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Henderson State University *

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3063

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Accounting

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Jan 9, 2024

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Which of the following contracts is most appropriately determined to be a lease? A 5. c. o. A contract that is with another lessee for use of a specified property being leased by the lessee A contract that is for use of a portion of the capacity of an asset that is not physically distinct from other portions. A contract that is for a specific amount of space, the location of which may be selected and changed by the lessor A contract that is for use of defined equipment that may be substituted by the lessor when economically beneficial to the, lessor Explanation Choice A" 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 “B” is incorrect. To quaiify as a lease, the contract must depend on an identifiable asset (distinct from other components of the same asset). Choice “C" is incorrect. To quaiify as a lease, the lessor cannot have a substantive substitution right. So, the location cannot be changed by the lessor. Choice “D" is incorrect. To quaiify 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.

Watts Inc. enters into an agreement to lease a printer/copier from Jennings Co. The lease is for three years and does not stipulate an ownership transfer or contain a written option to purchase. The printer/copier has a five-year life and the equipment is standard equipment that Jennings can use for many projects and functions. The net present value of the lease payments is approximately half of the overall fair value of the equipment and there is no guaranteed residual value associated with the lease. Watts and Jennings will account for this lease as: Watts Jennings A. Finance Sales-type B. Finance Operating C. Operating Sales-type D. Operating Operating Explanation Choice "D" is correct. Both Watts (the lessee) and Jennings (the lessor) will account for the lease as an operating lease. None of the "OWNES" criteria are met: there is no ownership transfer; there is no written option to purchase; the net present value is far below the threshold needed to be considered equal to the fair value of the asset; the lease term is only 60 percent of the economic life of the asset; and the equipment is not specialized. As such, Watts must treat the lease as an operating lease. Jennings must also treat the lease as operating because the "sales-type" classification can only be used when at least one of the OWNES criteria are met. Note that although a lessor may also use a "direct financing” classification when the OWNES criteria are not met, in this case that would not be an option because of the relatively low net present value (and absence of guaranteed residual value) compared with the asset's fair value.

Anton owns equipment originally purchased four years ago for $325,000. On January 1, Year 5, Anton sells the equipment to Bridges for $208,000. The equipment has a remaining useful life of six years, a carrying value of $195,000, and a fair value of $202,000. Bridges has agreed to lease the equipment back to Anton for three years with annual payments of $48,375 at an implicit interest rate of 5.25 percent. The lease qualifies as a sale. When the transfer takes place, Anton will record a financing liability equal to: A. $0. © B. $6,000 Choice "B" is correct. The difference between the sale price ($208,000) and the fair value ($202,000) is recorded as a financing liability on the books of the seller/lessee. Anton’s journal entry will be as follows: Debit (Dr) Credit (Cr) Cash $208,000 A/D—Equipment 130,000 Equipment $ 325,000 Financing liability 6,000 Gain on equipment sale 7,000

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Note that the A/D (accumulated depreciation) on the equipment is derived by comparing the original purchase price of $325,000 with the carrying value of $195,000. Lease A does not contain a purchase option, but the lease term is equal to 90 percent of the estimated economic life of the leased property. Lease B does not transfer ownership of the property to the lessee by the end of the lease term, but the lease term is equal to 75 percent of the estimated economic life of the leased property. How should the lessee classify these leases under U.S. GAAP? Lease A Lease B A. Operating lease Finance lease B. Operating lease Operating lease C. Finance lease Finance lease

Explanation Choice "C" is correct. Both leases have terms equal to or more than 75 percent of their estimated economic life; therefore, both are finance leases under U.S. GAAP. Rule: If any one of the following conditions is met, a lease is considered a finance lease under U.S. GAAP and is treated as if owned by the lessee 1. The lease transfers ownership to the lessee by the end of the lease term 2. The lease contains a written purchase option that the lessee is reasonably certain to exercise. 3. The present value at the beginning of the lease term of the "minimum lease payments” equals or exceeds the fair value of the leased property (generally 90 percent of FV is the minimum threshold) 4. The lease term is the major part (75 percent or more) of the estimated economic life of the leased property. 5. The asset is specialized such that there is no alternative use to the lessor. 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. There is no written purchase option. B. Ownership does not transfer at the end of the lease. C. The lease term is equal to 70% of the economic life of the asset. © D. The present value of the minimum lease payments is equal to 95% of fair value.

