ACCOUNTING FOR LEASES | My Assignment Tutor

CHAPTER 21 ACCOUNTING FOR LEASES IFRS questions are available at the end of this chapter. Multiple Choice—Conceptual Answer No. Description d 21. Advantages of leasing. d 22. Advantages of leasing. b 23. Basic principle of lease accounting. c 24. Conceptual support for treating all leases as a sale/purchase. a S25. Essential element of a lease. b S26. Bargain purchase option and minimum lease payments. b P27. Cost amount for a capital lease. a 28. Lease accounting by lessee. c 29. Knowledge of the capitalization criteria. d 30. Components of minimum lease payments. d 31. Identification of executory costs. c 32. Discount rate used by lessee. a 33. Depreciation of a leased asset by lessee. b 34. Effect of a capital lease on lessee’s debt. a P35. Depreciation of a capital lease. a 36. Identification of lease type for lessor. d 37. Elements of lease receivable by lessor. a 38. Recognition of unearned lease income. c S39. Direct-financing lease receivable. d S40. Third party guarantee of residual value. a 41. Lessor’s accounting for residual value. c 42. Accounting for initial direct costs. c S43. Difference between direct financing and sales-type lease. b P44. Amount of revenue in sales-type lease. c 45. Accounting for a sales-type lease. d 46. Accounting for initial direct costs. c 47. Disclosing obligations under capital leases. c 48. Leasing criteria to avoid asset capitalization. d *49. Recording asset and interest expense in sale-leaseback lease. b *50. Accounting for sale-leaseback lease. d *51. Gain/loss recognition in a sale-leaseback. P These questions also appear in the Problem-Solving Survival Guide. S These questions also appear in the Study Guide. *This topic is dealt with in an Appendix to the chapter. Multiple Choice—Computational Answer No. Description b 52. Operating lease expense for year. c 53. Calculate interest expense and depreciation expense for lessee. c 54. Calculate minimum annual lease payment. d 55. Calculate total annual lease payment. a 56. Identification of lease type for lessor. c 57. Identification of lease type for lessee. c 58. Calculate depreciation expense for lessee. d 59. Identification of lease type for lessee. c 60. Calculate leased asset amount. c 61. Calculate total lease obligation. a 62. Compute interest expense for year. b 63. Compute interest expense for year. d 64. Calculate lease liability amount. c 65. Compute interest expense and depreciation expense for year. c 66. Compute interest expense and depreciation expense for year. d 67. Compute depreciation expense for lease with transfer of title. a 68. Calculate leased asset amount. c 69. Compute interest expense for first year. d 70. Compute principal reduction for second year. c 71. Calculate depreciation expense for lessee. b 72. Compute interest expense for first year. c 73. Calculate leased asset and lease liability amounts. a 74. Calculate annual lease payments. b 75. Identification of lease type for lessee. b 76. Expense recorded by lessee/operating lease. c 77. Calculate reduction of lease obligation for lessee. a 78. Identification of lease type for lessor. c 79. Calculate lease receivable. d 80. Revenues and expenses recorded by lessor/operating lease. a 81. Operating lease expense for year. d 82. Calculate expense of an operating lease. a 83. Calculate income from operating lease. d 84 Journal entry in direct-financing lease. b 85. Calculate lease payments. b 86. Journal entry for lessee. c 87. Journal entry for lessee. c 88. Calculate loss on guaranteed residual value lease. c 89. Calculate interest revenue in sales-type lease. c 90. Determine gross profit and interest revenue. a 91. Calculate interest expense and depreciation expense for lessee. b 92. Calculate profit and interest income for lessor/sales-type lease. c 93. Calculate profit on sales-type lease and interest income. c 94. Identification of lease type for lessor. b 95. Determine discount rate implicit in lease payments. d 96. Lease-related expenses recognized by lessee. d 97. Determine long-term lease obligation for lessee. b *98. Gain recognized by lessee in a sale-leaseback. b *99. Sale-leaseback/operating lease. Exercises Item Description E21-110 Capital lease (essay). E21-111 Capital lease amortization and journal entries. E21-112 Operating lease. E21-113 Lease criteria for classification by lessor. E21-114 Direct-financing lease (essay). E21-115 Lessor accounting—sales-type lease. *E21-116 Lessee and lessor accounting (sale-leaseback). *E21-117 Sale-leaseback. PROBLEMS Item Description P21-118 Lessee accounting—capital lease. P21-119 Lessee accounting—capital lease. P21-120 Lessor accounting—direct-financing lease. MULTIPLE CHOICE—Conceptual 21. Major reasons why a company may become involved in leasing to other companies is (are) a. interest revenue. b. high residual values. c. tax incentives. d. all of these. 22. Which of the following is an advantage of leasing? a. Off-balance-sheet financing b. Less costly financing c. 100% financing at fixed rates d. All of these 23. Which of the following best describes current practice in accounting for leases? a. Leases are not capitalized. b. Leases similar to installment purchases are capitalized. c. All long-term leases are capitalized. d. All leases are capitalized. 24. While only certain leases are currently accounted for as a sale or purchase, there is theoretic justification for considering all leases to be sales or purchases. The principal reason that supports this idea is that a. all leases are generally for the economic life of the property and the residual value of the property at the end of the lease is minimal. b. at the end of the lease the property usually can be purchased by the lessee. c. a lease reflects the purchase or sale of a quantifiable right to the use of property. d. during the life of the lease the lessee can effectively treat the property as if it were owned by the lessee. S25. An essential element of a lease conveyance is that the a. lessor conveys less than his or her total interest in the property. b. lessee provides a sinking fund equal to one year’s lease payments. c. property that is the subject of the lease agreement must be held for sale by the lessor prior to the drafting of the lease agreement. d. term of the lease is substantially equal to the economic life of the leased property. S26. What impact does a bargain purchase option have on the present value of the minimum lease payments computed by the lessee? a. No impact as the option does not enter into the transaction until the end of the lease term. b. The lessee must increase the present value of the minimum lease payments by the present value of the option price. c. The lessee must decrease the present value of the minimum lease payments by the present value of the option price. d. The minimum lease payments would be increased by the present value of the option price if, at the time of the lease agreement, it appeared certain that the lessee would exercise the option at the end of the lease and purchase the asset at the option price. P27. The amount to be recorded as the cost of an asset under capital lease is equal to the a. present value of the minimum lease payments. b. present value of the minimum lease payments or the fair value of the asset, whichever is lower. c. present value of the minimum lease payments plus the present value of any unguaranteed residual value. d. carrying value of the asset on the lessor’s books. 28. The methods of accounting for a lease by the lessee are a. operating and capital lease methods. b. operating, sales, and capital lease methods. c. operating and leveraged lease methods. d. none of these. 29. Which of the following is a correct statement of one of the capitalization criteria? a. The lease transfers ownership of the property to the lessor. b. The lease contains a purchase option. c. The lease term is equal to or more than 75% of the estimated economic life of the leased property. d. The minimum lease payments (excluding executory costs) equal or exceed 90% of the fair value of the leased property. 30. Minimum lease payments may include a a. penalty for failure to renew. b. bargain purchase option. c. guaranteed residual value. d. any of these. 31. Executory costs include a. maintenance. b. property taxes. c. insurance. d. all of these. 