Test Bank Docx Chapter.13 Leases 13th Edition

Chapter 13

1. Under the finance method of accounting for leases, under ASC 842, the excess of aggregate rentals over the cost of leased property should be recognized as revenue of the lessor
2. In increasing amounts during the term of the lease
3. In constant amounts during the term of the lease
4. In decreasing amounts during the term of the lease
5. After the cost of leased property has been fully recovered through rentals
6. Which of the following is one of the lease capitalization criteria under ASC 842?
   1. The minimum lease payments (excluding executory costs) equal or exceed 90% of the fair value of the leased property
   2. The lease transfers ownership of the property to the lessor
   3. The lease contains a purchase option
   4. The lease term is a major part of the asset’s economic life, not near the end of the asset’s life
7. When measuring the present value of future rentals to be capitalized as part of the purchase price in a lease that is be accounted for as a purchase, identifiable payments to cover taxes, insurance, and maintenance should be
8. Included in the future rentals to be capitalized
9. Excluded from future rentals to be capitalized
10. Capitalized but at a different discount rate and recorded in a different account than future rental payments
11. Capitalized but at a different discount rate and for a relevant period that tends to be different than that for future rental payments
12. Under ASC 842, equal monthly rental payments for a particular lease should be charged to rental expense by the lessee for which of the following?

Finance lease Short-term lease

1. Yes No
2. Yes Yes
3. No No
4. No Yes
5. In computing the present value of the minimum lease payments under ASC 842, the lessee should
   1. Use its incremental borrowing rate in all cases
   2. 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
   3. 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
   4. Use the implicit rate in all cases.
6. Under ASC 842, for a lease that is recorded as a sales-type lease by the lessor, the difference between the gross investment in the lease and sum of the present values of the components of the gross investment should be recognized as income
   1. In full at the lease’s expiration
   2. In full at the lease’s inception
   3. Over the period of the lease using the interest method of amortization
   4. Over the period of the lease using the straight-line method of amortization
7. For a six-year finance lease, under ASC 842, the portion of the minimum lease payment in the third year applicable to the reduction of the obligation should be
8. Less than in the second year
9. More than in the second year
10. The same as in the fourth year
11. More than in the fourth year
12. 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
13. Effectively controls the right of use of identified property
14. Is an example of form over substance
15. Provides the use of the leased asset to the lessee for a limited period of time
16. Must be recorded in accordance with the concept of cause and effect
17. The primary difference between a direct-financing lease and a sales-type lease under ASC 842 is the
    1. Whether the five lease recognition criteria are met
    2. Amount of the depreciation recorded each year by the lessor
    3. Allocation of initial direct costs by the lessor to periods benefited by the lease arrangements
    4. Manner in which rental receipts are recorded as rental income
18. Lessees prefer to account for their leases as short-term leases because:
    1. This decreases the amount of liability reported
    2. This increases their debt to total equity ratio
    3. This decreases the income tax expense.
    4. This increases the amount of total assets.
19. The appropriate valuation of an operating lease on the statement of financial position of a lessee is
20. Zero
21. The absolute sum of the lease payments
22. The present value of the sum of the lease payments discounted at an appropriate rate
23. The book value of the asset on the lessor’s books at the date of the inception of the lease
24. A six-year-finance lease entered into on December 31, 2020, specified equal minimum annual lease payments due on December 31, 2021. Minimum payment applicable to which of the following increased over the corresponding December 31, 2021, minimum payment? (The company is applying SFAS No. 13)

Reduction of

Interest Expense Liability

1. Yes Yes
2. Yes No
3. No Yes
4. No No
5. Office equipment recorded under a finance lease containing a bargain purchase option should be amortized under SFAS No. 13
   1. Over the period of the lease using the interest method of amortization
   2. Over the period of the lease using the straight-line method of amortization
   3. In a manner consistent with the lessee’s normal depreciation policy for owned assets
   4. In a manner consistent with the lessee’s normal depreciation policy for owned assets except that the period of amortization should be the lease term
6. What was the primary accounting issue for lessees that lead to the issuance of ASU 2016-02?
7. Recording interest expense on the lease obligation.
8. Determining whether the lease meets the 90% of fair value test.
9. Off-balance sheet financing.
10. The measurement of the leased asset under a finance lease.
11. What is the primary accounting issue for lessors?
12. Off-balance sheet financing.
13. Revenue recognition and expense allocation over the lease term.
14. Treating the lease in the same manner as the lessee does.
15. Determining whether the lease is a sales-type lease or a direct financing lease.

