Chapter 18 Intermediate Accounting 2e Gordon TB

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TB
Intermediate Accounting I (Southern Methodist University)
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Intermediate Accounting, 2e (Gordon/Raedy/Sannella)

Chapter 18 Accounting for Leases
18.1 Leases: Overview
1) In general, the cost of an asset over the life of the lease is lower than if the lessee
purchased the asset.
Answer: FALSE
Diff: 1 Var: 1
Objective: 18.1
IFRS/GAAP: GAAP
AACSB: Reflective thinking
2) When a company purchases equipment by issuing a long-term note, the interest element
of the payment is tax deductible. However, if the company leases equipment, the entire
lease payment may be tax deductible.
Answer: TRUE
Diff: 1 Var: 1
Objective: 18.1
IFRS/GAAP: GAAP
3) The concept of substance over form can be applied to leases. Which lease terms are most
important to understanding the economic substance of the lease contract?
Answer: The amount and timing of lease payments; the length of the lease; the economic
life of the leased asset; whether the lease transfers ownership of the leased asset to the
lessee at the end of the lease; and whether the lessee can, and is likely to, buy the leased
item at the end of the lease.
Diff: 1 Var: 1
Objective: 18.1
IFRS/GAAP: GAAP
18.2 Lease Contracts, Lease Components, and Contract Consideration
1) After identifying a lease, both the lessee and the lessor are required to separate the
various lease and nonlease components and allocate consideration to these components.
Answer: TRUE
Diff: 1 Var: 1
Objective: 18.2
IFRS/GAAP: GAAP
AACSB: Application of knowledge
2) When there are several assets as part of the lease, only some must be separately
identified.
Answer: FALSE
Diff: 1 Var: 1
Objective: 18.2
IFRS/GAAP: GAAP
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3) Which of the following assets is always considered a separate lease component in a lease,
unless the impact on the financial statements of not separating it from the other asset(s) is
insignificant?
A) land
B) services associated with the lease
C) fully depreciated assets
D) All of the above
Answer: A
Diff: 2 Var: 1
Objective: 18.2
IFRS/GAAP: GAAP
4) In cases where the standalone price is highly variable or uncertain, the lessee may use
what type of method for determining standalone prices?
A) market method
B) residual method
C) component method
D) Both A and C are correct.
Answer: B
Diff: 2 Var: 1
Objective: 18.2
IFRS/GAAP: GAAP
5) Which of the following items are not examples of initial direct lease costs?
A) commissions
B) legal fees resulting from the execution of the lease
C) costs to prepare documents after the execution of the lease
D) All of the above are examples of indirect lease costs.
Answer: D
Diff: 1 Var: 1
Objective: 18.2
IFRS/GAAP: GAAP
6) In instances where there is not an observable standalone selling price, the lessor must
use an estimate of the standalone selling price and allocate it based on which of the
following methods?
A) adjusted market assessment approach
B) expected-cost-plus-a-margin approach
C) residual approach
D) any of the above approaches
Answer: D
Diff: 1 Var: 1
Objective: 18.2
IFRS/GAAP: GAAP
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7) Alpha Company has three components in their lease agreement: the building, the
equipment and the maintenance service. Total consideration in the contract is $500,000 per
year. Alpha Company has identified the following standalone prices:
Component Standalone Price

Building $400,000
Equipment 100,000
Maintenance/Service 50,000
Total $550,000
Calculate the percentages and allocate the consideration to each component.

Answer: As the total consideration in the contract is not equal to the sum of the standalone
prices, Alpha Company uses the relative standalone prices to allocate the total consideration
to each component. The $500,000 total consideration is allocated as follows: (Round
percentages to two decimal places.)
Standalone Allocated
Component Price Percentage Consideration
Building $400,000 72.73% $363,650
Equipment 100,000 18.18% 90,900
Maintenance/Service 50,000 9.09% 45,450
Total $550,000 $500,000
Diff: 2 Var: 1
Objective: 18.2
IFRS/GAAP: GAAP
18.3 Lease Classifications
1) Present value of lease payments + Present value of guaranteed or unguaranteed residual

asset = Fair value of leased asset + Deferred initial direct costs.
Answer: TRUE
Diff: 2 Var: 1
Objective: 18.3
IFRS/GAAP: GAAP
2) The initial direct costs cannot be deferred and the lessor must expense initial direct costs
at the lease commencement.
Answer: FALSE
Diff: 2 Var: 1
Objective: 18.3
IFRS/GAAP: GAAP
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3) IFRS does not classify leases as operating and financing and does not distinguish two
types of leases. Rather, lessee accounting treatment is the same for all leases under IFRS.
Answer: TRUE
Diff: 1 Var: 1
Objective: 18.3
IFRS/GAAP: IFRS
4) The Group II criteria seem like a simple way to achieve a reporting outcome. FASB wanted
lessors to recognize a profit at lease commencement from nonoperating lease treatment
due partly to a third-party residual value guarantee.
Answer: FALSE
Diff: 2 Var: 1
Objective: 18.3
IFRS/GAAP: GAAP
5) The ________ date is when the lease agreement is signed. The ________ date is the date on
which the lessee is allowed to begin using the leased asset.
A) lease inception; lease commencement
B) lease consideration; lease commencement
C) lease inception; lease finalization
D) Both A and B are correct.
Answer: A
Diff: 1 Var: 1
Objective: 18.3
IFRS/GAAP: GAAP
6) If the lessor meets any one of the five Group I criteria, then the lessor classifies the lease
as a(n) ________. If the lessor meets both of the Group II criteria, but none of the Group I
criteria, then the lessor classifies the lease as a(n) ________. If the transaction does not meet
either the Group I or Group II criteria, then the lessor classifies the lease as a(n) ________.
A) operating lease; direct financing lease; sales-type lease
B) sales-type lease; direct financing lease; operating lease
C) standalone price lease; sales-type lease; direct financing lease
D) direct financing lease; operating lease; sales-type lease
Answer: B
Diff: 2 Var: 1
Objective: 18.3
IFRS/GAAP: GAAP
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7) Prior to 2019, lessees did not include the right-of-use asset and the lease liability for
operating leases on their balance sheets. Both FASB and IASB wrote new standards to
require that lessees nearly always report an asset and liability on their balance sheets when
they engage in a lease transaction. This accounting results in which of the following?
A) a more reliable estimation of the lease's value
B) a more faithful representation of the rights and obligations arising from leases
C) a better determination on whether the lessor held the risks and rewards of the leased
asset's ownership
D) All of the above
Answer: B
Diff: 2 Var: 1
Objective: 18.3
IFRS/GAAP: GAAP/IFRS
8) Kataran Company enters into a 4-year lease transaction, with payments due at the
beginning of each year.
The lease payments are $78,000 per year.
The fair value of the leased asset is $290,000.
The lessor's deferred initial direct costs are equal to $24,000.
The lessor's estimate of the unguaranteed residual asset is $115,000.
Based on the above information, what is the implicit rate in the lease for Kataran?
A) 11.48%
B) 21.81%
C) 14.77%
D) 16.54%
Answer: D
Explanation: Kataran should apply time value of money concepts to identify the terms
needed to solve for the implicit rate. The present value, PV, is the present value of the lease
payments plus the expected residual value which equals the fair value of the leased asset
plus the deferred initial direct costs:
Present Value of Lease Payments + Present Value of Estimated Residual Value
= $290,000 Fair Value of Leased Asset + $24,000 Initial Direct Costs = $314,000
The number of periods, N, is 4 years. The payments each period, PMT, are $78,000. The
future value, FV, is the residual value of $115,000. Using the RATE function in Excel,
(=RATE(4,78000,-314000,115000,1)), the implicit rate in the lease is 16.54%.
Diff: 2 Var: 1
Objective: 18.3
IFRS/GAAP: GAAP
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9) Kataran Company enters into a 4-year lease transaction, with payments due at the
beginning of each year.
The lease payments are $68,000 per year.
The fair value of the leased asset is $280,000.
The lessor's deferred initial direct costs are equal to $14,000.
The lessor's estimate of the unguaranteed residual asset is $125,000.
Based on the information above, what is the implicit rate?
Answer: Kataran should apply time value of money concepts to identify the terms needed to
solve for the implicit rate. The present value, PV, is the present value of the lease payments
plus the expected residual value which equals the fair value of the leased asset plus the
deferred initial direct costs:
Present Value of Lease Payments + Present Value of Estimated Residual Value = $280,000
Fair Value of Leased Asset + $14,000 Initial Direct Costs = $294,000. The number of
periods, N, is 4 years. The payments each period, PMT, are $68,000. The future value, FV, is
the residual value of $125,000. Using the RATE function in Excel (=RATE(4,68000,-
294000,125000,1)), the implicit rate in the lease is 15.14%.
Diff: 3 Var: 1
Objective: 18.3
IFRS/GAAP: GAAP
10) Group I criteria provide guidance to operationalize the concept of ownership and control
of an asset. To meet the Group I criteria, a transaction only needs to meet one of the five
criteria. List those five criteria.
Answer:
1. The lease transfers ownership of the leased asset to the lessee at the end of the lease
term. If the lease transfers ownership, then the lessee firm has, in essence, purchased the
asset.
2. The lessee is given an option to purchase the asset that the lessee is reasonably certain
to exercise. For example, it might be reasonably certain that the lessee would exercise a
purchase option if the specified purchase price is well below the expected value of the
leased asset at the completion of the lease term.
3. The lease term is for a major part of the economic life of the asset. If the lease term
provides the lessee the use and control over substantially all of the asset's useful life, then
the agreement should be considered equivalent to purchasing the asset.
4. The present value of the sum of the lease payments and any residual value the lessee
guarantees to pay (that is not otherwise included in the lease payments) is equal to
substantially all of the asset's fair value. The present value computation includes lease
payments in the renewal periods, if any. Meeting this criterion implies that the lessee is
providing the lessor compensation that is equivalent to the purchase of the asset.
5. The leased asset is of a specialized nature. An asset with a specialized nature has no
alternative use to the lessor at the end of the lease term. Because the asset has no
alternative use to the lessor, its specialized nature implies that the lessor must have
transferred control over the asset to the lessee.
Diff: 2 Var: 1
Objective: 18.3
IFRS/GAAP: GAAP
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11) List the three additional indicators that IFRS recognizes individually or in combination
that could lead to classifying a lease as a finance lease.
Answer:
1. The lessee bears the lessor's losses if the lessee cancels the lease.
2. The lessee absorbs the gains or losses from fluctuations in the fair value of the residual
value of the asset.
3. The lessee may extend the lease for a secondary period at a rent substantially below the
market rent in a renewal option.
Diff: 2 Var: 1
Objective: 18.3
IFRS/GAAP: IFRS
18.4 Accounting for Operating Leases: Lessee and Lessor
1) Measuring the right-of-use asset includes the following components: the lease liability
determined as the future value of the remaining lease payments, lease payments the lessee
makes to the lessor at or before the commencement date, a reduction for any lease
incentives the lessee receives and any initial direct costs the lessee incurs.
Answer: FALSE
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
2) For an operating lease, the lessee will record a(n) ________ and an associated lease
liability on the balance sheet.
A) intangible asset
B) capital adjustment
C) contra-liability account
D) right-of-use asset
Answer: D
Diff: 2 Var: 1
Objective: 18.4
3) On the balance sheet, the lease liability is measured as ________.

