Test Bank, Intermediate Accounting, 14th ed.

59

CHAPTER 15
Leases
MULTIPLE CHOICE QUESTIONS
Theory/Definitional Questions
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
value

GAAP basis for recognizing some leases as purchases

Characteristics of an operating lease
Present value criteria for capital lease
Accounting for rental payments under operating leases
Capital versus operating lease--use of present value
Lease term criteria for capital lease
Capital lease--recording initial liability of lessee
Depreciation term for leased machine
Reduction of liability on lessee's books
Three types of period costs associated with lessee and capital lease
Effect of minimum lease payments on net liability
Treatment of guaranteed residual values by lessee
Amortization of capital lease asset
Items included in minimum lease payments
Treatment of bargain purchase option
Characteristics of sales-type lease
Treatment of initial direct costs by lessor
Treatment by lessee of equal monthly rental payments
Classification of leases--capital or operating
Treatment of gain on rental
Capitalization and amortization of building and land
Accounting for residual values by lessor
Treatment of lease with no bargain purchase option
Nature of executory costs
Guaranteed residual values
Definition of lease term
Composition of minimum lease payment
Lease disclosure requirements
Lease disclosure requirements
International accounting standards for leases
Lessee treatment of leases involving real estate
Real estate lease--fair market value of land greater than 25 % of total fair

60

Chapter 15 Leases

33
34

Real estate lease--fair market value of land less than 25% of total fair value
Sale-leaseback transactions

Computational Questions
* 35
Computation of total present value and first year interest expense for lease
36
Computation of lease liability on noncancelable lease
37
Computation of interest revenue of lease
38
Computation of lease liability with discounted lease payments
39
Computation of profit and interest income amounts
40
Computation of interest expense on noncancelable lease
41
Computation of capital lease liability amount
42
Computation of income from leased equipment
43
Computation of present value amount to classify asset as capital lease
44
Computation of deferred revenue from leaseback
45
Computation of booked amount for equipment lease
46
Computation of net rental income on lease
47
Computation of interest expense for capital lease
48
Computation of income on lease transactions
49
Computation of amortization expense
50
Computation of amount of rent expense on lease
51
Computation of total capital lease liability
52
Classification of leases under international accounting standards
*This question requires the use of present value tables to solve.
1
2
3
4
5
6
7
8
9
10
11
12

PROBLEMS

Journalize lease transactions for lessee and lessor

Journalize lease transactions for lease
Journalize lease transaction, payments, and interest revenue
Journalize lease transaction, manufacturer's profit, interest revenue
Journalize lease payments with bargain purchase option
Journalize noncancelable lease
Determine whether lease should be capital or operating
Prepare lease amortization schedule
Prepare partial balance sheet for lease
Journalize sale and leaseback
Economics of leasing for the lessee
Economics of leasing for the lessor

Test Bank, Intermediate Accounting, 14th ed.

61

MULTIPLE CHOICE QUESTIONS

a
LO2

1. Generally accepted accounting principles require that certain lease

agreements be accounted for as 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.

d
LO2

2. Which of the following statements characterizes 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.

3. One of the four general criteria for a capital lease is that the present value
at
the beginning of the lease term of the minimum lease payments equals or
exceeds
a. the property's fair market value.
b. 90 percent of the property's fair market value.
c. 75 percent of the property's fair market value.
d. 50 percent of the property's fair market value.

LO4

d
LO5

4. In a lease that is recorded as an operating lease by the lessee, the equal

monthly rental payments should be
a. 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.

a
LO4

5. The present value of the minimum lease payments should be used by the
lessee in the determination of a(n)
Capital
Operating
Lease Liability Lease Liability
a.
Yes
No
b.
Yes
Yes
c.
No
Yes
d.
No
No

62

Chapter 15 Leases

c
LO4

6. One of the four general criteria for a capital lease specifies that the lease
term
be equal to or greater than
a. the estimated economic life of the property.
b. 90 percent of the estimated economic life of the property.
c. 75 percent of the estimated economic life of the property.
d. 50 percent of the estimated economic life of the property.

c
LO5

7. For a capital lease, the amount recorded initially by the lessee as a liability
should
a. 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.

8. Johnson Institute leased a new machine having an expected useful life of

12
years. The noncancelable lease term is 10 years, and Johnson may
exercise a purchase option at the end of the noncancelable term. The
machine should be capitalized by Johnson and depreciated over
a. 9 years.
b. 12 years.
c. 10 years.
d. 10 or 12 years at Johnsons option.

LO5

d
LO5

9. The lessees balance sheet liability for a capital lease would be periodically
reduced by the
a. minimum lease payment.
b. minimum lease payment plus the amortization of the related asset.
c. minimum lease payment less the amortization of the related asset.
d. minimum lease payment less the portion of the minimum lease payment
allocable to interest.

10. What are the three types of period costs that a lessee experiences with
capital
leases?
a. Interest expense, amortization expense, executory costs
b. Amortization expense, executory costs, lease expense
c. Executory costs, interest expense, lease expense
d. Lease expense, executory costs, initial costs

LO5

Test Bank, Intermediate Accounting, 14th ed.

c
LO5

63

11. An eight-year capital lease specifies equal minimum annual lease

payments.
Part of this payment represents interest and part represents a reduction in
the net lease liability. The portion of the minimum lease payment in the
fourth year applicable to the reduction of the net lease liability should be
a. the same as in the third year.
b. less than in the third year.
c. less than in the fifth year.
d. more than in the fifth year.

d
LO5

12. Which of the following statements concerning guaranteed residual values is

appropriate for the lessee?
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.

13. Johntech Inc. leased a new machine having an expected useful life of 30
years
from Carbide Co. Terms of the noncancelable 25-year lease were that
Johntech would gain title to the property upon payment of a sum equal to
the fair market value of the machine at the termination of the lease.
Johntech accounted for the lease as a capital lease and recorded an asset
and a liability in the financial records. The asset recorded under this lease
should properly be amortized over
a. 5 years (the period of actual ownership).
b. 22.5 years (75 percent of the 30-year asset life).
c. 25 years (the term of the lease).
d. 30 years (the total asset life).

