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Chapter 15Leases

MULTIPLE CHOICE
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.
ANS: A

OBJ: LO 2

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.
ANS: D

OBJ: LO 2

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.
ANS: B

OBJ: LO 4

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.
ANS: D

OBJ: LO 5

5. The present value of the minimum lease payments should be used by the lessee in the
determination of a(n)
Capital
Lease Liability
a.
b.
c.
d.

Yes
Yes
No
No

ANS: A

Operating
Lease Liability
No
Yes
Yes
No

OBJ: LO 4

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.
ANS: C

OBJ: LO 4

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.
ANS: C

OBJ: LO 5

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 Johnson's option.
ANS: C

OBJ: LO 5

9. The lessee's 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.
ANS: D

OBJ: LO 5

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
ANS: A

OBJ: LO 5

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.
ANS: C

OBJ: LO 5

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.
ANS: D

OBJ: LO 5

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).
ANS: C

OBJ: LO 5

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

OBJ: LO 5

15. A lease contains a bargain purchase option. In determining the lessee's 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.
ANS: C

OBJ: LO 5

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 dealer's profit at lease inception and interest revenue over the lease
term.
d. The lessor recognizes a dealer's profit at lease inception and interest revenue over the asset
life.
ANS: C

OBJ: LO 6

a.
b.
c.
d.

17.
Initial direct costs incurred by a lessor in consummating a sales-type lease are
charged to unearned income in the first period of the lease term.
charged to cost of sales in the first period of the lease term.
deferred and allocated over the lease term in proportion to the recognition of rent revenue.
deferred and allocated over the lease term on a straight-line basis.

ANS: B

OBJ: LO 6

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
a.
b.
c.
d.

Operating Lease

Yes
Yes
No
No

No
Yes
No
Yes

ANS: D

OBJ: LO 5

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
a.
b.
c.
d.

Lease Z

Capital lease
Capital lease
Operating lease
Operating lease

ANS: B

Operating lease
Capital lease
Capital lease
Operating lease

OBJ: LO 4

20. 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.
ANS: D

OBJ: LO 6

21. 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 Draper's treatment of the lease?
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.
ANS: A

OBJ: LO 4

22. 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.
ANS: D

OBJ: LO 3

23. 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.
ANS: C

OBJ: LO 3

24. 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 lessor's option.
ANS: B

OBJ: LO 3

25. From the standpoint of the lessee, the minimum lease payment includes all of the following
except
a. the guaranteed residual value.
b. the lessee's obligation to pay executory costs.
c. the bargain purchase option.
d. any payment that the lessee must make upon failure to extend or renew the lease.
ANS: B

OBJ: LO 3

26. Which of the following is (are) not correct regarding disclosure requirements lessees?

a.

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.
I only.

b.
c.
d.
ANS: D

II only.
Both I and II.
Both III and IV.
OBJ: LO 7

27. 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 lessor's leasing arrangements.
ANS: A

OBJ: LO 7

28. In order for a lease to be considered a finance (or capital) lease, international 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.
ANS: A

OBJ: LO 8

29. 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
year's 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
ANS: A

OBJ: LO 5

30. Stockton, Inc. leased machinery with a fair value of $250,000 from Layton Machine Co. on
December 31, 2005. 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, 2005.
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, 2005?
a. $189,540
b. $200,000
c. $230,240
d. $239,540
ANS: A

OBJ: LO 5

31. Baxter Company leased equipment to Fritz Inc. on January 1, 2005. The lease is for an eight-year
period expiring December 31, 2012. The first of eight equal annual payments of $900,000 was
made on January 1, 2005. Baxter had purchased the equipment on December 29, 2004, 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, 2005, 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
2006 (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
ANS: D

OBJ: LO 6

32. Jordan Co. leased a machine on December 31, 2005. 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, 2005, and the second
payment was made on December 31, 2006. 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, 2006, balance sheet?
a. $466,500
b. $515,000
c. $534,150
d. $576,500
ANS: A