32. In computing the present value of the minimum lease payments, the lessee should a. use its incremental borrowing rate in all cases. b. use either its incremental borrowing rate or the implicit rate of the lessor, whichever is higher, assuming that the implicit rate is known to the lessee. c. use either its incremental borrowing rate or the implicit rate of the lessor, whichever is lower, assuming that the implicit rate is known to the lessee. d. none of these. 33. In computing depreciation of a leased asset, the lessee should subtract a. a guaranteed residual value and depreciate over the term of the lease. b. an unguaranteed residual value and depreciate over the term of the lease. c. a guaranteed residual value and depreciate over the life of the asset. d. an unguaranteed residual value and depreciate over the life of the asset. 34. In the earlier years of a lease, from the lessee’s perspective, the use of the a. capital method will enable the lessee to report higher income, compared to the operating method. b. capital method will cause debt to increase, compared to the operating method. c. operating method will cause income to decrease, compared to the capital method. d. operating method will cause debt to increase, compared to the capital method. P35. A lessee with a capital lease containing a bargain purchase option should depreciate the leased asset over the a. asset’s remaining economic life. b. term of the lease. c. life of the asset or the term of the lease, whichever is shorter. d. life of the asset or the term of the lease, whichever is longer. 36. Based solely upon the following sets of circumstances indicated below, which set gives rise to a sales-type or direct-financing lease of a lessor? Transfers Ownership Contains Bargain Collectibility of Lease Any Important By End Of Lease? Purchase Option? Payments Assured? Uncertainties? a. No Yes Yes No b. Yes No No No c. Yes No No Yes d. No Yes Yes Yes 37. Which of the following would not be included in the Lease Receivable account? a. Guaranteed residual value b. Unguaranteed residual value c. A bargain purchase option d. All would be included 38. In a lease that is appropriately recorded as a direct-financing lease by the lessor, unearned income a. should be amortized over the period of the lease using the effective interest method. b. should be amortized over the period of the lease using the straight-line method. c. does not arise. d. should be recognized at the lease’s expiration. S39. In order to properly record a direct-financing lease, the lessor needs to know how to calculate the lease receivable. The lease receivable in a direct-financing lease is best defined as a. the amount of funds the lessor has tied up in the asset which is the subject of the direct-financing lease. b. the difference between the lease payments receivable and the fair market value of the leased property. c. the present value of minimum lease payments. d. the total book value of the asset less any accumulated depreciation recorded by the lessor prior to the lease agreement. S40. If the residual value of a leased asset is guaranteed by a third party a. it is treated by the lessee as no residual value. b. the third party is also liable for any lease payments not paid by the lessee. c. the net investment to be recovered by the lessor is reduced. d. it is treated by the lessee as an additional payment and by the lessor as realized at the end of the lease term. 41. When lessors account for residual values related to leased assets, they a. always include the residual value because they always assume the residual value will be realized. b. include the unguaranteed residual value in sales revenue. c. recognize more gross profit on a sales-type lease with a guaranteed residual value than on a sales-type lease with an unguaranteed residual value. d. All of the above are true with regard to lessors and residual values. 42. The initial direct costs of leasing a. are generally borne by the lessee. b. include incremental costs related to internal activities of leasing, and internal costs related to costs paid to external third parties for originating a lease arrangement. c. are expensed in the period of the sale under a sales-type lease. d. All of the above are true with regard to the initial direct costs of leasing. S43. The primary difference between a direct-financing lease and a sales-type lease is the a. manner in which rental receipts are recorded as rental income. b. amount of the depreciation recorded each year by the lessor. c. recognition of the manufacturer’s or dealer’s profit at the inception of the lease. d. allocation of initial direct costs by the lessor to periods benefited by the lease arrangements. P44. A lessor with a sales-type lease involving an unguaranteed residual value available to the lessor at the end of the lease term will report sales revenue in the period of inception of the lease at which of the following amounts? a. The minimum lease payments plus the unguaranteed residual value. b. The present value of the minimum lease payments. c. The cost of the asset to the lessor, less the present value of any unguaranteed residual value. d. The present value of the minimum lease payments plus the present value of the unguaranteed residual value. 45. For a sales-type lease, a. the sales price includes the present value of the unguaranteed residual value. b. the present value of the guaranteed residual value is deducted to determine the cost of goods sold. c. the gross profit will be the same whether the residual value is guaranteed or unguaranteed. d. none of these. 46. Which of the following statements is correct? a. In a direct-financing lease, initial direct costs are added to the net investment in the lease. b. In a sales-type lease, initial direct costs are expensed in the year of incurrence. c. For operating leases, initial direct costs are deferred and allocated over the lease term. d. All of these. 47. The Lease Liability account should be disclosed as a. all current liabilities. b. all noncurrent liabilities. c. current portions in current liabilities and the remainder in noncurrent liabilities. d. deferred credits. 48. To avoid leased asset capitalization, companies can devise lease agreements that fail to satisfy any of the four leasing criteria. Which of the following is not one of the ways to accomplish this goal? a. Lessee uses a higher interest rate than that used by lessor. b. Set the lease term at something less than 75% of the estimated useful life of the property. c. Write in a bargain purchase option. d. Use a third party to guarantee the asset’s residual value. *49. If the lease in a sale-leaseback transaction meets one of the four leasing criteria and is therefore accounted for as a capital lease, who records the asset on its books and which party records interest expense during the lease period? Party recording the Party recording asset on its books interest expense a. Seller-lessee Purchaser-lessor b. Purchaser-lessor Seller-lessee c. Purchaser-lessor Purchaser-lessor d. Seller-lessee Seller-lessee *50. In a sale-leaseback transaction where none of the four leasing criteria are satisfied, which of the following is false? a. The seller-lessee removes the asset from its books. b. The purchaser-lessor records a gain. c. The seller-lessee records the lease as an operating lease. d. All of the above are false statements. *51. When a company sells property and then leases it back, any gain on the sale should usually be a. recognized in the current year. b. recognized as a prior period adjustment. c. recognized at the end of the lease. d. deferred and recognized as income over the term of the lease. Multiple Choice Answers—Conceptual ItemAns.ItemAns.ItemAns.ItemAns.ItemAns.ItemAns.ItemAns.21.d26.b31.d36.a41.a46.d*51.d22.d27.b32.c37.d42.c47.c23.b28.a33.a38.a43.c48.c24.c29.c34.b39.c44.b*49.d25.a30.d35.a40.d45.c*50.b Multiple Choice—Computational 52. On December 1, 2011, Goetz Corporation leased office space for 10 years at a monthly rental of $90,000. On that date Perez paid the landlord the following amounts: Rent deposit $ 90,000 First month’s rent 90,000 Last month’s rent 90,000 Installation of new walls and offices 495,000 $765,000 The entire amount of $765,000 was