LO5

c
LO5

14. Which one of the following items is not part of the minimum lease payments
from the standpoint of the lessee?
a. The minimum rental payments called for by the lease
b. Any guarantee the lessee is required to make at the end of the lease
term regarding any deficiency from a specified minimum
c. Any estimated residual value at the end of the lease term

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Chapter 15 Leases

d. Any payment the lessee must make at the end of the lease term to
purchase the leased property under a bargain purchase option

c
LO5

15. A lease contains a bargain purchase option. In determining the lessees

capitalizable cost at the beginning of the lease term, the payment called for
by the bargain purchase option would be
a. subtracted at its present value.
b. added at its exercise value.
c. added at its present value.
d. subtracted at its exercise price.

c
LO6

16. Which of the following statements characterizes a sales-type lease?

a. The lessor recognizes only interest revenue over the life of the asset.
b. The lessor recognizes only interest revenue over the lease term.
c. The lessor recognizes a dealers profit at lease inception and interest
revenue over the lease term.
d. The lessor recognizes a dealers profit at lease inception and interest
revenue over the asset life.

17. Initial direct costs incurred by a lessor in consummating a sales-type lease

are
a. 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.

LO6

d
LO5

18. Equal monthly rental payments for a particular lease should be charged to
Rental Expense by the lessee for which of the following?
Capital Lease Operating Lease
a.
Yes
No
b.
Yes
Yes
c.
No
No
d.
No
Yes

b
LO4

19. Lease Y does not contain a bargain purchase option, but the lease term is
equal to 90 percent of the estimated economic life of the leased property.
Lease Z 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 percent of the
estimated economic life of the leased property. How should the lessee
classify these leases?
Lease Y
Lease Z

Test Bank, Intermediate Accounting, 14th ed.

a.
b.
c.
d.
c
LO9

Capital lease
Capital lease
Operating lease
Operating lease

65

Operating lease
Capital lease
Capital lease
Operating lease

20. M & J Construction built an office building at a cost of $500,000. M & J sold
this building to Matson at a material gain and then leased it back from
Matson for a stipulated annual rental. This gain should be
a. recognized in full as an ordinary item in the year of the transaction.
b. recognized in full as an extraordinary item in the year of the
transaction.
c. deferred and amortized proportionately over the life of the lease.
d. treated as a reduction in the obligation under the capital lease.

c 21. If a lease involves both land and buildings and a bargain purchase option is
LO10
reasonably assured, then
a. both will be capitalized and amortized.
b. buildings are capitalized and amortized; land is an operating lease.
c. buildings are capitalized and amortized; land is capitalized and left at
cost.
d. both are operating leases since criteria 3 and 4 are not met.
d
LO6

a
LO4

22. Which of the following statements characterizes lessor accounting for

residual
values?
a. Guaranteed residual values are included in the gross investment
amount, but unguaranteed residual values are excluded from the gross
investment.
b. Unguaranteed residual values are included in the gross investment
amount, 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.
23. Draper Corp. leased a new building and land from Baylor Leasing Inc. for
25
years. At the inception of the lease the building and land have fair market
values of $200,000 and $25,000, respectively. The building has an
expected economic life of 30 years. Which of the following statements is
correct regarding Drapers treatment of the lease?

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Chapter 15 Leases

a. Draper 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. Draper 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.
c. Draper should treat the lease as a capital lease provided that the land
and building are recorded in separate asset accounts and accounted for
separately.
d. Draper should treat the lease as a capital lease only if Baylor treats the
transaction as a leveraged lease.
d
LO3

c
LO3

24. Which of the following would be considered an executory cost?

a. Minimum lease payments.
b. Interest expense incurred.
c. Bargain purchase option.
d. Maintenance costs.
25. If the residual value of a leased asset is greater than the amount
guaranteed
by the lessee
a. the lessee pays the lessor for the difference.
b. the lessee recognizes 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.

b
LO3

26. Which 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 lessors option.

b
LO3

27. From the standpoint of the lessee, the minimum lease payment includes all
of the following except
a. the guaranteed residual value.
b. the lessees 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.

Test Bank, Intermediate Accounting, 14th ed.

67

d 28. Which of the following is (are) not correct regarding disclosure

requirements
LO7
lessees?
I. For capital leases, future minimum lease payments in the aggregate and
for each of the succeeding five years must be disclosed.
II. For operating leases with initial or remaining lease terms in excess of
one year, future minimum rental payments in the aggregate and for each
of the five succeeding fiscal years must be disclosed.
III. For capital leases, future minimum lease payments for each of the
succeeding five years must be disclosed.
IV. For operating leases with initial or remaining lease terms in excess of
one year, future minimum lease payments for each of the five
succeeding fiscal years must be disclosed.
a. I only.
b. II only.
c. Both I and II.
d. Both III and IV.
a
LO7

29. Which of the following is not a required disclosure for lessors?

a. Total of minimum sublease rentals to be received in the future under
noncancelable subleases.
b. Unearned interest revenue?
c. Unguaranteed residual values accruing to the benefit of the lessor.
d. A general description of the lessors leasing arrangements.

a 30. In order for a lease to be considered a finance (or capital) lease,

international
LO8
accounting standards require that a lease agreement
a. 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.
a 31. For leases involving real estate, the lessee treats the lease as a capital
lease
LO10
if the lease agreement provides for a transfer of title or a bargain purchase
option. The lessee also would
a. record the building and land separately.
b. record the building and land separately only if the land is less than 25%
of the total fair market value of the leased property.

