but not
recorded until 1/3/Year 2 at amount net of
2% discount ($153,061 x 98%)

150,000

No entry for goods shipped FOB destination on
12/20/Year 1 but not received until 1/2/Year 2

0

Total accounts payable at 12/31/Year 1

1,450,000

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3
Q

At the beginning of the year, the carrying value of an asset was $1,000,000 with 20 years of remaining life. The fair value of the liability for the asset retirement obligation was $100,000. At year end, the carrying value of the asset was $950,000. The risk-free interest rate was 5%. The credit-adjusted risk-free interest rate was 10%. What was the amount of accretion expense for the year related to the asset retirement obligation?

A.	 $100,000

B.	 $95,000

C.	 $50,000

D.	 $10,000
A

Choice “D” is correct. Accretion expense is the increase in the ARO liability due to the passage of time. The credit adjusted interest rate is used to calculate the ARO, as follows:

Beginning ARO × Risk-adjusted rate = $100,000 × 10% = $10,000

Choice “A” is incorrect. Accretion expense is not equal to the asset retirement obligation. Accretion expense is the increase in the ARO liability due to the passage of time. Accretion expense is beginning asset retirement obligation times the appropriate accretion rate, in this case the credit-adjusted rate.

Choice “B” is incorrect. Accretion expense is not equal to the ending carrying value of the asset times the risk-adjusted rate. Accretion expense is the increase in the ARO liability due to the passage of time. Accretion expense is beginning asset retirement obligation times the appropriate accretion rate, in this case the credit-adjusted rate.

Choice “C” is incorrect. Accretion expense is not equal to the carrying value of the asset times the risk-free rate. Accretion expense is the increase in the ARO liability due to the passage of time. Accretion expense is beginning asset retirement obligation times the appropriate accretion rate, in this case the credit-adjusted rate

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4
Q

9

MCQ-00361
Application
At December 31, Year 1, Cain, Inc. owed notes payable of $1,750,000, due on May 15, Year 2. Cain expects to retire this debt with proceeds from the sale of 100,000 shares of its common stock. The stock was sold for $15 per share on March 10, Year 2, prior to the issuance of the year-end financial statements. In Cain’s December 31, Year 1, balance sheet, what amount of the notes payable should be excluded from current liabilities?

A.	 $1,750,000

B.	 $1,500,000

C.	 $250,000

D.	 $0
A

Choice “B” is correct. $1,500,000 should be excluded from current liabilities because 100,000 shares of common stock were sold at $15 per share. The remaining $250,000 should be included in current liabilities because current assets will be used to pay off the balance.

Rule: Long-term debt that matures within one year should be classified as a current liability, unless retirement is to be accomplished with other than current assets.

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5
Q

A company recorded a decommissioning liability and recognized the amount recorded as part of the cost of the related property. After the property was fully depreciated, the decommissioning liability was reviewed and adjusted. How should this change in the decommissioning liability be recognized?

A.	 The change in the liability is recognized as a change in the carrying amount of the property if the liability increases but is otherwise recognized in profit or loss.

B.	 The change in the liability is recognized in other comprehensive income.

C.	 The change in the decommissioning liability is not recognized until it is settled.

D.	 The change in the liability is recognized in profit or loss.
A

Choice “D” is correct. Any change in the value of the liability after the property has been fully depreciated will be recognized in profit or loss.

Choice “A” is incorrect. The change in the liability will be booked as profit/loss regardless of whether it increases or decreases.

Choice “B” is incorrect. The change in the liability should be booked as a profit/loss on the income statement rather than going into other comprehensive income on the balance sheet.

Choice “C” is incorrect. The change is recognized when the liability is reviewed and adjusted rather than only at settlement.

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6
Q

As of December 1, Year 2 a company obtained a $1,000,000 line of credit maturing in one year on which it has drawn $250,000, a $750,000 secured note due in five annual installments, and a $300,000 three-year balloon note. The company has no other liabilities. How should the company’s debt be presented in its classified balance sheet on December 31, Year 2 if no debt repayments were made in December?

A.	 Current liabilities of $400,000; long-term liabilities of $900,000.

B.	 Current liabilities of $1,000,000; long-term liabilities of $1,050,000.

C.	 Current liabilities of $500,000; long-term liabilities of $800,000.

D.	 Current liabilities of $500,000; long-term liabilities of $1,550,000.
A

Choice “A” is correct. The current liabilities ($400,000) consist of the $250,000 draw on the line of credit due within one year and $150,000 (1/5 of the $750,000), which represents the portion of the secured note due within the next year. The long-term liabilities are $900,000, which consist of the four remaining installments of the secured note, which is $600,000 (4 × $150,000) plus the $300,000 three-year balloon note.

Choice “B” is incorrect. Only the portion which has been drawn off the line of credit will be reported as a liability on the balance sheet. Furthermore, the portion of the secured note due within one year, $150,000 ($750,000 / 5), will be reported as a current liability and not a long-term liability.

Choices “D” and “C” are incorrect based on the above explanations.

