k17 Sol Ch21

CHAPTER 21
Accounting for Leases
ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)

Brief Concepts
Topics Questions Exercises Exercises Problems for Analysis
1. Rationale for leasing. 1, 2, 3
2. Concepts, 4, 5, 6, 7, 8, 5, 9 1 1
classification, and 10, 11, 12,
measurement 13, 14, 17,
of leases. 19, 20
3. Finance / Sales – 16, 18, 19, 1, 2, 3, 4, 2, 3, 4, 1, 2, 3, 4, 2, 4, 5

Type Leases. 22, 23, 24, 6, 7, 8, 10, 5,6,7,8,9,10, 5, 6, 7, 8,
25 11, 12, 13, 11, 12, 13, 9, 10, 11,
14 14, 15 12, 13, 14
4. Operating leases. 15, 21, 22 15, 16, 17, 16, 17, 18, 15, 16, 17 2, 4
18, 19 19, 20, 21,
22
5. Special Issues 9, 10, 12, 4, 8, 9, 20, 1, 2, 3, 4,5, 1, 2, 3, 4, 1, 2, 3, 4,

Residual values; 17, 26, 27, 21, 22, 23, 6,7,8, 9, 10, 5, 6, 7, 8, 5, 6
bargain-purchase 28, 30, 31 24, 25, 26, 11, 12, 13, 9, 10, 11,
options; Other lease 27, 28 14, 15, 16, 12, 13, 14
costs; initial direct 17, 18, 19,
costs, presentation 20,21, 22
and disclosure.
*6. Sale-leaseback. 32, 33 29, 30 23, 24 7
*7. Direct financing 34, 35, 36 31, 32 25

lease.
*This material is dealt with in an Appendix to the chapter.
Copyright © 2019 WILEY Kieso, Intermediate Accounting, 17/e, Solutions Manual (For Instructor Use Only) 21-1
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)
Concepts
Brief for
Learning Objectives Questions Exercises Exercises Problems Analysis
1. Describe the 1, 2, 3, 4, 5, 5, 9 1 1
environment related to 6, 7, 8, 10,
leasing transactions. 11, 12, 14,
17, 19, 20
2. Explain the accounting 16, 18, 19, 1, 2, 3, 4, 6, 2, 3, 4, 5, 1, 2, 3, 5, 2, 4, 7, 5

for finance leases. 22, 23, 24, 7, 8, 10, 11, 6,7,8,9, 6, 7, 8, 10,
25 12, 13, 14 10, 11, 12, 11, 12, 13,
13, 14, 15 14, 15
3. Explain the accounting 15, 21, 22 15, 16, 17, 16, 17, 18, 9, 15, 16, 2, 4
for operating leases. 18, 19 19, 20, 21, 17
22
4. Discuss the accounting 9, 10, 12, 4, 8, 9, 20, 1, 2, 3, 4, 1, 2, 3, 5, 1, 2, 3, 4,

and reporting for 13, 17, 26, 21, 22, 23, 5, 6, 7, 8, 6, 7, 8, 9, 5, 7
special features of 27, 28, 29, 24, 25, 26, 9, 10, 11, 10, 11, 12,
lease arrangements. 30, 31 27, 28 12, 13, 14, 13, 14
15, 16, 17,
18, 19, 20,
21, 22
*5. Describe the lessee’s 32, 33 29, 30 23, 24 7

accounting for sale-
leaseback
transactions.
*6 Describe the lessor’s 34, 35, 36 31, 32 25