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Chapter 15 Leases

c. record the building and land separately only if the fair market value of
the land equals or exceeds 25 percent of the total fair market value of
the lease property.
d. classify the building as a capital lease and the land as an operating
lease.
b 32. A lease agreement for land and a building does not provide for transfer of
title
or a bargain purchase option. The fair market value of the land is
greater than
or equal to 25 percent of the fair market value of the leased
property. In this
situation, the lessee would
a. treat both the land and building as an operating lease.
b. allocate a portion of the minimum lease payments to the land and the
remainder to the building to determine if the present value of the lease
payments allocated to the building was 90 percent of more of the fair
value of the building at the beginning of the lease.
c. treat the land and building as a single unit using the building life as the
basis for the economic life test.
d. always treat the building as a capital lease and the land as an operating
lease.
a

33. A lease agreement does not provide for transfer of title or a bargain
purchase
option. The additional two criteria for lessors
relating to the collectibility of
lease payments and unreimbursable costs
to be incurred by the lessor have
been met. The fair market value of the
land is less than 25 percent of the total
fair market of the leased property.
In this situation, the lessor would
a. treat the lease of the land and building as an operating lease if neither
the economic life test (using the life of the building) nor the present
value of the minimum lease payments test is met.
b. treat the lease as a sales-type capital lease for the building and an
operating lease for the land if either the economic life test or the present
value of the minimum lease payments test is met.
c. treat the lease as a direct-financing-type lease for the building and an
operating lease for the land if either the economic life test or present
value of the minimum lease payments test is met.
d. would not apply the economic life or present value of the minimum lease
payments test to a lease agreement involving real estate.

Test Bank, Intermediate Accounting, 14th ed.

69

c
LO9

34. On January 1, 2002, a seller-lessee sells a warehouse to a buyer-lessor.

The fair value of the warehouse is greater than the book value. There is no
transfer of title or bargain purchase option. In conjunction with the sale of
the warehouse, the seller-lessee and the buyer-lessor enter into a five-year
lease (a sale-leaseback). How should the seller-lessee treat the gain?
a. Gains to lessees resulting from sale-leaseback transactions are always
deferred.
b. Gains to lessees resulting from sale-leaseback transactions are always
recognized.
c. Gains to lessees resulting from sale-leaseback transactions are
recognized only when the present value of the lease payments is less
than or equal to 10 percent of the fair value of the asset sold.
d. Gains to lessees resulting from sale-leaseback transactions are
recognized only when the present value of the lease payments is less
than or equal to 25 percent of the fair value of the asset sold.

35. State Repairs acquires equipment under a noncancelable lease at an

annual
rental of $45,000, payable in advance for five years. After five years, there
is a bargain purchase option of $75,000. The appropriate interest rate is 12
percent. What is the total present value of the lease and the first years
interest expense?
a. $224,234 and $21,508
b. $224,234 and $26,908
c. $204,771 and $21,508
d. $204,771 and $19,173

LO5

a
LO5

36. Stockton, Inc. leased machinery with a fair value of $250,000 from Layton
Machine Co. on December 31, 2002. The contract is a six-year noncancelable lease with an implicit interest rate of 10 percent. The lease requires
annual payments of $50,000 beginning December 31, 2002. Stockton
appropriately accounted for the lease as a capital lease. Stockton's
incremental borrowing rate is 12 percent. Assuming the present value of an
annuity due of 1 for 6 years at 10 percent is 4.7908 and the present value
of an annuity due of 1 for 6 years at 12 percent is 4.6048, what is the lease
liability that Stockton should report on the balance sheet at December 31,
2002?
a. $189,540
b. $200,000

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Chapter 15 Leases

c. $230,240
d. $239,540

d
LO6

a
LO5

37. Baxter Company leased equipment to Fritz Inc. on January 1, 2002. The
lease
is for an eight-year period expiring December 31, 2009. The first of eight
equal annual payments of $900,000 was made on January 1, 2002. Baxter
had purchased the equipment on December 29, 2001, for $4,800,000. The
lease is appropriately accounted for as a sales-type lease by Baxter.
Assume that the present value at January 1, 2002, of all rent payments
over the lease term discounted at a 10 percent interest rate was
$5,280,000. What amount of interest revenue should Baxter record in 2003
(the second year of the lease period) as a result of the lease?
a. $490,000
b. $480,000
c. $438,000
d. $391,800
38. Jordan Co. leased a machine on December 31, 2002. Annual payments
under
the lease are $110,000 (which includes $10,000 annual executory costs)
and are due on December 31 each year, for a ten-year period. The first
payment was made on December 31, 2002, and the second payment was
made on December 31, 2003. According to the agreement, the lease
payments are discounted at 10 percent over the lease term. Assume the
present value of minimum lease payments at the inception of the lease and
before the first annual payment was $615,000 and Jordan appropriately
classified the lease as a capital lease. What is the lease liability Jordan
should report in its December 31, 2003, balance sheet?
a. $466,500
b. $515,000
c. $534,150
d. $576,500

Test Bank, Intermediate Accounting, 14th ed.

71

b
LO6

39. Aerotech Inc., a dealer in machinery and equipment, leased equipment to

Quality Products on July 1, 2002. The lease is appropriately accounted for
as a sale by Aerotech and as a purchase by Quality. The lease is for a tenyear period (the useful life of the asset) expiring June 30, 2012. The first of
ten equal annual payments of $250,000 was made on July 1, 2002.
Aerotech had purchased the equipment for $1,337,500 on January 1, 2002,
and established a list selling price of $1,687,500 on the equipment.
Assume that the present value at July 1, 2002, of the rent payments over
the lease term discounted at 12 percent (the appropriate interest rate) was
$1,582,500. What is the amount of profit on the sale and the amount of
interest income that Aerotech should record for the year ended December
31, 2002?
a. $245,000 and $94,950
b. $245,000 and $79,950
c. $350,000 and $79,950
d. $350,000 and $94,950