OBJ: LO 5

33. Aerotech Inc., a dealer in machinery and equipment, leased equipment to Quality Products on
July 1, 2005. The lease is appropriately accounted for as a sale by Aerotech and as a purchase by
Quality. The lease is for a ten-year period (the useful life of the asset) expiring June 30, 2015.
The first of ten equal annual payments of $250,000 was made on July 1, 2005. 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, 2005, 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, 2005?
a. $245,000 and $94,950
b. $245,000 and $79,950
c. $350,000 and $79,950
d. $350,000 and $94,950
ANS: B

OBJ: LO 6

34. On January 1, 2005, 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 2005 income statement from this lease transaction?
a. $0
b. $16,000
c. $24,000
d. $33,333
ANS: C

OBJ: LO 5

35. 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, 2005, 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, 2006, balance sheet,
Epson should report a liability under capital lease of
a. $871,400.
b. $876,600.
c. $974,000.
d. $1,091,400.
ANS: A

OBJ: LO 5

36. Slice Company manufactures equipment that they sell or lease. On December 31, 2005, 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, 2005. The normal sales
price of the equipment is $220,000, and cost is $176,000. For the year ended December 31, 2005,
what amount of income should Slice report from the lease transaction?
a. $10,000
b. $30,000
c. $44,000
d. $74,000
ANS: C

OBJ: LO 6

37. On March 1, 2006, Sturdy Corp. became the lessee of new equipment under a noncancelable sixyear lease. The total estimated economic life of this equipment is ten years. The fair value of this
equipment on March 1, 2006, 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.
ANS: C

OBJ: LO 4

38. On December 31, 2006, 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,
2006.
B & B's implicit interest rate of 12 percent is known to Gephardt.
Gephardt's 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.
ANS: B

OBJ: LO 5

39. On January 1, 2005, 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 finder's fee. The warehouse is depreciated at $20,000 per year. During
2005, Collins incurred insurance and property tax expense totaling $15,000. Collins' net rental
income for 2005 should be
a. $9,000.
b. $41,400.
c. $44,000.
d. $45,000.
ANS: B

OBJ: LO 6

40. 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.
ANS: C

OBJ: LO 5

41. Hazard Inc. manufactures equipment that is sold or leased. On December 31, 2005, Hazard leased
equipment to Robards for a five-year period expiring December 31, 2010, 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, 2005.
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, 2005, how much income should Hazard recognize from the lease
transaction?
a. $46,000
b. $40,000
c. $34,000
d. $28,000
ANS: C

OBJ: LO 6

42. 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.
ANS: C

OBJ: LO 5

43. On December 1, 2005, 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 Blake's income statement for the year ended December 31,
2005, as rent expense?
a. $0
b. $2,000
c. $24,000
d. $48,000
ANS: B

OBJ: LO 5

44. On December 31, 2005, 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, 2005, of the ten lease payments over
the lease term discounted at 10 percent was $676,000. At December 31, 2006, Cooke's total
capital lease liability is
a. $486,000.
b. $518,000.
c. $533,600.
d. $607,960.
ANS: C

OBJ: LO 5

45. 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
a.
b.
c.
d.

Lease Z

Capital lease
Capital lease
Operating lease
Operating lease

ANS: B

Operating lease
Capital lease
Capital lease
Operating lease

OBJ: LO 8

PROBLEMS
1. On July 1, 2005, Hawkeye Aviation leased two helicopters from Honnicutt Aircraft for an initial
period of 12 months with a provision for a continuation on a month-to-month basis. The lease is
properly classified as an operating lease. Lease payments are to be made as follows:
First two months .................................
Second three months ..............................
Third three months ...............................
Last four months .................................

$15,000
12,000
10,000
8,000

per
per
per
per

month
month
month
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
(1)
(2)

Hawkeye Aviation.
Honnicutt Aircraft.

