Leases

Hard Practice Test

Intermediate Accounting 2

Key Things To Know

j

Practice As You Learn

Self Test

b

Easy Practice Test

h

Medium Practice Test

i

Hard Practice Test

Hard Practice Test

Click the “Check Your Answer” box below each problem to reveal the correct answer and explanation.

1. When the lessee’s interest rate is different than the lessor’s interest rate

a. the cost or residual value of the leased asset is unknown
b. the lessee and lessor will use the same amortization schedule
c. either the lessee or the lessor has not followed GAAP
d. this situation will not occur with a finance lease

Answer
A. This situation can occur when the rate, the cost, and the residual value is unknown to the lessee. In this case, GAAP requires the lessee to use their incremental borrowing rate for the annual financing rate. Different rates necessitate different amortization schedules.

2. Fair market value of the asset is greater than the cost of manufacturing the asset. The lessee’s payments will cover substantially all the fair value of the asset and the lessor reasonably expects to collect all payments. The lessor should account for this lease as

a. a sales-type lease with profit
b. a direct financing lease with profit
c. an operating lease
d. a purchase lease

Answer
A. A lessor who leases the asset for more than the cost of the asset is in substance selling the asset at a profit. A direct financing lease occurs when a 3rd party guarantees some of the value. The situation meets one of the five criteria for a sales-type lease (substantially all of the fair value) and therefore is not an operating lease. GAAP has no classification called a “purchase” lease.

3. Total lease payments do not include

a. fixed payments specified in the lease agreement
b. penalties for non-payment stated in the lease agreement
c. variable payments based on an inflation index
d. the excess of a guaranteed residual value over the expected residual value at the end of the lease

Answer
B. Total lease payments include a., c., and d.

4. The useful life used to compute amortization on a right to use asset is

a. the life of the asset when title transfers to the lessee
b. the life of the lease when title transfers to the lessee
c. the total life of the lease when there is a bargain purchase option
d. the life of the asset when the lease contains a residual value

Answer
A. The amount of amortization is based on the life of the asset when the lessee will own and use asset after the lease ends which occurs with a title transfer or bargain purchase option. The life of the lease is used when the lease contains a residual value and the asset is returned to the lessor at the end of the lease.

5. When recording a sale leaseback

a. the lessor buys the asset and depreciates the cost of the asset
b. the lessee sells the asset and records a gain or loss on the sale
c. the sale occurs at the end of the lease
d. the lessee accounts for the lease using very different accounting procedures than a finance or sales-type lease

Answer
B. The lessee sells the asset and then immediately leases the asset back. The lessee records a gain or loss in the same way they record the sale of an asset that is not leased-back. The lessor exchanges the leased asset for a lease receivable and does not depreciate the cost of the asset. The lessee accounts for the sale lease-back in the same way as they do for a lease that does not include a sale prior to the lease.

6. An unguaranteed residual value in a sales-type with profit lease

a. is not included when determining the amount of lease receivable
b. is included in the present value of lease payment when determining the amount of lease receivable
c. is not included when determining the value recorded for sales revenue
d. is not part of the value the lessor must receive from the use of the asset

Answer
C. The lessor does not include the unguaranteed residual value (RV) in the sale price of the leased asset in a sales-type with profit lease because the buyer who finances the purchase will not pay for the unguaranteed residual value amount. Unguaranteed residual value is included in the lease receivable because the lessor will receive the RV when the asset is returned.

7. The lessee always records a right to use asset at the present value of total lease payments at inception of the lease except when the agreement contains

a. a reasonably certain purchase option
b. an un-guaranteed residual value
c. a guaranteed residual value
d. there is no exception

Answer
D. Without exception, the lessee records the right to use asset at the present value of the total lease payments when the lease begins. The payments cover the cost of the asset to the lessee and the interest expense. The bargain purchase option and residual value are included in the fixed payments specified in the agreement.