Explanation Choice “D” 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 “A” 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. Choice “B” 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 “C” 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 Which of the following situations would require that a lessor not book a lease as an operating lease under U.S. GAAP? A. The lease does not contain a written purchase option. B. The lessor is able to predict the collectibility of the lease payments. © €. The lease term represents 80% of the economic life of the asset leased. D. The lessor is unsure about unreimbursable costs that may be incurred in the near future. Explanation Choice “C” is correct. A lease term which represents 80% of the economic life of the asset will meet the "E" in the OWNES criteria, meaning that the lessee will book this as a finance lease and the lessor will book it as a sales-type lease.

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On January 1, Year 1, Frost Co. entered into a two-year lease agreement with Ananz Co. to lease 10 new computers. The lease term begins on January 1, Year 1, and ends on December 31, Year 2. The lease agreement requires Frost to pay Ananz two annual lease payments of $8,000. The present value of the minimum lease payments is $13,000. Which of the following circumstances would require Frost to classify and account for the arrangement as a finance lease under U.S. GAAP? A. The economic life of the computers is three years. © B. The fair value of the computers on January 1, Year 1 is $14,000. C. Frost does not have the option of purchasing the computers at the end of the lease term. D. Ownership of the computers remains with Ananz throughout the lease term and after the lease ends. Explanation Choice "B" 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 If the fair value of the computers at lease inception is $14,000 and the present value of the minimum lease payments is $13,000, then the lease will be accounted for as a finance lease: 13,000/14,000 = 93%

Bain Co. entered into a 10-year lease agreement for a new piece of equipment worth $500,000. At the end of the lease, Bain will have the option to purchase the equipment. Which of the following would require the lease to be accounted for as a finance lease under U.S. GAAP? A. The lease includes an option to purchase stock in the company. ©B. The estimated useful life of the leased asset is 12 years. C. The present value of the minimum lease payments is $400,000. D. The purchase option at the end of the lease is above fair market value_ Explanation Choice "B" 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 If the lease term is 10 years and the useful life of the asset is 12 years, then the "75%" criteria is met (10/12 = 83%) and the lease will be accounted for as a finance lease.

Which of the following is a characteristic of a finance lease under U.S. GAAP? A. The lease term is substantially less than the estimated economic life of the leased property. © B. The lease contains a written purchase option that the lessee is reasonably certain to exercise. C. The present value of the minimum lease payments at the beginning of the lease term is 75% or more of the fair value of the property at the inception of the lease. D. The future obligation does not appear in the balance sheet of the lessee. Explanation Choice "B" is correct. A lease that contains a bargain-purchase option will be accounted for by the lessee as a finance lease. At least one of the following criteria must be met for a lease to be capitalized: « 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 the asset's useful life * Asset is specialized such that it has no alternative use to the lessor

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Which of the following is a criterion for a lease to be classified as a finance lease in the books of a lessee under U.S. GAAP? © A. The lease contains a written purchase option. B. The lease does not transfer ownership of the property to the lessee. C. The lease term is equal to 65% or more of the estimated useful life of the leased property. D The present value of the minimum lease payments is 70% or more of the fair market value of the leased property. Explanation Choice "A" is correct. One of the five U.S. GAAP criteria (OWNES) for a lease to be classified as a finance lease on the books of a lessee is the existence of a written purchase option.

Which of the following is a criterion for classifying a lease as a finance lease by a lessee? © A. The lease term is equal to 75 percent or more of the estimated economic life of the leased property. B. The present value of the minimum lease payments is 75 percent or more of the fair value of the leased property. C. The lease agreement contains an option to purchase the leased property at its fair value at the end of the lease term D. The lease agreement requires that title of the leased property remains with the lessor at the end of the lease term. Explanation Choice “A” is correct. There are five criteria that may be used to determine whether a lessee should capitalize a lease, and only one criterion has to be met in order to capitalize. If the lease term is equal to 75 percent or more of the economic life of the asset, then the lessee will capitalize the lease on its books. Choice “B” is incorrect. The present value of the minimum lease payments must be 90 percent or more of the fair value of the leased property in order to qualify for capitalization Choice “C” is incorrect. The option to purchase the leased property at the end of the lease term must specifically be an option that the lessee is reasonably certain to exercise. The fact that the price associated with the option is aligned with fair value does not provide "reasonable assurance” of exercise. Choice “D” is incorrect. Title of the leased property must transfer to the lessee in order for this to be a criterion for lessee capitalization.

