(b) This is a sales-type lease, so at the inception of the lease, the lessor would

recognize sales of $3,300,000 (the PV of the lease payments), and cost of goods sold
of $2,800,000, resulting in profit on the sale of $500,000 ($3,300,000 - $2,800,000).
Note that the list selling price of an asset ($3,520,000 in this case) is not always
representative of its FV. An asset can often be purchased for less than its list price.
23. The excess of the fair value of leased property at the inception of the lease over its
cost or carrying amount should be classified by the lessor as

a. Unearned income from a sales-type lease.

b. Unearned income from a direct-financing lease.
c. Manufacturer's or dealer's profit from a sales-type lease.
d. Manufacturer's or dealer's profit from a direct-financing lease.
Correct Answer: C) Manufacturer's or dealer's profit from a sales-type lease.

Notes

(c) The excess of the fair value of leased property at the inception of the lease over the
lessor's cost is defined as the manufacturer's or dealer's profit. Answer (a) is incorrect
because the unearned income from a sales-type lease is defined as the difference
between the gross investment in the lease and the sum of the present values of the
components of the gross investment. Answer (b) is incorrect because the unearned
income from a direct-financing lease is defined as the excess of the gross investment
over the cost (also the PV of lease payments) of the leased property. Answer (d) is
incorrect because a sales-type lease involves a manufacturer's or dealer's profit while a
direct financing lease does not.
24. In a lease that is recorded as a sales-type lease by the lessor, interest revenue

a. Should be recognized in full as revenue at the lease's inception.

b. Should be recognized over the period of the lease using the straight-line method.
c. Should be recognized over the period of the lease using the interest method.
d. Does not arise.
Correct Answer: C) Should be recognized over the period of the lease using the interest
method.

Notes

(c) Revenue is to be recognized for a sales-type lease over the lease term so as to
produce a constant rate of return on the net investment in the lease. This requires the
use of the interest method. Interest revenue does arise in a salestype lease. Answer (a)
is incorrect because the interest is to be earned over the life of the lease, not in full at
the lease's inception.
25. Lease M does not contain a bargain purchase option, but the lease term is equal to
90% of the estimated economic life of the leased property. Lease P does not transfer
ownership of the property to the lessee at the end of the lease term, but the lease term
is equal to 75% of the estimated economic life of the leased property. How should the
lessee classify these leases? I. Lease M II. Lease P
a. I. Capital lease ; II. Operating lease
b. I. Capital lease ; II. Capital lease
c. I. Operating lease ; II. Capital lease
d. I. Operating lease ; II. Operating lease
Correct Answer: B) I. Capital lease ; II. Capital lease

Notes

(b) If any of the criteria for classification as a capital lease are met, the lease is
classified as such. One of the capital lease criterion is that the lease term is equal to
75% or more of the estimated economic life of the leased property. Thus, both leases M
and P should be classified as capital leases.
26. On December 31, year 1, Day Co. leased a new machine from Parr with the
following pertinent information:

Lease term: 6 years

Annual rental payable at beginning of each year: $50,000
Useful life of machine: 8 years
Day's incremental borrowing rate: 15%
Implicit interest rate in lease (known by Day): 12%
Present value of annuity of 1 in advance for 6 periods at 12%: 4.61
Present value of annuity of 1 in advance for 6 periods at 15%: 4.35

The lease is not renewable, and the machine reverts to Parr at the termination of the
lease. The cost of the machine on Parr's accounting records is $375,500. At the
beginning of the lease term, Day should record a lease liability of

a. $375,500
b. $230,500
c. $217,500
d. $0
Correct Answer: B) $230,500

Notes

(b) This is a capital lease for the lessee because the lease term is 75% of the useful life
of the machine [6 years = (75% × 8 years)]. For a capital lease, the lessee records as a
leased asset and a lease obligation 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 (15%)
or the implicit rate used by the lessor if known by the lessee (12%). Since the implicit
rate is lower, and known by the lessee, it is used to compute the PV ($50,000 × 4.61 =
$230,500). The cost of the asset on the lessor's books ($375,500) is irrelevant.
27. On January 1, year 1, Day Corp. entered into a ten-year lease agreement with
Ward, Inc. for industrial equipment. Annual lease payments of $10,000 are payable at
the end of each year. Day knows that the lessor expects a 10% return on the lease. Day