1. For the lessor to recognize a lease as a sales-type lease, under ASC 842, the following must occur.
2. At least one of the finance lease criteria is met, at least one of the certainty criteria is met, and there is a manufacturer or dealer’s profit.
3. At least one of the finance lease criteria is met.
4. More than one of the finance lease criteria are met, both certainty criteria are met, and there is a manufacturer or dealer’s profit.
5. Only one of the finance lease criteria is met, both certainty criteria are met, and there is a manufacturer or dealer’s profit.
6. For a sales-type lease, under ASC 842, the net investment is equal to
7. The present value of the minimum lease payments plus executor costs.
8. The net investment minus unearned income.
9. Sales minus the gross profit recognized on the sale.
10. The present value of the gross lease payments.
11. When a lease contract does not transfer title to the lessee, there is no purchase option reasonably certain to be exercised, and the lease term is not the major part of the asset’s remaining economic life
12. The lessee must classify the lease as an operating lease.
13. The amount of unguaranteed salvage value, if any, determines whether the lease is a finance lease or an operating lease.
14. The interest rate used to determine the present value of the minimum lease payments also determines whether the lease is a finance lease or an operating lease.
15. The lessee must use the greater of the lessor’s rate of return or the lessee’s incremental borrowing rate to determine whether the lease is a finance lease or an operating lease.
16. When does the lessee report executory costs as an expense?
17. When they are spelled out in the lease agreement.
18. Only when they are incurred by the lessee and the lease is classified as a finance lease.
19. When they are incurred by the lessee.
20. Only when they are incurred by the lessee and the lease is classified as an operating lease.
21. Which of the following would indicate that the lessee should not classify a lease as a finance lease under ASC 842?
22. The fair value of the leased asset is $100,000 and the present value of the minimum lease payments is $95,000.
23. The lease provides for no unguaranteed salvage value.
24. The lessee has the option to purchase the leased asset in 4 years for $2 when the asset’s salvage value is expected to be $20,000.
25. The asset’s useful life is 20 years; a 4-year lease occurs when the asset is 26 years old.
26. Under the provisions of ASC 842 which of the following is not a criterion to use in determining whether a lessee should classify a lease as a finance lease?
    1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term
    2. The lease grants the lessee an option to purchase the underlying asset the lessee is reasonably certain to exercise
    3. The lease term is for the major part of the remaining economic life of the underlying asset
    4. The present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds 50 percent of the fair value of the underlying asset.
27. Under the provisions of ASC 842
    1. Accounting by lessors for leases is virtually unchanged from what was required by SFAS No. 13
    2. Accounting by lessees for leases is virtually unchanged from what was required by SFAS No. 13
    3. Accounting by lessors for leases re is significantly changed from what was required by SFAS No. 13
    4. Accounting by lessees and lessors for leases is virtually unchanged from what was required by SFAS No. 13.
28. The major difference between ASU 2016-02 and IFRS No. 16 is
    1. All leases must be recorded as finance leases by lessees under ASU 2016-02; whereas, some leases may be recorded as operating leases by lessees under IFRS No. 16.
    2. All leases must be recorded as finance leases by lessees under IFRS No. 16; whereas, some leases may be recorded as operating leases by lessees under ASU 2016-02
    3. All leases must be recorded as finance leases by lessors under ASU 2016-02; whereas, some leases may be recorded as operating leases by lessors under IFRS No. 16
    4. All leases must be recorded as finance leases by lessors under IFRS No. 16; whereas, some leases may be recorded as operating leases by lessors under ASU 2016-02.
29. The key difference between ASC 842 and SFAS No. 13 in accounting for leases by lessees is
    1. The recognition of a right‐to‐use asset (ROU) and lease liability on the statement of financial position for those leases previously classified as operating leases under SFAS No. 13
    2. Leases will be measured at their fair value by lessees
    3. The classification of a lease as a finance by a lessee is based on a completely new set of criteria than was used in SFAS No. 13.
    4. There are no major differences between the two standards in accounting for leases by lessees.
30. Under the provisions of ASC 842 sale‐leaseback accounting is virtually eliminated as an off‐balance sheet financing proposition, because both the seller‐lessee and a buyer‐lessor will apply the provisions of FASB ASC 602 Revenue Recognition to determine whether a sale has occurred. Accordingly, which of the following is not a criterion that must be met to record a sale-leaseback a sale?
    1. The transaction meets the sale guidance in the new revenue recognition standard.
    2. The transaction is a leveraged lease
    3. The leaseback is not a finance or a sales‐type lease
    4. If there is a repurchase option, the exercise price is at the asset’s fair value at the time of exercise, and alternative assets that are substantially the same as the transferred asset are readily available in the marketplace.
31. Under the provisions of ASC 842, which of the following is not required in a lease modification when the lease payments are required to be remeasured?
    1. Any variable lease payments that are based on a rate or index will need to be remeasured.
    2. The total lease liability is remeasured
    3. The remeasured lease must be subsequently recorded as an operating lease
    4. The lessee is generally required to use an updated discount rate.
32. The amount to be recorded as the cost of an asset under finance lease is equal to the
33. Present value of the lease payments plus the present value of any unguaranteed residual value.
34. Carrying value of the asset on the lessor’s books.
35. Present value of the lease payments.
36. Present value of the lease payments or the fair value of the asset, whichever is lower.