A) the present value of the lease payments plus the present value of the guaranteed
residual value if the lessee guarantees it(if any)
B) the present value of the lease payments less the present value of the guaranteed residual
value (if any)
C) the future value of the lease payments plus the future value of the guaranteed residual
value (if any)
D) the present value of the lease payments plus the future value of the guaranteed residual
value (if any)
Answer: A
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
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4) Which of the following statements is true?

A) The right-of-use asset is increased by prepaid lease payments, but reduced by lease
incentives and the lessee's initial direct costs.
B) The right-of-use asset is increased by prepaid lease payments and the lessee's initial
direct costs, but reduced by lease incentives.
C) The right-of-use asset is reduced by the lessee's initial direct costs, but increased by
lease incentives and prepaid lease payments.
D) The right-of-use asset is reduced by prepaid lease payments and the lessee's initial direct
costs, but increased by lease incentives.
Answer: B
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
5) Leewin Brokerage enters into a lease agreement with Bumble Motors to lease an
automobile with a fair value of $77,000 under a 5-year lease on December 20, 2018. The
lease commences on January 1, 2019, and Leewin will return the automobile to Bumble on
December 31, 2023. The automobile has an estimated useful life of 7 years. Leewin made a
lease payment of $10,900 on December 20, 2018. In addition, the lease agreement
stipulates annual payments of $10,900, due on January 1 of 2019, 2020, 2021, 2022, and
2023. The implicit rate of the lease is 7% and is known by Leewin. There is no purchase
option, no lease incentives, no residual value guarantees, and no transfer of ownership.
Leewin incurs initial direct costs of $1,200.
Assuming that this is classified as an operating lease, what is the amount of the lease
liability on January 1, 2019 before the lease payment?
A) $47,821
B) $45,892
C) $44,692
D) $64,200
Answer: A
Explanation: The lease liability is calculated as the present value of the future payments.
Using Excel, the present value of the future lease payments, based on a rate of 7%, 5
periods, and payments at the beginning of each period of $10,900, is $47,821. The Excel
formula: =PV(0.07,5,-10900,0,1) = $47,821.
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
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Compute the present value of the lease payments in order to determine if the lease meets
the fourth Group I criterion. Calculate the present value of each payment individually.
Assuming that this is classified as an operating lease, what is the value of the right-of-use
asset at the lease's commencement?
A) $44,518
B) $46,018
C) $57,799
D) $47,799
Answer: C
Explanation: The right-of-use asset is valued as the initial measurement of the lease liability
(the present value of the future lease payments) plus prepayments plus initial direct costs.
periods, and payments at the beginning of each period of $10,000, is $46,299. The value of
the right-of-use asset is $46,299 + $10,000 + $1,500 = $57,799.
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
Assuming that this is classified as an operating lease, what is the annual lease expense
reported on the income statement?
A) $10,900
B) $13,300
C) $12,000
D) $11,120
Answer: B
Explanation: To calculate the annual lease expense, the first step is to calculate the total
payments over the life of the lease, which include prepaid payments, annual payments and
initial direct costs. Total payments are $10,900 + (5 × $10,900) + $1,100 = $66,500.
Annual lease expense is calculated by allocating this amount equally over the 5-year lease
life, $66,500 / 5 = $13,300.
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
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In addition to the information provided above, assume that Bumble provided a $6,000
incentive. Assuming that this is classified as an operating lease, what is the annual lease
expense reported on the income statement?
A) $10,000
B) $12,220
C) $11,100
D) $11,020
Answer: D
Explanation: To calculate the annual lease expense, the first step is to calculate the total
payments over the life of the lease, which include prepaid and annual payments and initial
direct costs, less lease incentives. Total payments are $10,000 + (5 × $10,000) + $1,100 -
$6,000 = $55,100. Annual lease expense is calculated by allocating this amount equally
over the 5-year lease life, $55,100 / 5 = $11,020.
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
Assuming that this is classified as an operating lease, how much interest expense is
recorded in 2019?
A) $1,982
B) $0
C) $2,140
D) $1,554
Answer: D
Explanation: Interest for 2019 is calculated based on the lease liability reduced by the first
payment of $10,700 times the interest rate. The lease liability is calculated as the present
value of the future payments. Using Excel, the present value of the future lease payments,
based on a rate of 4%, 5 periods, and payments at the beginning of each period of $10,700,
is $49,540. ($49,540 - $10,700) × 4% = $1,554.
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
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Assuming that this is classified as an operating lease, how much amortization is recorded on
the right-of-use asset in 2019?
A) $11,612
B) $0
C) $13,180
D) $1,568
Answer: A
Explanation: Amortization is the difference between the lease expense for the year and
interest for the year. To calculate the annual lease expense, the first step is to calculate the
total payments over the life of the lease, which include prepaid and annual payments and
initial direct costs. Total payments are $10,800 + (5 × $10,800) + $1,100 = $65,900.
Annual lease expense is calculated by allocating this amount equally over the 5-year lease
life, $65,900 / 5 = $13,180. Interest for 2019 is calculated based on the lease liability
reduced by the first payment of 5 times the interest rate. The lease liability is calculated as
the present value of the future payments. Using Excel, the present value of the future lease
payments, based on a rate of 4%, 5 periods, and payments at the beginning of each period
of $10,800, is $50,003. ($50,003 - $10,800) × 4% = $1,568. Therefore, amortization is
$13,180 - $1,568 = $11,612.
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
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11) Starboard Industries enters into a lease agreement with Bumble Motors to lease an
lease commences on January 1, 2019, and Starboard will return the automobile to Bumble
on December 31, 2023. The automobile has an estimated useful life of 7 years. Starboard
made a lease payment of $10,300 on December 20, 2018. In addition, the lease agreement
2023. The implicit rate of the lease is 4% and is known by Starboard. Starboard guarantees
a residual value of $3,000 and incurs initial direct costs of $1,700.
Assuming that this is classified as an operating lease, what is the amount of the lease
A) $47,688
B) $50,154
C) $45,854
D) $60,100
Answer: B
periods, payments at the beginning of each period of $10,300, and a future value of $3,000
is $50,154. The Excel formula is =PV(0.04,5,-10300,-3000,1) = $50,154.
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
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12) Starboard Industries enters into a lease agreement with Bumble Motors to lease an
Assuming that this is classified as an operating lease, what is the value of the right-of-use
asset at the lease's commencement?
A) $45,027
B) $46,627
C) $59,278
D) $62,804
Answer: D
Explanation:
Initial measurement of the lease liability $50,804
Payments lessee makes to the lessor prior to the lease
commencement date 10,400
Lease incentives received 0
Initial direct costs incurred by the lessee 1,600
Initial measurement of the right-of-use asset $62,804
The lease liability is calculated as the present value of the future payments. Using Excel, the
present value of the future lease payments, based on a rate of 5%, 5 periods, payments at
the beginning of each period of $10,400, and a future value of $4,500 is $50,804. The Excel
formula is =PV(0.05,5,-10400,-4500,1) = $50,804.
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
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Leewin Brokerage
Leewin Brokerage enters into a lease agreement with Bumble Motors to lease an automobile
with a fair value of $75,000 under a 5-year lease on December 20, 2018. The lease
commences on January 1, 2019, and Leewin will return the automobile to Bumble on
13) Assuming that this is classified as an operating lease, what is the amount of the lease
liability at January 1, 2019 before the payment?
Answer: The lease liability is calculated as the present value of the future payments. Using
Excel, the present value of the future lease payments, based on a rate of 7%, 5 periods, and
payments at the beginning of each period of $10,000, is $43,872. The Excel formula is:
=PV(.07,5,-10000,0,1) = $43,872.
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
14) Based on the above information, calculate the right-of-use asset on January 1, 2019.
Answer:
*The lease liability is found using the Excel formula: =PV(.07,5,-10000,0,1) = $43,872.
Diff: 1 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
15) Based on the above information, what is the journal entry Leewin made to record the
initial payment of $10,000?
Answer:
Account December 20, 2018
Prepaid Lease Payment 10,000
Cash 10,000
Diff: 1 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
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16) Based on the above information, record the lessee's journal entry for the payment of
initial direct costs.
Answer:
Account January 1, 2019
Prepaid Initial Direct Costs 2,000
Cash 2,000
Diff: 1 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
17) Assuming this is an operating lease, what journal entries does Leewin make on January
1, 2019?
Answer:
January 1, 2019
Account Debit Credit
Cash 2,000

Right-of-Use Asset 55,872
Prepaid Initial Direct
Costs 2,000
Lease Liability 43,872
January 1, 2019
Cash 10,000
present value of the future lease payments, based on a rate of 7%, 5 periods, and payments
at the beginning of each period of $10,000, is $43,872. The Excel formula is =PV(.07,5,-
10000,0,1) = $43,872.
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
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18) What journal entry does Leewin make on January 1, 2019 to record the annual lease
payment?
Answer:
Cash 10,000
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
19) Assuming that this is classified as an operating lease, what is the annual lease expense
Answer: To calculate the annual lease expense, the first step is to calculate the total
payments over the life of the lease, which include initial and annual payments and indirect
costs. Total payments are $10,000 + (5 × $10,000) + $2,000 = $62,000. Annual lease
expense is calculated by allocating this amount equally over the 5-year lease life, $62,000 /
5 = $12,400.
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
20) Assuming that this is classified as an operating lease, create an amortization table for
periodic interest and reduction in the liability.
Periodic Interest and Reduction in the Liability

Reduction in
Payment Interest Lease Liability Balance
Lease commencement:
1/1/2019
1/1/2020
1/1/2021
1/1/2022
1/1/2023
Answer:
Payment Interest Reduction Balance
43,872
Lease commencement:
1/1/2019 10,000 10,000 33,872
1/1/2020 10,000 2,371 7,629 26,243
1/1/2021 10,000 1,837 8,163 18,080
1/1/2022 10,000 1,266 8,734 9,346
1/1/2023 10,000 654 9,346 (0)
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
the right-of-use asset.
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Amortization of Right-of-Use Asset

Lease Amortization of
Expense Interest Right-of-Use Asset
12/31/2019
12/31/2020
12/31/2021
12/31/2022
12/31/2023
Total
Answer:
12/31/2019 12,400 2,371 10,029
12/31/2020 12,400 1,837 10,563
12/31/2021 12,400 1,266 11,134
12/31/2022 12,400 654 11,746
12/31/2023 12,400 0 12,400
Total 62,000 6,128 55,872
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
22) Prepare the journal entry required on December 31, 2019. Assume this is an operating
lease.
Answer:
Date Account Debit Credit
12/31/2019Lease Expense 12,400
Accumulated Amortization–Right-of-Use
Asset 10,029
Accrued Lease Payable 10,000
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
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Starboard Industries
Starboard Industries enters into a lease agreement with Bumble Motors to lease an
Excel, the present value of the future lease payments, based on a rate of 7%, 5 periods,
payments at the beginning of each period of $10,000, and a future value of $5,000 is
$47,437. The Excel formula is: =PV(.07,5,-10000,-5000,1) = $47,437.
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
Answer:
Initial measurement of the lease liability $47,437*
*Using Excel, =PV(.07,5,-10000,-5000,1) = $47,437

Diff: 1 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
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25) Assuming this is an operating lease, what journal entries does Starboard make on
January 1, 2019?
Answer:
January 1, 2019
Cash 2,000

the beginning of each period of $10,000, and a future value of $5,000 is $47,437.
January 1, 2019
Cash 10,000
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
Incentive Industries
Incentive Industries enters into a lease agreement with Bumble Motors to lease an
automobile with a fair value of $75,000 under a 5-year lease on December 20, 2018. Bumble
provides Incentive Industries with a lease incentive in the amount of $6,000 to terminate
another lease. The lease commences on January 1, 2019, and Incentive will return the
automobile to Bumble on December 31, 2023. The automobile has an estimated useful life
of 7 years. Incentive made a lease payment of $10,000 on December 20, 2018. In addition,
the lease agreement stipulates annual payments of $10,000, due on January 1 of 2019,
2020, 2021, 2022, and 2023. The implicit rate of the lease is 7% and is known by Incentive.
Incentive incurs initial direct costs of $2,000.
liability at on January 1, 2019 before the lease payment?
Excel, the present value of the future lease payments, based on a rate of 7%, 5 periods, and
payments at the beginning of each period of $10,000 = $43,872. The Excel formula is:
=PV(.07,5,-10000,0,1) = $43,872.
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
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Answer:
Initial measurement of the lease liability $43,872*
Lease incentives received (6,000)
*The Excel formula is: =PV(.07,5,-10000,0,1) = $43,872.

