Leases

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Intermediate Accounting 2

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1. Which of the following is NOT one of the criteria that requires a lease to be accounted for as a finance lease.

a. ownership transfers to the lessee
b. the lessor reasonably expects the lessee to purchase the asset prior to or at the end of the lease
c. the lease term is for most of the asset’s useful life
d. the lessor can use the asset in other ways

Answer
D. One of the criteria is that the asset is specialized and the lessor does not expect to have an alternative use if the lessee does not pay for using the asset. The other three stated above are criteria that if met require accounting for a finance lease.

2. Which of the following accounts does the lessor use to record an operating lease?

a. lease revenue and deferred lease revenue
b. equipment (the asset) and lease receivable
c. lease liability and right to use asset
d. amortization expense and interest expense

Answer
A. Cash the lessor receives from the lessee for an operating lease in advance is recorded as deferred lease revenue until time passes and the revenue is earned. The lessor reports the asset instead of a lease receivable on the balance sheet. The lessee uses the accounts in c. and d.

3. A bargain purchase option only occurs when

a. the purchase price is $1
b. the purchase price is high enough to reasonably expect the purchase to occur
c. the purchase price is low enough to reasonably expect the sale purchase to occur
d. the lease is an operating lease

Answer
C. A bargain purchase is defined as a price that is low enough to reasonably expect the lessee will exercise the option to purchase the right to use asset. The dollar amount depends on the expected value of the asset at the time the option goes into effect and the periodic payment amount. A purchase option prevents the lease from being accounted for as an operating lease.

4. A lessor may classify a lease as

a. financing or capital
b. capital or direct financing
c. operating or capital
d. a sales-type with or without sales profit

Answer
D. The types of capital leases for a lessor are operating, direct financing or sales type. The sales type lease is either with sales profit or without sales profit.

5. The lessee reports the asset obtained through a finance lease at

a. present value of lease payments on a subsequent balance sheet date
b. the fair market value of the asset at inception of the lease
c. total of all lease payments
d. the lessee does not report the asset

Answer
B. The lessee records the asset at cost, which is equal to the present value of the lease payments at inception of the lease. Cost is also equal to fair market value at the inception of the lease. The value reported for the leased asset is established at the inception of the lease and the cost does not change as time passes.

6. The lease term does not include

a. the noncancelable lease period
b. reasonably certain lessee renewal options
c. time after the purchase option a lessee is expected to exercise
d. lessor controlled options for renewal

Answer
C. The lease is assumed to end on the date of a purchase option because the lease will end when the lessee purchases the right to use asset. The lease term includes all time that the lessee is reasonably expected to pay to use the right to use asset.

7. The present value table the lessor should use for a sales-type lease that requires the lessee to make payments at the beginning of the period is

a. ordinary annuity
b. typical annuity
c. annuity due
d. annuity owed

Answer
C. The present value of an annuity due is used when payment is made at the beginning of the period.

8. Which account will the lessor increase when initially accounting for a finance lease?

a. the asset
b. lease receivable
c. lease liability
d. interest expense

Answer
B. The lessor records a reduction to the asset and an increase to a lease receivable. The lease receivable is debited. The asset is credited. The lessee, not the lessor, uses the accounts lease liability and interest expense.

9. Which account would the lessee increase when recording transactions related to a finance lease?

a. accumulated amortization
b. right to use asset
c. lease receivable
d. interest revenue

Answer
B. When recording an initial finance lease, the lessee increases (debit) a right to use asset and increases (credits) lease payable. The lessor records a lease receivable and interest revenue. The lessee reduces the right to use asset directly as time passes and the accumulated amortization account is not used.

10. The amortization schedule for a lease with a guaranteed residual value begins with

a. the fair market value of the asset at the inception of the lease
b. the cost of the asset to the lessee
c. the present value of minimum lease payments
d. all of the above

Answer
D. The amortization schedule begins with the fair market value of the asset for the lessee and the lessor. The fair market value is also the cost to the lessee and the present value of minimum lease payments. All these terms mean the same thing for a lease with a guaranteed residual value because the entire cost is covered by the lease.

11. Deseret Finance Company purchased a printing press to lease to Quality Printing Company. The lease was structured so that at the end of the lease period of 15 years, Quality would own the printing press. The periodic lease payment is $190,000, payable at the beginning of the lease and the end of each year the lease is in effect. The cost of the printing press to Deseret was $1,589,673, which is also the fair market value at the time of the lease. The interest rate stated in the lease is 10%. The printing press has a useful life of 20 years with a residual value of $0 at the end of 20 years.