28. The classifications of a lease by the lessee are

1. Operating and finance leases.
2. Operating, sales, and finance leases.
3. Operating and leveraged leases.

29. In computing the present value of the lease payments, the lessee should

1. Use the implicit rate in all cases.
2. Use the implicit rate of the lessor, assuming that the implicit rate is known to the lessee/
3. Use its incremental borrowing rate in all cases.
4. Use both its incremental borrowing rate and the implicit rate of the lessor, assuming that the implicit rate is known to the lessee.

30. Which of the following is not one of the lease classification tests?

1. Transfer of ownership
2. Collectibility
3. Purchase option
4. Lease term

31. From the lessee’s perspective, in the earlier years of a lease,

1. Operating leases will cause debt to increase, compared to finance leases.
2. Operating leases will cause income to increase, compared to finance leases.
3. Finance leases will cause debt to increase, compared to operating leases.
4. Finance leases will enable the lessee to report higher income, compared to operating leases.

32. In a finance lease, the lessee records

1. Interest expense only.
2. Amortization expense only.
3. Lease expense only.
4. Amortization expense and interest expense.

33. In an operating lease, the lessee records

1. Amortization expense and lease expense.
2. Interest expense.
3. Lease expense.
4. Amortization expense.

Essay

1. List some advantages of leasing
2. It offers 100 percent financing at fixed rates. Leases often do not require down payments from the lessee. This helps companies conserve scarce cash which is an especially desirable feature for new and developing companies. Additionally, the lease payments usually remain fixed, thereby protecting the lessee from uncertainty.
3. It permits alternative uses. A leasing arrangement provides a firm with the use and control over the assets without incurring a huge up-front capital expenditure and requires making only periodic rental payments. Thus, leasing saves funds for alternative uses.
4. It offers protection against obsolescence. Leasing assets reduces the risk of obsolescence to the lessee and in many cases passes the risk of residual value to the lessor. That is, the lease agreement may allow an original lease to be cancelled and replaced by a new lease when improved technology becomes available. In these cases, the lessor protects itself by requiring the lessee to pay higher rental payments.
5. It allows flexibility. Lease agreements may contain more flexible provisions than other debt agreements by tailoring the lease agreement to the lessee's special needs. For example, the lease term may range from a short period of time to the entire expected economic life of the asset. The rental payments may be level from year to year, or they may increase or decrease in amount. The payment amount may be predetermined or may vary with sales, the prime interest rate, the Consumer Price Index, or some other factor.
6. It can result in less costly financing. Some companies find leasing cheaper than other forms of financing.
7. It offers tax advantages. For financial reporting purposes, companies do not report operating lease (discussed later in the chapter) assets or liabilities. However, for income tax purposes companies are allowed to capitalize and depreciate the leased asset. As a result, a company takes deductions earlier rather than later and thereby reduces its taxes.
8. It allows off-balance-sheet financing. Short-term operating leases can offer off-balance sheet financing and do not add debt on a balance sheet or affect financial ratios and therefore may add to borrowing capacity.
9. Define the following:
   1. Finance lease
   2. Operating lease
10. List the five criteria for recording a lease transaction as a finance lease according to ASC 842.
11. The lease transfers ownership of the property to the lessee by the end of the lease term. This includes the fixed noncancelable term of the lease plus various specified renewal options and periods.
12. The lease contains a purchase option that the lessee is reasonably certain to exercise. This means that when the lessee has the option to purchase the leased asset, at the inception of the lease the stated purchase price is sufficiently lower than the fair market value of the property expected at the date the option will become exercisable such that it appears to be at a bargain price. In this case, exercise of the option appears to be reasonably assured.
13. The lease term is equal to 75 percent or more of the estimated remaining economic life of the leased property, unless the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property.
14. At the beginning of the lease term, the present value of the minimum lease payments (the amounts of the payments the lessee is required to make excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessee) equals or exceeds 90 percent of the fair value of the leased property less any related investment tax credit retained by the lessor. (This criterion is also ignored when the lease term falls within the last 25 percent of the total estimated economic life of the leased property).
15. The leased asset is not so specialized that it is expected to have no alternative use.
16. How is the recorded amount of a lessee finance lease determined under ASC 842?
17. The sum of the present value of the minimum lease payments at the inception of the lease (see the following discussion).
18. The fair value of the leased property at the inception of the lease.
19. What is the difference between a sales-type and a direct financing type of finance lease under ASC 842?
20. What is a leveraged lease? How do lessees and lessors record leveraged leases under ASC 842?
21. What is the definition of a lease under the provisions of ASU 2016-02?