Diff: 1 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
28) What journal entries does Incentive make on January 1? Assume this is an operating
lease.
Answer:
January 1, 2019
Cash 2,000

Liability for Lease Incentive 6,000
present value of the future lease payments, based on a rate of 7%, 5 periods, and payments
at the beginning of each period of $10,000 = $43,872. The Excel formula is: =PV(.07,5,-
10000,0,1) = $43,872.
January 1, 2019
Cash 10,000
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
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29) What journal entry does Incentive make on January 1, 2019 to record the annual lease
payment?
Answer:
Cash 10,000
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
30) Assuming that this is classified as an operating lease, what is the annual lease expense
Answer: To calculate the annual lease expense, the first step is to calculate the total
payments over the life of the lease, which include prepaid and annual payments and initial
direct costs, and reduced by the lease incentive. Total payments are $10,000 + (5 ×
$10,000) + $2,000 - $6,000 = $56,000. Annual lease expense is calculated by allocating this
amount equally over the 5-year lease life, $56,000 / 5 = $11,200.
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
periodic interest and reduction in the liability.

Lease commencement:
1/1/2019
1/1/2020
1/1/2021
1/1/2022
1/1/2023
Answer: Periodic Interest and Reduction in the Liability

43,872
Lease commencement:
1/1/2019 10,000 10,000 33,872
1/1/2020 10,000 2,371 7,629 26,243
1/1/2021 10,000 1,837 8,163 18,080
1/1/2022 10,000 1,266 8,734 9,346
1/1/2023 10,000 654 9,346 (0)
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
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32) Incentive Industries enters into a lease agreement with Bumble Motors to lease an
automobile with a fair
Assuming that this is classified as an operating lease, create an amortization table for the
right-of-use asset?

12/31/2019
12/31/2020
12/31/2021
12/31/2022
12/31/2023
Total
Answer:
12/31/2019 11,200 2,371 8,829
12/31/2020 11,200 1,837 9,363
12/31/2021 11,200 1,266 9,934
12/31/2022 11,200 654 10,546
12/31/2023 11,200 0 11,200
Total 56,000 6,128 49,872
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
33) Prepare the journal entry required on December 31, 2019. Assume this is an operating
lease.
Answer:
Date Account Debit Credit
12/31/2019Lease Expense 11,200
Asset 8,829
Accrued Lease Payable 10,000
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
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34) Lexus Company rents a copier from Heavenly Co on January 1, 2017. Under the terms of
the agreement, Lexus Company will pay rentals of $7,000 per month for a 6-month period.
Lexus Company will make these payments at the beginning of every month, beginning on
January 1, 2017. Lexus Company elects to apply the exemption for short-term leases. That
is, Lexus Company makes a policy election not to record the lease liability and the right-of-
use asset. What journal entry will Lexus Company make each month to record the rental
payments?
Answer: The monthly journal entry follows:
Account
Rent Expense 7,000
Cash 7,000
Diff: 1 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
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35) On January 1, 2018, Jones AutoWorld, Inc. leases an SUV to Mains Company. The lease
term is 4 years with no renewal options and the economic life of the SUV is 7 years. The fair
value of the automobile is $65,000 and Jones' cost or carrying value is also $65,000. There
are no lease incentives. The lease calls for monthly payments of $800 at the end of each
month. Mains incurs initial direct costs of $2,400 on January 1, 2018. The implicit rate in the
lease is 5%. There is no transfer of ownership at the end of the lease term. Lease payment
collection is probable.
To determine whether Jones, the lessor, should classify the lease as operating, direct
financing, or sales-type, we assess both Group I and Group II criteria. Complete the below
table and draw a conclusion about how the lease should be classified.
Group I Criteria Met? Explanation

Transfer of ownership?
Purchase option likely to be exercised?
Lease term major part of economic life?
Present value substantial part of fair
value?
Asset is specialized?
Group II Criteria
Present value including third-party
guarantees substantially all of fair value?
Lease payment collection probable?
Answer: We have information to assess all of the criteria except for the fourth criterion of
Group I. The present value of an ordinary annuity of the 48 remaining lease payments of
$800 at a discount rate of 0.4167% per period (5%/12) is $34,738. The Excel formula is:
=PV(.004166667,48,-800) = $34,738.
Group I Criteria Met? Explanation

Transfer of ownership? No
Purchase option likely to be exercised? No
The lease term is 57% (4 yrs/7
Lease term major part of economic life? No yrs) of economic life
Present value substantial part of fair The PV of $34,738 is 53% of the
value? No $65,000 fair value.
Asset is specialized? No
Group II Criteria
Present value including third-party
guarantees substantially all of fair The PV of $34,738 is 53% of fair
value? No value.
Lease payment collection probable? Yes
The lease does not meet the Group I or both of the Group II criteria and thus it is an
operating lease.
Diff: 2 Var: 1
Objective: 18.4
IFRS/GAAP: GAAP
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18.5 Accounting for Finance Leases: Lessee
1) For both finance and operating leases, if the residual value is guaranteed by a third party
or is unguaranteed, then the residual value does not impact the lessee's accounting
treatment.
Answer: TRUE
Diff: 1 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
2) Each period of a finance lease, the lessee records a lease expense that includes which of
the following?
A) Interest expense on the lease liability, using the effective interest rate method and the
discount rate it used to compute the present value of the liability at the lease
commencement date; variable lease payments not included in the lease liability in the
period in which the obligation for the variable payments is incurred.
B) Interest expense on the lease liability, using the effective interest rate method and the
commencement date; variable lease payments not included in the lease liability in the
period in which the obligation for the variable payments is incurred; and changes in variable
lease payments that depend on an index or rate.
C) Neither A nor B is correct.
D) Both A and B are correct.
Answer: B
Diff: 3 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
3) Nace Manufacturing Company leased a piece of nonspecialized equipment for use in its
operations from Righteous Leasing on January 1, 2019. The 10-year lease requires lease
payments of $4,000, beginning on January 1, 2019, and at each December 31 thereafter
through 2027. The equipment is estimated to have a 10-year life, is depreciated on the
straight-line basis and will have no residual value at the end of the lease term. Nace's
incremental borrowing rate is 11%. Initial direct costs of $1,000 are incurred by the lessee
on January 1, 2019. Righteous Leasing acquired the asset just prior to the lease term at a
cost of $27,000. Collection of all lease payments is reasonably assured.
What is the proper classification of the lease to Nace?
A) Sales-type lease
B) Finance lease
C) Operating lease
D) Either A or B
Answer: B
Explanation: The lease is classified as a finance lease as the lease term is equal to the
asset's useful life and because the present value of the lease payments is 97% of the fair
value of the asset. Using Excel, the formula is =PV(.11,10,-4000,0,1) = $26,148. Calculation:
$26,148/$27,000 = 97%.
Diff: 3 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
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incremental borrowing rate is 6%. Initial direct costs of $1,400 are incurred by the lessee on
January 1, 2019. Righteous Leasing acquired the asset just prior to the lease term at a cost
of $63,468. Collection of all lease payments is reasonably assured.
What is the amount of the lease liability recorded by Nace at the lease's commencement?
A) $58,881
B) $62,414
C) $63,468
D) $64,868
Answer: B
periods, and payments at the beginning of each period of $8,000, is $62,414. Using Excel,
the formula is =PV(0.06,10,-8000,0,1) = $62,414.
Diff: 2 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
incremental borrowing rate is 9%. Initial direct costs of $1,000 are incurred by the lessee on
January 1, 2019. Righteous Leasing acquired the asset just prior to the lease term at a cost
of $29,035. Collection of all lease payments is reasonably assured.
What is the value of the right-of-use asset to Nace at the lease's commencement?
A) $30,035
B) $26,981
C) $26,671
D) $28,981
Answer: D
Explanation:
Initial direct costs incurred by the lessee $1,000
present value of the future lease payments, based on a rate of 9%, 10 periods, and
payments at the beginning of each period of $4,000, is $27,981. Using Excel, the formula is
=PV(0.09,10,-4000,0,1) = $27,981.
Diff: 2 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
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What is the reduction in the lease liability recorded with the first and second lease
payments, respectively?
A) $6,000; $2,545
B) $4,165; $4,165
C) $36,499; $2,350
D) $4,055; $3,650
Answer: A
Explanation: The first payment is made on the commencement of the lease, so the entire
payment reduces the lease liability. See the following amortization table, using the effective
interest method:

Commencement 40,554
1-Jan-19 6,000 6,000 34,554
31-Dec-19 6,000 3,455 2,545 32,009
Diff: 2 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
What is the amortization of the right-of-use asset recorded in 2019 and 2020, respectively?
A) $7,000; $2,737
B) $4,676; $4,676
C) $4,480; $2,520
D) $5,033; $4,480
Answer: B
Explanation: The right-of-use asset is amortized on a straight-line basis over the lease term.
Right-of-use asset = $45,759 + $1,000 = $46,759. $46,759 / 10 = $4,676. Using Excel, the
formula is =PV(0.11,10,-7000,0,1) = $45,759.
Diff: 2 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
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8) Nice Manufacturing Company leased a piece of nonspecialized equipment for use in its
straight-line basis and will have a $2,000 residual value at the end of the lease term on
December 31, 2028, which is guaranteed by Nice. Nice's incremental borrowing rate is 7%.
Initial direct costs of $2,500 are incurred on January 1, 2019. Righteous Leasing acquired the
asset just prior to the lease term at a cost of $64,012. Collection of all lease payments is
reasonably assured.
What is the amount of the lease liability recorded by Nice at the lease's commencement?
A) $67,741
B) $72,412
C) $74,912
D) $22,500
Answer: B
periods, payments at the beginning of each period of $9,500, and a $2,000 residual value is
$72,412. Using Excel, the formula is: =PV(0.07,10,-9500,-2000,1)=$72,412.
Diff: 2 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
9) Describe the accounting for a finance lease by the lessee if the lessee provides a residual
value guarantee.
Answer: If the lessee provides a residual value guarantee, the lessee includes the present
value of the residual value guarantee in the initial measurement of the lease liability. As is
the case with an operating lease, if the residual value is guaranteed by a third party or is
unguaranteed, then the residual value does not impact the lessee's accounting treatment.
Diff: 2 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
10) For a finance lease, what are the components of lease expense recorded by the lessee?
Answer:
1. Interest expense on the lease liability, using the effective interest rate method and the
commencement date.
2. Variable lease payments not included in the lease liability in the period in which the
obligation for the variable payments is incurred.
3. Changes in variable lease payments that depend on an index or rate.
Diff: 2 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
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11) Since IFRS makes an exception for leased assets that have low values, reporters may
account for leased assets with values of less than $5,000 as a rental agreement rather than
recognizing a right-of-use asset and a lease liability. For example, suppose a company
leases a $4,800 computer for 2.5 years. How does IFRS differ from how U.S. GAAP would
record this?
Answer: Under U.S. GAAP, the company records a right-of-use asset and a lease liability
because the lease term is greater than 1 year. Under IFRS, the company does not record the
right-of-use asset and a lease liability because the value of the leased asset is less than
$5,000, and it is a simple rental agreement.
Diff: 2 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
Nace Manufacturing Company

Nace Manufacturing Company leased a piece of nonspecialized equipment for use in its
incremental borrowing rate is 11%. Initial direct costs of $1,000 are incurred on January 1,
2019. Righteous Leasing acquired the asset just prior to the lease term at a cost of $27,000.
Collection of all lease payments is reasonably assured.
12) What is the proper classification of the lease to Nace?

