FAR-Lease

On January 1 of the current year, Tree Co. enters into a five-year lease agreement for production equipment. The lease requires Tree to pay $12,500 per year in lease payments. At the end of the five-year lease term, Tree can purchase the equipment for $30,000. The fair value of the equipment is $75,000. The estimated useful life of the equipment is 10 years. The present value of the lease payments is $50,000. The present value of the purchase option is $20,000. Tree's controller believes the purchase option price is sufficiently below the expected fair value of the equipment at the date the option becomes exercisable to reasonably assure its exercise. Tree would normally depreciate equipment of this type using the straight-line method. What amount is the carrying value of the asset related to this lease at December 31, of the current year?

• a. $40,000

• b. $45,000

• c. $56,000

• d. $63,000

Answer explanation

Tree Co.'s lease meets the criteria for a finance lease because the controller believes Tree will likely exercise the purchase option. The ROU asset recognized is $70,000, and Tree will amortize the ROU asset by its useful life. The carrying value at the end of the first year of the lease is $63,000.

ROU asset ($50,000 PV lease payments + $20,000 PV purchase option)

$70,000

(−) Annual depreciation ($70,000 ROU asset / 10 years useful life) ($7,000)

Carrying value after first year $63,000

Douglas Co. leased machinery with an economic useful life of six years. For tax purposes, the depreciable life is seven years. The lease is for five years, and Douglas can purchase the machinery at fair market value at the end of the lease. What is the amortizable life of the leased machinery for financial reporting purposes?

• a. 0

• b. 5 years

• c. 6 years

• d. 7 years

Answer explanation

A finance lease transfers the rights and risks of ownership of the leased asset from the lessor to the lessee. This occurs when the lease term is for a major part (≥ 75%) of the leased asset's useful life. The lessee recognizes a right-of-use (ROU) asset and a lease liability at the present value of the lease payments.

The lessee amortizes the ROU asset on a straight-line basis over the shorter of the asset's economic life (=useful life) or the lease term unless there is a purchase option that is reasonably certain to be exercised (below FMV) or the title transfers at the end of the lease, requiring amortization over its useful life.

Douglas Co. has a finance lease because the 5-year lease term is a major part of the machinery's 6-year useful life (five-sixths=83%). There is a purchase option, but it is not reasonably certain to be exercised at the asset's FMV. Because the lease term is shorter than the machinery's useful life, the ROU asset is amortized over 5 years.

On January 1, Year 1, Grout Co. entered into a 5-year finance lease for a new truck with annual payments of $20,000 beginning January 1, Year 1. Based on an implicit interest rate of 6%, the five lease payments have a present value of $89,300 at lease inception. What amount should Grout report as interest expense for the year ended December 31, Year 1?

• a. $4,158

• b. $4,800

• c. $5,358

• d. $6,000

Answer explanation

Grout Co. signed a 5-year finance lease with an implicit rate of 6%. The PV of lease payments (lease liability) is given as $89,300. After the first payment at lease inception, the liability balance equals $69,300: $89,300 PV of lease payments − $20,000 annual payment. Interest expense for Year 1 is $4,158: $69,300 liability balance × 6% interest rate.

A company leases a machine from Leasing, Inc. on January 1, Year 1. The lease terms include a $100,000 annual payment beginning January 1, Year 1. The machine's fair value is $500,000, the company guarantees a residual value of $50,000, and the amount expected to be owed as a result of the guaranteed residual value is $20,000. The useful life of the machine is six years, and the lease term is five years. The implicit rate of interest is 6% and is known by the company. The following present value factors are provided:

• a. $446,510

• b. $461,456

• c. $520,000

• d. $535,340

Answer explanation

In this scenario, the company has a finance lease because the lease term is a major part of the machine's economic life (5/6 of useful life). The lessee recognizes a right-of-use (ROU) asset and a liability at the present value (PV) of lease payments.

The lease term (5 years) and the lease's implicit rate (6%) are used to calculate the PV of lease payments. Annual payments of $100,000 are made at the beginning of each period (annuity due). The guaranteed residual value of $20,000 is a single payment due at the end of the lease. The machine and corresponding lease liability are recorded as $461,456.