Under U.S. GAAP, one criterion for a finance lease classification is that the term of the lease represents the major part of the leased property's estimated economic life at the inception of the lease. What is a reasonable minimum threshold percentage for representing a "major part” of the asset's economic life? A 51% © B 75% c. 80% D. 90% Explanation Choice "B" is correct. A reasonable minimum threshold is that the lease term be greater than or equal to 75% of the economic life of the leased asset. Choice "A" is incorrect. 51% would be below the minimum threshold Choice "C" is incorrect. 80% is higher than the reasonable minimum threshold. Choice "D" is incorrect. Under U.S. GAAP, if the present value of the minimum lease payments is greater than or equal to 90% of the fair value of the leased asset, then that represents a reasonable percentage for considering the lease a finance lease. 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

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Expianauon Choice "A" is correct. The lessee should begin the recognition of lease expenses for the new office in January, as this is the commencement date. The commencement date is the date the underlying asset is made available to the lessee for use. Lease expense is recorded over the lease term. Choice "B" is incorrect. The recognition of lease expense for the new offices would not begin in March when the alterations began but in January, the commencement date, when the asset became available for lessee use. Choice "C" is incorrect. The recognition of lease expense for the new offices would not begin in May when the company's staff moved into the property but in January, the commencement date, when the asset became available for lessee use. Choice "D" is incorrect. The recognition of lease expense for the new offices would not begin in July when the payments began on the property but in January, the commencement date, when the company entered into the operating lease for the property and the asset became available for lessee use. Able Co. leased equipment to Baker under a noncancellable lease with a transfer of title. Will Able record depreciation expense on the leased asset and interest revenue related to the lease? Depreciation Interest expense revenue A. Yes Yes B. Yes No c. No No © D No Yes

Explanation Choice "D" is correct. Baker, the lessee, will capitalize the lease (due to the transfer of title) and will incur both depreciation and interest expense. Able will earn and book interest income when the payments from Baker are received. Able will remove the asset from its books at the inception of the lease and will not depreciate the asset. Which of the following statements regarding the lessor’s accounting under an operating lease is most accurate? A. Depreciation is booked over the life of the lease. B. Income earned over the life of the lease is part interest and part principal. C. Any applicable impairment charges to the leased asset will be booked by the lessee. © D. Arefundable security deposit is booked as a liability until refunded to the lessee. Explanation Choice “D” is correct. If a security deposit is refundable to the lessee, the lessor has to book the deposit as a liability until the point it is returned to the lessee (typically at the end of the lease). Choice “A” is incorrect. The lessor will keep the asset on his/her books and take depreciation over the life of the asset (rather than the life of the lease). Choice “B” is incorrect. The lessor will recognize rental income over the life of an operating lease. Choice “C” is incorrect. The lessor will book any relevant impairment charges to the asset.

The lessee should recognize amounts probable of being owed under a residual value guarantee as a component of lease payments: A. Atthe conclusion of the lease. B. At no time during the lease term. C. On a straight-line basis during the lease. D. On the commencement date of the lease. Choice "D" is correct. The lessee calculates lease payments at commencement of the lease based on the present value of the following items: fixed payments, variable payments, exercise price of purchase option, termination penalties, and the probable amount owed of the guaranteed residual Choice the commencement of the lease, not at the end of the lease term. is incorrect. The probable amount of the guaranteed residual value is included in the lease payment calculation at Choice "B" is incorrect. If the residual value is not guaranteed, it will not be included in the present value calculation of the lease payments. The probable amount of the guaranteed residual value is included in the calculation of lease payments on the lessee's books. Choice "C" is incorrect. The probable amount of the guaranteed residual value is included in the lease payments. As the company makes the payments, the lease liability is reduced using the effective interest method, not the straight-line method, to allocate the lease payment between interest expense and the reduction of the lease liability.

