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Chapter 15Leases

MULTIPLE CHOICE

1. Generally accepted accounting principles require that certain lease agreements be accounted foras purchases. The theoretical basis for this treatment is that a lease of this type

a. effectively conveys all of the benefits and risks incident to the ownership of property.b. is an example of form over substance.c. provides the use of the leased asset to the lessee for a limited period of time.d. must be recorded in accordance with the concept of cause and effect.

AN! A "#$! %" &

&. 'hich of the following statements characteri(es an operating lease)a. The lessee records depreciation and interest.b. The lessee records the lease obligation related to the leased asset.c. The lessor transfers title of the leased property to the lessee for the duration of the lease

term.

d. The lessor records depreciation and lease revenue.AN! * "#$! %" &

+. "ne of the four general criteria for a capital lease is that the present value at the beginning of thelease term of the minimum lease payments equals or exceedsa. the property,s fair market value.b. - percent of the property,s fair market value.c. /0 percent of the property,s fair market value.d. 0 percent of the property,s fair market value.

AN! # "#$! %"

. 2n a lease that is recorded as an operating lease by the lessee3 the equal monthly rental paymentsshould bea. allocated between interest expense and depreciation expense.b. allocated between a reduction in the liability for leased assets and interest expense.c. recorded as a reduction in the liability for leased assets.d. recorded as rental expense.

AN! * "#$! %" 0

0. The present value of the minimum lease payments should be used by the lessee in thedetermination of a4n5

6apital "perating%ease %iability %ease %iability

a. Yes No

b. Yes Yes

c. No Yes

d. No No

AN! A "#$! %"

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7. "ne of the four general criteria for a capital lease specifies that the lease term be equal to orgreater thana. the estimated economic life of the property.b. - percent of the estimated economic life of the property.c. /0 percent of the estimated economic life of the property.d. 0 percent of the estimated economic life of the property.

AN! 6 "#$! %"

/. 8or a capital lease3 the amount recorded initially by the lessee as a liability shoulda. exceed the present value at the beginning of the lease term of minimum lease payments

during the lease term.b. exceed the total of the minimum lease payments during the lease term.c. not exceed the fair value of the leased property at the inception of the lease.d. equal the total of the minimum lease payments during the lease term.

AN! 6 "#$! %" 0

9. $ohnson 2nstitute leased a new machine having an expected useful life of 1& years. Thenoncancelable lease term is 1 years3 and $ohnson may exercise a purchase option at the end ofthe noncancelable term. The machine should be capitali(ed by $ohnson and depreciated overa. - years.b. 1& years.c. 1 years.d. 1 or 1& years at $ohnson,s option.

AN! 6 "#$! %" 0

-. The lessee,s balance sheet liability for a capital lease would be periodically reduced by thea. minimum lease payment.b. minimum lease payment plus the amorti(ation of the related asset.c. minimum lease payment less the amorti(ation of the related asset.d. minimum lease payment less the portion of the minimum lease payment allocable to

interest.

AN! * "#$! %" 0

1. 'hat are the three types of period costs that a lessee experiences with capital leases)a. 2nterest expense3 amorti(ation expense3 executory costsb. Amorti(ation expense3 executory costs3 lease expensec. :xecutory costs3 interest expense3 lease expensed. %ease expense3 executory costs3 initial costs

AN! A "#$! %" 0

11. An eight;year capital lease specifies equal minimum annual lease payments.

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1&. 'hich of the following statements concerning guaranteed residual values is appropriate for thelessee)a. The asset and related liability should be increased by the amount of the residual value.b. The asset and related liability should be decreased by the amount of the residual value.c. The asset and related liability should be decreased by the present value of the residual

value.d. The asset and related liability should be increased by the present value of the residual

value.

AN! * "#$! %" 0

1+. $ohntech 2nc. leased a new machine having an expected useful life of + years from 6arbide 6o.Terms of the noncancelable &0;year lease were that $ohntech would gain title to the propertyupon payment of a sum equal to the fair market value of the machine at the termination of thelease. $ohntech accounted for the lease as a capital lease and recorded an asset and a liability inthe financial records. The asset recorded under this lease should properly be amorti(ed overa. 0 years 4the period of actual ownership5.b. &&.0 years 4/0 percent of the +;year asset life5.c. &0 years 4the term of the lease5.d. + years 4the total asset life5.