charged to rent expense in 2011. What amount should Goetz have charged to expense for the year ended December 31, 2011? a. $90,000 b. $94,125 c. $184,125 d. $495,000 53. On January 1, 2011, Dean Corporation signed a ten-year noncancelable lease for certain machinery. The terms of the lease called for Dean to make annual payments of $100,000 at the end of each year for ten years with title to pass to Dean at the end of this period. The machinery has an estimated useful life of 15 years and no salvage value. Dean uses the straight-line method of depreciation for all of its fixed assets. Dean accordingly accounted for this lease transaction as a capital lease. The lease payments were determined to have a present value of $671,008 at an effective interest rate of 8%. With respect to this capitalized lease, Dean should record for 2011 a. lease expense of $100,000. b. interest expense of $44,734 and depreciation expense of $38,068. c. interest expense of $53,681 and depreciation expense of $44,734. d. interest expense of $45,681 and depreciation expense of $67,101. Use the following information for questions 54 through 59. (Annuity tables on page 21-20.) On January 1, 2011, Yancey, Inc. signs a 10-year noncancelable lease agreement to lease a storage building from Holt Warehouse Company. Collectibility of lease payments is reasonably predictable and no important uncertainties surround the amount of costs yet to be incurred by the lessor. The following information pertains to this lease agreement. (a) The agreement requires equal rental payments at the end of each year. (b) The fair value of the building on January 1, 2011 is $3,000,000; however, the book value to Holt is $2,500,000. (c) The building has an estimated economic life of 10 years, with no residual value. Yancey depreciates similar buildings on the straight-line method. (d) At the termination of the lease, the title to the building will be transferred to the lessee. (e) Yancey’s incremental borrowing rate is 11% per year. Holt Warehouse Co. set the annual rental to insure a 10% rate of return. The implicit rate of the lessor is known by Yancey, Inc. (f) The yearly rental payment includes $10,000 of executory costs related to taxes on the property. 54. What is the amount of the minimum annual lease payment? (Rounded to the nearest dollar.) a. $188,237 b. $478,236 c. $488,236 d. $498,236 55. What is the amount of the total annual lease payment? a. $188,237 b. $478,237 c. $488,237 d. $498,237 56. From the lessee’s viewpoint, what type of lease exists in this case? a. Sales-type lease b. Sale-leaseback c. Capital lease d. Operating lease 57. From the lessor’s viewpoint, what type of lease is involved? a. Sales-type lease b. Sale-leaseback c. Direct-financing lease d. Operating lease 58. Yancey, Inc. would record depreciation expense on this storage building in 2011 of (Rounded to the nearest dollar.) a. $0. b. $250,000. c. $300,000. d. $488,237. 59. If the lease were nonrenewable, there was no purchase option, title to the building does not pass to the lessee at termination of the lease and the lease were only for eight years, what type of lease would this be for the lessee? a. Sales-type lease b. Direct-financing lease c. Operating lease d. Capital lease 60. Metcalf Company leases a machine from Vollmer Corp. under an agreement which meets the criteria to be a capital lease for Metcalf. The six-year lease requires payment of $102,000 at the beginning of each year, including $15,000 per year for maintenance, insurance, and taxes. The incremental borrowing rate for the lessee is 10%; the lessor’s implicit rate is 8% and is known by the lessee. The present value of an annuity due of 1 for six years at 10% is 4.79079. The present value of an annuity due of 1 for six years at 8% is 4.99271. Metcalf should record the leased asset at a. $509,256. b. $488,661. c. $434,366. d. $416,799. 61. On December 31, 2011, Lang Corporation leased a ship from Fort Company for an eight-year period expiring December 30, 2019. Equal annual payments of $200,000 are due on December 31 of each year, beginning with December 31, 2011. The lease is properly classified as a capital lease on Lang ‘s books. The present value at December 31, 2011 of the eight lease payments over the lease term discounted at 10% is $1,173,685. Assuming all payments are made on time, the amount that should be reported by Lang Corporation as the total obligation under capital leases on its December 31, 2012 balance sheet is a. $1,091,054. b. $1,000,159. c. $871,054. d. $1,200,000. Use the following information for questions 62 and 63. On January 1, 2011, Sauder Corporation signed a five-year noncancelable lease for equipment. The terms of the lease called for Sauder to make annual payments of $50,000 at the beginning of each year for five years with title to pass to Sauder at the end of this period. The equipment has an estimated useful life of 7 years and no salvage value. Sauder uses the straight-line method of depreciation for all of its fixed assets. Sauder accordingly accounts for this lease transaction as a capital lease. The minimum lease payments were determined to have a present value of $208,493 at an effective interest rate of 10%. 62. In 2011, Sauder should record interest expense of a. $15,849. b. $29,151. c. $20,849. d. $34,151. 63. In 2012, Sauder should record interest expense of a. $10,849. b. $12,434. c. $15,849. d. $17,434. 64. On December 31, 2011, Kuhn Corporation leased a plane from Bell Company for an eight-year period expiring December 30, 2019. Equal annual payments of $150,000 are due on December 31 of each year, beginning with December 31, 2011. The lease is properly classified as a capital lease on Kuhn’s books. The present value at December 31, 2011 of the eight lease payments over the lease term discounted at 10% is $880,264. Assuming the first payment is made on time, the amount that should be reported by Kuhn Corporation as the lease liability on its December 31, 2011 balance sheet is a. $880,264. b. $818,290. c. $792,238. d. $730,264. Use the following information for questions 65 and 66. On January 1, 2011, Ogleby Corporation signed a five-year noncancelable lease for equipment. The terms of the lease called for Ogleby to make annual payments of $60,000 at the end of each year for five years with title to pass to Ogleby at the end of this period. The equipment has an estimated useful life of 7 years and no salvage value. Ogleby uses the straight-line method of depreciation for all of its fixed assets. Ogleby accordingly accounts for this lease transaction as a capital lease. The minimum lease payments were determined to have a present value of $227,448 at an effective interest rate of 10%. 65. With respect to this capitalized lease, for 2011 Ogleby should record a. rent expense of $60,000. b. interest expense of $22,745 and depreciation expense of $45,489. c. interest expense of $22,745 and depreciation expense of $32,493. d. interest expense of $30,000 and depreciation expense of $45,489. 66. With respect to this capitalized lease, for 2012 Ogleby should record a. interest expense of $22,745 and depreciation expense of $32,493. b. interest expense of $20,469 and depreciation expense of $32,493. c. interest expense of $19,019 and depreciation expense of $32,493. d. interest expense of $14,469 and depreciation expense of $32,493. 