A. Recompute the annual payment
B. Prepare an amortization schedule for the first three payments of the lease
C. Record the entry made at the inception of the lease for the lessor and the lessee
D. Record the entry(s) at the end of year 1 for the lessor
E. Record the entry(s) at the end of year 2 for the lessee

Answer

The title transfer and PV of MLP at 100% make this a finance (lessee) and sales-type (lessor) lease.

A. Calculate the lease payment: 15p/ 10%

Cost or FMV of asset                 1,589,673
– Present value of RV or BPO                  0
= Payments cover                      1,589,673
/ PV factor from annuity due      8.36669
= Annual Payment                        190,000

B. Amortization Schedule – Payments made at the beginning of the lease:

Payment
Date		 Payments 10%
Interest		 Decrease Outstanding
    Balance
 
1/1/20X1 $1,589,673
1/1/20X1 $190,000 $190,000 $1,399,673
12/31/X1 $190,000 $139,967 $ 50,033 $1,349,640
12/31/X2 $190,000 $134,964 $ 55,036 $1,294,604

C. Inception of the lease

Lessor Lessee
 
Lease Receivable     $1,589,673 Right of Use Asset     $1,589,673
              Asset                          $1,589,673              Lease Payable             $1,589,673
 
Cash                           $190,000 Lease Payable            $190,000
         Lease Receivable          $190,000             Cash                               $190,000

D. Lessor – End of Year 1

Cash $190,000
          Lease Receivable                 $  50,033
          Interest Revenue                 $139,967

E. Lessee – End of Year 2

Interest Expense $134,964
Lease Payable $ 55,036
          Cash                   $190,000
Amortization Expense $79,484
          Right to Use Asset            $79,484

Depreciation Expense =
   1,589,673 –  0
20 years: life of asset

Use the life of the asset when the lessee will keep the asset

12. At the beginning of the current year, Jewell Company leased equipment for 15 years. Annual payments of $75,000 are payable at the beginning of the lease and the end of each year the lease is in effect. The interest rate is 7%. Jewell recorded a lease payable of $740,000, the fair value of the equipment. The leased equipment has a useful life of 18 years. The lease has a guaranteed residual value of $135,000. The fair market value at the end of the lease was $150,000. The interest for the last year on the last amount owed is $8,834.

A. Prepare an amortization schedule for the first three payments of the lease
B. Record the entry made at the inception of the lease for the lessor and the lessee
C. Record the entries required at the end of year 2 for the lessor and the lessee
D. Record the entries required at the end of the lease for the lessor and the lessee.

Answer

Finance and Sales-type without profit lease:

The lease is for 15 years / 18-year life, greater than 75% of the life of the asset.
The PV of lease payments is 100% of the fair value of the equipment

A. Amortization Schedule:

Payment
Date		 Payments 10%
Interest		 Decrease Outstanding
    Balance
1/1/20X1 $740,000 
1/1/20X1 $  70,912 $  70,912  $669,088 
12/31/X1 $  70,912  $46,836  $  24,076  $645,012 
12/31/X2 $  70,912  $45,151  $  25,761  $619,251
Year 14 $  xx,xxx $xx,xxx $   xx,xxx $126,166
Year 15 $135,000 $  8,834 $126,166 $           0

B. Inception of the lease

Lessor Lessee
 
Lease Receivable     $740,000 Right of Use Asset     $740,000
              Asset                          $740,000              Lease Payable            $740,000
 
Cash                           $70,912 Lease Payable           $70,912
         Lease Receivable          $70,912             Cash                               $70,912

B. Inception of the lease

Lessor Lessee
 
Cash                          $70,912 Interest Expense      $45,151
              Lease Receivable     $25,761 Lease Payable           $25,761
              Interest Revenue     $45,151              Cash                          $70,912
 
Amortization Expense   $49,333
                     Right to Use Asset      $49,333
             ($740,000  / 15 yr life of asset)      

C.  End of Year 2

Asset $135,000                       No entry – right to use asset is at 0
          Lease Receivable           $126,166
          Interest Revenue           $    8,834

13. Universal Leasing leases electronic equipment to a variety of businesses at an interest rate of 10% and the intent to earn profit on the equipment. Universal leased a server purchased for $30,000 to Howe, Inc. for $35,000 for 5 years with a guaranteed residual value at the end of the lease of $6,000. Periodic payments are due at the inception of the lease and the end of each year thereafter. The server has a typical useful life of 6 years.