AN! 6 "#$! %" 0

1. 'hich one of the following items is notpart of the minimum lease payments from the standpointof the lessee)a. The minimum rental payments called for by the leaseb. Any guarantee the lessee is required to make at the end of the lease term regarding any

deficiency from a specified minimumc. Any estimated residual value at the end of the lease termd. Any payment the lessee must make at the end of the lease term to purchase the leased

property under a bargain purchase option

AN! 6 "#$! %" 0

10. A lease contains a bargain purchase option. 2n determining the lessee,s capitali(able cost at thebeginning of the lease term3 the payment called for by the bargain purchase option would bea. subtracted at its present value.b. added at its exercise value.c. added at its present value.d. subtracted at its exercise price.

AN! 6 "#$! %" 0

17. 'hich of the following statements characteri(es a sales;type lease)a. The lessor recogni(es only interest revenue over the life of the asset.b. The lessor recogni(es only interest revenue over the lease term.

c. The lessor recogni(es a dealer,s profit at lease inception and interest revenue over the leaseterm.d. The lessor recogni(es a dealer,s profit at lease inception and interest revenue over the asset

life.

AN! 6 "#$! %" 7

+

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1/. 2nitial direct costs incurred by a lessor in consummating a sales;type lease area. charged to unearned income in the first period of the lease term.b. charged to cost of sales in the first period of the lease term.c. deferred and allocated over the lease term in proportion to the recognition of rent revenue.d. deferred and allocated over the lease term on a straight;line basis.

AN! # "#$! %" 7

19. :qual monthly rental payments for a particular lease should be charged to =ental :xpense by the

lessee for which of the following)

6apital %ease "perating %ease

a. Yes No

b. Yes Yes

c. No No

d. No Yes

AN! * "#$! %" 0

1-. %ease > does not contain a bargain purchase option3 but the lease term is equal to - percent ofthe estimated economic life of the leased property. %ease ? does not transfer ownership of theproperty to the lessee by the end of the lease term3 but the lease term is equal to /0 percent of theestimated economic life of the leased property. @ow should the lessee classify these leases)

%ease > %ease ?

a. Capital lease Operating lease

b. Capital lease Capital lease

c. Operating lease Capital lease

d. Operating lease Operating lease

AN! # "#$! %"

&. 'hich of the following statements characteri(es lessor accounting for residual values)a. Guaranteed residual values are included in the gross investment amount3 but unguaranteed

residual values are excluded from the gross investment.b. nguaranteed residual values are included in the gross investment amount3 but guaranteed

residual values are excluded from the gross investment.c. Guaranteed residual values and unguaranteed residual values are excluded from the gross

investment.d. Guaranteed residual values and unguaranteed residual values are included in the gross

investment.

AN! * "#$! %" 7

&1. *raper 6orp. leased a new building and land from #aylor %easing 2nc. for &0 years. At theinception of the lease the building and land have fair market values of B&3 and B&033respectively. The building has an expected economic life of + years. 'hich of the followingstatements is correct regarding *raper,s treatment of the lease)a. *raper should treat the lease as a capital lease even though there is no bargain purchase

option and no automatic transfer of ownership at the termination of the lease.b. *raper should treat the lease as a capital lease only if there is either a bargain purchase

option or an automatic transfer of ownership at the termination of the lease.

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c. *raper should treat the lease as a capital lease provided that the land and building arerecorded in separate asset accounts and accounted for separately.

d. *raper should treat the lease as a capital lease only if #aylor treats the transaction as aleveraged lease.

AN! A "#$! %"

&&. 'hich of the following would be considered an executory cost)a. Cinimum lease payments.

b. 2nterest expense incurred.c. #argain purchase option.d. Caintenance costs.

AN! * "#$! %" +

&+. 2f the residual value of a leased asset is greater than the amount guaranteed by the lesseea. the lessee pays the lessor for the difference.b. the lessee recogni(es a gain at the end of the lease term.c. the lessee has no obligation related to the residual value.d. the lessee pays the lessor for the difference.