67. Emporia Corporation is a lessee with a capital lease. The asset is recorded at $450,000 and has an economic life of 8 years. The lease term is 5 years. The asset is expected to have a market value of $150,000 at the end of 5 years, and a market value of $50,000 at the end of 8 years. The lease agreement provides for the transfer of title of the asset to the lessee at the end of the lease term. What amount of depreciation expense would the lessee record for the first year of the lease? a. $90,000 b. $80,000 c. $60,000 d. $50,000 68. Pisa, Inc. leased equipment from Tower Company under a four-year lease requiring equal annual payments of $86,038, with the first payment due at lease inception. The lease does not transfer ownership, nor is there a bargain purchase option. The equipment has a 4-year useful life and no salvage value. If Pisa, Inc.’s incremental borrowing rate is 10% and the rate implicit in the lease (which is known by Pisa, Inc.) is 8%, what is the amount recorded for the leased asset at the lease inception? PV Annuity Due PV Ordinary Annuity 8%, 4 periods 3.57710 3.31213 10%, 4 periods 3.48685 3.16986 a. $307,767 b. $272,728 c. $284,969 d. $300,000 69. Pisa, Inc. leased equipment from Tower Company under a four-year lease requiring equal annual payments of $86,038, with the first payment due at lease inception. The lease does not transfer ownership, nor is there a bargain purchase option. The equipment has a 4-year useful life and no salvage value. Pisa, Inc.’s incremental borrowing rate is 10% and the rate implicit in the lease (which is known by Pisa, Inc.) is 8%. Assuming that this lease is properly classified as a capital lease, what is the amount of interest expense recorded by Pisa, Inc. in the first year of the asset’s life? PV Annuity Due PV Ordinary Annuity 8%, 4 periods 3.57710 3.31213 10%, 4 periods 3.48685 3.16986 a. $0 b. $24,621 c. $17,738 d. $22,798 70. Pisa, Inc. leased equipment from Tower Company under a four-year lease requiring equal annual payments of $86,038, with the first payment due at lease inception. The lease does not transfer ownership, nor is there a bargain purchase option. The equipment has a 4 year useful life and no salvage value. Pisa, Inc.’s incremental borrowing rate is 10% and the rate implicit in the lease (which is known by Pisa, Inc.) is 8%. Assuming that this lease is properly classified as a capital lease, what is the amount of principal reduction recorded when the second lease payment is made in Year 2? PV Annuity Due PV Ordinary Annuity 8%, 4 periods 3.57710 3.31213 10%, 4 periods 3.48685 3.16986 a. $86,038 b. $61,417 c. $63,240 d. $68,300 71. Pisa, Inc. leased equipment from Tower Company under a four-year lease requiring equal annual payments of $86,038, with the first payment due at lease inception. The lease does not transfer ownership, nor is there a bargain purchase option. The equipment has a 4-year useful life and no salvage value. Pisa, Inc.’s incremental borrowing rate is 10% and the rate implicit in the lease (which is known by Pisa, Inc.) is 8%. Pisa, Inc. uses the straight-line method to depreciate similar assets. What is the amount of depreciation expense recorded by Pisa, Inc. in the first year of the asset’s life? PV Annuity Due PV Ordinary Annuity 8%, 4 periods 3.57710 3.31213 10%, 4 periods 3.48685 3.16986 a. $0 because the asset is depreciated by Tower Company. b. $71,242 c. $76,942 d. $75,000 72. Haystack, Inc. manufactures machinery used in the mining industry. On January 2, 2011 it leased equipment with a cost of $200,000 to Silver Point Co. The 5-year lease calls for a 10% down payment and equal annual payments at the end of each year. The equipment has an expected useful life of 5 years. Silver Point’s incremental borrowing rate is 10%, and it depreciates similar equipment using the double-declining balance method. The selling price of the equipment is $325,000, and the rate implicit in the lease is 8%, which is known to Silver Point Co. What is the amount of interest expense recorded by Silver Point Co. for the year ended December 31, 2011? PV Annuity Due PV Ordinary Annuity PV Single Sum 8%, 5 periods 4.31213 3.99271 .68508 10%, 5 periods 4.16986 3.79079 .62092 a. $29,250 b. $23,400 c. $26,000 d. $32,500 73. Haystack, Inc. manufactures machinery used in the mining industry. On January 2, 2011 it leased equipment with a cost of $200,000 to Silver Point Co. The 5-year lease calls for a 10% down payment and equal annual payments of $73,259 at the end of each year. The equipment has an expected useful life of 5 years. Silver Point’s incremental borrowing rate is 10%, and it depreciates similar equipment using the double-declining balance method. The selling price of the equipment is $325,000, and the rate implicit in the lease is 8%, which is known to Silver Point Co. What is the book value of the leased asset at December 31, 2011, and what is the balance in the Lease Liability account? Book Value of Balance in Lease Leased Asset Liability________ a. $325,000 $219,243 b. $260,000 $248,491 c. $195,000 $242,643 d. $208,000 $248,491 74. Haystack, Inc. manufactures machinery used in the mining industry. On January 2, 2011 it leased equipment with a cost of $200,000 to Silver Point Co. The 5-year lease calls for a 10% down payment and equal annual payments at the end of each year. The equipment has an expected useful life of 5 years. If the selling price of the equipment is $325,000, and the rate implicit in the lease is 8%, what are the equal annual payments? PV Annuity Due PV Ordinary Annuity PV Single Sum 8%, 5 periods 4.31213 3.99271 .68508 10%, 5 periods 4.16986 3.79079 .62092 a. $73,259 b. $67,831 c. $75,822 d. $81,398 Use the following information for questions 75 through 80. (Annuity tables on page 21-25.) Alt Corporation enters into an agreement with Yates Rentals Co. on January 1, 2011 for the purpose of leasing a machine to be used in its manufacturing operations. The following data pertain to the agreement: (a) The term of the noncancelable lease is 3 years with no renewal option. Payments of $155,213 are due on December 31 of each year. (b) The fair value of the machine on January 1, 2011, is $400,000. The machine has a remaining economic life of 10 years, with no salvage value. The machine reverts to the lessor upon the termination of the lease. (c) Alt depreciates all machinery it owns on a straight-line basis. (d) Alt’s incremental borrowing rate is 10% per year. Alt does not have knowledge of the 8% implicit rate used by Yates. (e) Immediately after signing the lease, Yates finds out that Alt Corp. is the defendant in a suit which is sufficiently material to make collectibility of future lease payments doubtful. 75. What type of lease is this from Alt Corporation’s viewpoint? a. Operating lease b. Capital lease c. Sales-type lease d. Direct-financing lease 76. If Alt accounts for the lease as an operating lease, what expenses will be recorded as a consequence of the lease during the fiscal year ended December 31, 2011? a. Depreciation Expense b. Rent Expense c. Interest Expense d. Depreciation Expense and Interest Expense 77. If the present value of the future lease payments is $400,000 at January 1, 2011, what is the amount of the reduction in the lease liability for Alt Corp. in the second full year of the lease if Alt Corp. accounts for the lease as a capital lease? (Rounded to the nearest dollar.) a. $115,213 b. $123,213 c. $126,734 d. $133,070 78. From the viewpoint of Yates, what type of lease agreement exists? a. Operating lease b. Capital lease c. Sales-type lease d. Direct-financing lease 79. If Yates records this lease as a direct-financing lease, what amount would be recorded as Lease Receivable at the inception of the lease? a. $155,213 b. $385,991 c. $400,000 d. $465,638 80. Which of the following lease-related revenue and expense items would be recorded by Yates if the lease is accounted for as an operating lease? a. Rental Revenue b. Interest Income c. Depreciation Expense d. Rental Revenue and Depreciation Expense 81. Hook Company leased equipment to Emley Company on July 1, 2010, for a one-year period expiring June 30, 2011, for $60,000 a month. On July 1, 2011, Hook leased this piece of equipment to Terry Company for a three-year period expiring June 30, 2014, for $75,000 a month. The original cost of the equipment was $4,800,000. The equipment, which has been continually on lease since July 1, 2006, is being depreciated on a straight-line basis over an eight-year period with no salvage value. Assuming that both the lease to Emley and the lease to Terry are appropriately recorded as operating leases for accounting purposes, what is the amount of income (expense) before income taxes that each would record as a result of the above facts for the year ended December 31, 2011? Hook Emley Terry a. $210,000 $(360,000) $(450,000) b. $210,000 $(360,000) $(750,000) c. $810,000 $(60,000) $(150,000) d. $810,000 $(660,000) $(450,000) Use the following information for questions 82 and 83. Hull Co. leased equipment to Riggs Company on May 1, 2011. At that time the collectibility of the minimum lease payments was not reasonably predictable. The lease expires on May 1, 2012. Riggs could have bought the equipment from Hull for $3,200,000 instead of leasing it. Hull’s accounting records showed a book value for the equipment on May 1, 2008, of $2,800,000. Hull’s depreciation on the equipment in 2011 was $360,000. During 2011, Riggs paid $720,000 in rentals to Hull for the 8-month period. Hull incurred maintenance and other related costs under the terms of the lease of $64,000 in 2011. After the lease with Riggs expires, Hull will lease the equipment to another company for two years. 