c
LO5

40. On January 1, 2002, Shak, Inc. signed a noncancelable lease for a sneaker
shining machine. The machine has an estimated useful life of nine years.
The term of the lease is a six-year term with title passing to Shak at the end
of the lease. The agreement called for annual payments of $40,000 starting
at the end of the first year. Assume aggregate lease payments were
determined to have a present value of $200,000, based on implicit interest
of 12 percent. What amount of interest expense should Shak report in its
2002 income statement from this lease transaction?
a. $0
b. $16,000
c. $24,000
d. $33,333

a
LO5

41. Epson Distributing leased a machine for a period of eight years, contracting
to pay $200,000 at the beginning of the lease term on December 31, 2002,
and $200,000 annually on December 31 for each of the next seven years.
The present value of the eight rent payments over the lease term,
appropriately discounted at 10 percent, is $1,174,000. On its December
31, 2003, balance sheet, Epson should report a liability under capital lease
of
a. $871,400.
b. $876,600.
c. $974,000.
d. $1,091,400.

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Chapter 15 Leases

c
LO6

c
LO4

d
LO9

42. Slice Company manufactures equipment that they sell or lease. On

December
31, 2002, Slice leased equipment to Hook Company for a five-year period
after which ownership of the leased asset will be transferred to Hook. The
lease calls for equal annual payments of $50,000, due on December 31 of
each year. The first payment was made on December 31, 2002. The
normal sales price of the equipment is $220,000, and cost is $176,000. For
the year ended December 31, 2002, what amount of income should Slice
report from the lease transaction?
a. $10,000
b. $30,000
c. $44,000
d. $74,000
43. On March 1, 2003, Sturdy Corp. 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 this equipment on March 1, 2003,
was $100,000. The lease does not meet the criteria for classification as a
capital lease with respect to transfer of ownership of the leased asset, or
bargain purchase option, or lease term. Nevertheless, Sturdy must classify
this lease as a capital lease if, at inception of the lease, the present value
of the minimum lease payments (excluding executory costs) is equal to at
least
a. $67,500.
b. $75,000.
c. $90,000.
d. $100,000.
44. On December 31, 2002, Divot Company sold a machine to Drive Company
and
simultaneously leased it back for one year. The machine has an estimated
remaining useful life of 10 years. The present value of the individual lease
payments at the date of sale is $25,000. The sales price was $275,000 and
at the time of sale the book value of the machine on Divots records was
$245,000. What amount of deferred revenue from the sale of this machine
should Divot show on its December 31, 2002 balance sheet?
a. $0
b. $5,000
c. $25,000
d. $30,000

Test Bank, Intermediate Accounting, 14th ed.

b
LO5

73

45. On December 31, 2003, Gephardt Enterprises leased equipment from B &
B
Equipment Rental. Pertinent lease transaction data are as follows:
The estimated seven-year useful equipment life coincides with the lease
term.
The first of the seven equal annual $200,000 lease payments was paid
on December 31, 2003.
B & Bs implicit interest rate of 12 percent is known to Gephardt.
Gephardts incremental borrowing rate is 14 percent.
Present values of an annuity of 1 in advance for seven periods are 5.11
at 12 percent and 4.89 at 14 percent.
Gephardt should record the equipment on the books at
a. $1,400,000.
b. $1,022,000.
c. $978,000.
d. $0.

b
LO6

c
LO5

46. On January 1, 2002, Collins Company leased a warehouse to Cuthbert

under
an operating lease for ten years at $80,000 per year, payable the first day
of each lease year. Collins paid $36,000 to a real estate broker as a
finders fee. The warehouse is depreciated at $20,000 per year. During
2002, Collins incurred insurance and property tax expense totaling
$15,000. Collins net rental income for 2002 should be
a. $9,000.
b. $41,400.
c. $44,000.
d. $45,000.
47. On January 1, Twix Company as lessee signed a ten-year noncancelable
lease for a machine with annual payments of $60,000. The first payment
was also made on January 1. Twix appropriately treated this transaction as
a capital lease. The ten lease payments have a present value of $405,000
at January 1, based on implicit interest of 10 percent. For the first year,
Twix should record interest expense of
a. $0.
b. $6,000.
c. $34,500.
d. $40,500.

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Chapter 15 Leases

c
LO6

c
LO5

b
LO5

48. Hazard Inc. manufactures equipment that is sold or leased. On December

31,
2002, Hazard leased equipment to Robards for a five-year period expiring
December 31, 2007, at which date ownership of the leased asset will be
transferred to Robards. Equal $40,000 payments under the lease are due
on December 31 of each year. The first payment was made on December
31, 2002. Collectibility of the remaining lease payments is reasonably
assured, and Hazard has no material cost uncertainties. The normal sales
price of the equipment is $154,000 and cost is $120,000. For the year
ended December 31, 2002, how much income should Hazard recognize
from the lease transaction?
a. $46,000
b. $40,000
c. $34,000
d. $28,000
49. On January 1, Gregory Company signed a ten-year noncancelable lease
for
a new machine, requiring $40,000 annual payments at the beginning of
each year. The machine has a useful life of 15 years, with no salvage
value. Title passes to Gregory at the lease expiration date. Gregory uses
straight-line depreciation for all of its plant assets. Aggregate lease
payments have a present value on January 1 of $252,000, based on an
appropriate rate of interest. For the first year, Gregory should record
depreciation (amortization) expense for the leased machine at
a. $40,000.
b. $25,200.
c. $16,800.
d. $14,133.
50. On December 1, 2002, Blake Inc. signed an operating lease for a
warehouse
for ten years at $24,000 per year. Upon execution of the lease, Blake paid
$48,000 covering rent for the first two years. How much should be shown
in Blakes income statement for the year ended December 31, 2002, as rent
expense?
a. $0
b. $2,000
c. $24,000
d. $48,000

Test Bank, Intermediate Accounting, 14th ed.