A. Calculate the lease payment
B. Prepare the amortization schedule for the lease.
C. Prepare the journal entries at the inception of the lease for the lessee and the lessor
D. Record the entry at the end of the third year for the lessee and the lessor
E. Record the entries required at the end of the lease given the FMV of the equipment is $4,000 at the end of the lease.

Answer

This is a finance (lessee) and sales-type with profit (lessor) lease. The present value of minimum lease payments is substantially all of the cost. The asset is leased for more than 75% of useful life (5/6). Two of the five criteria are met.

A. Calculate the lease payment: 5p / 10%

Cost or FMV of asset 35,000
– Present value of RV or BPO (3,726)
= Payments cover 31,274
/ PV factor from annuity table 4.16987
= Annual Payment 7,500

B. Amortization Schedule:

Payment
Date		 Payments 10%
Interest		 Decrease Outstanding
 Balance
1/1/20X1 $35,000 
1/1/20X1 $7,500 $7,500  $27,500 
12/31/X1 $7,500  $2,750  $4,750  $22,750 
12/31/X2 $7,500  $2,275  $5,225  $17,525 
12/31/X3 $7,500 $1,752 $5,748 $11,778
12/31/X4 $7,500  $1,178  $6,322  $  5,455 
12/31/X5 $6,000  $   545  $5,455  $           0

C. Inception of the lease

Lessor Lessee
 
Lease Receivable    $35,000 Right of Use Asset     $35,000
              Sales Revenue        $35,000              Lease Payable            $35,000
Cost of Goods Sold $30,000
              Inventory                 $30,000
 
Cash                           $7,500 Lease Payable          $7,500
         Lease Receivable          $7,500             Cash                              $7,500

D. End of  Year 3:

Lessor Lessee
 
Cash                          $7,500 Interest Expense      $1,752
              Lease Receivable        $5,748 Lease Payable           $5,748
              Interest Revenue        $1,752              Cash                                $7,500
 
Amortization Expense  $7,000
                     Right to Use Asset        $7,000
             ($35,000  / 5 yr life of asset)  

D.  End of Lease

Asset                          $4,000 Loss on Lease          $2,000
Cash                           $2,000              Cash                          $2,000
          Lease Receivable        $5,455
          Interest Revenue        $   545

14. At the beginning of the current year, Jewell Company leased a common piece of equipment for 3 years. The lessee will pay annual payments of $6,000 at the beginning of each year, and the interest rate is 6%. The equipment cost the lessor $65,000. The leased equipment has an estimated useful life of 17 years. The lessee will not own the equipment.

A. Compute the PV of the lease payments
B. Prepare the amortization schedule
C. Record all journal entries associated with the lease at inception.
D. Record all journal entries associated with the lease for the second year of the lease.

Answer

The lease is an operating lease. None of the 5 criteria are met:

1) There is no title transfer

2) The life of the lease is not greater than most (75%) of the life (3 / 15 = 20%)

3) The present value of minimum lease payment is not greater than 90% of the cost of the asset (less than $22,038 compared to $65,000)

4) There is no bargain purchase option

5) The asset is useful to the lessor after the lease ends

A. Compute the PV of the lease payment: 3p/6%

Cost or FMV of asset 17,000
– Present value of RV or BPO     (0)
= Payments cover 17,000
/ PV factor from annuity table 2.83339
= Annual Payment 6,000

Work up from 6,000 payment given to compute the cost or FMV which equal the PV of payments.

B. Amortization Schedule:

Payment
Date		 Payments 10%
Interest		 Decrease Outstanding
    Balance
1/1/20X1 $17,000 
1/1/20X1 $6,000 $6,000  $11,000 
12/31/X1 $6,000  $660  $5,340  $  5,660 
12/31/X2 $6,000  $340  $5,660  $          0  

C. Inception of the lease

Lessor Lessee
Right of Use Asset     $17,000

No entry

 

             Lease Payable            $17,000

 
Cash                             $6,000 Lease Payable            $6,000
              Deferred Revenue      $6,000             Cash                            $6,000

D. Second year of Lease

Lessor Lessee
Cash                            $6,000 Lease Payable            $6,000
              Deferred Revenue      $6,000              Cash                            $6,000
 
 Deferred Revenue      $6,000  Interest Expense         $    660
            Lease Revenue          $6,000             Lease Payable            $  660
       
Depreciation Expense     $3,824 Amortization Expense     $5,340   
            Accumulated Depreciation    $3,824            Right of Use Asset           $5,340
        ($65,000 / 17 year life)         ($6,000 payment – $660 interest)