AN! 6 "#$! %" +

&. 'hich of the following is true regarding the lease term)a. The lease term does not include all periods covered by bargain renewal options.b. The lease term includes all periods for which failure to renew imposes a penalty

sufficiently high that the lessee probably will renew.c. The lease term may extend beyond the date a bargain purchase option becomes

exercisable.d. The lease term does not include all periods representing renewals or extensions of the lease

at the lessor,s option.

AN! # "#$! %" +

&0. 8rom the standpoint of the lessee3 the minimum lease payment includes all of the followingexcepta. the guaranteed residual value.b. the lessee,s obligation to pay executory costs.c. the bargain purchase option.d. any payment that the lessee must make upon failure to extend or renew the lease.

AN! # "#$! %" +

&7. 'hich of the following is 4are5 not correct regarding disclosure requirements lessees)

2.8or capital leases3 future minimum lease payments in the aggregate and for each of thesucceeding five years must be disclosed.

22.8or operating leases with initial or remaining lease terms in excess of one year3 futureminimum rental payments in the aggregate and for each of the five succeeding fiscalyears must be disclosed.

222.8or capital leases3 future minimum lease payments for each of the succeeding five yearsmust be disclosed.

2D.8or operating leases with initial or remaining lease terms in excess of one year3 futureminimum lease payments for each of the five succeeding fiscal years must be disclosed.

a. 2 only.

0

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b. 22 only.c. #oth 2 and 22.d. #oth 222 and 2D.

AN! * "#$! %" /

&/. 'hich of the following is nota required disclosure for lessors)a. Total of minimum sublease rentals to be received in the future under noncancelable

subleases.

b. nearned interest revenuec. nguaranteed residual values accruing to the benefit of the lessor.d. A general description of the lessor,s leasing arrangements.

AN! A "#$! %" /

&9. 2n order for a lease to be considered a finance 4or capital5 lease3 international accountingstandards require that a lease agreementa. transfers substantially all risks and rewards incident to ownership of an asset to the lessee.b. contains a provision requiring transfer of title to the lessee by the end of the lease term.c. provides that the term of the lease contract be longer than one year.d. provides for a bargain purchase option.

AN! A "#$! %" 9

&-. tate =epairs acquires equipment under a noncancelable lease at an annual rental of B033payable in advance for five years. After five years3 there is a bargain purchase option of B/03.The appropriate interest rate is 1& percent. 'hat is the total present value of the lease and the firstyear,s interest expense)a. B&&3&+ and B&1309b. B&&3&+ and B&73-9c. B&3//1 and B&1309d. B&3//1 and B1-31/+

AN! A "#$! %" 0

+. tockton3 2nc. leased machinery with a fair value of B&03 from %ayton Cachine 6o. on*ecember +13 &0. The contract is a six;year noncancelable lease with an implicit interest rateof 1 percent. The lease requires annual payments of B03 beginning *ecember +13 &0.tockton appropriately accounted for the lease as a capital lease. tockton,s incrementalborrowing rate is 1& percent. Assuming the present value of an annuity due of 1 for 7 years at 1percent is ./-9 and the present value of an annuity due of 1 for 7 years at 1& percent is .793what is the lease liability that tockton should report on the balance sheet at *ecember +13 &0)a. B19-30b. B&3c. B&+3&d. B&+-30

AN! A "#$! %" 0

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+1. #axter 6ompany leased equipment to 8rit( 2nc. on $anuary 13 &0. The lease is for an eight;yearperiod expiring *ecember +13 &1&. The first of eight equal annual payments of B-3 wasmade on $anuary 13 &0. #axter had purchased the equipment on *ecember &-3 &3 forB393. The lease is appropriately accounted for as a sales;type lease by #axter. Assume thatthe present value at $anuary 13 &03 of all rent payments over the lease term discounted at a 1percent interest rate was B03&93. 'hat amount of interest revenue should #axter record in&7 4the second year of the lease period5 as a result of the lease)a. B-3b. B93