8. A modification of a lease agreement requires the lessee to

a. recompute the present value of the total lease payments since the original inception of the lease
b. continue using the prior lease payable amount
c. continue to use the prior amortization schedule
d. recompute the present value of the lease payments using the remaining lease payments and adjust the lease payable to the recomputed value

Answer
D. When a lease agreement is modified, the lessee must adjust the lease payable to the present value of the remaining lease payments under the modified agreement. The lessee must use a revised amortization schedule that begins with the recomputed lease payable to compute interest expense for the remainder of the lease term.

9. The lessor will not consider the residual value when computing the lease payment when the agreement

a. contains a purchase option the lessee will reasonably exercise before the agreement terminates
b. specifies an un-guaranteed residual value
c. specifies a guaranteed residual value
d. meets the criteria for a sale-lease back

Answer
A. A residual value (both guaranteed and unguaranteed) is not applicable when the lessee is reasonably expected to purchase the asset prior to the end of the lease. The amount for the periodic payments will consider the purchase price and ignore the residual value. A sale-leaseback agreement considers the residual value when there is no purchase option.

10. The purpose of the amortization schedule is to

a. determine when the lessee will repay the amount owed
b. determine the implicit interest rate
c. determine interest expense for each period
d. determine the present value of lease payments

Answer
C. The amortization schedule is used to determine the interest expense portion of the periodic payment given the amount owed during the period. The payment amount, interest rate, and present value of lease payments are known (stated in the agreement or computed) prior to preparing the amortization schedule.
11. At the beginning of the current year, Krey Company leased a machine that it manufactured for a cost of $100,000 for the fair value of $135,000. The initial lease term is 3 years with the option to extend for 3 more years and Krey Co. expects the lessee to extend the lease. The lessor assumed an unguaranteed residual value of $10,000 that is not stated in the lease. Most buyers of the same machine use the machine for 7 years. The lessor determined the payment using a 9% annual rate. The lessee is unaware of the fair value and the lessor’s annual rate. The lessee must return the asset to the lessor at the end of the lease. The lessee’s incremental borrowing rate is 7%. The lessee agreed to pay periodic payments at the inception of the lease and the end of each subsequent year.

A. Calculate the lease payment.
B. Prepare the lease amortization schedule for the lessor and the lessee.
C. Prepare the journal entries for the beginning of the lease for the lessor
D. Record all journal entries on 12/31/Y2 for the lessor and the lessee.
E. Record the settlement of the unguaranteed residual value at the end of the lease given the machine has a fair value of $8,000 at the end of year 6.
F. Determine the amount that the lessee will record the right of use asset.
G. State the line items and the amounts the lessor and the lessee will report on the financial statements for the year ended 12/31/Y1.

Answer

 Use 6 years as the lease term since the lessor reasonably expects the lessee to exercise the extension.

Use 9% for the lessor, the amount they used to determine the payment
Use the incremental borrowing rate for the lessee of 7% given the lessee does not have the information necessary to determine the rate the lessor used to determine the payment.  The payment will be the same for both parties.

A. Calculate the lease payment: 6p/9%

Lessor:

Cost or FMV of asset 135,000
– Present value of RV or BPO (  5,963)
= Payments cover 129,037
/ PV factor from annuity due table 4.88965

= Annual Payment                                           

26,390

Lessee: 6p / 7%
Cost or FMV of asset 134,594
– Present value of RV or BPO (          0)
= Payments cover 134,594
/ PV factor from annuity due table 5.10020
= Annual Payment 26,390

B. Amortization Schedule

Lessor:

Payment
Date		 Payments 9%
Interest		 Decrease Outstanding
    Balance
1/1/20X1 $135,000
1/1/20X1 $26,390 $26,390 $108,610
12/31/X1 $26,390 $9,775  $16,615 $  91,995
12/31/X2 $26,390 $8,280 $18,110 $  73,884
12/31/X3 $26,390 $6,650 $19,740 $  54,144
12/31/X4 $26,390 $4,873  $21,517 $  32,627
12/31/X5 $26,390 $2,936 $23,454 $    9,173
12/31/X6 $10,000 $   826 $  9,173 $           0

Lessee:

Payment
Date		 Payments 7%
Interest		 Decrease Outstanding
    Balance
1/1/20X1 $134,594
1/1/20X1 $26,390 $26,390 $108,204
1/1/20X1 $26,390 $7,574 $18,816 $  89,388
1/1/20X2 $26,390 $6,257 $20,133 $  69,255
1/1/20X3 $26,390 $4,848 $21,542 $  47,713
1/1/20X4 $26,390 $3,340 $23,050 $  24,663
1/1/20X5 $26,390 $1,726 $24,664 $            0

C. Beginning of the Lease for Lessor:

Lease Receivable                $135,000
            Sales Revenue                    $135,000
Cost of Goods Sold             $100,000
            Inventory                               $100,000
Cash                                      $26,390
            Lease Receivable                $26,390

D. End of the year, 12/31/Y2

Lessor Lessee
 
Cash                          $26,390 Interest Expense      $  6,257
            Lease Receivable    $18,110 Lease Payable           $20,133
            Interest Revenue    $  8,280             Cash                          $26,390
 
Amortization Expense      $22,449

            Right to Use Asset      $22,449 
            ($134,594 / 6-yr life of asset)

E. End of the lease

Lessor                      Lessee
Loss on Lease              $2,000 No Entry
Asset                              $8,000 Right to Use Asset balance = 0
            Interest Receivable      $9,174
            Interest Revenue          $   826

 

F.  Cost of the Asset to the Lessee:

PV of lease payments = $134,594

 

G.  Reported on the Y1 financial statements:

Lessee:

Interest Expense     7,574
Amortization Expense

  22,449 

Right to Use Asset

112,145
Lease Liability   89,388

134,594 – 22,449 = 112,145

Lessor:

Interest Revenue   9,775
Lease Receivable 91,995
12. England Construction Company, leased heavy construction equipment from Atwater on the beginning of the current year with an initial lease term of 4 years. England can require Atwater to extend the lease for 2 additional years. The fair market value of the equipment was $291,881 at inception of the lease, which is also the lessee’s cost to lease the equipment. The lease contains a guaranteed residual value of $65,000. Periodic payments made at the inception of the lease and the end of each year are $50,257. The equipment has a useful life of 8 years with an expected residual value of $25,000 at the end of 8 years. The fair market value of the equipment at the end of the lease is $75,000.

A. Determine the implicit interest rate in the lease.
B. Prepare the lease amortization schedule for the lessee and the lessor for the first 2
years of the lease.
C. Prepare the journal entries at the inception of the lease for the lessee and the lessor.
D. Prepare the journal entries at the end of the third year for the lessee and
the lessor.
E. Prepare the journal entries for the transfer of the asset at the end of the lease for
the lessee and the lessor.
F. State the line items and the amounts the lessor and the lessee will report on the financial statements for the year ended X3 (third year).

Answer

Include the time the lessor can require the lessee to extend the lease in the lease term.

A. Recalculate the lease payment and plug to find the rate that makes the PV factor
the rate that works the formula

Cost or FMV of asset                               291,881
– Present value of RV or BPO                ( 40,961) 65,000 x .63017 6p/8%
= Payments cover                                    250,920
/ PV factor from annuity table             4.99271 PV table annuity due 6p/8%
= Annual Payment                                  50,257

The lease is 6 periods. Try one interest rate and see how close you are and then try another one until you see that 8% works.

B. Amortization Schedule:

Payment
Date		 Payments 8%
Interest		 Decrease Outstanding
Balance
 
1/1/20X1       $291,881
1/1/20X1 $50,257   $50,257 $241,624
12/31/X1 $50,257 $19,330 $30,927 $210,697
12/31/X2 $50,257 $16,856 $33,401 $177,296
12/31/X3 $50,257 $14,184 $36,073 $141,222
12/31/X4 $50,257 $11,298 $38,959 $102,263
12/31/X4 $50,257 $  8,181 $42,076 $  60,187
12/31/X4 $65,000 $  4,813 $60,187 $            0

C. Beginning of the Lease:

                Lessor                    Lessee
 
Lease Receivable      $291,881   Right of Use Asset     $291,881
            Asset                        $291,881               Lease Payable                $291,881
 