c
LO5

75

51. On December 31, 2002, Cooke Company leased a machine under a capital
lease for a period of ten years, contracting to pay $100,000 on signing the
lease and $100,000 annually on December 31 of the next nine years. The
present value at December 31, 2002, of the ten lease payments over the
lease term discounted at 10 percent was $676,000. At December 31, 2003,
Cookes total capital lease liability is
a. $486,000.
b. $518,000.
c. $533,600.
d. $607,960.

b 52.
LO8

Lease Y does not contain a bargain purchase option, but the lease term is
equal to 90 percent of the estimated economic life of the leased property.
Lease Z 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 percent of the
estimated economic life of the leased property. What is the most likely
classification of these leases under currently existing international
standards of accounting for leases?
Lease Y
Lease Z
a. Capital lease
Operating lease
b. Capital lease
Capital lease
c. Operating lease
Capital lease
d. Operating lease
Operating lease

PROBLEMS
Problem 1
On July 1, 2002, Hawkeye Aviation leased two helicopters from Honnicutt Aircraft
for an initial period of 12 months with a provision for a continuation on a month-tomonth basis. The lease is properly classified as an operating lease. Lease
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
Last four months.............................................................. 8,000 per month
After the first year, the rent continues at $6,000 per month. Provide the entries
required to record the lease payments for the first year on the books of

76

Chapter 15 Leases

(1) Hawkeye Aviation.

(2) Honnicutt Aircraft.
Solution 1
LO5, LO6
(1) Hawkeye Aviation (Lessee)
2002
July, Aug.
Prepaid Rent......................................
Rent Expense ([2($15,000) + 3($12,000) +
3($10,000) + 4($8,000)] / 12).......................
Cash..............................................
Sept., Oct., Nov. Prepaid Rent......................................
Rent Expense.....................................
Cash..............................................
2002
Dec.
2003
Jan., Feb.
2003
Mar., Apr.
May, June

10,667
15,000
1,333
10,667
12,000

Rent Expense.....................................
Cash..............................................
Prepaid Rent.................................

10,667

Rent Expense.....................................
Cash..............................................
Prepaid Rent.................................

10,667

(2) Honnicutt Aircraft (Lessor)

2002
July, Aug.
Cash...................................................
Unearned Rent Revenue..............
Rent Revenue...............................
Sept., Oct.
Nov.

4,333

10,000
667

8,000
2,667

15,000
4,333
10,667

Cash...................................................
Unearned Rent Revenue..............
Rent Revenue...............................

12,000

2002
Dec.
2003
Jan., Feb.

Cash...................................................
Unearned Rent Revenue...................
Rent Revenue...............................

10,000
667

2003
Mar., Apr.

Cash...................................................

8,000

1,333
10,667

10,667

77

Test Bank, Intermediate Accounting, 14th ed.

May, June

Unearned Rent Revenue...................

Rent Revenue...............................

2,667
10,667

Problem 2
On January 2, 2002, the Wilcox Studios leased six computers for use in the
engineering department. The lease period is for 13 years and the estimated
economic life of the leased property is 15 years. The lease does not contain
automatic title transfer or a bargain purchase option. Lease payments are $9,000
per year, payable each December 31. The incremental borrowing rate for Wilcox is
12 percent and the implicit interest rate (known by Wilcox) is 10 percent. The
company uses straight-line depreciation for this type of equipment.
Provide the necessary journal entries to record the transactions for Wilcox for the
period January 2, 2002 through December 31, 2003.
Solution 2
LO5
PVn = R(PVAFn/i)
PVn = $9,000(Table IV 13/10%)
PVn = $9,000(7.1034)
PVn = $63,931
2002
Jan. 2
Dec. 31

2003
Dec. 31

Leased Equipment................................................
Obligations under Capital Lease.....................

63,931

Amortization Expense ($63,931/13)..........................

Accumulated Amortization...............................

4,918

Obligations under Capital Lease..........................

Interest Expense ($63,931 x 10%).............................
Cash. ...............................................................

2,607
6,393

Amortization Expense...........................................
Accumulated Amortization...............................

4,918

Obligations under Capital Lease..........................

Interest Expense [($63,931 - $2,607) x 10%]................
Cash ..............................................................
Cash. ...............................................................

2,868
6,132

63,931
4,918

9,000

4,918

9,000
9,000

78

Chapter 15 Leases

Problem 3
Washington Financing, Inc. purchased a packing machine to lease to Puyallup
Fruits. The lease qualifies as a direct financing lease and requires lease payments
of $58,860 per year, payable in advance, over a ten-year period. There is no
expected residual value. The fair market value of the packing machine is
$330,000--the same amount paid by Washington to purchase the asset. The lease
term begins on January 1, 2002.
Provide the journal entries required on Washingtons books to
(1) record the lease transaction and the first lease payment.
(2) recognize interest revenue at the end of the first year. Washington uses a
calendar-year accounting period. (Round all computations to the nearest
dollar.)
Solution 3
LO6
(1) 2002
Jan. 1
Lease Payments Receivable........................... 588,600
Equipment Purchased for Lease................
330,000
Unearned Interest Revenue.......................
258,600

(2) Dec. 31

Cash.................................................................
Lease Payments Receivable.....................

58,860

Unearned Interest Revenue............................

Interest Revenue........................................

43,382

58,860
43,382

[($588,600 - $58,860 - $258,600) x 16%*]

*
Computation of implicit interest rate:
$330,000/$58,860 = 5.6065
5.6065 - 1.0000 = 4.6065 for 9 periods
From Table IV, the rate is 16%

Problem 4
Jason Inc. uses leases as a means of selling its equipment. On January 1, 2002,
the company leased a machine to Jeremy Manufacturing Inc. The cost of the
machine to Jason was $78,450. The fair market value (which was the sales price)
was $101,184 at the time of the lease. Annual lease payments are $13,500 and
are payable in advance for 12 years. At the end of the lease term, title to the
machine will pass to Jeremy Manufacturing.