82. Ignoring income taxes, the amount of expense incurred by Riggs from this lease for the year ended December 31, 2011, should be a. $296,000. b. $360,000. c. $656,000. d. $720,000. 83. The income before income taxes derived by Hull from this lease for the year ended December 31, 2011, should be a. $296,000. b. $360,000. c. $656,000. d. $720,000. 84. On January 2, 2011, Gold Star Leasing Company leases equipment to Brick Co. with 5 equal annual payments of $40,000 each, payable beginning December 31, 2011. Brick Co. agrees to guarantee the $25,000 residual value of the asset at the end of the lease term. Brick’s incremental borrowing rate is 10%, however it knows that Gold Star’s implicit interest rate is 8%. What journal entry would Gold Star make at January 2, 2011 assuming this is a direct–financing lease? PV Annuity Due PV Ordinary Annuity PV Single Sum 8%, 5 periods 4.31213 3.99271 .68508 10%, 5 periods 4.16986 3.79079 .62092 a. Lease Receivable 225,000 Equipment 225,000 b. Lease Receivable 159,708 Loss 65,292 Equipment 225,000 c. Lease Receivable 167,155 Equipment 167,155 d. Lease Receivable 176,835 Equipment 176,835 85. Mays Company has a machine with a cost of $400,000 which also is its fair market value on the date the machine is leased to Park Company. The lease is for 6 years and the machine is estimated to have an unguaranteed residual value of $40,000. If the lessor’s interest rate implicit in the lease is 12%, the six beginning-of-the-year lease payments would be a. $92,361. b. $82,465. c. $78,180. d. $66,667. 86. On January 2, 2011, Gold Star Leasing Company leases equipment to Brick Co. with 5 equal annual payments of $40,000 each, payable beginning December 31, 2011. Brick Co. agrees to guarantee the $25,000 residual value of the asset at the end of the lease term. Brick’s incremental borrowing rate is 10%, however it knows that Gold Star’s implicit interest rate is 8%. What journal entry would Brick Co. make at December 31, 2011 to record the first lease payment? PV Annuity Due PV Ordinary Annuity PV Single Sum 8%, 5 periods 4.31213 3.99271 .68508 10%, 5 periods 4.16986 3.79079 .62092 a. Lease Liability 40,000 Cash 40,000 b. Lease Liability 25,853 Interest Expense 14,147 Cash 40,000 c. Lease Liability 23,285 Interest Expense 16,715 Cash 40,000 d. Lease Liability 8,285 Interest Expense 16,715 Cash 25,000 87. On January 2, 2010, Gold Star Leasing Company leases equipment to Brick Co. with 5 equal annual payments of $40,000 each, payable beginning December 31, 2010. Brick Co. agrees to guarantee the $25,000 residual value of the asset at the end of the lease term. Brick’s incremental borrowing rate is 10%, however it knows that Gold Star’s implicit interest rate is 8%. What journal entry would Brick Co. make at December 31, 2011 to record the second lease payment? PV Annuity Due PV Ordinary Annuity PV Single Sum 8%, 5 periods 4.31213 3.99271 .68508 10%, 5 periods 4.16986 3.79079 .62092 a. Lease Liability 40,000 Cash 40,000 b. Lease Liability 25,613 Interest Expense 14,387 Cash 40,000 c. Lease Liability 27,921 Interest Expense 12,079 Cash 40,000 d. Lease Liability 23,760 Interest Expense 16,240 Cash 40,000 88. Geary Co. leased a machine to Dains Co. Assume the lease payments were made on the basis that the residual value was guaranteed and Geary gets to recognize all the profits, and at the end of the lease term, before the lessee transfers the asset to the lessor, the leased asset and obligation accounts have the following balances: Leased equipment under capital lease $400,000 Less accumulated depreciation–capital lease 384,000 $ 16,000 Interest payable $ 1,520 Obligations under capital leases 14,480 $16,000 If, at the end of the lease, the fair market value of the residual value is $8,800, what gain or loss should Geary record? a. $6,480 gain b. $7,120 loss c. $7,200 loss d. $8,800 gain 89. Harter Company leased machinery to Stine Company on July 1, 2011, for a ten-year period expiring June 30, 2021. Equal annual payments under the lease are $75,000 and are due on July 1 of each year. The first payment was made on July 1, 2011. The rate of interest used by Harter and Stine is 9%. The cash selling price of the machinery is $525,000 and the cost of the machinery on Harter’s accounting records was $465,000. Assuming that the lease is appropriately recorded as a sale for accounting purposes by Harter, what amount of interest revenue would Harter record for the year ended December 31, 2011? a. $47,250 b. $40,500 c. $20,250 d. $0 90. Pye Company leased equipment to the Polan Company on July 1, 2011, for a ten-year period expiring June 30, 2021. Equal annual payments under the lease are $80,000 and are due on July 1 of each year. The first payment was made on July 1, 2011. The rate of interest contemplated by Pye and Polan is 9%. The cash selling price of the equipment is $560,000 and the cost of the equipment on Pye’s accounting records was $496,000. Assuming that the lease is appropriately recorded as a sale for accounting purposes by Eby, what is the amount of profit on the sale and the interest revenue that Pye would record for the year ended December 31, 2011? a. $64,000 and $50,400 b. $64,000 and $43,200 c. $64,000 and $21,600 d. $0 and $0 Use the following information for questions 91 and 92. Metro Company, a dealer in machinery and equipment, leased equipment to Sands, Inc., onJuly 1, 2011. The lease is appropriately accounted for as a sale by Metro and as a purchase by Sands. The lease is for a 10-year period (the useful life of the asset) expiring June 30, 2021. The first of 10 equal annual payments of $621,000 was made on July 1, 2011. Metro had purchased the equipment for $3,900,000 on January 1, 2011, and established a list selling price of $5,400,000 on the equipment. Assume that the present value at July 1, 2011, of the rent payments over the lease term discounted at 8% (the appropriate interest rate) was $4,500,000. 91. Assuming that Sands, Inc. uses straight-line depreciation, what is the amount of deprecia-tion and interest expense that Sands should record for the year ended December 31, 2011? a. $225,000 and $155,160 b. $225,000 and $180,000 c. $270,000 and $155,160 d. $270,000 and $180,000 92. What is the amount of profit on the sale and the amount of interest income that Metro should record for the year ended December 31, 2011? a. $0 and $155,160 b. $600,000 and $155,160 c. $600,000 and $180,000 d. $900,000 and $360,000 93. Roman Company leased equipment from Koenig Company on July 1, 2011, for an eight-year period expiring June 30, 2019. Equal annual payments under the lease are $300,000 and are due on July 1 of each year. The first payment was made on July 1, 2011. The rate of interest contemplated by Roman and Lennon is 8%. The cash selling price of the equipment is $1,861,875 and the cost of the equipment on Koenig’s accounting records was $1,650,000. Assuming that the lease is appropriately recorded as a sale for accounting purposes by Koenig, what is the amount of profit on the sale and the interest income that Lennon would record for the year ended December 31, 2011? a. $0 and $0 b. $0 and $62,475 c. $211,875 and $62,475 d. $211,875 and $74,475 Use the following information for questions 94 through 98. Gage Co. purchases land and constructs a service station and car wash for a total of $360,000. At January 2, 2010, when construction is completed, the facility and land on which it was constructed are sold to a major oil company for $400,000 and immediately leased from the oil company by Gage. Fair value of the land at time of the sale was $40,000. The lease is a 10-year, noncancelable lease. Gage uses straight-line depreciation for its other various business holdings. The economic life of the facility is 15 years with zero salvage value. Title to the facility and land