Answer: The lease is classified as a finance lease as the lease term is equal to the asset's
useful life and because the present value of the lease payments is 97% of the fair value of
the asset. Using Excel, the formula is =PV(.11,10,-4000,0,1) = $26,148. Calculation:
$26,148/$27,000 = 97%.
Diff: 3 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
13) What is the amount of the lease liability recorded by Nace at the lease's
commencement?
and payments at the beginning of each period of $4,000, is $26,148. Using Excel, the
formula is =PV(.11,10,-4000,0,1) = $26,148.
Diff: 2 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
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14) What is the value of the right-of-use asset to Nace at the lease's commencement?
Answer:
present value of the future lease payments, based on a rate of 11%, 10 periods, and
payments at the beginning of each period of $4,000, is $26,148. Using Excel, the formula is
=PV(.11,10,-4000,0,1) = $26,148.
Diff: 2 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
15) Based on the above information, prepare an amortization table for the Nace
Manufacturing's lease liability.

Commencement
1-Jan-19
31-Dec-19
31-Dec-20
31-Dec-21
31-Dec-22
31-Dec-23
31-Dec-24
31-Dec-25
31-Dec-26
31-Dec-27
Answer:
Commencement 26,148
1-Jan-19 4,000 4,000 22,148
31-Dec-19 4,000 2,436 1,564 20,584
31-Dec-20 4,000 2,264 1,736 18,848
31-Dec-21 4,000 2,073 1,927 16,921
31-Dec-22 4,000 1,861 2,139 14,782
31-Dec-23 4,000 1,626 2,374 12,408
31-Dec-24 4,000 1,365 2,635 9,773
31-Dec-25 4,000 1,075 2,925 6,848
31-Dec-26 4,000 753 3,247 3,601
31-Dec-27 4,000 399 3,601 (0)
Diff: 2 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
16) Based on the above information, prepare Nace Manufacturing's journal entries at the
commencement of the lease, January 1 and December 31, 2019 payments, and amortization
of the right-of-use asset.
and payments at the beginning of each period of $4,000, is $26,148. Using Excel, the
30

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formula is: =PV(.11,10,-4000,0,1) = $26,148.

The following entries are made by the lessee during the first year of the lease:
Lease commencement:

Costs 1,000
Cash 1,000

Costs 1,000
Initial payment:

Cash 4,000
End of year payment:

Interest Expense 2,436
Cash 4,000
**Interest Expense = 11% × ($26,148 - $4,000)
Amortization of right-of-use asset:

Amortization Expense–Right-of-Use Asset 2,715
Accumulated Amortization–Right-of-Use Asset 2,715
Right-of-use asset is amortized on a straight-line basis over the life of the asset. $27,148/10
= $2,715.
Diff: 2 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
Nice Manufacturing Company

Nice Manufacturing Company leased a piece of nonspecialized equipment for use in its
straight-line basis and will have a $5,000 residual value at the end of the lease term on
December 31, 2028, which is guaranteed by Nice. Nice's incremental borrowing rate is 9%.
Initial direct costs of $2,000 are incurred by the lessee on January 1, 2019. Righteous
Leasing acquired the asset just prior to the lease term at a cost of $27,000. Collection of all
lease payments is reasonably assured.
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17) What is the amount of the lease liability recorded by Nice at the lease's
commencement?
payments at the beginning of each period of $8,000, and a $5,000 residual value is $58,074.
The Excel formula is: =PV(.09,10,-8000,-5000,1) = $58,074.
Diff: 2 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
18) What is the value of the right-of-use asset to Nice at the lease's commencement?
Answer:
the beginning of each period of $8,000, and a $5,000 residual value is $58,074. The Excel
formula is: =PV(.09,10,-8000,-5000,1) = $58,074.
Diff: 2 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
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19) Based on the above information, prepare an amortization table for the Nice
Manufacturing's lease liability.

Commencement
1-Jan-19
31-Dec-19
31-Dec-20
31-Dec-21
31-Dec-22
31-Dec-23
31-Dec-24
31-Dec-25
31-Dec-26
31-Dec-27
31-Dec-28
Answer:
Commencement $ 58,074
1-Jan-19 $ 8,000 $ 8,000 $ 50,074
31-Dec-19 $ 8,000 $ 4,507 $ 3,493 $ 46,581
31-Dec-20 $ 8,000 $ 4,192 $ 3,808 $ 42,773
31-Dec-21 $ 8,000 $ 3,850 $ 4,150 $ 38,623
31-Dec-22 $ 8,000 $ 3,476 $ 4,524 $ 34,099
31-Dec-23 $ 8,000 $ 3,069 $ 4,931 $ 29,168
31-Dec-24 $ 8,000 $ 2,625 $ 5,375 $ 23,793
31-Dec-25 $ 8,000 $ 2,141 $ 5,859 $ 17,934
31-Dec-26 $ 8,000 $ 1,614 $ 6,386 $ 11,548
31-Dec-27 $ 8,000 $ 1,039 $ 6,961 $ 4,587
31-Dec-28 $ 5,000 $ 413 $ 4,587 $ (0)

Diff: 2 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
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20) Based on the above information, prepare Nice Manufacturing's journal entries at the
commencement of the lease, January 1 and December 31, 2019 payments, and amortization
of the right-of-use asset.
payments at the beginning of each period of $8,000, and a $5,000 residual value is $58,074.
The following entries are made by the lessee during the first year of the lease:
Lease commencement:

Costs 1,000
Cash 1,000

Costs 2,000
Initial payment:

Cash 8,000
End of year payment:

Interest Expense 4,507
Cash 8,000
**Interest Expense = 9% × ($58,074 - $8,000)

Right-of-use asset is amortized on a straight-line basis (reduced by the guaranteed residual)

over the life of the asset. ($60,074 - $5,000) = $55,074. $55,074/10 = $5,507.
Diff: 2 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
21) Based on the information provided above, what are the journal entries on the lease
termination date of December 31, 2028, assuming that Nice must pay the guaranteed
residual value.
Answer:
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Using the following amortization table:

1-Jan-19 $ 8,000 $ 8,000 $ 50,074
31-Dec-19 $ 8,000 $ 4,507 $ 3,493 $ 46,581
31-Dec-20 $ 8,000 $ 4,192 $ 3,808 $ 42,773
31-Dec-21 $ 8,000 $ 3,850 $ 4,150 $ 38,623
31-Dec-22 $ 8,000 $ 3,476 $ 4,524 $ 34,099
31-Dec-23 $ 8,000 $ 3,069 $ 4,931 $ 29,168
31-Dec-24 $ 8,000 $ 2,625 $ 5,375 $ 23,793
31-Dec-25 $ 8,000 $ 2,141 $ 5,859 $ 17,934
31-Dec-26 $ 8,000 $ 1,614 $ 6,386 $ 11,548
31-Dec-27 $ 8,000 $ 1,039 $ 6,961 $ 4,587
31-Dec-28 $ 5,000 $ 413 $ 4,587 $ (0)

Asset 5,507

Interest Expense 413
Asset 55,074
Loss on Lease 5,000
Cash 5,000

over the life of the asset. ($60,074 - $5,000) = $55,074
Diff: 2 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
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22) Based on the information provided above, what are the journal entries on the lease
termination date of December 31, 2028, assuming that Nice does not have to pay the
guaranteed residual value.
Answer: Using the following amortization table:

1-Jan-19 $ 8,000 $ 8,000 $ 50,074
31-Dec-19 $ 8,000 $ 4,507 $ 3,493 $ 46,581
31-Dec-20 $ 8,000 $ 4,192 $ 3,808 $ 42,773
31-Dec-21 $ 8,000 $ 3,850 $ 4,150 $ 38,623
31-Dec-22 $ 8,000 $ 3,476 $ 4,524 $ 34,099
31-Dec-23 $ 8,000 $ 3,069 $ 4,931 $ 29,168
31-Dec-24 $ 8,000 $ 2,625 $ 5,375 $ 23,793
31-Dec-25 $ 8,000 $ 2,141 $ 5,859 $ 17,934
31-Dec-26 $ 8,000 $ 1,614 $ 6,386 $ 11,548
31-Dec-27 $ 8,000 $ 1,039 $ 6,961 $ 4,587
31-Dec-28 $ 5,000 $ 413 $ 4,587 $ (0)

Asset 5,507

Interest Expense 413

over the life of the asset. ($60,074 - $5,000) = $55,074.
Diff: 2 Var: 1
Objective: 18.5
IFRS/GAAP: GAAP
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23) With respect to lessees, how do IFRS and U.S. GAAP differ in the accounting treatment of
operating and finance leases?
Answer: The primary difference in IFRS and U.S. GAAP related to lessee accounting is that
IFRS does not distinguish operating from finance leases in the same way that U.S. GAAP
does. Under IFRS, lessees use the same accounting treatment for both types of leases.
Specifically, IFRS uses the U.S. GAAP accounting for finance leases for both operating and
finance leases. Thus, under IFRS, lessees report interest expense and amortization expense
on all leases.
In addition to the short-term policy election to account for a lease as a rental agreement,
IFRS makes an exception for leased assets that have low values. IFRS reporters may account
for leased assets with original costs of less than $5,000 as rental agreements.
Diff: 2 Var: 1
Objective: 18.5
18.6 Accounting for Sales-Type Leases: Lessor
1) For lessors of sales-type leases, cost of goods sold is equal to the carrying value of the
leased asset less the present value of any unguaranteed residual asset plus any deferred
initial direct costs paid by the lessor.
Answer: TRUE
Diff: 2 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
2) For lessors of sales-type leases, the lease receivable is the present value of payments to
be received plus the present value of residual value guarantees.
Answer: TRUE
Diff: 1 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
3) The lessor of a sales-type lease records the following items in net income, if they are part
of the lease agreement: Interest revenue on the net investment in the lease for a sales-type
lease and any variable payments received that were not included in the net investment.
Answer: TRUE
Diff: 1 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
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4) For a(n) ________ lease, a lessor recognizes revenue on the sale and records the asset,
________ lease. It also removes the leased asset from its accounts and records the ________.
A) sales-type; finance; revenue
B) operating; net investment in lease–sales-type; cost of goods sold
C) finance; gross investment in lease–sales-type; cost of goods sold
D) sales-type; net investment in lease–sales-type; cost of goods sold
Answer: D
Diff: 2 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
5) The net investment in the lease for a sales-type lease reflects the assets related to the
lease transaction and is comprised of the following: ________.
A) the lease receivable and the present value of any unguaranteed residual asset
B) the lease receivable and the present value of any guaranteed residual asset
C) the lease receivable and the future value of any unguaranteed residual asset
D) the lease receivable and the future value of any guaranteed residual asset
Answer: A
Diff: 2 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
6) Revenue for a sales-type lease is the lower of ________.