(1) Provide the entries required on Jasons books to record the lease and the first
payment.
(2) Compute the manufacturers profit to be recognized by Jason in the first year of
the lease.
(3) Provide the entry required on Jasons books to recognize interest revenue at
the end of the first year. (Round computations to the nearest dollar.)
Solution 4
LO6
(1) 2002
Jan. 1

Lease Payments Receivable ($13,500 x 12)....... 162,000

Cost of Goods Sold......................................... 78,450
Finished Goods Inventory..........................
Unearned Interest Revenue.......................
Sales...........................................................
Cash.................................................................
Lease Payments Receivable.....................

78,450
60,816
101,184

13,500
13,500

(2) Sales price of machine.................................................... $101,184

Cost to manufacture......................................................... 78,450
Manufacturers profit........................................................ $ 22,734
(3) 2002
Dec. 31

Unearned Interest Revenue............................

Interest Revenue........................................

8,768
8,768

[($162,000 - $13,500 - $60,816) x .10*]

*
Computation of implicit interest rate:
$101,184/$13,500 = 7.4951
7.4951 - 1.0000 = 6.4951 for 11 periods.
From Table IV, the rate is 10%.

Problem 5
On January 1, 2002, Franklin Industries leased equipment on an eight-year term at
$15,000 annual rental payments, paid in advance. There is a bargain purchase
option on December 31, 2009 (end of lease), of $24,000. The economic life of the
equipment is estimated to be 15 years. The interest rate is 12 percent.
(1) Give the necessary entries for 2002 assuming all payments after the initial
payment are made on December 31.
(2) Give the entry at December 31, 2009, assuming the option is permitted to
lapse and that there is no residual value because of obsolescence. Assume
2009 amortization and interest entries have been made.
Solution 5
LO5
(1) 2002

Jan. 1

Dec. 31

(2) 2009
Dec. 31

Leased Equipment...........................................
Obligations under Capital Lease...............
[($15,000 x 5.5638) + ($24,000 x .4039)]

93,151

Obligations under Capital Lease.....................

Cash. ..........................................................

15,000

Amortization Expense ($93,150/15)....................

Accumulated Amortization..........................

6,210

Interest Expense ($78,150 x 12%)........................

Obligations under Capital Lease.....................
Cash. ..........................................................

9,378
5,622

Loss from Failure to Exercise Bargain

Purchase Option..............................................
Obligations under Capital Lease.....................
Accumulated Amortization ($6,210 x 8)...............
Leased Equipment.....................................

93,151

15,000
6,210

15,000

19,471
24,000
49,680
93,151

Problem 6
Farewell Inc. leases equipment to its customers under noncancelable leases. On
January 1, 2002, Farewell leased equipment costing $400,000 to Norman Co., for
nine years. The rental cost was $44,000 payable in advance semiannually
(January 1 and July 1), plus $2,000 semiannually for executory costs. The
equipment had an estimated life of 15 years and sold for $533,025 with an
estimated unguaranteed residual value of $80,000. The implicit interest rate is 12
percent.
Prepare all journal entries for 2002 on Farewells and Normans books. Round all
calculations to the nearest dollar. Use straight-line depreciation.

Solution 6
LO5, LO6
Farewells Books (Lessor)
2002
Jan. 1

Lease Payments Receivable [($44,000 x 18)

+ $80,000]......................................................... 872,000
Cost of Goods Sold ($400,000 - 28,024)............... 371,976
Finished Goods Inventory..........................
Unearned Interest Revenue.......................
Sales .........................................................

400,000
338,975
505,001

$44,000 x 11.4773 = $505,001

$80,000 x .3503 =
28,024
$533,025

July 1

July 1
Dec. 31

Cash.................................................................
Lease Payments Receivable.....................
Executory Costs.........................................

46,000

Cash.................................................................
Lease Payments Receivable.....................
Executory Costs.........................................

46,000

Unearned Interest Revenue............................

Interest Revenue [($533,025 - $44,000) x .06]. . .

29,342

44,000
2,000
44,000
2,000
29,342

Unearned Interest Revenue............................ 28,462

Interest Revenue [($489,025 - $44,000 + 29,342) x .06]

28,462

Normans Books (Lessee)

2002
Jan. 1

July 1

Leased Equipment........................................... 505,001

Obligations under Capital Leases..............
Lease Expense................................................
Obligations under Capital Leases...................
Cash...........................................................

2,000
44,000

Interest Expense [($505,001 - $44,000) x 0.06]........

Obligations under Capital Leases...................
Lease Expense................................................
Cash...........................................................

27,660
16,340
2,000

505,001

46,000

46,000

Dec. 31

Amortization Expense......................................
Accumulated Amortization ($505,001/9)........
Interest Expense..............................................
Interest Payable [($461,001 - $16,340) x .06].....

56,111
56,111
26,680
26,680

Problem 7
Henri Retail Stores is negotiating three leases for store locations. Henris
incremental borrowing rate is 12 percent. Each store will have an economic useful
life of 30 years. Lease payments will be made at the end of each year. Based on
the data below, properly classify each of the leases as an operating lease or a
capital lease. The purchase price for each property is listed as an alternative to
leasing.
Location A
Location B
Location C

Location Lease Term

26 years
20 years
20 years

Lease Payment
$1,500,000
1,300,000
1,400,000

Purchase Price
$12,000,000
10,000,000
15,000,000

Determine whether each of the leases should be classified by Henri as an

operating lease or a capital lease. Show computations and reasons to support
your answers.
(1) Location A
(2) Location B
(3) Location C
Solution 7
LO5
(1) Location A:

Capital lease

Computations:
26 years/30 years = 86.7% of useful life, so the third criterion (75% of
useful life) is met.

$1,500,000 payment x 7.8957 = $11,843,550 (present value of minimum

lease payments). $11,843,550/$12,000,000 = 98.7% of F.V., so the fourth
criterion (90% of F.V.) is also met.