PV of annual payments: $100,000 × 4.4651 (annuity due, 5 years) $446,510

PV of guaranteed residual value: $20,000 × 0.7473 (lump sum, 5 years) $14,946

PV of machine (ROU asset) and lease liability $461,456

On January 1, Year 1, Harrow Co. as lessee signed a 5-year noncancelable equipment lease with annual payments of $100,000 beginning December 31, Year 1. Harrow treated this transaction as a finance lease. The five lease payments have a present value of $379,000 on January 1, Year 1, based on interest of 10%. What amount should Harrow report as interest expense for the year ended December 31, Year 1?

• a. $10,000

• b. $27,900

• c. $37,900

• d. $50,000

Answer explanation

A company may either lease or buy equipment for business use. Leases usually have lower upfront costs and can help reduce equipment obsolescence. A finance lease, which must meet one of several criteria, effectively transfers the rights and risks of ownership of the leased asset from the lessor to the lessee.

At lease inception, the lessee recognizes a right-of-use asset and a lease liability at the present value (PV) of the lease payments. Interest expense equals the lease liability balance multiplied by the lease's interest rate. The difference between the lease payment and the interest expense is the lease liability reduction.

In this scenario, Harrow Co. (ie, lessee) has a finance lease with a January 1, Year 1, inception date. Annual payments of $100,000 are made at the end of each year. The PV of lease payments (ie, lease liability) is given as $379,000. Interest expense for the year ended December 31, Year 1, equals $37,900 ($379,000 liability balance × 10% interest rate).

(Choices A and D) Interest expense of $10,000 and $50,000 equals the 10% interest rate multiplied by the lease payment and the total of lease payments, respectively.

(Choice B) Interest expense of $27,900 equals the initial lease liability less the first-year payment ($379,000 − $100,000) multiplied by 10%.

Note:
In a finance lease, the lessee records a right-of-use asset and liability equal to the present value of the lease payments. Interest expense equals the lease liability balance multiplied by the interest rate. The difference between the lease payment and the interest expense is the lease liability reduction.

On December 30, Year 1, Rafferty Corp. leased equipment under a finance lease. Annual lease payments of $20,000 are due December 31 for 10 years. The equipment's useful life is 10 years, and the interest rate implicit in the lease is 10%. The finance lease obligation was recorded on December 30, Year 1, at $135,000, and the first lease payment was made on that date. What amount should Rafferty include in current liabilities for this finance lease in its December 31, Year 1, balance sheet for Year 2?

• a. $6,500

• b. $8,500

• c. $11,500

• d. $20,000

Answer explanation

A finance lease transfers the rights and risks of ownership of the leased asset from the lessor to the lessee. The lessee recognizes both a right-of-use (ROU) asset and a liability at the present value (PV) of the lease payments.

Lease payments made each period are composed of interest expense and a reduction of the lease liability.

• Interest expense equals the outstanding lease liability balance multiplied by the implicit lease interest rate.

• The lease liability is reduced by the difference between the lease payment and the interest expense.

• When the first lease payment is made at lease inception, the lease liability used to calculate the interest expense for the second payment is reduced by the entire payment.

Rafferty Corp.'s initial lease obligation was $135,000. After the first payment of $20,000 at lease inception, the liability balance as of December 31, Year 1 is $115,000. This balance has a current portion due in Year 2, and a long-term portion due in Years 3-10. The current portion of the lease liability is $8,500, which equals the lease liability reduction based on the Year 2 payment.

Year 2 interest expense ($115,000 Year 1 balance × 10% implicit lease rate) $11,500

Lease liability reduction ($20,000 lease payment − $11,500 interest expense) $8,500

Lease M does not contain a purchase option likely to be exercised, but the lease term is equal to 90% of the estimated economic life of the leased property. Lease P does not transfer ownership of the property to the lessee at the end of the lease term, but the lease term is equal to 75% of the estismated economic life of the leased property. How should the lessee classify these leases?

• a

• b

• c

• d

Answer explanation

A finance lease transfers the rights and risks of ownership of a leased asset from a lessor to a lessee. The lessee accounts for the lease as a finance lease if the lease meets at least one of five criteria (ie, Special-PO-T-75-90):

• Specialized nature of leased property (eg, custom-built equipment) means the property has no foreseeable alternative use to the lessor at the end of the lease term.

• Purchase Option in the lease that is reasonably certain to be exercised.

• Title of the property transfers (ie, ownership) to the lessee by the end of the lease term.

• Lease term is a "major part" (ie, ≥ 75%) of the remaining economic life of the property.

• Present value of the lease payments plus any residual value guaranteed by the lessee equals substantially all (ie, ≥ 90%) of the FMV of the property at inception.