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7
Q

On March 1, Year 1, Fine Co. borrowed $10,000 and signed a two-year note bearing interest at 12% per annum compounded annually. Interest is payable in full at maturity on February 28, Year 3. What amount should Fine report as a liability for accrued interest at December 31, Year 2?

A.	 $1,200

B.	 $0

C.	 $2,320

D.	 $1,000
A

Explanation
Choice “C” is correct.

12%, 2-yr note payable

10,000

Year 1 interest expense [12% x $10,000 x 10/12]

1,000

Year 1 net liability

11,000

Year 2 interest expense = [12% x $11,000]

1,320

Accrued interest payable at 12/31/Year 2 equals $2,320 [$1,000 + $1,320]

Choice “A” is incorrect. This is simple interest on the original note [12% x $10,000] for one year and is not the accrued interest payable balance.

Choice “B” is incorrect. Accrued interest must be recognized and recorded during the term of the note.

Choice “D” is incorrect. Year 1 accrued interest equals $1,000 [$10,000 x 12% x 10/12].

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8
Q

The following information pertains to Dash Co.’s utility bills:

Period covered Amount Date paid
April 16–May 15 $5,000 June 1
May 16–June 15 $6,000 July 1
June 16–July 15 $8,000 August 1
What is the amount that Dash should report as a liability in its June 30 balance sheet?

A.	 $10,000

B.	 $7,000

C.	 $6,000

D.	 $14,000
A

Choice “A” is correct. The liability amount that should be reflected on the June 30 balance sheet will represent all amounts that are owed as of June 30 that have not been paid out yet. So for each of the three utility bills:

$5,000 for the period April 16–May 15 was already paid June 1, so no liability is needed.
$6,000 to be paid July 1 for the period May 16–June 15. Because this covers a time period that occurred prior to June 30, and the payment won’t be made until July 1, this entire $6,000 needs to be reflected as a liability.
$8,000 to be paid August 1 for the period June 16–July 15. As of June 30, only half of this period has occurred (June 16–June 30). The liability on June 30 should reflect ½ of this total cost, or $4,000.
$6,000 + $4,000 = $10,000 on the June 30 balance sheet.

Choice “B” is incorrect. This choice incorrectly averages the most recent two bills.

Choice “C” is incorrect. This choice does not account for the ½ of the $8,000 amount to be paid August 1 that covers the June utilities costs.

Choice “D” is incorrect. The portion of the $8,000 bill covering July 1–July 15 should not be reflected as a liability on the June 30 balance sheet.

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9
Q

Zach Corp. pays commissions to its sales staff at the rate of 3% of net sales. Sales staff are not paid salaries but are given monthly advances of $15,000. Advances are charged to commission expense, and reconciliations against commissions are prepared quarterly. Net sales for the year ended March 31 were $15,000,000. The unadjusted balance in the commissions expense account on March 31 was $400,000. March advances were paid on April 3. In its income statement for the year ended March 31 what amount should Zach report as commission expense?

A.	 $400,000

B.	 $465,000

C.	 $415,000

D.	 $450,000
A

Choice “D” is correct. The commission expense is 3% of net sales of $15,000,000, or $450,000. An adjustment would be required on March 31 to bring the expense to this amount.

Choice “A” is incorrect. The unadjusted balance in the commissions expense account is not the amount reported as commission expense. Net sales for the period must be considered.

Choice “B” is incorrect. Advances should not be considered as expenses at year-end. Charging an expense subject to adjustment is permitted, but Zach should adjust the expense to 3% of net sales of $15,000,000.

Choice “C” is incorrect. Advances should not be considered as expenses at year-end. Charging an expense subject to adjustment is permitted, but Zach should adjust the expense to 3% of net sales of $15,000,000.

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10
Q

An entity, upon initial recognition of an asset retirement obligation, should not take which of the following actions?

A.	 Capitalize the asset retirement cost by increasing the carrying amount of the related asset.

B.	 Measure the asset retirement cost at fair value.

C.	 Capitalize the asset retirement cost at its undiscounted cash flow value.

D.	 Allocate asset retirement cost to expense over the useful life of the related asset.
A

Choice “C” is correct. When an asset retirement obligation exists, the entity should record an asset retirement cost (ARC) which increases the carrying value of the long-lived asset as well as an asset retirement obligation (ARO), which is the liability recorded on the balance sheet related to the retirement. The amount recorded to both the asset and liability will be equal to the fair value of the asset retirement obligation (which is determined by discounting the future cash flows required). The ARC will be depreciated over the useful life of the related asset while the ARO will be “accreted” based on the relevant accretion rate.

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11
Q

Able Co. provides an incentive compensation plan under which its president receives a bonus equal to 10% of the corporation’s income before income tax but after deduction of the bonus. If the tax rate is 40% and net income after bonus and income tax was $360,000, what was the amount of the bonus?

A.	 $66,000

B.	 $90,000

C.	 $60,000

D.	 $36,000
A

Explanation
Choice “C” is correct. $60,000 bonus.