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Assuming that no direct costs are involved, what are the components of the lease receivable for a lessor involved in a direct- financing lease? A. The minimum lease payments plus any executory costs. © B. The minimum lease payments plus residual value. C. The minimum lease payments less residual value. D. The minimum lease payments less executory costs. Explanation Choice "B" is correct. Lessors recording a lease receivable for a direct-financing lease should include the minimum lease payments PLUS any residual value. The reason for this is because the lessor can also expect to collect this residual value from the lessee at the culmination of the lease. Choice "A" is incorrect. Executory costs, like insurance, taxes, and maintenance, are always recorded separately and do not affect the computation of the minimum lease payments nor the lease receivable. Choice "C" is incorrect. The residual value needs to be added, not subtracted, since the lessee is obligated to pay this to the lessor at the culmination of the lease. Choice "D" is incorrect. Executory costs do not affect the computation of the lease receivable.

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 No C. Yes Yes Explanation Choice "D" 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 " At the inception of a finance lease, the residual value expected to be owed at the end of the lease term should be: A. Included as part of minimum lease payments at present value. B. Included as part of minimum lease payments at future value. C. Included as part of minimum lease payments only to the extent that guaranteed residual value is expected to exceed estimated residual value. D. Excluded from minimum lease payments.

Explanation Choice "A" is correct. The residual value expected to be owed at the end of the lease term is, in effect, an additional lease payment and must be included in the calculation of the present value of the minimum lease payments. Choice "B" is incorrect. Finance leases are valued at present value rather than future value. Choice "C" is incorrect. Because the residual value expected to be owed at the end of the lease term is effectively an additional lease payment, its full value must be included in the calculation of the present value of the minimum lease payments. Choice "D" is incorrect. The residual value expected to be owed at the end of the lease term is, in effect, an additional lease payment As an inducement to enter a lease, Graf Co., a lessor, granted Zep, Inc., a lessee, twelve months of free rent under a five-year operating lease. The lease was effective on January 1, Year 1, and provides for monthly lease payments to begin January 1, Year 2. Zep made the first lease payment on December 30, Year 1. In its Year 1 income statement, Graf should report lease revenue in an amount equal to: A. Zero. B. Cash received during Year 1 C. One-fourth of the total cash to be received over the life of the lease. © D. One-fifth of the total cash to be received over the life of the lease.

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Explanation Choice "D" is correct. Annual lease revenue equals the total lease revenue from the lease allocated over the full life of the lease. In this case, revenue equals total cash divided by five years. Choice "A" is incorrect. Since a service was provided and the revenue is realizable through future collections, revenue must be recognized in Year 1 Choice is incorrect. Revenue is recognized when a performance obligation is satisfied. In the case of leases, this obligation is satisfied over the life of the lease. Cash basis accounting would recognize revenue when cash was collected. Choice "C" is incorrect. Revenue is recognized over the full life of the lease (five years) rather being limited to the time frame during which cash is collected

On January 1, Year 1, a shipping company sells a boat and leases it from the buyer in a sale-leaseback transaction. At the end of the 10-year lease, ownership of the boat reverts to the shipping company. The fair value of the boat, at the time of the transaction, was less than its undepreciated cost. Which of the following outcomes most likely will result from the sale-leaseback transaction? A. The boat will not be classified in property, plant and equipment of the shipping company. B. The shipping company will recognize the total profit on the sale of the boat in the current year. C. The shipping company will not recognize depreciation expense for the boat in the current year. © D. The shipping company will recognize in the current year a loss on the sale of the boat Able sold its headquarters building at a gain, and simultaneously leased back the building. The lease was reported as a finance lease under U.S. GAAP. At the time of sale, the sale-leaseback will be considered: A. Operating income. B. Areduction of lease expense. C. A separate component of stockholders' equity. D A failed sale. Explanation Choice "D" is correct. A failed sale_ Rule: If the underlying lease in a sale-leaseback is a finance lease, it is considered equivalent to a repurchase and will therefore be considered a "failed sale." Choices "A", "B", and "C" are incorrect, per the explanation above.

Choice "D" is correct. GAAP requires that a loss to be recognized immediately in a sales-leaseback transaction when the fair value of the property at the time of the sale-leaseback is less than book value. Accordingly, the shipping company will recognize a loss in the current year because the fair value at the time of the sales-leaseback transaction was less than the undepreciated cost. Choice "A" is incorrect. The boat will likely be classified in property, plant, and equipment of the shipping company if the lease is regarded as a finance lease. Choice "B" is incorrect. This sales-leaseback transaction results in a loss to the shipping company that is recognized in the current year. Choice "C" is incorrect. If the lease is recognized as a finance lease, the leased asset will likely be depreciated in a manner consistent with the lessee’s normal policies.

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