c. B+93d. B+-139

AN! * "#$! %" 7

+&. $ordan 6o. leased a machine on *ecember +13 &0. Annual payments under the lease areB113 4which includes B13 annual executory costs5 and are due on *ecember +1 eachyear3 for a ten;year period. The first payment was made on *ecember +13 &03 and the secondpayment was made on *ecember +13 &7. According to the agreement3 the lease payments arediscounted at 1 percent over the lease term. Assume the present value of minimum leasepayments at the inception of the lease and before the first annual payment was B7103 and$ordan appropriately classified the lease as a capital lease. 'hat is the lease liability $ordanshould report in its *ecember +13 &73 balance sheet)a. B7730b. B0103c. B0+310d. B0/730

AN! A "#$! %" 0

++. Aerotech 2nc.3 a dealer in machinery and equipment3 leased equipment to Euality

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+0. :pson *istributing leased a machine for a period of eight years3 contracting to pay B&3 atthe beginning of the lease term on *ecember +13 &03 and B&3 annually on *ecember +1for each of the next seven years. The present value of the eight rent payments over the lease term3appropriately discounted at 1 percent3 is B131/3. "n its *ecember +13 &73 balance sheet3:pson should report a liability under capital lease ofa. B9/13.b. B9/737.c. B-/3.d. B13-13.

AN! A "#$! %" 0

+7. lice 6ompany manufactures equipment that they sell or lease. "n *ecember +13 &03 liceleased equipment to @ook 6ompany for a five;year period after which ownership of the leasedasset will be transferred to @ook. The lease calls for equal annual payments of B033 due on*ecember +1 of each year. The first payment was made on *ecember +13 &0. The normal salesprice of the equipment is B&&33 and cost is B1/73. 8or the year ended *ecember +13 &03what amount of income should lice report from the lease transaction)a. B13b. B+3c. B3

d. B/3

AN! 6 "#$! %" 7

+/. "n Carch 13 &73 turdy 6orp. became the lessee of new equipment under a noncancelable six;year lease. The total estimated economic life of this equipment is ten years. The fair value of thisequipment on Carch 13 &73 was B13. The lease does not meet the criteria forclassification as a capital lease with respect to transfer of ownership of the leased asset3 orbargain purchase option3 or lease term. Nevertheless3 turdy must classify this lease as a capitallease if3 at inception of the lease3 the present value of the minimum lease payments 4excludingexecutory costs5 is equal to at leasta. B7/30.b. B/03.

c. B-3.d. B13.

AN! 6 "#$! %"

+9. "n *ecember +13 &73 Gephardt :nterprises leased equipment from # F # :quipment =ental.

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+-. "n $anuary 13 &03 6ollins 6ompany leased a warehouse to 6uthbert under an operating leasefor ten years at B93 per year3 payable the first day of each lease year. 6ollins paid B+73 toa real estate broker as a finder,s fee. The warehouse is depreciated at B&3 per year. *uring&03 6ollins incurred insurance and property tax expense totaling B103. 6ollins, net rentalincome for &0 should bea. B-3.b. B13.c. B3.d. B03.

AN! # "#$! %" 7

. "n $anuary 13 Twix 6ompany as lessee signed a ten;year noncancelable lease for a machine withannual payments of B73. The first payment was also made on $anuary 1. Twix appropriatelytreated this transaction as a capital lease. The ten lease payments have a present value ofB03 at $anuary 13 based on implicit interest of 1 percent. 8or the first year3 Twix shouldrecord interest expense ofa. B.b. B73.c. B+30.d. B30.

AN! 6 "#$! %" 0

1. @a(ard 2nc. manufactures equipment that is sold or leased. "n *ecember +13 &03 @a(ard leasedequipment to =obards for a five;year period expiring *ecember +13 &13 at which dateownership of the leased asset will be transferred to =obards. :qual B3 payments under thelease are due on *ecember +1 of each year. The first payment was made on *ecember +13 &0.6ollectibility of the remaining lease payments is reasonably assured3 and @a(ard has no materialcost uncertainties. The normal sales price of the equipment is B103 and cost is B1&3. 8orthe year ended *ecember +13 &03 how much income should @a(ard recogni(e from the leasetransaction)a. B73b. B3c. B+3d. B&93