Step 1 - Determine pre-tax income

After tax income

-

$360,000 (after bonus & income tax)

Pre-tax income

-

$360,000 ÷ 60%

Pre-tax income

-

$600,000 after deduction for bonus

Step 2 - Determine bonus

Bonus

=

Pre-tax income after deduction for bonus x 10%

Bonus

=

$600,000 x 10%

Bonus

=

$60,000

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12
Q

On October 1, Year 1, Gold Co. borrowed $900,000 to be repaid in three equal, annual installments. The note payable bears interest at 5% annually. Gold paid the first installment of $300,000 plus interest on September 30, Year 2. What amount should Gold report as a current liability on December 31, Year 2?

A.	 $307,500

B.	 $303,750

C.	 $300,000

D.	 $330,000
A

Choice “A” is correct. On December 31, Year 2, Gold Co. should report a current liability related to the principal of the note which will be paid within the next year and the accrued interest at December 31st. Current liabilities associated with the note include the following: $300,000 note payable plus $7,500 of interest payable = $307,500. The interest is calculated as follows: Remaining note payable at December 31, Year 2 of $600,000 x 5% = $30,000 (this represents interest for 12 months). When $30,000 of interest is divided by 12 months, we get $2,500 per month. Interest is accrued for the months of October, November, and December. 3 x $2,500 = $7,500.

Choices “D”, “B”, and “C” are incorrect. They do not correctly accrue the three months of interest that should be recorded as an adjusting entry on December 31, Year 2. The interest will not be paid until September 30, Year 3. However, because of the matching principle, the interest related to Year 2 must be accrued during Year 2.

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13
Q

Paisley Incorporated borrowed $2,000,000 from State Bank on March 1, Year 1, at a rate of 6 percent. According to the loan agreement, Paisley must make principal payments of $200,000 plus appropriate interest payments every March 1 until the loan balance is paid off. Paisley has made timely principal and interest payments since the loan began. The interest payable balance to report in the December 31, Year 3, balance sheet should total:

A.	 $98,000

B.	 $100,000

C.	 $96,000

D.	 $80,000
A

Choice “D” is correct. Principal and interest payments were made March 1, Year 2, and March 1, Year 3. From March 1 to December 31, Year 3, the remaining loan balance totals $1,600,000 ($2,000,000 – $200,000 paid 3/1; Year 2 – $200,000 paid 3/1, Year 3). Interest must be accrued on that amount, but only for the months where interest has not been paid in cash (March to December): $1,600,000 × 6% × 10/12 = $80,000.

Choice “A” is incorrect. $98,000 is the interest revenue for Year 3: Two months of interest on $1,800,000 outstanding loan balance ($18,000) and 10 months of interest on $1,600,000 outstanding loan balance ($80,000). The $18,000 has already been paid in cash.

Choice “B” is incorrect. The interest payable is calculated on the outstanding principal at December 31, Year 3. At that date, the outstanding principal is $1,600,000, not $2,000,000.

Choice “C” is incorrect. Interest payable as of December 31, Year 3, is calculated for 10 months (because of the last cash interest and principal payment), not 12 months.

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14
Q

During the current year, Casual Wear Co. had total retail sales of $800,000 and collected a 5 percent state sales tax on all sales. At the end of the prior year, Casual Wear had $4,500 in sales taxes that had not been remitted to the state authorities. During the current year, Casual Wear remitted $39,500 in state sales tax. What amount should be recorded in Casual Wear’s current year financial statements?

A.	 $840,000 in sales revenue.

B.	 $40,000 in sales tax revenue.

C.	 $5,000 in sales tax payable.

D.	 $39,500 in sales tax expense.
A

Explanation
Choice “C” is correct. The beginning balance in sales tax payable totaled 4,500. Sales tax is collected from the consumer by a company and recorded to a liability account before it is remitted to the government. The current year increase to sales tax payable totaled $40,000 ($800,000 × 5%) as a result of the following journal entry:

Debit (Dr) Credit (Cr)
Cash
840,000

Sales revenue
800,000

Sales tax payable
40,000

The balance paid in cash during the year totaled $39,500, which results in a reduction to sales tax payable.

Sales Tax Payable

|

4,500

39,500 |

40,000

|

?

Based on the activity in the account, the calculated liability remaining at year-end totals $5,000.

Choice “A” is incorrect. Sales tax is collected from the consumer by a company and recorded to a liability account before it is remitted to the government. It is not sales revenue of the collecting company.

Choice “B” is incorrect. Sales tax is collected from the consumer by a company and recorded to a liability account before it is remitted to the government. It is not revenue of the collecting company.

Choice “D” is incorrect. Sales tax is collected from the consumer by a company and recorded to a liability account before it is remitted to the government. It is not an expense of the collecting company.

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15
Q

Which of the following is a cost associated with exit and disposal activities?

A.	 Costs to terminate a capital lease.

B.	 Costs associated with the retirement of a fixed asset.

C.	 Costs to relocate employees.

D.	 Benefits related to voluntary employee termination.
A

Choice “C” is correct. Costs to relocate employees are costs associated with exit and disposal activities.

Choice “A” is incorrect. Exit and disposal activities include costs to terminate a contract that is not a capital lease. Capital lease termination costs are accounted for separately from exit and disposal activities.

Choice “B” is incorrect. The cost of retiring a fixed asset is not considered an exit or disposal cost.