A) the fair value of the leased asset or the sum of the lease receivable and any lease
payments paid before the lease commencement date
B) the present value of the leased asset or the sum of the lease payable and any lease
payments paid before the lease commencement date
C) the fair value of the leased asset or the sum of the lease receivable and lease payments
paid after the lease commencement date
D) the present value of the leased asset or the sum of the lease payable and any lease
payments paid after the lease commencement date
Answer: A
Diff: 2 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
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7) Plessings Company leased a piece of machinery to Banana, Inc. on January 1, 2019. The
lease is correctly classified as a sales-type lease. Plessings will receive three annual lease
payments of $20,100, with the first one received on January 1, 2019. There is no guaranteed
or unguaranteed residual value. The fair value of the machine is $50,000 and Plessings
incurs initial direct costs of $5,000. What is the implicit rate assuming the initial direct costs
are expensed?
A) 22.22%
B) 9.97%
C) 4.74%
D) 9.98%
Answer: A
Explanation: To solve for the rate using Excel and the RATE function, the following inputs
are used: N=3, PMT=20,100, PV=-50000 TYPE=1. As a result, the implicit rate is 22.22%.
The Excel formula is: =Rate(3,20100,-50000,0,1) = 22.22%.
Diff: 3 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
incurs initial direct costs of $5,000. What is the implicit rate assuming the initial direct costs
are deferred?
A) 26.5%
B) 13.51%
C) 6.33%
D) 11.67%
Answer: B
Explanation: To solve for the rate using Excel and the RATE function, the following inputs
are used: N=3, PMT=20,700, PV=-55000 TYPE=1. As a result, the implicit rate is 13.51%.
The Excel formula is: =Rate(3,20700,-55000,0,1) = 13.51%.
Diff: 3 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
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9) Elton Electronics leases testing equipment to Startup Corporation. The equipment is not
specialized and is delivered on January 1, 2019. The fair value of the equipment is $103,000.
The cost of the equipment to Elton is $98,000 and the expected life of the testing equipment
is 8 years. Elton incurs initial direct costs of $10,000, which they elect to expense. The lease
term for the equipment is 8 years, with the first payment due upon delivery, and seven
subsequent annual payments beginning on December 31, 2019 and ending on December
31, 2025. Elton's implicit rate is 8% and they expect that collection of the $13,000 lease
payments is probable.
What is the principal balance in the Net Investment in Lease — Sale Type account at the
commencement of the lease?
A) $80,683
B) $67,683
C) $98,000
D) $60,098
Answer: A
Explanation: The present value of the lease payments, calculated using Excel, are $80,683,
using the following inputs: rate=8%, periods=8, payment=13,000. The Excel formula is:
=PV(0.08,8,13000,0,1) = $80,683.
Diff: 2 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
What is the principal balance in the Net Investment in Lease — Sale Type account after the
first payment?
A) $58,419
B) $47,919
C) $73,000
D) $43,169
Answer: B
Explanation: The present value of the lease payments, calculated using Excel, are $58,419,
using the following inputs: rate=12%, periods=8, payment=10,500. The first payment of
$10,500 reduces the principal balance with nothing allocated to interest, as it is made on the
date that the lease commences. $58,419 - $10,500 = $47,919.
Diff: 2 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
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The cost of the equipment to Elton is $113,000 and the expected life of the testing
equipment is 8 years. Elton incurs initial direct costs of $10,000, which they elect to
expense. The lease term for the equipment is 8 years, with the first payment due upon
delivery, and seven subsequent annual payments beginning on December 31, 2019 and
ending on December 31, 2025. Elton's implicit rate is 5% and they expect that collection of
the $14,500 lease payments is probable.
What is the principal balance in the Net Investment in Lease — Sale Type account after the
second payment on December 31, 2019?
A) $98,402
B) $83,902
C) $113,000
D) $73,597
Answer: D
Explanation: See amortization table.
Date Payment Interest Principal NIL-ST Balance

Commencement $98,402
1-Jan-19 $14,500 $14,500 $83,902
31-Dec-19 $14,500 $4,195 $10,305 $73,597
Diff: 2 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
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How much interest will Elton record for 2019?
A) $12,500
B) $7,294
C) $5,206
D) $6,206
Answer: C
Explanation:
See amortization table.

1-Jan-19 $12,500 $12,500 $65,080
31-Dec-19 $12,500 $5,206 $7,294 $57,786
Diff: 2 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
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13) Northern Equipment leases cooling towers to Warmup Corporation. The equipment is not
The cost of the equipment to Northern is $170,000 and the expected life of the testing
equipment is 8 years. At the end of the useful life, it is expected that the equipment will
have a residual value of $20,000, although the lessee guarantees only $15,000. Northern
incurs initial direct costs of $20,000, which they elect to expense. The lease term for the
equipment is 8 years, with the first payment due upon delivery, and seven subsequent
annual payments beginning on December 31, 2019 and ending on December 31, 2025.
Northern's implicit rate is 8% and they expect that collection of the $30,000 payments is
probable. The lease is properly classified as a sales-type lease.
What is Northern's implicit rate for the lease? (Round any intermediate calculations to the
nearest dollar, and round your final percentage two decimal places, X.XX%.)
A) 9.64%
B) 9.85%
C) 7.6%
D) 7.33%
Answer: B
Explanation: Because the lease contains a residual value, the implicit rate must be
recalculated including the residual amount as a future value. Using Excel, the first step is to
calculate the present value of the future lease payments, using the following formula in
Excel: =PV(8%,8,30000,0,1) = $186,191. This value is used in a rate calculation, using this
amount as the present value and the residual value as the future value. Using the Excel
formula =RATE(8,30000,-186191,20000,1), the new implicit rate is 9.85%.
Diff: 2 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
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What is the amount of the lease receivable? (Round any present value calculations to the
nearest dollar, and round any percentages two decimal places, X.XX%.)
A) $165,251
B) $180,000
C) $167,674
D) $172,326
Answer: A
Explanation: The lease receivable is the present value of the payments and any guaranteed
residual value, using the recomputed implicit rate.
Because the lease contains a residual value, the implicit rate must be recalculated including
the residual amount as a future value. Using Excel, the first step is to calculate the present
value of the future lease payments, using the following formula in Excel:
=PV(8%,8,27000,0,1) = $167,572. This value is used in a rate calculation, using this amount
as the present value and the residual value as the future value. Using the Excel formula
=RATE(8,27000,-167572,20000,1), the new implicit rate is 10.04%.
The lease receivable is calculated using the new implicit rate, payments as outlined in the
lease, and a future value equal to the guaranteed residual value. Using the formula
=PV(10.04%,8,27000,15000,1), the lease receivable is $165,251.
Diff: 2 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
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What amount will be recorded for cost of goods sold? (Round any present value calculations
to the nearest dollar, and round any percentages two decimal places, X.XX%.)
A) $134,270
B) $180,000
C) $167,744
D) $172,256
Answer: C
Explanation: Cost of goods sold will be the cost of the equipment to Northern less the
present value of the unguaranteed residual value at the implicit rate. Using Excel, the
present value of the unguaranteed residual value is calculated as =PV(10.46%,8,0,5000) =
$2,256 and cost of goods sold is $167,744 = $170,000 -$2,256.
Diff: 2 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
incurs initial direct costs of $5,000. Compute the implicit rate assuming the initial direct
costs are expensed.
Answer: To solve for the rate using Excel and the RATE function, the following inputs are
used: N=3, PMT=20000, PV=-50000, TYPE=1. The Excel formula is: =RATE(3,20000,-
50000,0,1) = 21.53%. As a result, the implicit rate is 21.53%.
Diff: 3 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
incurs initial direct costs of $5,000. Compute the implicit rate assuming the initial direct
costs are deferred.
Answer: To solve for the rate using Excel and the RATE function, the following inputs are
used: N=3, PMT=20000, PV=-55000, TYPE=1. The Excel formula: =RATE(3,20000,-
55000,0,1) = 9.38%. As a result, the implicit rate is 9.38%.
Diff: 3 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
Elton Electronics
Elton Electronics leases testing equipment to Startup Corporation. The equipment is not
45

lOMoARcPSD|4810275
31, 2025. Elton's implicit rate is 8% and they expect that collection of the eight payments of
$14,500 payments is probable.
18) How will Elton Electronics classify this lease?

Answer: Elton will classify this as a sales type lease, as two of the Group I criteria are met.
First, the lease term is equal to the economic life, and the present value of the lease
payments is substantially equal to the fair value ($89,992/$90,000 = 100%). The present
value of the lease payments, calculated using Excel, is $89,992, using the following inputs:
rate=8%, periods=8, payment=14500. The Excel formula is: =PV(.08,8,14500,0,1) =
$89,992.
Diff: 3 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
19) Prepare the journal entries for the lessor to record the commencement of the lease, the
expensing of initial direct costs, and receipt of the first payment on January 1, 2019.
Answer: The present value of the lease payments, calculated using Excel, are $89,992,
using the following inputs: rate=8%, periods=8, payment=14500, type=1 (payments at
beginning of period). The Excel formula is: =PV(.08,8,14500,0,1) = $89,992.

Net Investment in Lease — Sales
Type 89,992
Cost of Goods Sold 85,000
Sales Revenue 89,992
Inventory of Testing Equipment 85,000

Initial Direct Costs Expense 10,000
Cash 10,000

Cash 14,500
Net Investment in Lease — Sales
Type 14,500
Diff: 2 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
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20) Prepare an amortization table for Elton's net investment.