AN! 6 "#$! %" 7

&. "n $anuary 13 Gregory 6ompany signed a ten;year noncancelable lease for a new machine3requiring B3 annual payments at the beginning of each year. The machine has a useful lifeof 10 years3 with no salvage value. Title passes to Gregory at the lease expiration date. Gregoryuses straight;line depreciation for all of its plant assets. Aggregate lease payments have a presentvalue on $anuary 1 of B&0&33 based on an appropriate rate of interest. 8or the first year3Gregory should record depreciation 4amorti(ation5 expense for the leased machine ata. B3.

b. B&03&.c. B1739.d. B131++.

AN! 6 "#$! %" 0

-

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+. "n *ecember 13 &03 #lake 2nc. signed an operating lease for a warehouse for ten years atB&3 per year. pon execution of the lease3 #lake paid B93 covering rent for the first twoyears. @ow much should be shown in #lake,s income statement for the year ended *ecember +13&03 as rent expense)a. Bb. B&3c. B&3d. B93

AN! # "#$! %" 0

. "n *ecember +13 &03 6ooke 6ompany leased a machine under a capital lease for a period often years3 contracting to pay B13 on signing the lease and B13 annually on *ecember+1 of the next nine years. The present value at *ecember +13 &03 of the ten lease payments overthe lease term discounted at 1 percent was B7/73. At *ecember +13 &73 6ooke,s totalcapital lease liability isa. B973.b. B0193.c. B0++37.d. B7/3-7.

AN! 6 "#$! %" 0

0. %ease > does notcontain a bargain purchase option3 but the lease term is equal to - percent ofthe estimated economic life of the leased property. %ease ? does nottransfer ownership of theproperty to the lessee by the end of the lease term3 but the lease term is equal to /0 percent of theestimated economic life of the leased property. 'hat is the most likely classification of theseleases under currently existing international standards of accounting for leases)

%ease > %ease ?

a. Capital lease Operating lease

b. Capital lease Capital lease

c. Operating lease Capital lease

d. Operating lease Operating lease

AN! # "#$! %" 9

PROBLEMS

1. "n $uly 13 &03 @awkeye Aviation leased two helicopters from @onnicutt Aircraft for an initialperiod of 1& months with a provision for a continuation on a month;to;month basis. The lease isproperly classified as an operating lease. %ease payments are to be made as follows!

First two months ................................. $15,000 per month

Second three months .............................. 12,000 per month

Third three months ............................... 10,000 per month

ast !o"r months ................................. #,000 per month

After the first year3 the rent continues at B73 per month.

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AN!415

@awkeye Aviation 4%essee5&0"l%, &"g. 'repaid (ent ............. ),***

(ent +pense -2-$15,000/

*-$12,000/ *-$10,000/

)-$#,000/ 12/

10,334

Cash ................... 15,000

Sept., Oct., No. 'repaid (ent ............. 1,***

(ent +pense ............. 10,334

Cash ................... 12,000

&06ec. (ent +pense ............. 10,334

&7 Cash ................... 10,000an., Fe7. 'repaid (ent ........... 334

&78ar., &pr. (ent +pense ............. 10,334

8a%, "ne Cash ................... #,000 'repaid (ent ........... 2,334

4&5@onnicutt Aircraft 4%essor5&0"l%, &"g. Cash ..................... 15,000

9nearned (ent (een"e .. ),***

(ent (een"e ........... 10,334

Sept., Oct. Cash ..................... 12,000

No. 9nearned (ent (een"e .. 1,***

(ent (een"e ........... 10,334

&06ec. Cash ..................... 10,000

&7 9nearned (ent (een"e .... 334an., Fe7. (ent (een"e ........... 10,334

&78ar., &pr. Cash ..................... #,000

8a%, "ne 9nearned (ent (een"e .... 2,334

(ent (een"e............ 10,334

"#$! %" 03 %" 7

&. "n $anuary &3 &03 the 'ilcox tudios leased six computers for use in the engineeringdepartment. The lease period is for 1+ years and the estimated economic life of the leasedproperty is 10 years. The lease does not contain automatic title transfer or a bargain purchaseoption. %ease payments are B-3 per year3 payable each *ecember +1. The incrementalborrowing rate for 'ilcox is 1& percent and the implicit interest rate 4known by 'ilcox5 is 1percent. The company uses straight;line depreciation for this type of equipment.