Choice “D” is incorrect. Exit and disposal activities include benefits related to involuntary (not voluntary) employee termination.

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16
Q

56

MCQ-00729
Application
Hudson Hotel collects 15% in city sales taxes on room rentals, in addition to a $2 per room, per night, occupancy tax. Sales taxes for each month are due at the end of the following month, and occupancy taxes are due 15 days after the end of each calendar quarter. On January 3, Year 2, Hudson paid its November Year 1 sales taxes and its fourth quarter Year 1 occupancy taxes. Additional information pertaining to Hudson’s operations is:

Year 1
Room
rentals
Room
nights
October

$100,000

1,100

November

110,000

1,200

December

150,000

1,800

What amounts should Hudson report as sales taxes payable and occupancy taxes payable in its December 31, Year 1, balance sheet?

Sales taxes
Occupancy taxes
A.
$39,000

$8,200

B.	 $39,000

$6,000

C.	 $54,000

$8,200

D.	 $54,000

$6,000

A

Choice “A” is correct.

15% City
Sales Tax
Date
Paid
Occupancy
Tax
Date
Paid
Oct

$ -

11/30

$2,200

1/3

Nov

16,500

1/3

2,400

1/3

Dec

22,500

-

3,600

1/3

$39,000

$8,200

The sales tax accrual is $39,000. The occupancy tax accrual is $8,200.

Choice “B” is incorrect. The occupancy tax accrual should include the $2,200 from October which was not paid until January 3.

Choice “C” is incorrect. The sales tax accrual should not include the $15,000 from October which was due November 30 and is presumed to be paid.

Choice “D” is incorrect. The sales tax accrual should not include the $15,000 from October which was due November 30 and is presumed to be paid. The occupancy tax accrual should include the $2,200 from October which was not paid until January 3.

17
Q

On December 31, Year 1, Neal Inc. leased machinery with a fair value of $105,000 from Frey Rentals Co. The agreement is a six-year noncancelable lease requiring annual payments of $20,000 beginning December 31, Year 1. The lease is appropriately accounted for by Neal as a finance lease. Neal’s incremental borrowing rate is 11%. Neal knows the interest rate implicit in the lease payments is 10%.

The present value of an annuity due of 1 for 6 years at 10% is 4.7908
The present value of an annuity due of 1 for 6 years at 11% is 4.6959
In its December 31, Year 1 balance sheet, Neal should report a lease liability of:

A.	 $75,816

B.	 $93,918

C.	 $85,000

D.	 $95,816
A

Choice “A” is correct. $75,816.

Rule: The present value rate used to value a finance lease is the lease’s “implicit rate,” if known by the lessee.

Annual lease payments

20,000

PV of annuity due of 1 for 6 years at 10%

x 4.7908

Lease liability before 12/31/Year 1 payment

95,816

Less 12/31/Year 1 payment

(20,000)

Lease liability in 12/31/Year 1 balance sheet

75,816

18
Q

Robbins Inc. leased a machine from Ready Leasing Co. The lease qualifies as a finance lease and requires 10 annual payments of $10,000 beginning immediately. The lease specifies an interest rate of 12% and a purchase option of $10,000 at the end of the tenth year, even though the machine’s estimated value on that date is $20,000. Robbins’ incremental borrowing rate is 14%. The present value of an annuity due of 1 at: 12% for 10 years is 6.328 and 14% for 10 years is 5.946. The present value of 1 at: 12% for 10 years is 0.322 and 14% for 10 years is 0.270.

What amount should Robbins record as lease liability at the beginning of the lease term?

A.	 $62,160

B.	 $64,860

C.	 $66,500

D.	 $69,720
A

Explanation
Choice “C” is correct. The lessee should record the finance lease at the present value of minimum lease payments. The interest rate to be applied is 12%. The lease payments begin immediately (annuity due basis). The purchase option must also be capitalized. The amount capitalized is:

Annual payments, $10,000 x 6.328

63,280

Written purchase option, $10,000 x 0.322

3,220

66,500

Choice “A” is incorrect. The interest rate should be 12% since it is specified in the lease and therefore known to the parties. If the rate was not known, the lessee’s incremental borrowing rate would be used.

Choice “B” is incorrect. The interest rate should be 12%. The written purchase option is $10,000, not the machine’s estimated value.

Choice “D” is incorrect. The purchase option is $10,000, not the machine’s estimated value.

19
Q

Assuming U.S. GAAP and given no other information on the terms of the lease, the lessee will account for a lease as operating in all of the following situations, except:

A.	 The present value of the minimum lease payments is equal to 95% of fair value.

B.	 The lease term is equal to 70% of the economic life of the asset.

C.	 Ownership does not transfer at the end of the lease.

D.	 There is no written purchase option.
A

Choice “A” is correct. When the present value of the minimum lease payments exceeds 90% of the fair value of the asset, the lessee will likely treat the lease as a finance lease.

Choice “B” is incorrect. If the lease term is not equal to 75% or more of the economic life of the asset, the lease will be treated as operating by the lessee.