will pass to Gage at termination of the lease. A partial amortization schedule for this lease is as follows: Payments Interest Amortization Balance Jan. 2, 2010 $400,000.00 Dec. 31, 2010 $65,098.13 $40,000.00 $25,098.13 374,901.87 Dec. 31, 2011 65,098.13 37,490.19 27,607.94 347,293.93 Dec. 31, 2012 65,098.13 34,729.39 30,368.74 316,925.19 94. From the viewpoint of the lessor, what type of lease is involved above? a. Sales-type lease b. Sale-leaseback c. Direct-financing lease d. Operating lease 95. What is the discount rate implicit in the amortization schedule presented above? a. 12% b. 10% c. 8% d. 6% 96. The total lease-related expenses recognized by the lessee during 2011 is which of the following? (Rounded to the nearest dollar.) a. $64,000 b. $65,098 c. $73,490 d. $61,490 97. What is the amount of the lessee’s liability to the lessor after the December 31, 2012 payment? (Rounded to the nearest dollar.) a. $400,000 b. $374,902 c. $347,294 d. $316,925 *98. The total lease-related income recognized by the lessee during 2011 is which of the following? a. $ -0- b. $2,667 c. $4,000 d. $40,000 *99. On June 30, 2011, Falk Co. sold equipment to an unaffiliated company for $700,000. The equipment had a book value of $630,000 and a remaining useful life of 10 years. That same day, Falk leased back the equipment at $7,000 per month for 5 years with no option to renew the lease or repurchase the equipment. Falk’s rent expense for this equipment for the year ended December 31, 2011, should be a. $84,000. b. $42,000. c. $35,000. d. $28,000. Multiple Choice Answers—Computational ItemAns.ItemAns.ItemAns.ItemAns.ItemAns.ItemAns.ItemAns.52.b59.d66.c73.c80.d87.c94.c53.c60.c67.d74.a81.a88.c95.b54.c61.c68.a75.b82.d89.c96.d55.d62.a69.c76.b83.a90.c97.d56.c63.b70.d77.c84.d91.a*98.b57.a64.d71.c78.a85.b92.b*99.b58.c65.c72.b79.c86.b93.c Future Value of Ordinary Annuity of 1 Period 5% 6% 8% 10% 12% 1 1.00000 1.00000 1.00000 1.00000 1.00000 2 2.05000 2.06000 2.08000 2.10000 2.12000 3 3.15250 3.18360 3.24640 3.31000 3.37440 4 4.31013 4.37462 4.50611 4.64100 4.77933 5 5.52563 5.63709 5.86660 6.10510 6.35285 6 6.80191 6.97532 7.33592 7.71561 8.11519 7 8.14201 8.39384 8.92280 9.48717 10.08901 8 9.54911 9.89747 10.63663 11.43589 12.29969 9 11.02656 11.49132 12.48756 13.57948 14.77566 10 12.57789 13.18079 14.48656 15.93743 17.54874 Present Value of an Ordinary Annuity of 1 Period 5% 6% 8% 10% 12% 1 .95238 .94340 .92593 .90909 .89286 2 1.85941 1.83339 1.78326 1.73554 1.69005 3 2.72325 2.67301 2.57710 2.48685 2.40183 4 3.54595 3.46511 3.31213 3.16986 3.03735 5 4.32948 4.21236 3.99271 3.79079 3.60478 6 5.07569 4.91732 4.62288 4.35526 4.11141 7 5.78637 5.58238 5.20637 4.86842 4.56376 8 6.46321 6.20979 5.74664 5.33493 4.96764 9 7.10782 6.80169 6.24689 5.75902 5.32825 10 7.72173 7.36009 6.71008 6.14457 5.65022 DERIVATIONS — Computational No. Answer Derivation 52. b $90,000 + = $94,125. 53. c $671,008 × .08 = $53,681, $671,008 ÷ 15 = $44,734. 54. c $3,000,000 ÷ 6.14457 = $488,236 (PV of Ordinary Annuity Table). 55. d $488,236 + $10,000 = $498,237. 56. c Conceptual. 57. a Conceptual, FV exceeds cost. 58. c $3,000,000 ÷ 10 = $300,000. 59. d 8/10 = .8 > 75% of economic life. 60. c ($102,000 – $15,000) × 4.99271 = $434,366. 61. c $1,173,685 – $200,000 = $973,685 × .10 = $97,369 $973,685 – ($200,000 – $97,369) = $871,054. 62. a ($208,493 – $50,000) × .10 = $15,849. 63. b [$158,493 – ($50,000 – $15,849)] × .10 = $12,434. 64. d $880,264 – $150,000 = $730,264. 65. c $227,448 × .10 = $22,745; ($227,448 – 0) ÷ 7 = $32,493. 66. c [$227,448 – ($60,000 – $22,745)] × .10 = $19,019. 67. d ($450,000 – $50,000) ÷ 8 = $50,000. 68 a $86,038  3.57710 = $307,767. 69. c $86,038  3.57710 = $307,767 ($307,767 – $86,038)  .08 = $17,738. 70. d $86,038  3.57710 = $307,767 $86,038 – [($307,767 – $86,038)  .08] = $68,300. 71. c $86,038  3.57710 = $307,767 ($307,767 – 0)  4 = $76,942. 72. b ($325,000  .90)  3.99271 = $73,259 $73,259  3.99271 = $292,502 $292,502  .08 = $23,400. DERIVATIONS — Computational (cont.) No. Answer Derivation 73. c $325,000 – (325,000  .40) = $195,000 $73,259  3.99271 = $292,502 $292,502 – [$73,259 – ($292,502  .08)] = $242,643. 74. a ($325,000 .90)  3.99271 = $73,259. 75. b $155,213 × 2.48685 = $385,991; $385,991 ———— = 96% > 90%. $400,000 76. b Conceptual. 77. c $400,000 – [$155,213 – ($400,000 × .1)] = $284,787. $155,213 – ($284,787 ×.1) = $126,734. 78. a Fails to meet Group II requirements. 79. c Fair value = $400,000. 80. d Conceptual. 81. a Hook: ($60,000 × 6) + ($75,000  6) – (4,800,000 ÷ 8) = $210,000 Emley: ($60,000) × 6 = $(360,000) Terry: ($75,000) × 6 = $(450,000). 82. d $720,000. 83. a $720,000 – $64,000 – $360,000 = $296,000. 84. d ($40,000  3.99271) + ($25,000  .68508) = $176,835. 85. b [$400,000 – ($40,000 × .50663)] ÷ 4.60478 = $82,465. 86. b ($40,000  3.99271) + ($25,000  .68508) = $176,835. $40,000 – ($176,835  .08) = $25,853. 87. c ($40,000  3.99271) + ($25,000  .68508) = $176,835 $40,000 – ($176,835  .08) = $25,853 ($176,835 – $25,853)  .08 = $12,079 Interest exp. 88. c $8,800 – $16,000 = ($7,200). 89. c ($525,000 – $75,000) × .09 × 6/12 = $20,250. 90. c $560,000 – $496,000 = $64,000; ($560,000 – $80,000) × .09 × 6/12 = $21,600. DERIVATIONS — Computational (cont.) No. Answer Derivation 91. a = $225,000. ($4,500,000 – $621,000) × .04 = $155,160. 92. b $4,500,000 – $3,900,000 = $600,000. ($4,500,000 – $621,000) × .04 = $155,160. 93. c $1,861,875 – $1,650,000 = $211,875. ($1,861,875 – $300,000) × .04 = $62,475. 94. c Conceptual. 95. b $40,000 $400,000 ———— = 10% or ————— = 6.1446* $400,000 $65,098.13 *6.1446 = PV factor of ordinary annuity of $1 for 10 years at 10%. 96. d [($400,000 – $40,000) ÷ 15] + $37,490 = $61,490. 97. d $316,925 (See amortization table.) *98. b ($400,000 – $360,000) ÷ 15 = $2,667. *99. b $7,000 × 6 = $42,000. Exercises Ex. 21-110—Capital lease (Essay). Explain the procedures used by the lessee to account for a capital lease. Solution 21-110 When the capital lease method is used, the lessee treats the lease transactions as if the asset were being purchased. The asset and liability are recorded at the lower of (1) the present value of the minimum lease payments (excluding executory costs) or (2) the fair value of the asset at the inception of the lease. The present value of the lease payments is computed using the lessee’s incremental borrowing rate, unless the implicit rate used by the lessor is lower and the lessee has knowledge of it. The effective-interest method is used to allocate each lease payment between interest expense and a reduction of the lease liability. If the lease transfers ownership or contains a bargain purchase option, the asset is amortized in a manner consistent with the lessee’s normal depreciation policy on assets owned, over the economic life of the asset and allowing for residual value. If the lease does not transfer ownership or contain a bargain purchase option, the leased asset is amortized over the lease term. Ex. 21-111—Capital lease amortization and journal entries. Hughey Co. as lessee records a capital lease of machinery on January 1, 2011. The seven annual lease payments of $350,000 are made at the end of each year. The present value of the lease payments at 10% is $1,704,000. Hughey uses the effective-interest method of amortization and sum-of-the-years’-digits depreciation (no residual value). Instructions (Round to the nearest dollar.) (a) Prepare an amortization table for 2011 and 2012. (b) Prepare all of Hughey’s journal entries for 2011. Solution 21-111 (a) Annual Reduction Date Payments 10% Interest Of Liability Lease Liability 1/1/11 $1,704,000 12/31/11 $350,000 $170,400 $179,600 1,524,400 12/31/12 350,000 152,440 197,560 1,326,840 (b) Leased Machinery 1,704,000 Lease Liability 1,704,000 Interest Expense 170,400 Lease Liability 179,600 Cash 350,000 Depreciation Expense (7/28 × $1,704,000) 426,000 Accumulated Depreciation 426,000 Ex. 21-112—Operating lease. Maris Co. purchased a machine on January 1, 2011, for $1,000,000 for the express purpose of leasing it. The machine is expected to have a five-year life, no salvage value, and be depreciated on a straight-line monthly basis. On April 1, 2011, under a cancelable lease, Maris leased the machine to Dunbar Company for $300,000 a year for a four-year period ending March 31, 2015. Maris