11

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4&56ec. *1 9nearned =nterest (een"e ........... )*,*#2

=nterest (een"e................... )*,*#2

-$5##,300 ? $5#,#30 ? $25#,300/

13>@

@ Comp"tation o! implicit interest

rateA

$**0,000$5#,#30 B 5.3035

5.3035 ? 1.0000 B ).3035 !or ;

periods

From Ta7le =, the rate is 13>

"#$! %" 7

. $ason 2nc. uses leases as a means of selling its equipment. "n $anuary 13 &03 the companyleased a machine to $eremy Canufacturing 2nc. The cost of the machine to $ason was B/930.The fair market value 4which was the sales price5 was B11319 at the time of the lease. Annuallease payments are B1+30 and are payable in advance for 1& years. At the end of the lease term3title to the machine will pass to $eremy Canufacturing.

415

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4.);51 ? 1.0000 B 3.);51 !or 11

periods.

From Ta7le =, the rate is 10>.

"#$! %" 7

0. "n $anuary 13 &03 8ranklin 2ndustries leased equipment on an eight;year term at B103annual rental payments3 paid in advance. There is a bargain purchase option on *ecember +13&1& 4end of lease53 of B&3. The economic life of the equipment is estimated to be 10 years.

The interest rate is 1& percent.

415 Give the necessary entries for &0 assuming all payments after the initial paymentare made on *ecember +1.

4&5 Give the entry at *ecember +13 &1&3 assuming the option is permitted to lapse andthat there is no residual value because of obsolescence. Assume &1& amorti(ationentries have been made.

AN!

415

&0an. 1 eased +:"ipment ..................... ;*,151

O7ligations "nder Capital ease .... ;*,151

-$15,000 5.53*#/ -$2),000

.)0*;/

O7ligations "nder Capital ease ...... 15,000

Cash ............................... 15,000

6ec. *1 &morti

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/. @enri =etail tores is negotiating three leases for store locations. @enri,s incremental borrowingrate is 1& percent. :ach store will have an economic useful life of + years. %ease payments willbe made at the end of each year. #ased on the data below3 properly classify each of the leases asan operating lease or a capital lease. The purchase price for each property is listed as analternative to leasing.

%ocation %ease Term %ease

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9. tandard *istributing entered into a leasing agreement with = F * =ental. The lease qualifies asa capital lease and calls for payments of B03 for 0 years with the first payment being made on$anuary 13 &03 and subsequent payments being made on *ecember +1 of each year. tandard,sincremental borrowing rate is 1& percent.

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"#$! %" /1. George @armon is the president of the tah 'estern =ailroad 6ompany. The tah 'estern is a

bridge line that receives traffic from the nion

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%easing also may afford the lessor with the opportunity of maintaining a business relationshipwith the lessee. 2n a purchase3 the relationship between the buyer and seller may be limited to thetime of the negotiation and consummation of the sale. A leasing transaction3 on the other hand3may result in the lessee and lessor maintaining contact over an extended period of time. uchcontracts may develop into long;term business relationships that prove useful both to the lesseeand the lessor.

Cany lease agreements are structured such that the title to the leased property remains with thelessor. The lessor thus stands to benefit from the residual value of the asset at the end of the lease

term. The asset may be leased to another lessee or sold. %arge increases in residual values canresult in significant gains to lessors when the assets are sold. This can be a two;edged sword3however. The lessor also can be saddled with an obsolete asset if he or she is not astute instructuring lease rates to encourage maximum use of the asset prior to its becoming obsolete. Thisaccomplished by charging higher leasing rates for short;term leases over long;term leases inorder to compensate the lessor for assuming the risk of obsolescence.

A maHor disadvantage of leasing to lessors results from fixed rates on long;term leases. uchfixed rates expose the lessor to the risk of opportunity losses if interest rates advance.

"#$! %" 1

1-