Choice “C” is incorrect. If there is no transfer of ownership at the end of the lease and no other information about the lease is given, the lease will be treated as an operating lease by the lessee.

Choice “D” is incorrect. If there is no written purchase option that the lessee is reasonably certain to exercise and no other information about the lease is given, the lease will be treated as an operating lease by the lessee.

20
Q

Besser Contractors leased a new piece of equipment. The lease is for three years and the economic life of the equipment is four years. The lease contains a written purchase option which Besser intends to exercise. Over how many years should Besser depreciate the leased equipment?

A.	 4

B.	 The equipment should not be depreciated.

C.	 2

D.	 3
A

Choice “A” is correct. The asset should be depreciated over the period of expected benefit. Since Besser intends to exercise the purchase option, the depreciable period is four years.

Choices “C”, “D”, and “B” are incorrect, per the above discussion.

21
Q

Harris Inc. leased equipment under a finance lease for a period of seven years, contracting to pay $100,000 rent in advance at the start of the lease term on December 31, Year 1, and $100,000 annually on December 31 of each of the next six years. The present value at December 31, Year 1, of the seven rent payments over the lease term discounted at 10 percent (the implicit interest rate) was $535,000. Harris amortizes its liability under the lease using the effective interest method. In its December 31, Year 2, balance sheet, Harris should report a lease liability of:

A.	 $500,000

B.	 $391,500

C.	 $378,500

D.	 $437,350
A

Choice “C” is correct. $378,500 lease liability at December 31, Year 2 (end of first year).

Present value at Dec 31, Year 1 (start of lease) of 7 payments at 10%

$535,000

Less: down payment at start of lease

(100,000)

Equals: liability under capital (finance) lease at December 31, Year 1

435,000

Less: payment on Dec 31, Year 2

$100,000

Less: 10% interest on PV of liability (435,000 x 10%)

(43,500)

Net payment applied to principal

(56,500)

Equals: Liability under capital (finance) lease at December 31, Year 2

$378,500

22
Q

A company leases a machine from Leasing Inc. on January 1, Year 1. The lease terms include a $100,000 annual payment beginning January 1, Year 1. The machine’s fair value is $500,000 and an additional $20,000 in residual value is expected to be owed at the end of the lease term. The useful life of the machine is six years, and the lease term is five years. The implicit rate of interest is 6% and is known by the company. The following present value factors are provided:

Five Years Six Years

Present value of $1 at 6%
0.7473

0.7050

Present value of an annuity due at 6%
4.4651

5.2124

Present value of an ordinary annuity at 6%
4.2124

4.9173

What is the value of the machine in the company’s balance sheet at lease inception?

A.	 $535,340

B.	 $520,000

C.	 $446,510

D.	 $461,456
A

Explanation
Choice “D” is correct. The lessee will record the lease as both a right-of-use asset and a liability at the present value of minimum lease payments.

The lease cost has two components:

Required payments: $100,000 × 4.4651 (the factor for an annuity due for five years at 6%) = $446,510.
Expected residual: $20,000 × 0.7473 (the present value of $1 at 6%) = $14,946.
The two components combine for a total cost of $461,456 ($446,510 + $14,946).

Choice “A” is incorrect. This choice incorrectly uses six-year (rather than five-year) present value factors.

Choice “B” is incorrect. This choice does not take time value of money into account and merely counts all future undiscounted cash flows in the calculation of cost.

Choice “C” is incorrect. This choice incorrectly excludes the expected residual.

23
Q

Choice “D” is correct. For a lessee to account for a lease as a finance lease under U.S. GAAP, the terms of the lease must meet at least one of the finance lease criteria:

Ownership transfers at the end of the lease
Written purchase option the lessee is reasonably certain to exercise
PV of minimum lease payments = Fair value of asset (approximately 90% of FV of leased property)
Lease term = Major part (75%) of asset useful life
Asset is specialized such that it has no alternative use to the lessor

A

Choice “D” is correct. For a lessee to account for a lease as a finance lease under U.S. GAAP, the terms of the lease must meet at least one of the finance lease criteria:

Ownership transfers at the end of the lease
Written purchase option the lessee is reasonably certain to exercise
PV of minimum lease payments = Fair value of asset (approximately 90% of FV of leased property)
Lease term = Major part (75%) of asset useful life
Asset is specialized such that it has no alternative use to the lessor

24
Q

Which of the following contracts is most appropriately determined to be a lease?

A.	 A contract that is for use of defined equipment that may be substituted by the lessor when economically beneficial to the lessor

B.	 A contract that is for a specific amount of space, the location of which may be selected and changed by the lessor

C.	 A contract that is for use of a portion of the capacity of an asset that is not physically distinct from other portions

D.	 A contract that is with another lessee for use of a specified property being leased by the lessee
A

Choice “D” is correct. A lease is defined as a contractual agreement between a lessor and a lessee. The lessor conveys the right to use an asset (real or personal property) and a lessee agrees to pay consideration to the lessor for this right.

When a lessee enters into a contract with another lessee for a specific property, this is called a sublease.

Choice “A” is incorrect. To qualify as a lease, the lessor cannot have a substantive substitution right. So, the equipment cannot be substituted by the lessor when it is economically beneficial for the lessor to do so.