accounting for a direct
financing lease.
*This material is dealt with in an Appendix to the chapter.
21-2 Copyright © 2019 WILEY Kieso, Intermediate Accounting, 17/e, Solutions Manual (For Instructor Use Only)
ASSIGNMENT CHARACTERISTICS TABLE
Level of Time
Item Description Difficulty (minutes)
E21.1 Lessee Entries; Finance Lease with No Residual Moderate 15–20
Value
E21.2 Lessee Entries; Finance Lease with Unguaranteed Moderate 15–20
Residual Value
E21.3 Lessee Computations and Entries; Finance Lease Moderate 20–25
with Guaranteed Residual Value
E21.4 Lessee Entries; Finance Lease and Unguaranteed Moderate 20–30
Residual Value
E21.5 Computation of Rental; Journal Entries for Lessor Moderate 15–25
E21.6 Lessor Entries; Sales-Type Lease with Option to Moderate 20-25
Purchase
E21.7 Type of Lease; Amortization Schedule Moderate 15-20
E21.8 Lessor Entries; Sales-Type Lease Moderate 15-20
E21.9 Lessee Entries; Initial Direct Costs Moderate 20–25
E21.10 Lessee Entries with Bargain-Purchase Option Moderate 20-30
E21.11 Lessor Entries with Bargain-Purchase Option Moderate 20–30
E21.12 Lessee-Lessor Entries; Sales-Type Lease with a Moderate 20-25
Bargain Purchase Option
E21.13 Lessee-Lessor Entries; Sales-Type Lease; Moderate 20-25
Guaranteed Residual Value
E21.14 Lessee Entries; Initial Direct Costs Moderate 20-25
E21.15 Amortization Schedule and Journal Entries for Moderate 20–30
Lessee.
E21.16 Amortization Schedule and Journal Entries for Moderate 20–30
Lessee.
E21.17 Accounting for an Operating Lease Moderate 10-20
E21.18 Accounting for an Operating Lease Moderate 15–20
*E21.23 Sale-Leaseback Moderate 20-30
*E21.24 Lessee-Lessor, Sale-Leaseback Moderate 20–30
‘*E21.25 Direct Financing Lease Moderate 20-25
P21.1 Lessee Entries, Finance Lease. Simple 20–25
P21.2 Lessee Entries and Balance Sheet Presentation, Moderate 20–30
Finance Lease.
P21.3 Lessee Entries and Balance Sheet Presentation, Moderate 35–45
Finance Lease.
P21.4 Lessee Entries, Finance Lease with Monthly Payments. Moderate 30–40
P21.5 Basic Lessee Accounting with Difficult PV Calculation Moderate 40-50
P21.6 Lessee-Lessor Entries, Finance Lease with a Moderate 25–35
Guaranteed Residual Value.
P21.7 Lessor Computations and Entries, Sales-Type Lease Complex 30-40
with Guaranteed Residual Value.
P21.8 Lessee Computations and Entries, Finance Lease with Complex 30–40
Guaranteed Residual Value.
P21.9 Lessor Computations and Entries, Sales-Type Lease Complex 30-40
with Unguaranteed Residual Value.
P21.10 Lessee Computations and Entries, Finance Lease with Complex 30–40
Unguaranteed Residual Value.
P21.11 Lessee-Lessor Accounting for Residual Values. Complex 30–40
P21.12 Lessee-Lessor Entries, Balance Sheet Presentation, Moderate 35-45
Finance and Sales-Type Lease.
P21.13 Balance Sheet and Income Statement Disclosure— Moderate 35–45
Lessee.
P21.14 Balance Sheet and Income Statement Disclosure— Moderate 40-50
Lessor.
P21.15 Finance and Operating Lease. Moderate 30–40
P21.16 Operating lease. Moderate 30–40
P21.17 Lessee-Lessor Entries, Operating Lease with an Moderate 30–40
Unguaranteed Residual Value.
Level of Time
Item Description Difficulty (minutes)
CA21.1 Lessee accounting and reporting. Moderate 15–25
CA21.2 Lessor and lessee accounting and disclosure. Moderate 25–35
CA21.3 Lessee capitalization tests. Moderate 20–30
CA21.4 Comparison of different types of accounting by lessee Moderate 15–25
and lessor.
CA21.5 Lease capitalization, bargain-purchase option. Moderate 20–25
CA21.6 Short-Term lease vs. finance lease. Moderate 20–30
*CA21.7 Sale-Leaseback. Moderate 15–25
ANSWERS TO QUESTIONS
1. The major lessor groups in the United States are banks, captives, and independents. Banks are the
largest players in the leasing business. Captives are subsidiaries whose primary business is to perform
leasing operations for the parent company. They have the point of sale advantage in finding leasing
customers for as soon as a parent receives a possible order, a lease financing arrangement can be
developed by its leasing subsidiary. Furthermore, the captive (lessor) has the product knowledge which
gives it an advantage when financing the parents’ product. The current trend is for captives to focus on the
company’s products rather than to do general lease financings. Last, independents are often good at
developing innovative contracts for lessees.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
2. (a) Possible advantages of leasing for the lessee:

1. Leasing may be more flexible in that the lease agreement may contain less restrictive
provisions than the bond indenture.
2. Leasing permits 100% financing of assets, as the lease is often signed without requiring any
money down from the lessee.
3. Leasing may permit more rapid changes in equipment, reduce the risk of obsolescence, and
pass the risk in residual value to the lessor or a third party.
4. Leasing may have favorable tax advantages.
(b) Assuming that funds are readily available through debt financing, there may not be great
advantages (in addition to the above-mentioned) to signing a noncancelable, long-term lease. One
additional advantage of leasing is its availability when other debt financing is unavailable.
(c) Given the new reporting standard on leasing the financial statement effects of a long-term
noncancelable lease versus the purchase of the asset are somewhat similar. That is assets under a long
term lease are capitalized at the present value of the future lease payments and this value is probably
equivalent to the purchase price of the assets. On the liability side, the bond payable amount would be
equivalent to the present value of the future lease payments. In summary, the amounts presented in the
balance sheet would be quite comparable. The description of the leased asset (right-of-use asset) and
related liability would however be different than under a bond financing as would the general
classifications; the specific labels (leased assets and lease liability) would be different.
LO: 1, Bloom: C, Difficulty: Moderate, Time: 5-10, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
3. Possible advantages of leasing for a lessor:

1. It often provides profitable interest margins.
2. It can stimulate sales of a lessor’s product whether it be from a dealer (lessor) or a
manufacturer (lessor).
3. It often provides tax benefits which enhances the return for the lessor and other parties to the
lease.
4. It can provide a high residual value to the lessor upon the return of the property at the end of the
lease term, which can potentially provide very large profits.
4. Lessees generally have two possible lease accounting methods: (a) the finance method and (b) the
operating method. Under both methods, the lessee records a right-of-use asset and a related lease
liability. However, the subsequent treatment of the right-of-use asset and lease liability differs under
each method. For a finance lease, the lessee recognizes interest expense on the lease liability over the
life of the lease using the effective interest method and records amortization expense on the right-of-use
asset generally on a straight line basis. A lessee therefore reports both interest expense and
amortization of the right to use asset on the income statement. In an operating lease, the lessee also
measures interest expense using the effective interest method. However, the lessee amortizes the right-
of-use asset, such that the total lease expense is the same from period to period. In other words, for
operating leases, only a single lease expense (comprised of interest on the liability and amortization of
the right-of-use asset) is recognized on the income statement typically on a straight-line basis.
To determine which method to apply, a lessee should classify a lease based on whether the
arrangement is effectively a purchase of the underlying asset (i.e. if control transfers to the lessee). If the
lease meets one of five classification tests to determine whether the arrangement is effectively a
purchase of the underlying asset, the lease is treated as a finance lease. Otherwise, if none of the tests
are met, the lessee is deemed to only obtain the right to use the asset (not ownership of the asset itself),
and accounts for the lease as an operating lease.
5. The five classification tests are the following:

1. Transfer of Ownership Test: if the lease transfers ownership of the asset to the lessee at the
end of the lease term, it is a finance lease.
2. Lease Purchase Option Test: if it is reasonably certain that the lessee will exercise the option
(i.e. it is a bargain purchase option), it is a finance lease.
3. Lease Term Test: when the lease term is a major part of the remaining economic life of the
leased asset (often indicated by a guideline of 75% or more of the economic life of the asset),
then the lease is a finance lease.
4. Present Value Test: if the present value of the lease payments (fixed payments + residual
value guarantee + bargain-purchase option) is reasonably close to the fair value of the asset
(often indicated by a guideline of 90% or more of the fair value of the asset), then the lease is a
finance lease.
5. Alternative Use Test: if at the end of the lease term, the lessor does not have an alternative
use for the asset, the lease is a finance lease.
6. The discount rate used by the lessee in the present value test and for valuing the lease liability is the
implicit interest rate used by the lessor. This rate is defined as the discount rate that, at the
commencement of the lease, causes the aggregate present value of the lease payments and
unguaranteed residual value to be equal to the fair value of the leased asset. However, if it is
impracticable for the lessee to determine the implicit rate of the lessor, the lessee should use its
incremental borrowing rate. The incremental borrowing rate is the rate of interest the lessee would have
to pay on a similar lease or incur to borrow over a similar term the funds necessary to purchase the
asset.
7. (a) If a lease is for a major part of the economic life of the lease, the lease is classified as a finance
lease. In practice, 75% of the economic life of the asset is generally used to meet this classification test.
That is, if the lease term is 75% or greater of the economic life of the asset, the lease is classified as a
finance lease.
(b) If the lease term is 12 months or less the lessee may elect to use the short-term lease exception, and
thus the lease would not be classified as finance lease. The lessee would expense the lease payment in
the applicable year.
(c) If the lease transfers ownership of the asset at the end of the lease, the lease is classified as a
finance lease. This situation meets one of the classification tests for a finance lease.
8. Paul Singer is for the most part correct. As long as the lease has a lease term of over 12 months, Paul is
correct that the lease must be recognized on the balance sheet of the lessee. However, the new lease
standard allows for a short-term lease exception. Under the short-term lease exception for lessees,
rather than recording a right-of-use asset and lease liability, lessees may elect to expense the lease
payments as incurred. In this case, the lease is not capitalized on the balance sheet as Paul suggested.
LO: 1, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
9. (a) Residual value is the expected value of the leased asset at the end of the lease term.
(b) A guaranteed residual value is a guarantee made to a lessor that the value of the leased asset
returned to the lessor at the end of a lease will be at least a specified amount. Any amounts guaranteed
under a residual value guarantee should be included in the present value test.
(c) Initial direct costs are incremental costs of a lease that would not have been incurred had the lease
not been executed. Initial direct costs incurred by the lessee are included in the cost of the right-of-use
asset but are not recorded as part of the lease liability.
LO: 1, 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
10. (a) A bargain purchase option is a lease purchase option in which the lessee can buy the asset for a
price that is significantly lower than the underlying asset’s expected fair value at the date the option
becomes exercisable, thus making the exercise of the option reasonably certain. A bargain renewal
option is essentially the same conceptually as a bargain purchase option, except the option is to renew
the lease as opposed to purchasing the asset. That is, a bargain renewal option is an option in which the
price of renewal at which the lessee can buy the asset is significantly lower than the underlying asset’s
expected fair value at the date the option becomes exercisable, thus making the exercise of the option
reasonably certain.
(b) A bargain purchase option and a bargain renewal option have similar impacts on the initial
classification and measurement of the lease. With respect to classification, the existence of a bargain
purchase option is one way a lease can meet the finance/sales-type lease classification criteria. In the
case of a bargain renewal option, the additional lease term that would be added by exercising the option
should be included in the lease term when assessing whether or not the lease meets the lease term test.
The present value of the option price would also be used in assessing whether the lease met the present
value test. For measurement purposes, the present value of both a bargain purchase option and a
bargain renewal option should be included in the initial value of the lease liability and right-of-use asset.
11. The lease liability is recorded at the present value of the lease payments. This includes the periodic