incurred total maintenance and other related costs under the provisions of the lease of $15,000 relating to the year ended December 31, 2011. Harley paid $300,000 to Maris on April 1, 2011. Instructions [Assume the operating method is appropriate for parts (a) and (b).] (a) Under the operating method, what should be the income before income taxes derived by Maris Co. from this lease for the year ended December 31, 2011? (b) What should be the amount of rent expense incurred by Dunbar from this lease for the year ended December 31, 2011? Solution 21-112 (a) Revenue 4/1/11—12/31/11 ($300,000 × 9/12) $225,000 Expenses: Depreciation ($200,000 × 9/12) $150,000 Maintenance, etc. 15,000 165,000 Income before taxes $ 60,000 (b) Rent expense, 4/1/11—12/31/11 ($300,000 × 9/12) = $225,000. Ex. 21-113—Lease criteria for classification by lessor. What are the criteria that must be satisfied for a lessor to classify a lease as a direct-financing or sales-type lease? Solution 21-113 In order for a lessor to classify a lease as a direct-financing or a sales-type lease, the lease at the date of inception must satisfy one or more of the following Group I criteria (a, b, c, and d) and both of the following Group II criteria (a and b): Group I (a) The lease transfers ownership of the property to the lessee. (b) The lease contains a bargain purchase option. (c) The lease term is equal to 75% or more of the estimated economic life of the leased property. (d) The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90% of the fair value of the leased property. Group II (a) Collectibility of the payments required from the lessee is reasonably predictable. (b) No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease. Ex. 21-114—Direct-financing lease (essay). Explain the procedures used to account for a direct-financing lease. Solution 21-114 The lessor records the present value of the minimum lease payments (excluding executory costs) plus the present value of the unguaranteed residual value (a guaranteed residual value is included in the minimum lease payments) as Lease Receivable and removes the asset from the books. The lessor records payments received as a reduction in Lease Receivable and Interest Revenue. Interest revenue is recognized by using the effective-interest method. The implicit interest rate is applied to the declining balance of the Lease Receivable balance. The implicit rate is the rate of interest that will discount the minimum lease payments (excluding executory costs) and the unguaranteed residual value to the fair value of the asset at the inception of the lease. Ex. 21-115—Lessor accounting—sales-type lease. Hayes Corp. is a manufacturer of truck trailers. On January 1, 2011, Hayes Corp. leases ten trailers to Lester Company under a six-year noncancelable lease agreement. The following information about the lease and the trailers is provided: 1. Equal annual payments that are due on December 31 each year provide Hayes Corp. with an 8% return on net investment (present value factor for 6 periods at 8% is 4.62288). 2. Titles to the trailers pass to Lester at the end of the lease. 3. The fair value of each trailer is $50,000. The cost of each trailer to Hayes Corp. is $45,000. Each trailer has an expected useful life of nine years. 4. Collectibility of the lease payments is reasonably predictable and there are no important uncertainties surrounding the amount of costs yet to be incurred by Hayes Corp. Instructions (a) What type of lease is this for the lessor? Discuss. (b) Calculate the annual lease payment. (Round to nearest dollar.) (c) Prepare a lease amortization schedule for Hayes Corp. for the first three years. (d) Prepare the journal entries for the lessor for 2011 and 2012 to record the lease agreement, the receipt of the lease rentals, and the recognition of income (assume the use of a perpetual inventory method and round all amounts to the nearest dollar). Solution 21-115 (a) It is a sales-type lease to the lessor, Hayes Corp. Hayes’s (the manufacturer) profit upon sale is $50,000, which is recognized in the year of sale (2011). It is not an operating lease because title to the assets passes to the lessee, the present value ($500,000) of the minimum lease payments equals or exceeds 90% ($450,000) of the fair value of the leased trailers, collectibility is reasonably assured, and no important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor. The remaining accounting treatment is similar to that accorded a direct-financing lease. (b) ($50,000 × 10) ÷ 4.62288 = $108,158. (c) Lease Amortization Schedule (Lessor) Lease Annual Interest on Receivable Lease Date Lease Rental Lease Receivable Recovery Receivable 1/1/11 $500,000 12/31/11 $108,158 $40,000 $68,158 431,842 12/31/12 108,158 34,547 73,611 358,231 12/31/13 108,158 28,658 79,500 278,731 (d) January 1, 2011 Lease Receivable 500,000 Cost of Goods Sold 450,000 Sales Revenue 500,000 Inventory 450,000 December 31, 2011 Cash 108,158 Lease Receivable 68,158 Interest Revenue 40,000 December 31, 2012 Cash 108,158 Lease Receivable 73,611 Interest Revenue 34,547 *Ex. 21-116—Lessee and lessor accounting (sale-leaseback). On January 1, 2011, Morris Company sells land to Lopez Corporation for $6,000,000, and immediately leases the land back. The following information relates to this transaction: 1. The term of the noncancelable lease is 20 years and the title transfers to Morris Company at the end of the lease term. 2. The land has a cost basis of $5,040,000 to Morris. 3. The lease agreement calls for equal rental payments of $611,112 at the end of each year. 4. The land has a fair market value of $6,000,000 on January 1, 2011. 5. The incremental borrowing rate of Morris Company is 10%. Morris is aware that Lopez Corporation set the annual rentals to ensure a rate of return of 8%. 6. Morris Company pays all executory costs which total $255,000 in 2011. 7. Collectibility of the rentals is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. Instructions (a) Prepare the journal entries for the entire year 2011 on the books of Morris Company to reflect the above sale and lease transactions (include a partial amortization schedule and round all amounts to the nearest dollar.) (b) Prepare the journal entries for the entire year 2011 on the books of Lopez Corporation to reflect the above purchase and lease transactions. *Solution 21-116 (a) Morris Company (Lessee) January 1, 2011 Cash 6,000,000 Land 5,040,000 Unearned Profit on Sale-Leaseback 960,000 Leased Land Under Capital Leases 6,000,000 Lease Liability 6,000,000 Throughout 2011 Executory Costs (Insurance and Taxes) 255,000 Accounts Payable and Cash 255,000 December 31, 2011 Unearned Profit on Sale-Leaseback 48,000 Revenue from Sale-Leaseback ($960,000 ÷ 20) 48,000 Interest Expense 480,000 Lease Liability 131,112 Cash 611,112 Partial Lease Amortization Schedule Annual Interest Reduction of Date Lease Payment 8% Lease Obligation Balance 1/1/11 $6,000,000 12/31/11 $611,112 $480,000 $131,112 5,868,888 (b) Lopez Corporation (Lessor) January 1, 2011 Land 6,000,000 Cash 6,000,000 Lease Receivable 6,000,000 Land 6,000,000 December 31, 2011 Cash 611,112 Lease Receivable 131,112 Interest Revenue 480,000 *Ex. 21-117—Sale-leaseback. On January 1, 2011, Hester Co. sells machinery to Beck Corp. at its fair value of $480,000 and leases it back. The machinery had a carrying value of $420,000, the lease is for 10 years and the implicit rate is 10%. The lease payments of $71,000 start on January 1, 2011. Hester uses straight-line depreciation and there is no residual value. Instructions (a) Prepare all of Hester’s entries for 2011. (b) Prepare all of Beck’s entries for 2011. *Solution 21-117 (a) Hester Co. (Lessee) January 1, 2011 Cash 480,000 Machinery 420,000 Unearned Profit on Sale-Leaseback 60,000 Leased Machinery 480,000 Lease Liability 480,000 Lease Liability 71,000 Cash. 71,000 December 31, 2011 Depreciation Expense 48,000 Accumulated Depreciation—Capital Lease 48,000 Unearned Profit on Sale-Leaseback 6,000 Depreciation Expense 6,000 Interest Expense [10% × ($480,000 – $71,000)] 40,900 Interest Payable 40,900 (b) Beck Corp. (Lessor) January 1, 2011 Machinery 480,000 Cash 480,000 Lease Receivable 480,000 Machinery 480,000 Cash 71,000 Lease Receivable 71,000 December 31, 2011 Interest Receivable 40,900 Interest Revenue 40,900 PROBLEMS Pr. 21-118—Lessee accounting—capital lease. Eubank Company, as lessee, enters into a lease agreement on July 1, 2010, for equipment. The following data are relevant to the lease agreement: 1. The term of the noncancelable lease is 4 years, with no renewal option. Payments of $422,689 are due on June 30 of each year. 2. The fair value of the equipment on July 1, 2010 is $1,400,000. The equipment has an economic life of 6 years with no salvage value. 