(2) Location B: Capital lease

Computations:
20 years/30 years = 66.7% of useful life, so the third criterion (75% of
useful life) is not met.

$1,300,000 payment x 7.4694 = $9,710,220 (present value of minimum

lease payments). $9,710,220/$10,000,000 = 97.1% of F.V., so the fourth
criterion (90% of F.V.) is met.

(3) Location C: Operating lease

Computations:
20 years/30 years = 66.7% of useful life, so the third criterion (75% of
useful life) is not met.

$1,400,000 payment x 7.4694 = $10,457,160 (present value of minimum

lease payments). $10,457,160/$15,000,000 = 69.7% of F.V., so the fourth
criterion (90% of F.V.) is also not met.

Problem 8
Standard Distributing entered into a leasing agreement with R & D Rental. The
lease qualifies as a capital lease and calls for payments of $5,000 for 5 years with
the first payment being made on January 1, 2002, and subsequent payments
being made on December 31 of each year. Standards incremental borrowing rate
is 12 percent.
Prepare a schedule amortizing Standards lease obligation.
Solution 8
LO5
Date
1/1/2002
1/1/2002
12/31/2002
12/31/2003
12/31/2004
12/31/2005
*

Payment
$5,000
5,000
5,000
5,000
5,000

$5,000 x 4.0373 = $20,187

Interest
Expense

Principal

$1,822
1,441
1,014
536

$5,000
3,178
3,559
3,986
4,464

Lease
Obligation
$20,187 *
15,187
12,009
8,450
4,464
0

Problem 9
Johnson Manufacturing entered into a noncancelable lease for an office building
on January 1, 2002. The lease calls for payments of $24,000 a year for eight
years. The first payment is due on January 1, 2002, with the other payments due
on December 31 of each year. Johnson has an incremental borrowing rate of 8
percent. The building is amortized by Johnson over eight years using the straightline method and assuming no salvage value.
Prepare a partial balance sheet for Johnson for the year ending December 31,
2002, disclosing the asset and the liability related to the leased building.
Solution 9
LO7
Asset:
Cost: $24,000 x 6.2064 = $148,954
Annual amortization: $148,954 / 8 years = $18,619
Liability:
($148,954 - $24,000) x .08 = $9,996 interest portion of 12/31/02 payment
$24,000 - $9,996 = $14,004 principal portion of 12/31/02 payment
$24,000 - ([$148,954 - $24,000 - $14,004] x .08) = $15,124 principal portion of
12/31/2003 payment
Johnson Manufacturing
Balance Sheet (partial)
December 31, 2002
Land, buildings, and equipment:
Leased building................................................................................
148,954
Less accumulated amortization........................................................
18,619

$
130,335
Current liabilities:
Obligations under capital lease--current portion.............................
Noncurrent liabilities:
Obligations under capital lease--exclusive of amount
included in current liabilities..................................................

15,124
95,826

Problem 10
On January 1, 2002, Washington Company sold machinery costing $411,750, at
the fair market value and then immediately leased the machinery back for $200,000
yearly, payable in advance. The life of the machinery and the lease was five years.
The implicit rate is 12 percent.
Record all entries for 2002 on Washingtons books. The fair market value and the
present value of the lease payments are equal.
Solution 10
LO9
2002
Jan. 1
Cash ($200,000 x 4.0373)...................................... 807,460
Machinery...................................................
Unearned Profit on Sale-Leaseback..........
Jan 1

Dec. 31

Dec. 31

Leased Machinery........................................... 807,460

Obligations under Capital Leases..............
Cash...........................................................
Amortization Expense...................................... 161,492
Accumulated Amortization ($807,460/5)........
Interest Expense ($607,460 x 0.12)...................... 72,895
Obligations under Capital Leases................... 127,105
Cash ..........................................................
Unearned Profit on Sale-Leaseback...............
Revenue on Sale-Leaseback ($395,710/5). . .

411,750
395,710
607,460
200,000
161,492
200,000

79,142
79,142

Problem 11
George Harmon is the president of the Utah Western Railroad Company. The Utah
Western is a bridge line that receives traffic from the Union Pacific Railroad and the
Burlington Northern railroads at Salt Lake City, Utah, and hauls the freight to Denver,
Colorado, for connections with other lines to points east. Recently, traffic on the Utah
Western has increased dramatically and the railroad is in need of additional
locomotives to haul its trains. Accordingly, George is considering leasing locomotives
to meet the demands of this increase in traffic until new engines can be ordered if the
surge subsides. As the controller of the railroad, George has asked you to advise him
as to the disadvantages associated with leasing generally.

Solution 11
LO1
Disadvantages of leasing for a lessee include the following:

86

Chapter 15 Leases

1. Leases allow a lessee to obtain 100% financing at fixed interest rates. The larger
amount financed means that the company will pay higher interest in terms of the total
dollar outlay.
2. Leasing ready-to-use equipment rather than custom built equipment may result in
lower
quality product or services, which may result in lost sales for the lessee. In
the case
of the railroad, the company may wish to lease six-axle, 3,000 horsepower
locomotives
with the power and speed needed to meet existing customer schedules
when such
equipment is not available. Another possibility is that only older units
may be
available and older equipment may be subject to more downtime from
breakdowns.
Replacement parts for the older units may need to be purchased if the
railroad does not
carry anything comparable in its parts inventory.
3. No guarantee exists that the equipment the company (lessee) wants will be
available when needed. Seasonal or other types of patterns that result in the need
to lease may be common to all firms in an industry. The demand for equipment also
may mean that leasing companies will increase interest rates charged.
4.

Short-term leasing rates are generally higher than long-term rates in order to
protect the lessor from obsolescence.

5. Tax benefits associated with leases are subject to changes in the tax law and thus
could be reduced or eliminated.
Problem 12
Business leasing has become a large market. Banks, other lending institutions, and
commercial leasing companies represent the largest share of the business leasing
market
with the remainder consisting of manufacturers, dealers, and distributors.
Identify the advantages and disadvantages to lessors of leasing rather than selling
property.