Cash                         $50,257   Lease Payable             $50,257
            Lease Receivable          $50,257               Cash                             $50,257

D. Year 3:

                             Lessor                                Lessee
 
Cash                         $50,257   Interest Expense             $14,184
            Lease Receivable             $36,073   Lease Payable                 $36,073
            Interest Revenue             $14,184               Cash                                     $50,257
 
    Amortization Expense     $48,647
                Right to Use Asset            $48,647
                  ($291,881 / 6 year lease)

E. End of the lease asset transfer

                      Lessor                                Lessee
 
Asset                         $65,000   No Entry
            Lease Receivable     $60,187   Right to Use Asset balance = 0
            Interest Revenue     $ 4,813    

F. Reported on the Year 3 financial statements:

Lessee:

Interest Expense 14,184
Amortization Expense 48,647
 
Right to Use Asset 145,940
Lease Liability 141,222

291,881 less (48,647 x 3 years) = 145,940

Lessor:

Interest Revenue   14,184
Lease Receivable 141,222
13. At the beginning of the current year, Small Town Groceries sold its manufacturing plant, which cost $900,000 and had accumulated depreciation of $425,000 to United Grocers, Inc. for $815,000. United Grocers immediately leased the building, for a total cost of $800,000, to Small Town Groceries for 10 annual payments, due at the beginning of each year. The terms of the lease agreement provide a bargain purchase option at the end of 5 years for $350,000, otherwise title transfers to Small Town Groceries at the end of the lease. The interest rate in the lease is 12%. The building has a useful life at the time of the lease of 30 years. Small Town Groceries has a history of having a shortage of cash and difficulty obtaining financing.

A. Calculate the annual lease payment
B. Prepare the lease amortization schedule for the first 4 years.
C. Prepare the journal entries at the beginning of the current year for the lessee and
the lessor.
D. Prepare the journal entries at the end of year 4 for the lessee and the lessor.
E. State the line items and the amounts the lessor and the lessee will report on the financial statements for the year ended X4 (fourth year).

Answer

Given Small Town Groceries has a history of not having cash and difficulty obtaining financing – United Grocers will not assume that Small Town Groceries will exercise the purchase option.

A. Calculate the lease payment: 10p / 12%

Cost or FMV of asset                                  800,000
– Present value of RV or BPO                   (           0)
= Payments cover                                       800,000
/ PV factor from annuity table                 6.32825
= Annual Payment                                      126,417

B. Amortization Schedule:

Payment
Date		 Payments 12%
Interest		 Decrease Outstanding
Balance
 
1/1/20X1 $800,000
1/1/20X1 $126,417 $126,417 $673,583
12/31/X1 $126,417 $80,830 $ 45,587 $627,996
12/31/X2 $126,417 $75,360 $ 51,057 $576,938
12/31/X3 $126,417 $69,233 $ 57,184 $519,754
12/31/X4 $126,417 $62,370 $ 64,047 $455,708

C. Beginning of the Current Year:

                        Lessor                           Lessee
 
Building             $815,000 Cash                            $815,000
            Cash                         $815,000 Accumulated Depr   $415,000
            Building                         $900,000
            Gain on Sale                  $330,000
 
Loss on Lease             $ 15,000
Lease Receivable       $800,000 Right of Use Asset     $800,000
            Asset                         $815,000             Lease Payable              $800,000
 
Cash                         $126,417 Lease Payable             $126,417
            Lease Receivable    $126,417             Cash                             $126,417

D. End of Year 4:

                        Lessor                           Lessee
 
Cash                           $126,417 Interest Expense     $62,370
            Lease Receivable     $64,047 Lease Payable          $64,047
            Interest Revenue     $62,370             Cash                         $126,417
 
Amortization Expense     $80,000
            Right to Use Asset        $80,000
            ($800,000 / 10-year lease)

E. Reported on the Year 4 financial statements:

Lessee:

Interest Expense 62,370
Amortization Expense 80,000
 
Right to Use Asset 480,000
Lease Liability 455,708

800,000 less 80,000 x 4 years = 480,000

Lessor:

Interest Revenue   62,370
Lease Receivable 455,708