(a) Rent on operating leases should be expensed on a straight-line basis unless another

method is better suited to the particular benefits and costs associated with the lease. In
this lease, the lessee must pay rent of $1,000 monthly for five years excluding the first
nine months, or fifty-one months (60 - 9). Therefore, total rent expense for the five years
is $51,000 (51 × $1,000). Recognizing rent expense on a straight-line basis, rent
expense for the first year is $10,200 ($51,000 ÷ 5 years).
9. On January 1, year 1, Park Co. signed a ten-year operating lease for office space at
$96,000 per year. The lease included a provision for additional rent of 5% of annual
company sales in excess of $500,000. Park's sales for the year ended December 31,
year 1, were $600,000. Upon execution of the lease, Park paid $24,000 as a bonus for
the lease. Park's rent expense for the year ended December 31, year 1, is

a. $98,400
b. $101,000
c. $103,400
d. $125,000

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Correct Answer: C) $103,400

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11. On January 1, year 1, Mollat Co. signed a seven-year lease for equipment having a
ten-year economic life. The present value of the monthly lease payments equaled 80%
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of the equipment's fair value. The lease agreement provides for neither a transfer of title
to Mollat nor a bargain purchase option. In its year 1 income statement Mollat should
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report
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a. Rent expense equal to the year 1 lease payments.

b. Rent expense equal to the year 1 lease payments less interest expense.
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c. Lease amortization equal to one-tenth of the equipment's fair value.

d. Lease amortization equal to one-seventh of 80% of the equipment's fair value.
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Correct Answer: A)
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12. A twenty-year property lease, classified as an operating lease, provides for a 10%
increase in annual payments every five years. In the sixth year compared to the fifth
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year, the lease will cause the following expenses to increase I. Rent II. Interest

a. II only
b. I only
c. Both I and II
d. Neither I nor II

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 Correct Answer: D) Neither I nor II

Notes

(d) When a leasing agreement is accounted for as an operating lease, the lessor and
the lessee recognize rental revenue and rental expense respectively on a straight-line
basis unless another systematic and rational basis more clearly reflects the time pattern
in which use benefit is given (received) by the respective parties. The straight-lining of
uneven lease payments includes scheduled rent increases. Even though the amount of
the annual lease payment increases in year six, rental expense would not change.
Interest is not an element of revenue (expense) in operating leases.
13. On December 1, year 1, Clark Co. leased office space for five years at a monthly
rental of $60,000. On the same date, Clark paid the lessor the following amounts:

First month's rent: $60,000

Last month's rent: $60,000

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Security deposit (refundable at lease expiration): $80,000
Installation of new walls and offices: $360,000

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What should be Clark's year 1 expense relating to utilization of the office space?

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a. $60,000 rs e
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b. $66,000
c. $120,000
d. $140,000
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Correct Answer: B) $66,000

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14. Star Co. leases a building for its product showroom. The ten-year nonrenewable
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lease will expire on December 31, year 11. In January year 6, Star redecorated its
showroom and made leasehold improvements of $48,000. The estimated useful life of
the improvements is eight years. Star uses the straight-line method of amortization.
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What amount of leasehold improvements, net of amortization, should Star report in its
June 30, year 6 balance sheet?
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a. $45,600
b. $45,000
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c. $44,000
d. $43,200
Correct Answer: C) $44,000

Notes

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 (c) Leasehold improvements are capitalized and amortized over the shorter of the
remaining life of the lease (six years from 1/1/Y6 to 12/31/Y11) or the useful life of the
improvements (eight years). Therefore, the $48,000 cost is amortized over six years,
resulting in annual amortization of $8,000 ($48,000 ÷ 6). For the period 1/1/Y6 to
6/30/Y6, amortization is $4,000 ($8,000 × 6/12), so the 6/30/Y6 net amount for
leasehold improvements is $44,000 ($48,000 - $4,000).
15. On January 2, year 1, Ral Co. leased land and building from an unrelated lessor for
a ten-year term. The lease has a renewal option for an additional ten years, but Ral has
not reached a decision with regard to the renewal option. In early January of year 1, Ral
completed the following improvements to the property:

Sales Office
Estimated Life: 10 Years
Cost: $47,000

Warehouse

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Estimated Life: 25 Years
Cost: $75,000

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Parking Lot

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Estimated Life: 15 Years
Cost: $18,000 rs e
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Amortization of leasehold improvements for year 1 should be
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a. $7,000
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b. $8,900
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c. $12,200
d. $14,000
Correct Answer: D) $14,000
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Notes
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(d) Leasehold improvements are properly capitalized and amortized over the shorter of
the remaining life of the lease or the useful life of the improvement. If the lease contains
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an option to renew and the likelihood of renewal is uncertain (as it is in this case), then
the remaining life of the lease is based on the initial lease term. In this case, the
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remaining life of the lease is therefore ten years. Since the estimated lives of all
improvements in this case are greater than or equal to ten years, the appropriate
amortization period is ten years. The year 1 amortization is thus computed as the total
cost of $140,000 ($47,000 + $75,000 + $18,000 = $140,000), divided by ten years, or
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$14,000. There is no salvage value for leasehold improvements, because the assets
revert to the lessor at the end of the lease term. Note that if the renewal of the lease for
an additional ten years were considered a certainty, the amortization periods would be
as follows: ten years for the sales office (estimated life); twenty years for the warehouse
(lease term); and fifteen years for the parking lot (estimated life).

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