Choice “B” is incorrect. To qualify as a lease, the lessor cannot have a substantive substitution right. So, the location cannot be changed by the lessor.

Choice “C” is incorrect. To qualify as a lease, the contract must depend on an identifiable asset (distinct from other components of the same asset).

25
Q

On January 2 of the current year, Cole Co. signed an eight-year noncancelable lease for a new machine, requiring $15,000 annual payments at the beginning of each year. The machine has a useful life of 12 years, with no salvage value. Title passes to Cole at the lease expiration date. Aggregate lease payments have a present value on January 2 of $108,000, based on an appropriate rate of interest. For the current year, Cole should record amortization expense for the leased machine at:

A.	 $13,500

B.	 $9,000

C.	 $0

D.	 $15,000
A

Explanation
The right-of-use asset associated with the lease should be amortized in accordance with the lessee’s normal amortization policy, not to exceed the estimated useful life, unless the lease does not transfer ownership or contain a bargain purchase option, in which case the shorter lease period should be used.

Capitalized value of lease

$ 108,000
Less estimated salvage valve

(0)
Amortizable base

108,000
Estimated life*

÷ 12 years
Amortization expense

$ 9,000
* Title passes at end of lease, so asset life of 12 years is used

Choice “B” is correct. $9,000 amortization expense.

26
Q

A lease is classified as a finance lease because it contains a written purchase option that the lessee is reasonably certain to exercise. Over what period of time should the lessee amortize the leased property?

A.	 The economic life of the asset, not to exceed 40 years.

B.	 The economic life of the asset.

C.	 The term of the lease.

D.	 The lease term or the economic life of the asset, whichever is shorter.
A

Choice “B” is correct. With a finance lease, the lessee should amortize the leased property over the economic life of the asset when there is a written purchase option or when the lessee takes ownership of the asset at the end of the lease term.

Choice “A” is incorrect. There is not a provision for a maximum of 40 years.

Choice “C” is incorrect. The term of the lease is not the appropriate period over which to amortize the leased asset in this case. It is appropriate when the 75 percent or 90 percent criteria are met.

Choice “D” is incorrect. When the determination is made that a lease is a finance lease, the leased asset is to be amortized over its economic life or the asset life based on the capitalization criterion met.

27
Q

Rule: Amortization of leasehold improvements should be over the life of the improvements or the remaining life of the lease, whichever is shorter. In this case, the lease term is equal to or less than each category of improvements, accordingly all improvements should be amortized over 10 years. Since there is uncertainty as to whether the lease will be renewed, the renewal option is not a factor.

A

Rule: Amortization of leasehold improvements should be over the life of the improvements or the remaining life of the lease, whichever is shorter. In this case, the lease term is equal to or less than each category of improvements, accordingly all improvements should be amortized over 10 years. Since there is uncertainty as to whether the lease will be renewed, the renewal option is not a factor.

28
Q

A company has an operating lease for its office space. The lease term is 120 months and requires monthly lease payments of $15,000. As an incentive for the company to enter into the lease, the lessor granted the first eight months at no cost. What amount of monthly lease expense should be recognized over the life of the lease?

A.	 $14,000

B.	 $16,072

C.	 $14,062

D.	 $15,000
A

Choice “A” is correct. The lessor is granting 8 months free, so the total lease expense that will be recorded over the lease period is $1,680,000 (112 months × $15,000 per month). This expense must be equally allocated over the lease period of 120 months according to the revenue recognition and expense recognition principles (recognize expenses in the period in that they are incurred). Therefore, $14,000 of lease expense will be recorded every month ($1,680,000/120 months).

120 months @ $15,000

1,800,000

8 months free

(120,000)

Total cost for 120 months

1,680,000

Total months leased

÷ 120

Monthly lease expense

14,000

Choice “B” is incorrect. Both the original lease expense of $1,800,000 and the reduced term of 112 months have been used to calculate this incorrect answer ($1,800,000/112 months = $16,072), which would overstate total lease expense.

Choice “C” is incorrect. Both the original lease expense of $1,800,000 and an incorrect lease term of 128 months have been used to calculate this incorrect answer ($1,800,000/128 months = $14,062). The 8 months free consideration should reduce the denominator, not increase it. And total lease expense is $1,680,000, not the original $1,800,000.

Choice “D” is incorrect. Recording monthly lease expense of $15,000 over the life of the lease (120 months) would overstate total lease expense as the lessor is granting 8 months free.

29
Q

On January 1, a company enters into an operating lease for office space and receives control of the property to make leasehold improvements. The company begins alterations to the property on March 1 and the company’s staff moves into the property on May 1. The monthly lease payments begin on July 1. The recognition of lease expense for the new offices should begin in which of the following months?

A.	 January

B.	 July

C.	 May

D.	 March
A

Explanation
Choice “A” is correct. The lessor is granting 8 months free, so the total lease expense that will be recorded over the lease period is $1,680,000 (112 months × $15,000 per month). This expense must be equally allocated over the lease period of 120 months according to the revenue recognition and expense recognition principles (recognize expenses in the period in that they are incurred). Therefore, $14,000 of lease expense will be recorded every month ($1,680,000/120 months).