• Fulfillment of the contract depends on the use of an identified asset.
• The contract conveys the right to control the use of the identified asset.

1. What are the two classifications of leases for lessees under ASU 2016-02 and how is that classification determined?
2. Finance leases (which replaces capital leases)
3. Operating leases

• The lease transfers ownership of the underlying asset to the lessee by the end of the lease term
• The lease grants the lessee an option to purchase the underlying asset the lessee is reasonably certain to exercise
• The lease term is for the major part of the remaining economic life of the underlying asset
• The present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the underlying asset.
• The underlying asset is of such specialized nature that there is no expected alternative use to the lessor at the end of the lease term.

1. How do lessees and lessors allocate the contract price to separate lease and nonlease components under the provisions of ASU 2016-02?
2. How do lessors determine whether to record a lease as: 1. Sales-type, 2. Direct financing or 3. Operating, under the provisions of ASU 2016-02?

• The present value of the sum of lease payments and any residual value guaranteed by the lessee that is not already reflected in lease payments and/or any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of the underlying asset
• It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.

1. What is a lease modification and what is the proper accounting treatment for lease modifications under ASU 2016-02?

A lease modification is a change to the contractual terms and conditions of a contract that results in a change in the scope of or the consideration for the lease. Initial direct costs, lease incentives, and any other payments made in connection with a modification are accounted for similar to the accounting fora new lease. In certain circumstances, the lessee may be required to remeasure the lease payments. Remeasurement of the lease payment may be triggered by a reassessment of the lease term. Remeasurement is also required when the contingency associated with a variable lease payment is subsequently resolved such that the variable lease payment now meets the definition of a lease payment or when there is a change in the amounts probable of being paid by the lessee under a residual value guarantee. When the lessee remeasures the lease payments, any variable lease payments that are based on a rate or index will need to be remeasured. Remeasurement of the lease payments also requires a remeasurement of the total lease liability, and the lessee is generally required to use an updated discount rate. The remeasurement to the lease liability results in an adjustment to the right‐of‐use asset until it is reduced to zero, after which any remaining adjustment is recorded in the income statement.

12. Lopez Company leases a new machine to Abbott Corporation. The machine has a cost of $70,000 and fair value of $95,000. Under the 3-year, non-cancelable contract, Abbott will receive title to the machine at the end of the lease. The machine has a 3-year useful life and no residual value. The lease was signed on January 1, 2020. Lopez expects to earn an 8% return on its investment, and this implicit rate is known by Abbott. The annual rentals are payable on each December 31, beginning December 31, 2020. How should this lease be recorded by Lopez and Abbott?

Because title to the asset passes to the lessee, the lease term is for the major part of the remaining economic life of the underlying asset. That is, (3/3 = 100%), and the present value of the lease payments is more than 90% of the fair value of the asset ($95,000/$95,000 = 100%), it is a financing lease to the lessee. Assuming the collectibility of the rents is probable, the lease is accounted for as a sales-type lease by Lopez.

Abbott should account for the lease as a finance lease and record the right-of-use asset and lease liability at the present value of the lease payments using the incremental borrowing rate if it is impracticable to determine the interest rate implicit in the lease. Because both the economic life of the asset and the lease term are three years, the leased asset should be depreciated over this period.

Lopez should account for the lease as a sales-type lease. The lessor should record a lease receivable and sales revenue equal to the present value of the lease payments of $95,000. In addition, the lessor should remove the asset (inventory) from its books at $70,000, and the related cost of goods sold $70,000. Interest is recognized annually at a constant rate relative to the unrecovered lease receivable.