Commencement
1-Jan-19
31-Dec-19
31-Dec-20
31-Dec-21
31-Dec-22
31-Dec-23
31-Dec-24
31-Dec-25
Answer:
1-Jan-19 $14,500 $14,500 $75,492
31-Dec-19 $14,500 $6,039 $8,461 $67,031
31-Dec-20 $14,500 $5,362 $9,138 $57,893
31-Dec-21 $14,500 $4,631 $9,869 $48,024
31-Dec-22 $14,500 $3,842 $10,658 $37,366
31-Dec-23 $14,500 $2,989 $11,511 $25,855
31-Dec-24 $14,500 $2,068 $12,432 $13,423
31-Dec-25 $14,500 $1,077 $13,423 $0
Diff: 2 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
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21) Based on the above information, what is the journal entry for the lessor on 12/31/19?
Answer:
Cash 14,500
Interest Revenue 6,039
Net Investment in Lease – Sales-Type 8,461

1-Jan-19 $14,500 $14,500 $75,492
31-Dec-19 $14,500 $6,039 $8,461 $67,031
31-Dec-20 $14,500 $5,362 $9,138 $57,893
31-Dec-21 $14,500 $4,631 $9,869 $48,024
31-Dec-22 $14,500 $3,842 $10,658 $37,366
31-Dec-23 $14,500 $2,989 $11,511 $25,855
31-Dec-24 $14,500 $2,068 $12,432 $13,423
31-Dec-25 $14,500 $1,077 $13,423 $0
Diff: 2 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
22) Based on the above information, what is the journal entry for the lessor on 12/31/20?
Answer:
Cash 14,500
Net Investment in Lease – Sales-Type 9,138

1-Jan-19 $14,500 $14,500 $75,492
31-Dec-19 $14,500 $6,039 $8,461 $67,031
31-Dec-20 $14,500 $5,362 $9,138 $57,893
31-Dec-21 $14,500 $4,631 $9,869 $48,024
31-Dec-22 $14,500 $3,842 $10,658 $37,366
31-Dec-23 $14,500 $2,989 $11,511 $25,855
31-Dec-24 $14,500 $2,068 $12,432 $13,423
31-Dec-25 $14,500 $1,077 $13,423 $0
Diff: 2 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
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23) How does a residual value affect accounting for a sales-type lease?
Answer: Including residual values has two implications for lease accounting. First, it
changes the implicit rate in the lease, which is defined as the interest rate at which the
present value of the lease payments plus the present value of the amount that a lessor
expects to derive from the leased asset at the end of the lease term equals the sum of the
asset's fair value plus any deferred initial direct costs of the lessor.
Second, the cost of goods sold is affected only by an unguaranteed residual value.
Specifically, the cost of goods sold is defined as the carrying value of the leased asset less
the present value of any unguaranteed residual asset plus any deferred initial direct costs of
the lessor. As a result, the inclusion of a residual value guarantee does not impact cost of
goods sold; only the inclusion of an unguaranteed residual asset reduces cost of goods sold.
Diff: 2 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
Northern Equipment
Northern Equipment leases cooling towers to Warmup Corporation. The equipment is not
24) Calculate Northern's implicit rate for the lease.

Answer: Because the lease contains a residual value, the implicit rate must be recalculated
including the residual amount as a future value. Using Excel, the first step is to calculate the
present value of the future lease payments, using the following formula in Excel:
=PV(8%,8,29002,0,1) = $179,997. This value is used in a rate calculation, using this amount
as the present value and the residual value as the future value. Using the Excel formula
Diff: 2 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
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25) What is the amount of the lease receivable?

Answer: The lease receivable is the present value of the payments and any guaranteed
residual value, using the recomputed implicit rate.
value of the future lease payments, using the following formula in Excel: =PV(8%,8,
29002,0,1) = $179,997. This value is used in a rate calculation, using this amount as the
present value and the residual value as the future value. Using the Excel formula
The lease receivable is calculated using the new implicit rate, payments as outlined in the
lease, and a future value equal to the guaranteed residual value. Using the formula
=PV(9.91%,8,29002,15000,1), the lease receivable is $177,659.
Diff: 2 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
26) What amount will be recorded for cost of goods sold?

Answer: Cost of goods sold will be the cost of the equipment to Northern less the present
value of the unguaranteed residual value at the implicit rate. Using Excel, the present value
of the unguaranteed residual value is calculated as =PV(9.91%,8,0,5000) = $2,348 and cost
of goods sold is $167,652.
value of the future lease payments, using the following formula in Excel: =PV(8%,8,
29002,0,1) = $179,997. This value is used in a rate calculation, using this amount as the
present value and the residual value as the future value. Using the Excel formula
Diff: 2 Var: 1
Objective: 18.6
IFRS/GAAP: GAAP
18.7 Accounting for Direct Financing Leases: Lessor
1) A direct financing lease meets the Group I but not the Group II criteria.
Answer: FALSE
Diff: 1 Var: 1
Objective: 18.7
IFRS/GAAP: GAAP
2) If the risks and rewards have been transferred, then IFRS classifies the lease as a finance
lease.
Answer: TRUE
Diff: 1 Var: 1
Objective: 18.7
IFRS/GAAP: IFRS
50

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3) For a dealer or manufacturer lessor, the use of a nonoperating lease is preferred because
it recognizes financing income and also accelerates revenue recognition in the form of the
gross profit on the sale in the year of commencement. Under an operating lease treatment,
the lessor only records rental income each year, spreading the revenue flow over the lease
term.
Answer: TRUE
Diff: 2 Var: 1
Objective: 18.7
IFRS/GAAP: GAAP
4) Revenue for a direct financing lease is calculated as ________.

A) the lower of (1) the fair value of the leased asset or (2) the sum of the lease receivable
and any lease payments paid before the lease commencement date
B) the higher of (1) the fair value of the leased asset or (2) the sum of the lease receivable
and any lease payments paid before the lease commencement date
C) the lower of (1) the residual value of the asset or (2) the sum of the lease receivable and
any lease payments paid before the lease commencement date
D) None of the above
Answer: A
Diff: 2 Var: 1
Objective: 18.7
IFRS/GAAP: GAAP
5) Net investment in the lease for a direct financing lease (NIL-DF) is comprised of ________.
A) the lease receivable, the future value of any unguaranteed residual asset and a reduction
for any deferred profit
B) the lease receivable, the present value of any unguaranteed residual asset, and a
reduction for any deferred profit
C) the lease receivable, the future value of any unguaranteed residual asset, and an addition
for any deferred profit
D) the lease receivable, the present value of any unguaranteed residual asset, and an
addition for any deferred profit
Answer: B
Diff: 2 Var: 1
Objective: 18.7
IFRS/GAAP: GAAP
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6) In subsequent measurement of a direct financing lease, the lessor computes interest

revenue using the ________ method. The lessor allocates lease payments first to cover the
________ and then to ________ the NIL-DF. The interest revenue, which is reported on the
income statement, is the amount that produces a constant periodic discount rate on the
remaining balance of the NIL-DF.
A) straight-line interest; interest; reduce
B) straight-line interest; interest; increase
C) effective interest rate; interest; reduce
D) effective interest rate; interest; increase
Answer: C
Diff: 2 Var: 1
Objective: 18.7
IFRS/GAAP: GAAP
7) The lessor would most likely prefer a ________ or ________ lease to an operating lease.
Nonoperating lease treatment would permit a financial service company lessor to remove
heavy machinery and equipment, jet airlines, oceangoing vessels, and such from its balance
sheet and replace it with the ________, a financial asset compatible with the nature of its
business. In addition, the nonoperating lease results in the recognition of ________, rather
than ________ revenue.
A) standalone price; sales-type; fair value of the leased asset; financing income; unearned
B) standalone; operating; fair value of the leased asset; interest income; rent
C) direct financing; sales-type; net investment in the lease; interest income; rent
D) direct financing; operating; net investment in the lease; financing income; unearned
Answer: C
Diff: 2 Var: 1
Objective: 18.7
IFRS/GAAP: GAAP
52

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8) On January 1, 2019, Precision Pumps leases nonspecialized pumping equipment to Mega

Construction. The equipment is delivered on January 1. The lease term is 4 years with no
renewal or purchase options, and title to the leased asset is retained by the lessor at the end
of the lease term. The lease requires annual fixed rental payments of $7,000 per year
beginning on January 1, 2019, and then December 31 of each year starting on December 31,
2019. The fair value of the equipment is $37,592 and has a carrying amount on Precision's
books of $22,000. The equipment has a remaining life of 8 years. The estimated residual
value of the equipment is $15,000. The lessee does not guarantee the residual value, but
Precision secured an unrelated third party to guarantee $15,000; collection of this
guaranteed residual value and lease payments are reasonably certain. The rate implicit in
the lease is 6%. There are no prepaid rentals, and neither party to the agreement pays initial
direct costs.
What is the proper classification of this lease for Precision Pumps?
A) sales-type lease
B) direct financing lease
C) operating lease
D) finance lease
Answer: B
Explanation: This lease is classified as a direct financing lease by Precision Pumps. None of
the Group I criteria are met, such as transfer of ownership, likely exercise of purchase
option, or specialized asset. The lease term is only 50% of the remaining economic life and
the present value of the lease payments (Excel =PV(6%,4,7000,0,1) = $25,711) represents
only $25,711/$37,592 = 68% of the fair value. However, the lease meets both Group 2
criteria. The present value of the lease payments and third-party guarantees (Excel
=PV(6%,4,7000,15000,1) = $37,592) is equal to 100% of the fair value and collection of the
lease payments is probable.
Diff: 2 Var: 1
Objective: 18.7
IFRS/GAAP: GAAP
53

lOMoARcPSD|4810275

the lease is 10%. There are no prepaid rentals, and neither party to the agreement pays
initial direct costs.
What amount of Sales Revenue is recorded at commencement of the lease?
A) $36,000
B) $31,382
C) $41,627
D) $28,306
Answer: C
Explanation: Sales revenue and net investment in the lease are calculated as the present
value of the lease payments plus the guaranteed residual. The present value of the lease
payments and third-party guarantees can be calculated in Excel, =PV(10%,4,9000,15000,1)
= $41,627.
Diff: 2 Var: 1
Objective: 18.7
IFRS/GAAP: GAAP
direct costs.
What amount is recorded for net investment in the lease at commencement of the lease?
A) $36,000
B) $33,057
C) $44,859
D) $30,504
Answer: C
Explanation: Sales revenue and net investment in the lease are calculated as the present
value of the lease payments plus the guaranteed residual. The present value of the lease
payments and third-party guarantees can be calculated in Excel, =PV(6%,4,9000,14900,1) =
$44,859.
Diff: 2 Var: 1
Objective: 18.7
IFRS/GAAP: GAAP
54

lOMoARcPSD|4810275
direct costs.
What is the balance in the net investment in the lease account after the first payment?
A) $26,982
B) $19,426
C) $32,675
D) $38,368
Answer: C
Explanation: The beginning balance of the net investment in the lease account is the
present value of the lease payments and third-party guarantees, which can be calculated in
Excel, =PV(4%,4,7000,15500,1) = $39,675. Since the first lease payment is made on the
date on which the lease commences, the entire payment reduces this amount and there is
no interest. As a result, the balance in the account after the first payment is $32,675.
Diff: 2 Var: 1
Objective: 18.7
IFRS/GAAP: GAAP
55