120 months @ $15,000

1,800,000

8 months free

(120,000)

Total cost for 120 months

1,680,000

Total months leased

÷ 120

Monthly lease expense

14,000

Choice “B” is incorrect. Both the original lease expense of $1,800,000 and the reduced term of 112 months have been used to calculate this incorrect answer ($1,800,000/112 months = $16,072), which would overstate total lease expense.

Choice “C” is incorrect. Both the original lease expense of $1,800,000 and an incorrect lease term of 128 months have been used to calculate this incorrect answer ($1,800,000/128 months = $14,062). The 8 months free consideration should reduce the denominator, not increase it. And total lease expense is $1,680,000, not the original $1,800,000.

Choice “D” is incorrect. Recording monthly lease expense of $15,000 over the life of the lease (120 months) would overstate total lease expense as the lessor is granting 8 months free.

30
Q

Quattro Corporation signed a lease from Cinco Leasing Company on July 1, Year 1, for equipment having a five-year useful life. The lease does not include any option to purchase the equipment at the end of the four-year lease term, nor does it include a provision for ownership transfer. Five equal payments of $10,000 per year are required by the terms of the lease, with the first payment due upon signing. Quattro’s incremental borrowing rate is 8 percent, but its implicit interest rate is unknown.

Present value of an annuity at 8% for 5 years = 3.993

Present value of an annuity at 8% for 4 years = 3.312

On its December 31, Year 1, financial statements, Quattro would display the following amounts in the indicated accounts under U.S. GAAP:

A

Explanation
Choice “A” is correct. Quattro’s lease qualifies for treatment as a finance lease since its term exceeds 75 percent of the useful life of the asset (4/5 or 80 percent). A liability (lease payable) will be recorded in the amount of the present value of the minimum lease payments and an ROU asset will be recorded for the same amount. Because the lease does not meet the ownership transfer or written purchase option criteria, the asset will be amortized over the term of the lease, not the life of the asset.

Down payment due at signing

$10,000

Annual lease payments
$10,000

Present value of an annuity (8% × 4 years)
3.312

Lease liability
33,120

Present value of minimum lease payments (asset)
43,120

Amortization period
4 years

Annual amortization expense
$10,780

Six months amortization
$ 5,390

Choice “B” is incorrect. This answer would result if you used the present value factor of an 8 percent annuity for five years, instead of the correct period, four years.

Choice “C” is incorrect. The lease would need to be reflected in the financial statements at Dec. 31, Year 1.

Choice “D” is incorrect. This answer would result if you used the correct present value factor but used a amortization period of five years in the above calculation.

31
Q

On April 1, year 1, Hall Fitness Center leased its gym to Dunn Fitness Center under a four-year operating lease. Hall normally charges $6,000 per month to lease its gym, but as an incentive, Hall gave Dunn half off the first year’s lease costs, and one quarter off the second year’s lease costs. Dunn’s lease payments were as follows:

Year 1

12 × $3,000 = $36,000

Year 2

12 × $4,500 = $54,000

Year 3

12 × $6,000 = $72,000

Year 4

12 × $6,000 = $72,000

Dunn’s lease payments were due on the first day of the month, beginning on April 1, Year 1. What amount should Dunn report as lease expense in its monthly income statement for April, Year 3?

A.	 $3,000

B.	 $4,875

C.	 $6,000

D.	 $4,500
A

Choice “B” is correct. Lease expense must be reported on a straight-line basis. When lease rates fluctuate and when reduced costs are given, the average lease rate must be computed. In this case, total lease expense over the life of the lease is $234,000 ($36,000 + $54,000 + $72,000 + $72,000) and the average lease expense is $58,500 per year ($234,000 / 4 years). $58,500 divided by 12 months equals $4,875 per month.

Choice “A” is incorrect. Under accrual accounting, we do not divide the first $36,000 by 12 months to report as monthly lease expense. Lease expense must be reported on a straight-line basis over the life of the lease.

Choice “C” is incorrect. Under accrual accounting, we do not divide the third and fourth year $72,000 by 12 months to report as monthly lease expense. Lease expense must be reported on a straight-line basis over the life of the lease.

Choice “D” is incorrect. Under accrual accounting, we do not divide the second $54,000 by 12 months to report as monthly lease expense. Lease expense must be reported on a straight-line basis over the life of the lease.

32
Q

On December 30, Year 1, Rafferty Corp. leased equipment under a finance lease. Annual lease payments of $20,000 are due December 31 for 10 years. The equipment’s useful life is 10 years, and the interest rate implicit in the lease is 10%. The finance lease obligation was recorded on December 30 Year 1, at $135,000, and the first lease payment was made on that date. What amount should Rafferty include in current liabilities for this finance lease in its December 31, Year 1 balance sheet?