rental payments made by the lessee, bargain-purchase option if any, and amounts probable to be owed
under a residual value guarantee. The present value of the lease payments is recorded as a lease
liability by the lessee.
12. Wonda Stone is correct in her interpretation. For purposes of lease classification, the present value of
the guaranteed residual value is used in determining whether the present value (90%) test is met.
However, the amount included in the measurement of the lease liability is only the amount that the
lessee expects to owe under the residual value guarantee at the end of the lease. For example, if a
lessee guarantees a residual value of $10,000, but it is also probable that the lessee does not expect to
owe any additional money at the end of the lease, then the guaranteed residual value would not be
included in the initial measurement of the lease liability.
LO: 1, 4, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
13. The right-of-use asset is initially measured as the same amount as the lease liability (i.e. present value of
lease payments), adjusted for initial direct costs, prepayments and lease incentives. Initial direct costs
paid by the lessee will increase the initial value of the right-of-use asset. Similarly, prepaid rent paid by
the lessee will increase the amount of the right-of-use asset recorded. Lease incentives granted to the
lessee by the lessor will decrease the initial value of the right-of-use asset.
14. Variable lease payments should be included at the level of the index/rate at the commencement date.
Increases or decreases in the index should not be assumed when valuing the lease liability. Thus, for the
lease in this question, the lessee should not assume any changes in the CPI. The difference in
the monthly payment in the second year from the first year of $100 ($5,100 - $5,000) is expensed in the
period incurred. Only if the lessee knows the amount of the variable payment in subsequent periods
should it include these payments in the lease liability computation. The lease payment in the second
year is $5,150.
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
15. The lessee records a right-of-use asset and lease liability at commencement of the lease. The lessee
records the same amount for lease expense each period over the lease term (often referred to as the
straight-line method). The straight-line amount to be recognized each period is computed by finding the
total cost of the lease to the lessee and dividing the total cost by the number of periods in the lease term.
To accomplish the goal of achieving a single operating cost that is constant from period to period,
companies continue to use the effective interest method for amortizing the lease liability. However
instead of reporting interest expense, a lessee reports interest on the lease liability as Lease Expense. In
addition, the lessee no longer reports amortization expense related to the right-of-use asset. Instead it
“plugs” in an amount that increases the Lease Expense amount so that it is constant from period to
period. This plugged amount then reduces the right-of-use asset, such that both the asset and liability
are amortized to zero at the end of the lease.
LO: 3, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, Measurement Analysis and Interpretation, AICPA PC:
None
16. For a finance lease, the lessee records a right-of-use asset and lease liability at commencement of the
lease. The lessee then recognizes interest expense on the lease liability over the life of the lease using
the effective interest method and records amortization expense on the right-of-use asset generally on a
straight line basis. A lessee therefore reports both interest expense and amortization of the right to use
asset on the income statement. As a result, the total expense for the lease transaction is generally
higher in the earlier years of the lease arrangement under a finance lease arrangement. The lessee
continues to amortize the right-of-use asset and decrease the principal of the lease liability until both are
reduced to zero at the end of the lease. The right-of-use asset should be amortized over the lease term,
unless there is a bargain-purchase option or ownership of the asset transfers to the lessee at the end of
the lease. If either of these criteria are met, then the lessee amortizes the right-of-use asset over the
economic life of the asset.
LO: 2, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, Measurement Analysis and Interpretation, AICPA PC:
None
17. The income statement presentation differs between the operating and finance lease methods of
accounting for the lessee. While both methods amortize the right-of-use asset and reduce the lease
liability over the course of the lease, the accounts used and amounts recognized are different. Under the
operating method, a lessee records the same amount for lease expense each period over the lease
term, partially made up of interest expense from the lease liability and amortization expense on the right-
of-use asset. While the total “Lease Expense” is composed of essentially two different components, only
one expense account is used on the income statement to recognize those two components. In contrast,
under the finance lease method, a lessee reports both interest expense and amortization of the right-of-