Test Bank, Intermediate Accounting, 14th ed.

87

Solution 12
LO1
Leasing has several advantages over sales for lessors. Customers may be unwilling or
unable to purchase property. The use of leasing offers the lessor a means of servicing
these customers and thus preserving a sale that otherwise might be lost. The lessor
sees
leasing as one component of a full-service, selling strategy.
Leasing also may afford the lessor with the opportunity of maintaining a business
relationship with the lessee. In a purchase, the relationship between the buyer and
seller
may be limited to the time of the negotiation and consummation of the sale. A leasing
transaction, on the other hand, may result in the lessee and lessor maintaining contact
over an extended period of time. Such contracts may develop into long-term business
relationships that prove useful both to the lessee and the lessor.
Many lease agreements are structured such that the title to the leased property remains
with the lessor. 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. Large
increases in residual values can result in significant gains to lessors when the assets
are
sold. This can be a two-edged sword, however. The lessor also can be saddled with
an
obsolete asset if he or she is not astute in structuring lease rates to encourage
maximum
use of the asset prior to its becoming obsolete. This accomplished by charging higher
leasing rates for short-term leases over long-term leases in order to compensate the
lessor
for assuming the risk of obsolescence.
A major disadvantage of leasing to lessors results from fixed rates on long-term leases.
Such fixed rates expose the lessor to the risk of opportunity losses if interest rates
advance.

CHAPTER 15 -- QUIZ A

Name _________________________
Section ________________________

T F

1. Noncancelable leases are contracts with cancellation provisions and

penalties that are so costly for the lessee to invoke that in all likelihood,
cancellation will not occur.

T F

2. Both cancelable and noncancelable leases are subject to capitalization.

T F

3. The inception of the lease is defined as the date of the lease agreement, or
the date of an earlier written commitment.

T F

4. The beginning of the lease term is defined as the date on which the leased
property is actually transferred to the lessee.

T F

5. Rental payments, including any executory costs, are part of the minimum
lease payments.

T F

6. Minimum lease payments include any amount to be paid for purchase options
and residual values.

T F

7. The lessor uses the implicit interest rate in determining the present value of
the minimum lease payments.

T F

8. The lessee always uses its incremental borrowing rate in determining the
present value of the minimum lease payments.

T F

9. If a lease transfers ownership of the property to the lessee by the end of the
lease term, it will be classified as a capital lease by the lessee.

T F 10. Any lease that contains a bargain purchase option must be treated as a
capital lease by both the lessee and lessor.

88

CHAPTER 15 -- QUIZ B

Name _________________________
Section ________________________

T F

1. When rental payments vary over the term of an operating lease, the lessee
should recognize rental expense on a straight-line basis.

T F

2. In a capital lease, the lessee records the acquisition of the asset at the lower
of the present value of the minimum lease payments or the fair market value
of the asset.

T F

3. Initial direct costs are immediately recognized as an expense by the lessor

when the costs are incurred in conjunction with an operating lease.

T F

4. Initial direct costs in a sales-type lease are immediately recognized as a

reduction in manufacturers profit.

T F

5. Initial direct costs incurred in connection with a direct financing lease are
recognized over the lease term through reduced interest revenue.

T F

6. Any adjustment for a permanent decline in an unguaranteed residual value

during the lease term should be accounted for as a change in estimate.

T F

7. A direct financing lease results in the recognition of two different types of

revenue.

T F

8. Losses incurred by the lessee in the sale portion of a sale-leaseback should

be deferred.

T F

9. Leases of land should be evaluated using the four criteria established in

FASB Statement No. 13.

T F 10. Under GAAP, it is impossible for a lease to be classified as a capital lease by

the lessor and an operating lease by the lessee.

89

CHAPTER 15 -- QUIZ C

A.
B.
C.
D.
E.
F.
G.
H.
I.

Name _________________________
Section ________________________

Bargain purchase option

Bargain renewal option
Capital lease
Direct financing lease
Executory costs
Guaranteed residual value
Implicit interest rate
Incremental borrowing rate
Initial direct costs

J.
K.
L.
M.
N.
O.
P.
Q.
R.

Lease term
Lessee
Lessor
Minimum lease payments
Net lease investment
Operating lease
Residual value
Sales-type lease
Unguaranteed residual value

Select the term that best fits each of the following definitions and descriptions. Indicate
your answer by placing the appropriate letter in the space provided.
____ 1. Rate that discounts minimum lease payments to the fair market value of the
leased asset at the inception of the lease.
____ 2. Costs such as commissions, legal fees, and document preparation that are
incurred in negotiating and completing a lease transaction.
____ 3. A lease entered into by a lessor who is primarily engaged in providing
financial services.
____ 4. The value of leased property that remains with the lessor at the end of the
lease term; market factors and asset condition determine the asset value
remaining.
____ 5. The rental payments required over the lease term plus any amount to be paid
by the lessee under a bargain purchase option or guaranteed residual value
provision.
____ 6. A lease provision allowing the lessee to acquire ownership of a leased asset
in the future at a price that is expected to be substantially less than market
value at the time of acquisition.
____ 7. A lease arrangement used by manufacturers or dealers to facilitate the
marketing of their products.
____ 8. A lease agreement that is in substance a purchase and sale of property.
____ 9. The time period from the beginning to the end of a lease.
____ 10. An entity that owns property and transfers the right to use that property to
another entity.

90

CHAPTER 15 -- QUIZ SOLUTIONS

Quiz A
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

T
F
T
T
F
T
T
F
T
F

2.
3.
4.
5.
6.
7.
8.
9.
10.

T
F
T
T
T
F
F
F
F

Quiz C
Quiz B
1. T

1.
2.
3.
4.

G
I
D
R

5.
6.
7.
8.
9.
10.

M
A
Q
C
J
L

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