3. Eubank depreciates similar machinery it owns on the sum-of-the-years’-digits basis. 4. The lessee pays all executory costs. 5. Eubank’s incremental borrowing rate is 10% per year. The lessee is aware that the lessor used an implicit rate of 8% in computing the lease payments (present value factor for 4 periods at 8%, 3.31213; at 10%, 3.16986. Instructions (a) Indicate the type of lease Eubank Company has entered into and what accounting treatment is applicable. (b) Prepare the journal entries on Eubank’s books that relate to the lease agreement for the following dates: (Round all amounts to the nearest dollar. Include a partial amortization schedule.) 1. July 1, 2010. 2. December 31, 2010. 3. June 30, 2011. 4. December 31, 2011. Solution 21-118 (a) Capitalized amount: $422,689 × PV of an ordinary annuity for 4 periods at 8% $422,689 × 3.31213 = $1,400,000 Because the present value of the lease payments ($1,400,000) equals the fair value, $1,400,000, of the leased property, it is a capital lease and must be accounted for under the capital lease method. (b) 1. July 1, 2010 Leased Equipment Under Capital Leases 1,400,000 Lease Liability 1,400,000 2. December 31, 2010 Depreciation Expense 280,000 Accumulated Depreciation—Capital Leases [($1,400,000 × 4/10) × 6/12] 280,000 Interest Expense ($112,000 × 6/12) 56,000 Interest Payable 56,000 Lease Amortization Schedule Annual Interest on Reduction of Balance of Date Lease Payment Unpaid Obligation Lease Obligation Lease Obligation 7/1/10 $1,400,000 6/30/11 $422,689 $112,000 $310,689 1,089,311 6/30/12 422,689 87,145 335,544 753,767 3. June 30, 2011 Interest Expense 112,000 Lease Liability 310,689 Cash 422,689 (Interest payable entry assumed to have been reversed 1/1/11) 4. December 31, 2011 Depreciation Expense 490,000 Accumulated Depreciation—Capital Leases 490,000 [($1,400,000 × 4/10) × 6/12 plus ($1,400,000 × 3/10) × 6/12] Interest Expense ($87,145 × 6/12) 43,573 Interest Payable 43,573 Pr. 21-119—Lessee accounting—capital lease. Krause Company on January 1, 2011, enters into a five-year noncancelable lease, with four renewal options of one year each, for equipment having an estimated useful life of 10 years and a fair value to the lessor, Daly Corp., at the inception of the lease of $3,000,000. Krause’s incremental borrowing rate is 8%. Krause uses the straight-line method to depreciate its assets. The lease contains the following provisions: 1. Rental payments of $219,000 including $19,000 for property taxes, payable at the beginning of each six-month period. 2. A termination penalty assuring renewal of the lease for a period of four years after expiration of the initial lease term. 3. An option allowing the lessor to extend the lease one year beyond the last renewal exercised by the lessee. 4. A guarantee by Krause Company that Daly Corp. will realize $100,000 from selling the asset at the expiration of the lease. However, the actual residual value is expected to be $60,000. Instructions (a) What kind of lease is this to Krause Company? (b) What should be considered the lease term? (c) What are the minimum lease payments? (d) What is the present value of the minimum lease payments? (PV factor for annuity due of 20 semi-annual payments at 8% annual rate, 14.13394; PV factor for amount due in 20 interest periods at 8% annual rate, .45639.) (Round to nearest dollar.) (e) What journal entries would Krause record during the first year of the lease? (Include an amortization schedule through 1/1/12 and round to the nearest dollar.) Solution 21-119 (a) This lease is a capital lease to Krause Company because its term (10 years—see computation in b below) exceeds 75% of the equipment’s estimated useful life. In addition, the present value (see computation in d below) of the minimum lease payments (see computation in c below) exceeds 90% of the fair value of the equipment ($3,000,000). (b) The lease term is: Noncancelable period 5 years Additional period for which termination penalty assures renewal 4 years Period covered by lessor extension option 1 year 10 years (c) The minimum lease payments are: Semi-annual rental payments $ 219,000 Executory costs (19,000) 200,000 Number of payments over lease term × 20 4,000,000 Residual guarantee 100,000 Minimum lease payments $4,100,000 (d) The present value of the minimum lease payments is: Factor for present value of an annuity due, 20 periods, 4% 14.13394 Semi-annual payments, net of executory costs $ 200,000 2,826,788 Factor for present value of $1 due in 20 interest periods at 4% .45639 Residual guarantee × 100,000 45,639 Present value of lease payments $2,872,427 (e) January 1, 2011 Leased Equipment Under Capital Leases 2,872,427 Lease Liability 2,872,427 January 1, 2011 Leases Liability 200,000 Property Taxes 19,000 Cash 219,000 July 1, 2011 Lease Liability 93,103 Property Taxes 19,000 Interest Expense 106,897 Cash 219,000 Lease Amortization Schedule Semi-Annual Interest Reduction of Date Lease Payment 4% Lease Obligation Balance Initial PV $2,872,427 1/1/11 $200,000 — $200,000 2,672,427 7/1/11 200,000 106,897 93,103 2,579,324 1/1/12 200,000 103,173 96,827 2,482,497 December 31, 2011 Depreciation Expense 281,243* Accumulated Depreciation—Capital Leases 281,243 Interest Expense 103,173 Interest Payable 103,173 *($2,872,427 – $60,000) ÷ 10 = $281,243. Pr. 21-120—Lessor accounting—direct-financing lease. Lucas, Inc. enters into a lease agreement as lessor on January 1, 2011, to lease an airplane to National Airlines. The term of the noncancelable lease is eight years and payments are required at the end of each year. The following information relates to this agreement: 1. National Airlines has the option to purchase the airplane for $9,000,000 when the lease expires at which time the fair value is expected to be $15,000,000. 2. The airplane has a cost of $38,000,000 to Lucas, an estimated useful life of fourteen years, and a salvage value of zero at the end of that time (due to technological obsolescence). 3. National Airlines will pay all executory costs related to the leased airplane. 4. Annual year-end lease payments of $5,766,425 allow Lucas to earn an 8% return on its investment. 5. Collectibility of the payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by Lucas. Instructions (a) What type of lease is this? Discuss. (b) Prepare a lease amortization schedule for the lessor for the first two years (2011-2012). (Round all amounts to nearest dollar.) (c) Prepare the journal entries on the books of the lessor to record the lease agreement, to reflect payments received under the lease, and to recognize income, for the years 2011 and 2012. Solution 21-120 (a) The lease is a direct-financing type lease from the lessor’s point of view or a capital lease from the lessee’s point of view. The lease contains a bargain purchase option which satisfies one of the criteria for classification as a direct-financing lease. The option to buy for $9,000,000 at the termination of the lease when the asset is expected to have a fair value of $15,000,000 constitutes a bargain purchase option. Additionally, the payments are collectible, and there are no uncertainties as to future lessor costs. (b) Lessor’s Lease Amortization Schedule Annual Interest on Lease Receivable Date Lease Rental Lease Receivable Recovery Lease Receivable 1/1/11 $38,000,000 12/31/11 $5,766,425* $3,040,000 $2,726,425 35,273,575 12/31/12 5,766,425 2,821,886 2,944,539 32,329,036 *[$38,000,000 – ($9,000,000 × .54027)] ÷ 5.74664 = $5,766,425. Solution 21-120 (cont.) January 1, 2011 (c) Lease Receivable 38,000,000 Airplanes 38,000,000 December 31, 2011 Cash 5,766,425 Lease Receivable 2,726,425 Interest Revenue 3,040,000 December 31, 2012 Cash 5,766,425 Lease Receivable 2,944,539 Interest Revenue 2,821,886

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