lOMoARcPSD|4810275
direct costs.
What is the balance in the net investment in the lease account after the second payment on
December 31, 2019?
A) $29,456
B) $23,588
C) $36,496
D) $43,536
Answer: A
Explanation: The beginning balance of the net investment in the lease account is the
present value of the lease payments and third-party guarantees, which can be calculated in
Excel, =PV(4%,4,8500,15100,1) = $44,996. Since the first lease payment is made on the
date on which the lease commences, the entire payment reduces this amount and there is
no interest. As a result, the balance in the account after the first payment is $36,496.
Interest of $36,496 × 4% = $1,460. From the $8,500 payment, $1,460 represents interest
and $7,040 reduces the principal balance to $29,456.
Diff: 2 Var: 1
Objective: 18.7
IFRS/GAAP: GAAP
13) List U.S. GAAP Lease Classification Criteria for both Group I and Group II.
Answer:
Group I
1. The lease transfers ownership of the leased asset to the lessee at the end of the lease
term.
2. The lessee is given an option to purchase the asset that the lessee is reasonably certain
to exercise.
3. The lease term is for a major part of the economic life of the asset.
4. The present value of the sum of the lease payments and any residual value guaranteed
by the lessee, that is not otherwise included in the lease payments, is equal to substantially
all of the fair value of the asset.
5. The leased asset is of a specialized nature.
Group II
1. The present value of the sum of the lease payments and any residual value guarantee
(from both the lessee and a third party in combination) that is not otherwise included in the
lease payments is equal to substantially all of the fair value of the asset.
2. It is probable that the lessor will collect the lease payments plus any amount necessary to
satisfy a residual value guarantee.
Diff: 2 Var: 1
Objective: 18.7
IFRS/GAAP: GAAP
Precision Pumps
On January 1, 2019, Precision Pumps leases nonspecialized pumping equipment to Mega
56

lOMoARcPSD|4810275
guaranteed residual value and lease payments is reasonably certain. The rate implicit in the
lease is 6%. There are no prepaid rentals, and neither party to the agreement pays initial
direct costs.
14) What is the proper classification of this lease for Precision Pumps?
Answer: This lease is classified as a direct financing lease by Precision Pumps. None of the
Group I criteria are met, such as transfer of ownership, likely exercise of purchase option, or
specialized asset. The lease term is only 50% of the remaining economic life and the present
value of the lease payments (Excel =PV(6%,4, 7000,0,1) = $25,711) represents only
$25,711/$37,592 = 68% of the fair value. However, the lease meets both Group 2 criteria.
The present value of the lease payments and third-party guarantees (Excel =PV(6%,4,
7000,15000,1) = $37,592) is equal to 100% of the fair value and collection of the lease
Diff: 2 Var: 1
Objective: 18.7
IFRS/GAAP: GAAP
57

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15) Assuming that Precision Pumps classifies this lease as a direct financing lease, prepare
the journal entries for the commencement of the lease and the payment of the first and
second lease payments.
Answer:
Commencement of the lease
January 1, 2019 Net Investment in Lease–Direct Financing22,000
Inventory of Equipment 22,000
First lease payment

January 1, 2019 Cash 7,000
Net Investment in Lease — Direct Financing 7,000
Second lease payment

December 31, 2019 Cash 7,000
Net Investment in Lease — Direct Financing 984
Sales revenue and net investment in the lease are calculated as the present value of the
lease payments plus the guaranteed residual. The present value of the lease payments and
third-party guarantees can be calculated in Excel, =PV(6%,4,7000,15000,1) = $37,592. The
Sales Revenue is the lower of the lease receivable or fair value of the asset. Revenue is
$37,592. Cost of goods sold is the carrying value of the leased asset less the present value
of unguaranteed residual value. Cost of goods sold is $22,000. The Profit is Sales Revenue
$37,592 — Cost of Goods Sold $22,000 = $15,592. In the case of a direct financing lease,
the profit is deferred and it reduces the net investment. The net investment is the present
value of lease payments less the deferred profit, which equals $37,592 - $15,592 = $22,000.
A new interest rate must be determined. Using Excel, the formula is: =Rate(4,7000,-
22000,15000,1) = 40.1072%. Since the first lease payment is made on the date on which
the lease commences, the entire payment reduces the net investment in lease and there is
no interest. As a result, the balance in the net investment in lease after the first payment is
$15,000. Interest of $15,000 × 40.1072% = $6,016. From the $7,000 payment, $6,016
represents interest and $984 reduces the principal balance to $14,016.
Diff: 2 Var: 1
Objective: 18.7
IFRS/GAAP: GAAP
16) How does IFRS differ from U.S. GAAP for direct financing leases?
Answer: IFRS does not distinguish sales-type leases from direct financing leases. IFRS
classifies leases based on whether the risks and rewards of ownership have been transferred
to the lessee. If the risks and rewards have been transferred, IFRS classifies the lease as a
finance lease.
The lessor's accounting for IFRS finance leases is similar to the U.S. GAAP accounting for
sales-type leases. There are two types of lessors under IFRS: (1) manufacturers and dealers
and (2) everyone else. Under IFRS, at the lease commencement manufacturers and dealers
report a profit computed the same way as lessors compute profit under U.S. GAAP.
Manufacturers and dealers always immediately expense initial direct costs. All other lessors
do not recognize a profit at lease commencement and defer initial direct costs.
Diff: 2 Var: 1
Objective: 18.7
18.8 Lease Disclosures
1) Generally, lease disclosures vary by the type of lease and whether the party to the lease
is the lessee or the lessor.
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Answer: TRUE
Diff: 1 Var: 1
Objective: 18.8
IFRS/GAAP: GAAP
2) With finance leases, interest payments decrease cash flows from operating activities.
Answer: TRUE
Diff: 1 Var: 1
Objective: 18.8
IFRS/GAAP: GAAP
3) On the balance sheet, the right-of-use asset under an operating lease is ________.
A) amortized by straight line
B) reduced to present value
C) amortized later than with a finance lease
D) not included
Answer: C
Diff: 1 Var: 1
Objective: 18.8
IFRS/GAAP: GAAP
4) On the statement of cash flows, the total lease payment reduces cash flow from operating
activities for the operating lease. Only the ________ reduces operating cash flows under the
________ lease. Therefore, cash flows from operating activities are ________ under the finance
lease each year and in total.
A) liability portion; finance; lower
B) interest portion; finance; higher
C) liability portion; operating; lower
D) interest portion; operating; higher
Answer: B
Diff: 2 Var: 1
Objective: 18.8
IFRS/GAAP: GAAP
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5) List the lessee's disclosures that provide the user with information about the nature of
leases.
Answer:
• Determination of variable lease payments
• Existence, terms, and conditions of options to extend or terminate the lease
• Existence, terms, and conditions of residual value guarantees
• Restrictions or covenants imposed by leases such as limits on dividends or incurring
additional financial obligations
Diff: 1 Var: 1
Objective: 18.8
IFRS/GAAP: GAAP
6) Why is operating income higher under a finance lease in the early years of the lease?
Answer: Because lease costs under an operating lease are usually higher than the
amortization expense under a finance lease in the early years of a lease, operating income
will be higher under a finance lease.
Diff: 2 Var: 1
Objective: 18.8
IFRS/GAAP: GAAP
7) How does IFRS report leased assets with low values?

Answer: IFRS makes an exception for leased assets that have low values. Leased assets
with values of less than $5,000 can be accounted for as a rental agreement rather than
recognized and measured as a right-of-use asset and lease liability.
Diff: 1 Var: 1
Objective: 18.8
IFRS/GAAP: IFRS
Appendix A: Complexities in Accounting for Lease Transactions
Sidekick Services
Sidekick Services leases several computer servers from Lycoming Computing Company. The
lease agreement includes consulting and training updates. The standalone prices charged
by Lycoming for each separate component are $750,000 for the servers and $250,000 for
the consulting and training updates. The lease is a 5-year lease with fixed payments of
$400,000 per year. There are also variable payments required amounting to $7,000 per
year, on average, based on the metered usage of the servers. There is no minimum charge
included in the contract.
1) Using the above information, the total consideration in this contract ________ the variable
payments.
A) increases
B) decreases
C) excludes
D) includes
Answer: C
Diff: 1 Var: 1
Objective: 18.A
IFRS/GAAP: GAAP
2) Using the above information and assuming that Sidekick allocates consideration based on
relative standalone selling prices, determine the allocation of the total consideration to the
computer servers and the consulting and training services.
Answer:
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Standalon Percenta Allocation of Allocation of

Contract e Selling ge Total Contract Annual Lease
Component Prices Consideration Payment
Server (Computer 75% × 75% × $400,000
Equipment): Lease $2,000,000 = =
Component $750,000 75% $1,500,000 $300,000
Consulting and
Training Services: 25% ×
Nonlease $2,000,000 = 25% × $400,000
Component 250,000 25% 500,000 = 100,000
$1,000,00
Total 0 100% $2,000,000 $400,000
Diff: 1 Var: 1
Objective: 18.A
IFRS/GAAP: GAAP
3) If, at the lease commencement date, it is likely that the lessee will exercise the purchase
option, then the amount of the purchase option is included in the computation of the lease
payments.
Answer: TRUE
Diff: 1 Var: 1
Objective: 18.A
IFRS/GAAP: GAAP
4) Lessees often incur costs related to the ownership of the leased asset. These costs,
referred to as, ________ include items such as property tax, insurance, and maintenance.
A) expenses
B) executory costs
C) overhead costs
D) All of the above
Answer: B
Diff: 1 Var: 1
Objective: 18.A
IFRS/GAAP: GAAP
5) Which of the following costs is a nonlease component for the lessee?

