which approximates the expected fair value of the machine on the option exercise date.

On May 1, year 1, East should record a capitalized lease asset of

a. $251,500
b. $238,000
c. $224,500
d. $198,000
Correct Answer: B) $238,000

Notes

(b) The requirement is to determine the amount to be recorded as a capitalized leased

asset. This is a capital lease for the lessee because the lease term exceeds 75% of the
economic life of the leased asset (10/12 > 75%). In a capital lease, the lessee records
as an asset and liability the present value (PV) of the minimum lease payments (unless
the PV exceeds the asset's FV, in which case the FV is recorded). The minimum lease
payments include rentals, and a lessee-guaranteed residual value or a bargain
purchase option. Only rentals apply in this case. Note that the $50,000 purchase option
is not a bargain purchase option that the lessee would be compelled to exercise. A
bargain purchase option is an option to purchase the leased asset at an amount less
than its expected fair value. Therefore, the present value of the minimum lease
payments is $238,000 ($40,000 × 5.95).
31. On January 1, year 1, Babson, Inc. leased two automobiles for executive use. The
lease requires Babson to make five annual payments of $13,000 beginning January 1,
year 1. At the end of the lease term, December 31, year 5, Babson guarantees the
residual value of the automobiles will total $10,000. The lease qualifies as a capital
lease. The interest rate implicit in the lease is 9%. Present value factors for the 9% rate
implicit in the lease are as follows:

For an annuity due with 5 payments: 4.240

For an ordinary annuity with 5 payments: 3.890
Present value of $1 for 5 periods: 0.650

Babson's recorded capital lease liability immediately after the first required payment
should be

a. $48,620
b. $44,070
c. $35,620
d. $31,070
Correct Answer: A) $48,620
32. On December 30, year 1, Rafferty Corp. leased equipment under a capital lease.
Annual lease payments of $20,000 are due December 31 for ten years. The
equipment's useful life is ten years, and the interest rate implicit in the lease is 10%. The
capital lease obligation was recorded on December 30, year 1, at $135,000, and the
first lease payment was made on that date. What amount should Rafferty include in
current liabilities for this capital lease in its December 31, year 1 balance sheet?

a. $6,500
b. $8,500
c. $11,500
d. $20,000
Correct Answer: B) $8,500

Notes

(b) The initial lease obligation at 12/30/Y1 was $135,000. The first lease payment was
made the same day, and therefore consisted entirely of principal reduction. After the
payment, the lease obligation was $115,000 ($135,000 - $20,000). This balance will be
reported as current (for the portion to be paid in year 2) and long-term (for the portion to
be paid beyond year 2). The next lease payment of $20,000 will be paid 12/31/Y2, and
will consist of both interest ($115,000 × 10% = $11,500) and principal reduction
($20,000 - $11,500 = $8,500). Thus, the portion of the $115,000 lease obligation to be
paid in the next year (and therefore reported as a current liability) is $8,500. Note that
the interest to be paid next year ($11,500) is not a liability at 12/31/Y1 because it has
not yet been incurred.
33. Oak Co. leased equipment for its entire nine-year useful life, agreeing to pay
$50,000 at the start of the lease term on December 31, year 1, and $50,000 annually on
each December 31 for the next eight years. The present value on December 31, year 1,
of the nine lease payments over the lease term, using the rate implicit in the lease which
Oak knows to be 10%, was $316,500. The December 31, year 1 present value of the
lease payments using Oak's incremental borrowing rate of 12% was $298,500. Oak
made a timely second lease payment. What amount should Oak report as capital lease
liability in its December 31, year 2 balance sheet?

a. $350,000
b. $243,150
c. $228,320
d. $0
Correct Answer: B) $243,150

Notes

(b) This is a capital lease for the lessee because the lease term (nine years) exceeds
75% of the useful life of the machine (also nine years). For a capital lease, the lessee
records as a leased asset and a lease obligation at the lower of the PV of the minimum
lease payments or the FV of the leased asset (not given in this problem). The PV of the
minimum lease payments is computed using the lower of the lessee's incremental
borrowing rate (12%) or the implicit rate used by the lessor if known by the lessee
(10%). Since the implicit rate is lower, and known by the lessee, it is used to compute
the PV ($316,500). The initial lease payment ($50,000) is entirely principal because it
was made at the inception of the lease. Therefore, after the 12/31/Y1 payment, the
lease liability is $266,500 ($316,500 - $50,000). The 12/31/Y2 payment consists of
interest incurred during year 2 ($266,500 × 10% = $26,650) and principal reduction
($50,000 - $26,650 = $23,350). Therefore, the 12/31/Y2 capital lease liability is
$243,150 ($266,500 - $23,350).
34. On December 31, year 1, Roe Co. leased a machine from Colt for a five-year
period. Equal annual payments under the lease are $105,000 (including $5,000 annual
executory costs) and are due on December 31 of each year. The first payment was
made on December 31, year 1, and the second payment was made on December 31,
year 2. The five lease payments are discounted at 10% over the lease term. The
present value of minimum lease payments at the inception of the lease and before the
first annual payment was $417,000. The lease is appropriately accounted for as a
capital lease by Roe. In its December 31, year 2 balance sheet, Roe should report a
lease liability of

a. $317,000
b. $315,000
c. $285,300
d. $248,700
Correct Answer: D) $248,700