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Leases and bargain options

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1. Lease A does not contain a bargain purchase option, but the lease term is equal to 90% of the estimated economic life of the leased property. Lease B does not transfer ownership of the property to the lessee by the end of the lease term, but the lease term is equal to 75% of the estimated economic life of the leased property. How should the lessee classify these leases? Lease A ; Lease B
A) Operating lease ; Capital lease
B) Operating lease ; Operating lease
C) Capital lease ; Capital lease
D) Capital lease ; Operating lease

2. On December 31, 2010, Harris Co. leased a machine from Catt, Inc. for a 5-year period. Equal annual payments under the lease are $630,000 (including $30,000 annual executory costs) and are due on December 31 of each year. The first payment was made on December 31, 2010, and the second payment was made on December 31, 2011. The five lease payments are discounted at 10% over the lease term. The present value of minimum lease payments at the inception of the lease and before the first annual payment was $2,502,000. The lease is appropriately accounted for as a capital lease by Harris. In its December 31, 2011 balance sheet, Harris should report a lease liability of
A) $1,902,000
B) $1,872,000
C) $1,711,800
D) $1,492,200

3. A lessee had a 10-year capital lease requiring equal annual payments. The reduction of the lease liability in year 2 should equal
A) the current liability shown for the lease at the end of year 1
B) the current liability shown for the lease at the end of year 2
C) the reduction of the lease liability in year 1
D) one-tenth of the original lease liability

4. On January 2, 2011, Hernandez, Inc. signed a 10-year noncancelable lease for a heavy duty drill press. The lease stipulated annual payments of $150,000 starting at the end of the first year, with title passing to Hernandez at the expiration of the lease. Hernandez treated this transaction as a capital lease. The drill press has an estimated useful life of 15 years, with no salvage value. Hernandez uses straight-line depreciation for all of its plant assets. Aggregate lease payments were determined to have a present value of $900,000, based on implicit interest of 10%. In its 2011 income statement, what amount of interest expense should Hernandez report from this lease transaction?
A) $0
B) $56,250
C) $75,000
D) $90,000

5. On January 2, 2011, Hernandez, Inc. signed a 10-year noncancelable lease for a heavy duty drill press. The lease stipulated annual payments of $150,000 starting at the end of the first year, with title passing to Hernandez at the expiration of the lease. Hernandez treated this transaction as a capital lease. The drill press has an estimated useful life of 15 years, with no salvage value. Hernandez uses straight-line depreciation for all of its plant assets. Aggregate lease payments were determined to have a present value of $900,000, based on implicit interest of 10%. In its 2011 income statement, what amount of depreciation expense should Hernandez report from this lease transaction?
A) $150,000
B) $100,000
C) $90,000
D) $60,000

6. In a lease that is recorded as a sales-type lease by the lessor, interest revenue:
A) should be recognized in full as revenue at the lease's inception
B) should be recognized over the period of the lease using the straight-line method
C) should be recognized over the period of the lease using the effective interest method
D) does not arise

7. Torrey Co. manufactures equipment that is sold or leased. On December 31, 2011, Torrey leased equipment to Dalton for a 5-year period ending December 31, 2016, at which date ownership of the leased asset will be transferred to Dalton. Equal payments under the lease are $220,000 (including $20,000 executory costs) and are due on December 31 of each year. The first payment was made on December 31, 2011. Collectibility of the remaining lease payments is reasonably assured, and Torrey has no material cost uncertainties. The normal sales price of the equipment is $770,000, and cost is $600,000. For the year ended December 31, 2011, what amount of income should Torrey realize from the lease transaction?
A) $170,000
B) $220,000
C) $230,000
D) $330,000

8. Jamar Co. sold its headquarters building at a gain, and simultaneously leased back the building. The lease was reported as a capital lease. At the time of the sale, the gain should be reported as
A) operating income
B) an extraordinary item, net of income tax
C) a separate component of stockholders' equity
D) a deferred gain

9. On January 1, 2011, Ogleby Corporation signed a 5-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 5 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%. 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

10. 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.

11. 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

12. 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

13. Executory costs include
A) maintenance
B) property taxes
C) insurance
D) all of these

14. 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

15. 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

16. On December 31, 2011, Haden Corp. sold a machine to Ryan and simultaneously leased it back for one year. Pertinent information at this day follows:
Sales price $900,000
Carrying amount $825,000
PV Lease $85,000
Estimate remaining useful life 12 years in Haden's December 31, 2011 balance sheet, the deferred profit from the sale of this machine should be
A) $85,000
B) $75,000
C) $10,000
D) $0

17. 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. 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

18. On January 2, 2010, Gold Star Leasing Company leases equipment to Brick Co. with five 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 0.68508
10%, 5 periods 4.16986 3.79079 0.62092

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

19. Pisa, Inc. leased equipment from Tower Company under a 4-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 of 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?
A) $0
B) $24,621
C) $17,738
D) $22,798

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.
A) $188,237
B) $478,237
C) $488,237
D) $498,237

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Q1 C
If the lease term is 75% of useful life or greater, it's considered capital lease.

Q2 D
Book value after first payment 1,902,000
Interest payment on 12/31/2011 190,200
Principal payment on 12/31/2011 409,800
Book value after second payment 1,492,200

Q3 A
The current portion of lease liability at the end of year 1 is the amount of liability to pay during year 2

Q4 D
Book value on 1/2/2011 900,000
Interet rate 10%
2011 Interest expense 90,000

Q5 C
Asset is depreciated over the lease term, rather than the useful life.
Depreciation ...

Solution Summary

The solution discusses leases and bargain options.

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