A.	 $8,500

B.	 $6,500

C.	 $11,500

D.	 $20,000
A

Note: The current liaability is the amortization from the next year because diue within. 1 year so it is the value of payment less interest paymentChoice “A” is correct. $8,500 finance lease current liability at 12/31/Year 1 (and $106,500 long-term portion)

Present value at December 30, Year 1 (start of lease) of 10 payments at 10%

$135,000

Less first payment at start of lease

(20,000)

Equals liability under finance lease at December 30, Year 1

115,000

Payment to be made Dec. 30, Year 2

$20,000

Less 10% interest on PV lease liability (10% x $115,000)

(11,500)

Equals “current liability” for finance lease at Dec. 31, Year 1

8,500

Total liability under finance lease at 12/31/Year 2

$106,500

33
Q

A 20-year property lease, classified as an operating lease, provides for a 10 percent increase in annual payments every five years. In the sixth year compared with the fifth year, the lease will cause the following expenses to increase:

Lease
Interest
A.
No

Yes

B.	 Yes

Yes

C.	 No

No

D.	 Yes

No

A

Choice “C” is correct. No change in lease expense; no change in interest.

Rule: The lessee shall record an operating lease as lease expense using the straight-line basis. Even though there is a variable payment, the payment is known at commencement of the lease term; therefore, the variable payments will be used in calculation of the present value of the lease liability. There is no separately recorded interest component for an “operating lease.”

34
Q

On January 1 of the current year, Tree Co. enters into a five-year lease agreement for production equipment. The lease requires Tree to pay $12,500 per year in lease payments. At the end of the five-year lease term, Tree can purchase the equipment for $30,000. The fair value of the equipment is $75,000. The estimated useful life of the equipment is 10 years. The present value of the lease payments is $50,000. The present value of the purchase option is $20,000. Tree’s controller believes the purchase option price is sufficiently below the expected fair value of the equipment at the date the option becomes exercisable to reasonably assure its exercise. Tree would normally depreciate equipment of this type using the straight-line method. What amount is the carrying value of the ROU asset related to this lease at December 31, of the current year?

A.	 $40,000

B.	 $63,000

C.	 $45,000

D.	 $56,000
A

Explanation
Choice “B” is correct. The lease qualifies for finance lease treatment as two of the four criteria are met for lease capitalization. First, a written purchase option that the lessee is reasonably certain to exercise is associated with the lease. Second, the present value of the minimum lease payments (the minimum rental payments and the purchase option) is greater than 90 percent of the fair value of the equipment [(50,000 + 20,000) > (90% × 75,000)]. An ROU asset of $70,000 (the present value of minimum lease payments and bargain purchase option) will be recorded at the lease inception. As this lease contains a bargain purchase option, the useful life of the asset rather than the lease period will be used to calculate amortization. The $70,000 ROU asset less amortization expense for one year of $7,000 (70,000/10-year useful life) results in a book value of $63,000 at the end of the current year.

Choice “A” is incorrect. This choice uses $50,000 as the value of the ROU asset; however, the bargain purchase option must also be considered. In addition, the lease term of 5 years is used for amortization purposes (resulting in depreciation of 10,000 for the current year), but a 10-year term should be used because a purchase option is associated with the lease.

Choice “C” is incorrect. Although the correct amortization period of 10 years is used in this answer, this answer uses $50,000 as the value of the ROU asset, erroneously excluding the value of the purchase option of $20,000.

Choice “D” is incorrect. The correct ROU asset value of $70,000 is recorded; however, the lease term of 5 years is used for amortization purposes (resulting in amortization of 14,000 for the current year). A 10-year term should be used because a purchase option is associated with the lease.

35
Q

On December 1 of the current year, Clark Co. leased office space for five years at a monthly rental of $60,000. On the same date, Clark paid the lessor the following amounts:

First month’s rent

$60,000

Last month’s rent

60,000

Security deposit (refundable at lease expiration)

80,000

Installation of new walls and offices

360,000

Assuming that the lease is treated as an operating lease, what should be Clark’s current year expense relating to utilization of the office space?

A.	 $66,000

B.	 $140,000

C.	 $120,000

D.	 $60,000
A

Explanation
December (first month rent)

60,000

Add: Amortization of improvements (walls and offices) cost $360,000 ÷ 60 months

6,000

Total current year expense

66,000

Choice “A” is correct. $66,000 expense relating to office space.

36
Q

On December 29, Action Corp. signed a seven-year finance lease for an airplane to transport its sports team around the country. The airplane’s fair value was $841,500. Action made the first annual lease payment of $153,000 on December 31. Action’s incremental borrowing rate was 12 percent, and the interest rate implicit in the lease, which was known by Action, was 9 percent. The following are the rounded present value factors for an annuity due:

9% for 7 years

5.5

12% for 7 years

5.1

What amount should Action report as a lease liability in its December 31 balance sheet?

A.	 $627,300

B.	 $780,300

C.	 $688,500

D.	 $841,500
A

Choice “C” is correct. $688,500.

Rule: The present value rate used to value a finance lease is the rate implicit in the lease if known by the lessee.

Annual lease payments

153,000

PV of annuity due of 1 for 7 years at 9%

x 5.5

Lease liability before 12/31 payment (FMV)

841,500

Less 12/31 payment

(153,000)

Equals lease liability in 12/31 BS

688,500