10

ANS:
(1)
Hawkeye Aviation (Lessee)
2005
July, Aug.

Sept., Oct., Nov.

Prepaid Rent .............


Rent Expense ([2($15,000) +
3($12,000) + 3($10,000) +
4($8,000)] / 12)
Cash ...................

4,333
10,667

Prepaid Rent .............


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

1,333
10,667

Rent Expense .............


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

10,667

Rent Expense .............


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

10,667

15,000

12,000

2005
Dec.

2006
Jan., Feb.

10,000
667

2006
Mar., Apr.
May, June

8,000
2,667

(2)
Honnicutt Aircraft (Lessor)
2005
July, Aug.

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

15,000

Sept., Oct.
Nov.

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

12,000

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

10,000
667

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

8,000
2,667

4,333
10,667
1,333
10,667

2005
Dec.

2006
Jan., Feb.

10,667

2006
Mar., Apr.
May, June

OBJ:

10,667

LO 5, LO 6

2. On January 2, 2005, 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.

11

Provide the necessary journal entries to record the transactions for Wilcox for the period January
2, 2005 through December 31, 2006.
ANS:
PVn = R(PVAFn/i)
PVn = $9,000(Table IV 13/10%)
PVn = $9,000(7.1034)
PVn = $63,931
2005
Jan. 2
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 10%) ...
Cash .............................

2,607
6,393

Amortization Expense ...............


Accumulated Amortization .........

4,918

Obligations under Capital Lease ....


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

2,868

63,931
4,918

9,000

2006
Dec. 31

OBJ:

4,918

6,132
9,000

LO 5

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, 2005.
Provide the journal entries required on Washington's books to
(1)
(2)

record the lease transaction and the first lease payment.


recognize interest revenue at the end of the first year. Washington uses a calendaryear accounting period. (Round all computations to the nearest dollar.)

ANS:
(1)
2005
Jan. 1

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


Equipment Purchased for Lease .....
Unearned Interest Revenue .........

588,600

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

58,860

12

330,000
258,600
58,860

(2)
Dec. 31

OBJ:

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


Interest Revenue...................
[($588,600 - $58,860 - $258,600)
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%

43,382
43,382

LO 6

4. Jason Inc. uses leases as a means of selling its equipment. On January 1, 2005, 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)
(2)
(3)

Provide the entries required on Jason's books to record the lease and the first
payment.
Compute the manufacturer's profit to be recognized by Jason in the first year of the
lease.
Provide the entry required on Jason's books to recognize interest revenue at the end
of the first year. (Round computations to the nearest dollar.)

ANS:
(1)
2005
Jan. 1

Lease Payments Receivable


($13,500 12) ..................
Cost of Goods Sold ................
Finished Goods Inventory ........
Unearned Interest Revenue .......
Sales ...........................

162,000

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

13,500

Sales price of machine .......................


Cost to manufacture ..........................
Manufacturer's profit ........................

$101,184
78,450
$ 22,734

78,450

78,450
60,816
101,184
13,500

(2)

(3)
2005
Dec. 31

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


Interest Revenue ................
[($162,000 - $13,500 - $60,816) .
10*]
* Computation of implicit interest
rate:
$101,184/$13,500 = 7.4951

13

8,768
8,768

7.4951 - 1.0000 = 6.4951 for 11


periods.
From Table IV, the rate is 10%.

OBJ:

LO 6

5. On January 1, 2005, 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,
2012 (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 2005 assuming all payments after the initial payment
are made on December 31.

(2)

Give the entry at December 31, 2012, assuming the option is permitted to lapse and
that there is no residual value because of obsolescence. Assume 2012 amortization
entries have been made.

ANS:
(1)
2005
Jan. 1

Dec. 31

Leased Equipment .....................


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

93,151

Obligations under Capital Lease ......