A) insurance
B) taxes
C) maintenance
D) All of the above
Answer: C
Diff: 1 Var: 1
Objective: 18.A
IFRS/GAAP: GAAP
6) On January 1, 2019, Murray Manufacturing leased a building for use in its operations from
Associated Realty. The 7-year, noncancellable lease requires annual lease payments of
$17,000, beginning January 1, 2019, and at each December 31 thereafter through 2024.
The lease payment includes costs related to property taxes of $2,000. They also include
payments for common area maintenance. The observable standalone price for the lease
(including the property taxes) is $15,000 and the observable standalone price for the
common area maintenance is $4,000.
In addition, Murray agrees to pay insurance on the building. Murray pays the insurance each
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year when it receives an invoice from Associated Realty for the insurance amount. On
December 15, 2019, Murray was billed and paid $2,500 for this insurance. Murray does not
make the election to account for each separate lease component, along with its associated
nonlease components, as a single lease component.
The lease agreement does not transfer ownership, nor does it contain a purchase option.
The building has a fair value of $87,000 and an estimated remaining life of 8 years.
Associated Realty's implicit rate of 10% is known to Murray. Round percentages to one
decimal place.
What amount of the $17,000 lease payment is used to compute the lease obligation?
A) $17,000
B) $13,000
C) $13,413
D) $12,938
Answer: C
Explanation: Insurance is a variable expense that is not dependent on an index or a rate
and is not included in the computation of the lease payment or lease liability. Common area
maintenance is a nonlease component, so the $17,000 must be allocated to the lease and
nonlease components.
Allocated
Component Standalone Price Percentage Consideration
Lease $15,000 78.9% $13,413
Nonlease
(maintenance) $4,000 21.1% $3,587
$19,000 100% $17,000
Diff: 1 Var: 1
Objective: 18.A
IFRS/GAAP: GAAP
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7) On January 1, 2019, Murray Manufacturing leased a building for use in its operations from
Associated Realty. The 7-year, noncancellable lease requires annual lease payments of
$22,000, beginning January 1, 2019, and at each December 31 thereafter through 2024.
In addition, Murray agrees to pay insurance on the building. Murray pays the insurance each
year when it receives an invoice from Associated Realty for the insurance amount. On
December 15, 2019, Murray was billed and paid $2,500 for this insurance. Murray does not
make the election to account for each separate lease component, along with its associated
nonlease components, as a single lease component.
The building has a fair value of $80,000 and an estimated remaining life of 8 years.
Associated Realty's implicit rate of 10% is known to Murray. Round percentages to one
decimal place.
Assuming this is classified by Murray as a finance lease, at what amount should the right-of-
use asset and lease liability be recorded?
A) $117,816
B) $96,395
C) $18,326
D) $98,141
Answer: D
Explanation: The right-of-use asset and lease liability will be recorded at the present value
of the lease payments. See computation of lease payment below. Use Excel to calculate the
present value, given 7 periods, 10% interest, and a payment of $18,326, with payments at
the beginning of the period. Using Excel, the formula is: =PV(.10,7,-18326,0,1) = $98,141.
Insurance is a variable expense that is not dependent on an index or a rate and is not
included in the computation of the lease payment or lease liability. Common area
maintenance is a nonlease component, so the $22,000 must be allocated to the lease and
nonlease components.
Allocated
Component Standalone Price Percentage Consideration
Lease $20,000 83.3% $18,326
Nonlease
(maintenance) $4,000 16.7% $3,674
$24,000 100% $22,000
Diff: 1 Var: 1
Objective: 18.A
IFRS/GAAP: GAAP
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8) On January 1, 2019, Wynn Manufacturing leased a floor of a building for use in its North
American operations from Easymoney Bank. The 9-year, noncancellable lease requires
annual lease payments of $12,000, beginning January 1, 2019, and at each January 1
thereafter through 2027.
The floor of the building has a fair value of $85,000 and an estimated remaining life of 10
years. Easymoney Bank's implicit rate of 11% is known to Wynn.
What is the type of lease for the lessee?
A) sales-type lease
B) operating lease
C) finance lease
D) direct financing lease
Answer: C
Explanation: This is classified as a finance lease because the lease term of 9 years is 90% of
the 10 years remaining in the asset's useful life.
Diff: 2 Var: 1
Objective: 18.A
IFRS/GAAP: GAAP
At what amount is the lease liability recorded at lease commencement?
A) $81,108
B) $76,019
C) $108,000
D) $85,735
Answer: B
Explanation: The lease liability is recorded at $76,019, based on the following Excel
formula:
= PV(0.1,9,-12000,0,1) = $76,019.
Diff: 2 Var: 1
Objective: 18.A
IFRS/GAAP: GAAP
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At the end of 2019, which of the following journal entries will be used by Wynn to record
Interest Expense?
A) debit to Interest Expense and credit to Interest Payable
B) debit to Interest Expense and Lease Liability and credit to Cash
C) debit to Lease Liability and credit to Interest Expense
D) No entry — payment is made on January 1, 2020.
Answer: A
Diff: 2 Var: 1
Objective: 18.A
IFRS/GAAP: GAAP
11) Elliott Brothers enters into a lease agreement with Central Leasing for a piece of
equipment. The terms of the 5-year lease state that payments of $22,500 will be made
annually on January 1, commencing with the date that the lease begins. The lease contains a
provision that Elliott Brothers may purchase the equipment at the end of the lease period for
$16,000, which is well below the expected fair value at the end of the lease. As such, it is
expected that Elliott Brothers will exercise this option. The implicit rate in the lease is 10%. If
this lease is treated as a finance lease for Elliott Brothers, at what value will the right-of-use
asset be recorded?
A) $103,757
B) $9,935
C) $93,822
D) $85,293
Answer: A
Explanation: The right-of-use asset will be valued at the sum of the present value of the
lease payments and the present value of the purchase option at lease termination. The
present value of the 5 lease payments is $93,822, calculated using the following Excel
formula: =PV(10%,5,-22500,0,1). The present value of the purchase option at the end of 5
years is $9,935, calculated using the following Excel formula: =PV(10%,5,0,-16000). The
sum of these two amounts is $103,757 (rounded). Alternatively, the Excel formula is:
=PV(.0.1,5,-22500,-16000,1)= $103,757.
Diff: 2 Var: 1
Objective: 18.A
IFRS/GAAP: GAAP
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12) What is the proper accounting treatment to record improvements to leased property for
a lessee?
A) Expense in the year in which expenses are incurred and increase basis of asset.
B) Capitalize and depreciate over the greater of the life of the improvement or lease term.
C) Expense in the year in which expenses are incurred.
D) Capitalize and depreciate over the lesser of the life of the improvement or lease term.
Answer: D
Diff: 2 Var: 1
Objective: 18.A
IFRS/GAAP: GAAP
13) What is the proper accounting treatment to record a variable lease payment indexed off
the CPI?
A) Calculate the lease liability based on expected payments over the life of the lease after
considering increases in the CPI.
B) Calculate the lease liability based on the base payment and debit an additional expense
in subsequent years based on the change in the CPI.
C) Record the lease liability based on highest annual increase in the CPI for the past 10
years.
D) Capitalize and depreciate the increased payments based on CPI indexing.
Answer: B
Diff: 2 Var: 1
Objective: 18.A
IFRS/GAAP: GAAP
14) Assume that Constance Industries leases equipment for 3 years with fixed rentals of
$10,000 per year. The agreement also requires that Constance purchase consumables such
as drive belts, etc. directly from the lessor and must spend a minimum of $1,500 per year
over the lease term. What are the lease payments to be used to classify the lease?
Answer: In this case, the $1,500 per year is unavoidable and therefore at the lease
commencement date, the annual payments are $11,500 ($10,000 + $1,500). The total lease
payments over the lease term consists of $34,500 total rentals, which are computed as
$30,000 ($10,000 per year for 3 years) plus the $4,500 ($1,500 minimum guaranteed
payments per year for 3 years for repair parts).
Diff: 1 Var: 1
Objective: 18.A
IFRS/GAAP: GAAP
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Captive Leasing Company

Captive Leasing Company recently leased machinery to VonBurn Building Associates. The 5-
year lease contract requires rental payments of $10,000 at the beginning of each year. The
lease meets at least one of the Group I criteria. The 9% implicit rate on the lease is known at
VonBurn. There is a $4,000 guaranteed residual value by the lessee, which is equal to the
expected residual value at the end of the lease term. Therefore, there is no unguaranteed
residual asset.
15) Based on the above information, calculate the value of the leased asset at the lease
commencement date.
Answer:
The PV of the lease payments is computed as follows:
N I/Y PV PMT FV Excel Formula

Given 5 9.00% -10,000 -4,000
44,99 = PV (0.09,5,-10,000,-
Solve For PV 7 4000,1)
Diff: 1 Var: 1
Objective: 18.A
IFRS/GAAP: GAAP
16) Based on the above information, calculate the present value of the guaranteed residual
value on the lease commencement date.
Answer:
The PV of the guaranteed residual value is computed as follows:
N I/Y PV PMT FV Excel Formula

Given 5 9.00% 0 -4,000
= PV (0.09,5,0,-
Solve For PV 2,600 4,000,0)
Diff: 1 Var: 1
Objective: 18.A
IFRS/GAAP: GAAP
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17) Catwalk Enterprises is currently leasing land with a lease that expires in 20 years. On
January 1 of the current year, Catwalk built a barn on the land costing $10,000 that is
expected to last for 40 years. Catwalk depreciates its assets using the straight-line method.
What is the journal entry to record the leasehold improvement?
Answer:
Leasehold Improvement 10,000
Cash 10,000
Diff: 1 Var: 1
Objective: 18.A
IFRS/GAAP: GAAP
18) Catwalk Enterprises is currently leasing land with a lease that expires in 20 years. On
January 1 of the current year, Catwalk built a barn on the land costing $10,000 that is
expected to last for 40 years. Catwalk depreciates its assets using the straight-line method.
What is the journal entry to record the depreciation for the barn every year?
Answer: Catwalk depreciates the barn over 20 years, which is the shorter of the life of the
asset and the life of the lease. Thus, it depreciates $500 per year ($10,000/20).
Account December 31
Depreciation Expense – Leasehold Improvement 500
Accumulated Depreciation – Leasehold
Improvement 500
Diff: 1 Var: 1
Objective: 18.A
IFRS/GAAP: GAAP
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Wynn Manufacturing
On January 1, 2019, Wynn Manufacturing leased a floor of a building for use in its North
annual lease payments of $12,000, beginning January 1, 2019, and at each December 31
In addition, Wynn agrees to pay insurance on the floor of the building. Wynn pays the
insurance each year when it receives an invoice from Easymoney Bank for the insurance
amount. On December 15, 2019, Wynn was billed and paid $1,500 for this insurance. Wynn
does not make the election to account for each separate lease component, along with its
associated nonlease components, as a single lease component.
years. Easymoney Bank's implicit rate of 11% is known to Wynn. Round percentages to two
decimal places.
19) Based on the above information, what is the present value of the leased asset on the
lease commencement date?
Answer: The lease is a finance lease for the lessee because the lease term of 9 years equals
90% of the life of the leased asset (10 years). The lease payment of $12,000 should be
allocated between lease and nonlease components. Lease component: $12,000 ×
$16,000/($16,000 + $2,000) = $10,667. Using Excel, the present value of the leased asset
on January 1, 2019 is: =PV(0.11,9,-10667,0,1) = $65,561.
Diff: 2 Var: 1
Objective: 18.A
IFRS/GAAP: GAAP
20) Based on the above information, create the Journal Entry for the lessee on the lease
commencement date.
Answer: The lease is a finance lease for the lessee because the lease term of 9 years equals
90% of the life of the leased asset (10 years). The lease payment of $12,000 should be
allocated between lease and nonlease components. Lease component: $12,000 ×
$16,000/($16,000 + $2,000) = $10,667. Using Excel, the present value of the leased asset
on January 1, 2019 is: =PV(0.11,9,-10667,0,1) = $65,561.

Diff: 2 Var: 1
Objective: 18.A
IFRS/GAAP: GAAP
69

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Gia02 tb chapter 18 - Intermediate Accounting 2E - Gordon -

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Intermediate Accounting, 2e (Gordon/Raedy/Sannella)

18.1 Leases: Overview

18.2 Lease Contracts, Lease Components, and Contract Consideration

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Component Standalone Price

Calculate the percentages and allocate the consideration to each component.

18.3 Lease Classifications

1) Present value of lease payments + Present value of guaranteed or unguaranteed residual

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18.4 Accounting for Operating Leases: Lessee and Lessor

3) On the balance sheet, the lease liability is measured as ________.

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4) Which of the following statements is true?

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option, no lease incentives, no residual value guarantees, and no transfer of ownership.

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Account January 1, 2019

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Periodic Interest and Reduction in the Liability

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Amortization of Right-of-Use Asset

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*Using Excel, =PV(.07,5,-10000,-5000,1) = $47,437

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Account January 1, 2019

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*The Excel formula is: =PV(.07,5,-10000,0,1) = $43,872.

Account January 1, 2019

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Periodic Interest and Reduction in the Liability

Answer: Periodic Interest and Reduction in the Liability

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Amortization of Right-of-Use Asset

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Group I Criteria Met? Explanation

Group I Criteria Met? Explanation

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18.5 Accounting for Finance Leases: Lessee

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Payment Interest Reduction Balance

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Nace Manufacturing Company

12) What is the proper classification of the lease to Nace?

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Payment Interest Reduction Balance

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formula is: =PV(.11,10,-4000,0,1) = $26,148.

Account January 1, 2019