If none of the criteria are met, the lease is an operating lease.

Leases M and P are finance leases because their lease terms are a major part (ie, ≥ 75%) of the remaining economic life of the leased property.

Which of the following is a criterion for classifying a lease as a finance lease by a lessee?

• a. The lease term is equal to the "major part" or more of the estimated economic life of the leased property.

• b. The present value of the minimum lease payments is 75% or more of the fair value of the leased property.

• c. The lease agreement contains an option to purchase the leased property at its fair value at the end of the lease term.

• d. The lease agreement requires that title of the leased property remains with the lessor at the end of the lease term.

Answer explanation

A finance lease transfers the rights and risks of ownership of a leased asset from a lessor to a lessee. If the lease meets any of the finance lease criteria below, the lessee accounts for the lease as a finance lease; if none of the criteria are met, it's an operating lease.

• The leased property is of a Specialized nature (custom-built equipment) with no alternative use to the lessor at the end of the lease term.

• The lease carries a Purchase Option that is reasonably certain to be exercised.

• The property's Title transfers to the lessee at the end of the lease term .

• The lease term is a major part (≥ 75%) of the property's remaining economic life (useful life).

• The present value of the lease payments equals substantially all (≥ 90%) of the property's fair value at inception.

• (Choice C) A lease with a purchase option is typically exercised when the option amount is less than the leased property's fair value. When the option equals fair value, it is not reasonably certain to be exercised.

On January 1, Year 1, Babson, Inc. leased two automobiles for executive use. The lease requires Babson to make five annual payments of $13,000 beginning January 1, Year 1. At the end of the lease term, December 31, Year 5, Babson guarantees the residual value of the automobiles will total $12,000, and the expected residual value at the time will be $2,000. The lease qualifies as a finance lease. The interest rate implicit in the lease is 9%, which is known to Babson. Present value factors for 5 periods at the 9% rate are as follows:

Annuity due 4.240

Ordinary annuity 3.890

Present value of $1 0.650

Babson's recorded lease liability immediately after the first required payment should be

• a. $37,570

• b. $42,120

• c. $44,070

• d. $48,620

Answer explanation

For finance leases containing a residual value guarantee, the total lease payments include the probable amount that the lessee will owe at the end of the lease. It is included in the liability because the lessee has an obligation to pay the leased asset's guaranteed minimum value to the lessor.

In this scenario, Babson, Inc. has a 5-year finance lease with a residual value guarantee of $12,000. The $13,000 annual payments are due at the beginning of each year (annuity due). The automobiles' expected residual value at the end of the lease is $2,000, and Babson has guaranteed a minimum value of $12,000. The $10,000 difference for the guarantee is included in the total lease payments ($12,000 − $2,000). After the first payment is made at lease inception, the lease liability equals $48,620.

PV of lease payments ($13,000 × 4.24 annuity due) $55,120

PV of guaranteed residual value ($10,000 × 0.65 PV of $1) $6,500

Initial lease liability $61,620

Less: Year 1 lease payment (applied to lease liability) ($13,000)

Remaining lease liability $48,620

On January 3, Year 1, Salas Company leased a piece of equipment to Merlin's Haberdashery over a 6-year period, which is equal to the equipment's useful life. The cost of the equipment on Salas' accounting records is $23,500. Equal annual payments under the lease are $6,000, beginning on January 3, Year 1. The lease's implicit rate, which is not known to the lessee, is 7%. The lessee's incremental borrowing rate is 8%. The present value of an annuity due for 6 periods is:

5.100 at 7%

4.993 at 8%

What is the amount of interest income Salas should record for the year ended December 31, Year 1?

• a. $1,722

• b. $1,917

• c. $2,142

• d. $2,397

Answer explanation

Salas Company (lessor) leases equipment to Merlin's Haberdashery (lessee) in a 6-year lease. Because the lease term equals the equipment's useful life, this meets the ≥ 75% criteria for a sales-type lease.

Salas calculates the present value (PV) of lease payments using the lease's 7% implicit rate as $30,600 ($6,000 payment × 5.1). The first lease payment made at lease inception is applied entirely to the net investment in lease balance. The lease is outstanding for 12 months in Year 1. Interest income of $1,722 is calculated below:

January 3, Year 1, net investment in lease (PV of lease payments) $30,600

Less: Year 1 lease payment (made at lease inception) ($6,000)

Year 1 net investment in lease balance $24,600

Implicit lease rate × 7%

Year 1 interest income $ 1,722