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

15,000

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


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

6,210

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


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

9,378
5,622

93,151

15,000
6,210

15,000

(2)
2012
Dec. 31

OBJ:

Loss from Failure to Exercise Bargain


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

19,476
2,571
21,424
49,680
93,151

LO 5

6. Farewell Inc. leases equipment to its customers under noncancelable leases. On January 1, 2005,
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.

14

Prepare all journal entries for 2005 on Farewell's and Norman's books. Round all calculations to
the nearest dollar. Use straight-line depreciation.
ANS:
Farewell's Books (Lessor)
2005
Jan. 1

Lease Payments Receivable


[($44,000 18) + $80,000] .........
Cost of Goods Sold
($400,000 - 28,024) ................
Finished Goods Inventory ..........
Unearned Interest Revenue .........
Sales .............................
$44,000 11.4773 = $505,001
$80,000 .3503 =
28,024
$533,025

872,000
371,976

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

46,000

July 1

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

46,000

July 1

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


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

29,342

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


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

28,462

Dec. 31

400,000
338,975
505,001

44,000
2,000
44,000
2,000

29,342

28,462

Norman's Books (Lessee)


2005
Jan. 1

July 1

Dec. 31

OBJ:

Leased Equipment ....................


Obligations under Capital Leases ..

505,001

Lease Expense .......................


Obligations under Capital Leases ....
Cash ..............................

2,000
44,000

Interest Expense
[($505,001 - $44,000) 0.06] .....
Obligations under Capital Leases ....
Lease Expense .......................
Cash ..............................

27,660

Amortization Expense ................


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

56,111

LO 5, LO 6

15

505,001

46,000

16,340
2,000

46,000
56,111

26,680

26,680

7. Henri Retail Stores is negotiating three leases for store locations. Henri's 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

Lease Payment

Purchase Price

26 years
20 years
20 years

$1,500,000
1,300,000
1,400,000

$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)
(2)
(3)

Location A
Location B
Location C

ANS:
(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 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 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 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.

OBJ:

LO 5

16

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, 2005, and subsequent payments being made on December 31 of each year. Standard's
incremental borrowing rate is 12 percent.
Prepare a schedule amortizing Standard's lease obligation.
ANS:
Date

Payment

1/1/2005
1/1/2005
$5,000
12/31/2005
5,000
12/31/2006
5,000
12/31/2007
5,000
12/31/2008
5,000
* $5,000 4.0373 = $20,187

OBJ:

Interest
Expense

Principal

Lease
Obligation

$1,822
1,441
1,014
536

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

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

LO 5

9. Johnson Manufacturing entered into a noncancelable lease for an office building on January 1,
2005. The lease calls for payments of $24,000 a year for eight years. The first payment is due on
January 1, 2005, 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 straight-line method and assuming no salvage value.
Prepare a partial balance sheet for Johnson for the year ending December 31, 2005, disclosing the
asset and the liability related to the leased building.
ANS:
Asset:
Cost: $24,000 6.2064 = $148,954
Annual amortization: $148,954 / 8 years = $18,619
Liability:
($148,954 - $24,000) .08 = $9,996 interest portion of 12/31/05 payment
$24,000 - $9,996 = $14,004 principal portion of 12/31/05 payment
$24,000 - ([$148,954 - $24,000 - $14,004] .08) = $15,124
principal portion of 12/31/2006 payment
Johnson Manufacturing
Balance Sheet (partial)
December 31, 2005
Land, buildings, and equipment:
Leased building .......................................
Less accumulated amortization .........................
Current liabilities:
Obligations under capital lease--current portion ......
Noncurrent liabilities:
Obligations under capital lease--exclusive of amount
included in current liabilities .......................

17

$148,954
18,619
$130,335
15,124
95,826

OBJ: LO 7
10. 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.
ANS:
Disadvantages of leasing for a lessee include the following:
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.

OBJ:

LO 1

11. 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.
ANS:
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.

18

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.
OBJ:

LO 1

19