13. On January 1, 2020, Abreau Company contracts to lease equipment for 5 years, agreeing to make a payment of $120,987 at the beginning of each year, starting January 1, 2020. The leased equipment is to be capitalized at $550,000. The asset is to be amortized on a double-declining-balance basis, and the obligation is to be reduced on an effective-interest basis. Abreau’s incremental borrowing rate is 6%, and the implicit rate in the lease is 5%, which is known by Abreau. Title to the equipment transfers to Abreau at the end of the lease. The asset has an estimated useful life of 5 years and no residual value.

What does $550,000 amount represent?

The $550,000 is the present value of the five annual lease payments of $120,987 to be made at the beginning of each year discounted at 5% since the lessee knows the implicit rate.

14. Under the provisions of SFAS No. 13, the difference between a sales-type and a direct financing lease for a lessor was the existence of manufacturer’s or dealer’s profit at (or loss) the inception of the lease. Under FASB ASC 842 this criterion no longer exists. What are the FASB ASC criteria for classifying a lease as either direct financing or sales-type?

Whether a lease is similar to a sale of a right of use asset depends on whether the lessee, in effect, obtains control of the leased asset. Since meeting any one of the five finance lease criteria implies that control of the leased asset passes from the lessor to the lessee, all leases that meet one or more of the finance lease criteria are classified as sales-type leases. In assessing the finance lease criteria, the lessor, unlike the lessee, the lessor shall always determine the present value the lease payments and any residual value guaranteed by the lessee using the rate implicit in the lease.

If none of the five finance lease criteria is met, the lessor is to classify the lease as either a direct financing lease or an operating lease. A lease is classified as a direct financing lease when both of the following conditions are met.

• The present value of the sum of lease payments and any residual value guaranteed by the lessee that is not already reflected in lease payments and/or any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of the underlying asset.

• It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.

All other leases are classified as operating leases

15. Burdi Leasing Company agrees to lease equipment to Hanson Corporation on January 1, 2020. (Its fiscal year ends on December 31st each year) The following information relates to the lease agreement.

1. The term of the lease is 7 years with no renewal option, and the machinery has an estimated economic life of 9 years.

2. The cost of the machinery is $525,000, and the fair value of the asset on January 1, 2020, is $700,000.

3. At the end of the lease term, the asset reverts to the lessor and has a guaranteed residual value of $50,000. Hanson estimates that the expected residual value at the end of the lease term will be $50,000. Hanson amortizes all of its leased equipment on a straight-line basis.

4. The lease agreement requires equal annual rental payments, beginning on January 1, 2020.

5. The collectibility of the lease payments is probable.

6. Burdi requires a 5% rate of return on its investments. Hanson’s incremental borrowing rate is 6%, and the lessor’s implicit rate is unknown.

How should Burdi and Hanson record this lease?

This is a sales-type lease for Burdi because collectibility of the lease payments is probable, and one of the five criteria for classifying the lease as a financing lease has been met because the lease term is for the major part of the remaining economic life of the underlying asset. That is. the lease term is greater than 75% of the asset’s economic life. In addition, the present value of the lease payments is greater than 90% of the asset’s fair value.

This is a finance lease for Hanson because the lease term is a major part of the asset’s economic life. 75% is still used in FASB ASC 842 as minimum threshold for measuring the major part” of the asset’s economic life of the leased asset. (The lease term is 78% (7 ÷ 9) of the asset’s economic life).

16. Discuss the difference between a finance lease and an operating lease from a lessee’s perspective.

From the lessee’s perspective, a lessee should classify a lease based on whether the arrangement is effectively a purchase of the underlying asset. If the lessee transfers control (or ownership) of the underlying asset to a lessee, then the lease is classified as a finance lease. In this situation, the lessee takes ownership or consumes the substantial portion of the underlying asset over the lease term. All leases that do not meet any of the finance lease tests are classified as operating leases. In an operating lease, a lessee obtains the right to use the underlying asset but not ownership of the asset itself.

For a finance lease, the lessee recognizes interest expense on the lease liability over the life of the lease using the effective-interest method and records amortization expense on the right-of-use asset generally on a straight-line basis. A lessee therefore reports both interest expense and amortization of the right-of-use asset on the income statement. As a result, the total expense for the lease transaction is generally higher in the earlier years of the lease arrangement under a finance lease arrangement.

In an operating lease, the lessee also measures interest expense using the effective interest method. However, the lessee amortizes the right-of-use asset such that the total lease expense is the same from period to period. In other words, for operating leases, only a single lease expense (comprised of interest on the liability and amortization of the right-of-use asset) is recognized on the income statement, typically on a straight-line basis.