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16. On January 1, year 1, Nobb Corp. signed a twelve-year lease for warehouse space.
Nobb has an option to renew the lease for an additional eight-year period on or before
January 1, year 5. During January year 3, Nobb made substantial improvements to the
warehouse. The cost of these improvements was $540,000, with an estimated useful
life of fifteen years. At December 31, year 3, Nobb intended to exercise the renewal
option. Nobb has taken a full year's amortization on this leasehold. In Nobb's December
31, year 3 balance sheet, the carrying amount of this leasehold improvement should be

a. $486,000
b. $504,000
c. $510,000
d. $513,000
Correct Answer: B) $504,000

Notes

(b) The cost of the leasehold improvements ($540,000) should be amortized over the
remaining life of the lease, or over the useful life of the improvements, whichever is
shorter. The remaining life of the lease should include periods covered by a renewal
option if it is probable that the option will be exercised. In this case, the remaining life of
the lease is eighteen years (12 years of original lease + 8 years in option period - 2
years gone by), and the useful life of the improvements is fifteen years. Therefore,
amortization is based on a fifteen-year life ($540,000 ÷ 15 = $36,000). The 12/31/Y1
carrying amount is $504,000 ($540,000 - $36,000).
17. During January year 1, Vail Co. made long-term improvements to a recently leased
building. The lease agreement provides for neither a transfer of title to Vail nor a bargain
purchase option. The present value of the minimum lease payments equals 85% of the
building's market value, and the lease term equals 70% of the building's economic life.
Should assets be recognized for the building and the leasehold improvements? I.
Building II. Leasehold improvements

a. Both I and II
b. II only
c. I only
d. Neither I nor II
Correct Answer: B) II only

Notes

(b) A lease should be classified as a capital lease by the lessee if the lease terms meet
any one of the following four criteria: (1) the lease transfers ownership of the property to
the lessee by the end of the lease term, (2) the lease contains a bargain purchase
option, (3) the lease term is greater than or equal to 75% of the economic life of the
leased property, or (4) the present value of the minimum lease payments is greater than
or equal to 90% of the fair market value of the leased property. In this question, the
terms of Vail's lease do not meet any of the four criteria for treatment as a capital lease,
so the lease should be accounted for as an operating lease. Vail should therefore not
recognize the building as an asset. In an operating lease, the lessee should capitalize
the cost of the leasehold improvements, recognizing them as assets, and amortize their
cost over the shorter of their useful lives or the term of the lease.

19. Glade Co. leases computer equipment to customers under direct-financing leases.
The equipment has no residual value at the end of the lease and the leases do not
contain bargain purchase options. Glade wishes to earn 8% interest on a five-year lease
of equipment with a fair value of $323,400. The present value of an annuity due of $1 at
8% for five years is 4.312. What is the total amount of interest revenue that Glade will
earn over the life of the lease?

a. $51,600
b. $75,000
c. $129,360
d. $139,450
Correct Answer: A) $51,600

Notes

(a) The annual lease payment is $75,000 ($323,400 ÷ 4.312). After five years, total
lease payments will be $375,000 (5 × $75,000). The total interest revenue over the life
of the lease is the excess of total lease payments over the fair value of the leased asset
($375,000 - $323,400 = $51,600).
20. On January 1, year 1, JCK Co. signed a contract for an eight-year lease of its
equipment with a ten-year life. The present value of the sixteen equal semiannual
payments in advance equaled 85% of the equipment's fair value. The contract had no
provision for JCK, the lessor, to give up legal ownership of the equipment. Should JCK
recognize rent or interest revenue in year 2, and should the revenue recognized in year
2 be the same or smaller than the revenue recognized in year 1? I. Year 2 revenues
recognized II. Year 2 amount recognized compared to year 1

a. I. Rent ; II. The same

b. I. Rent ; II. Smaller
c. I. Interest ; II. The same
d. I. Interest ; II. Smaller
Correct Answer: D) I. Interest ; II. Smaller

Notes

(d) This lease qualifies as a direct financing lease; therefore interest revenue will be
recognized rather than rent revenue. Had the lease qualified as an operating lease, rent
revenue would have been recognized. The lessor's criteria for direct financing
classification is as follows:
21. Peg Co. leased equipment from Howe Corp. on July 1, year 1 for an eight-year
period expiring June 30, year 9. Equal payments under the lease are $600,000 and are
due on July 1 of each year. The first payment was made on July 1, year 1. The rate of
interest contemplated by Peg and Howe is 10%. The cash selling price of the equipment
is $3,520,000, and the cost of the equipment on Howe's accounting records is
$2,800,000. The lease is appropriately recorded as a sales-type lease. What is the
amount of profit on the sale and interest revenue that Howe should record for the year
ended December 31, year 1? I. Profit on sale II. Interest revenue

a. I. $720,000 ; II. $176,000

b. I. $720,000 ; II. $146,000
c. I. $45,000 ; II. $176,000
d. I. $45,000 ; II. $146,000
Correct Answer: B) I. $720,000 ; II. $146,000

Notes

(b) This is a sales-type lease, so at the inception of the lease, the lessor would
recognize sales of $3,520,000 and cost of goods sold of $2,800,000, resulting in a profit
on sale of $720,000. In addition, interest revenue is recognized for the period July 1,
year 1, to December 31, year 1. The initial net lease payments receivable on 7/1/Y1 is
$3,520,000. The first rental payment received on 7/1/Y1 consists entirely of principal,
reducing the net receivable to $2,920,000 ($3,520,000 - $600,000). Therefore, year 1
interest revenue for the six months from 7/1/Y1 to 12/31/Y1 is $146,000 ($2,920,000 ×
10% × 6/12).
22. Howe Co. leased equipment to Kew Corp. on January 2, year 1, for an eight-year
period expiring December 31, year 8. Equal payments under the lease are $600,000
and are due on January 2 of each year. The first payment was made on January 2, year
1. The list selling price of the equipment is $3,520,000 and its carrying cost on Howe's
books is $2,800,000. The lease is appropriately accounted for as a sales-type lease.
The present value of the lease payments is $3,300,000. What amount of profit on the
sale should Howe report for the year ended December 31, year 1?

a. $720,000
b. $500,000
c. $90,000
d. $0
Correct Answer: B) $500,000

Notes