use asset on the income statement. In addition, instead of a straight-line, constant expense period to
period, the separate treatment of the right-of-use asset and lease liability leads to the total expense for
the lease transaction being higher in the earlier years of the lease arrangement than at the end of the
lease arrangement.
The balance sheet presentation is similar between the two methods, in that both methods require the
recognition of a lease liability and related right-of-use asset at the commencement of the lease.
However, it is the subsequent amortization and reduction of lease liability and right-of-use asset that
differs, as described in the income statement presentation above.
18. The lease agreement between Alice Foyle, M.D. and Brownback Realty, Inc. is in substance a purchase
of property. Because the lease has a bargain-purchase option which transfers ownership of the property
to the lessee, the lease is a finance lease to Alice Foyle and a sales-type lease to Brownback Realty. As
a finance lease, the right-of-use asset and related lease liability should be recorded at the discounted
amount of the future lease payments over the economic life of the medical building given the bargain
purchase option.
19. From the standpoint of the lessor, leases will (with few exceptions) be classified for accounting purposes as
either (a) operating leases or (b) sales-type leases.
A sales-type lease meets one or more of the following five tests:
1. The lease transfers ownership,
2. The lease contains a bargain-purchase option,
3. The lease term is a major part of the remaining economic life of the underlying asset (i.e. equal to
75% or more of the estimated economic life of the property),
4. The present value of the lease payments equals or exceeds substantially all of the underlying asset’s
fair value (i.e. 90% of the fair value of the property),
5. The asset is of such a specialized nature that it is expected to have no alternative use to the lessor at
the end of the lease term.
If none of the above five tests are met, the lease will be treated as an operating lease. The FASB
concluded that by meeting any one of the lease classification tests, the lessor transfers control of the
leased asset and therefore satisfies a performance obligation, which is required for revenue recognition
under the FASB’s recent standard on revenue. That is, if the lessee takes ownership or consumes a
substantial portion of the underlying asset over the lease term, the lessor has in substance transferred
control of the right-of-use asset and the lessor has a sales-type lease. On the other hand, if the lease
does not transfer control of the asset over the lease term, the lessor generally uses the operating
approach in accounting for the lease.
20. A lease receivable is defined as the present value of the periodic rental payments plus any guaranteed
residual value. A net investment in the lease includes not only the components of the lease receivable but
also any unguaranteed residual value. In other words, the net investment in the lease is equal to the present
value of the rental payments, plus any guaranteed residual value plus any unguaranteed residual value. As
indicated in the test, for homework problems, we assume that the present value of the unguaranteed residual
value should be included as part of the lease receivable.
21. Under the operating method, each rental receipt of the lessor is recorded as lease revenue. The
underlying leased asset is still recognized on the balance sheet of the lessor and depreciated in the
normal manner. In addition to depreciation, any other related costs to the lease arrangement (i.e.
insurance, maintenance, taxes, etc.) are recorded in the period incurred.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, Measurement Analysis and Interpretation, AICPA PC:
None
22. Under a sales-type lease, lessors report in the income statement Sales Revenue and Cost of Goods
Sold (and resultant gross profit) at commencement of the lease. During the lease term, Interest Revenue
on the Lease Receivable is reported. Under an operating lease, lessors report Lease Revenue (generally
when payments are received) and Depreciation Expense on the leased asset.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, Measurement Analysis and Interpretation, AICPA PC:
None
23. Walker Company can use the sales-type lease method if the lease meets one or more of the following five
tests:
(1) The lease transfers ownership of the property to the lessee,
(2) The lease contains a bargain-purchase option,
(3) The lease term is a major part of the remaining economic life of the underlying asset (i.e. equal to
75% or more of the estimated economic life of the property),
(4) The present value of the lease payments equals or exceeds substantially all of the underlying
asset’s fair value (i.e. 90% of the fair value of the property),
(5) The asset is of such a specialized nature that it is expected to have no alternative use to the lessor
at the end of the lease term.
24. Metheny Corporation should recognize the present value of the lease payments (normal sales price) as
sales revenue, and the carrying amount (book value) of the asset as cost of goods sold. Thus, the gross
profit from the lease should be recognized at the commencement of the lease as the difference between
the sales revenue and cost of goods sold. Subsequent to lease commencement, the company will
recognize interest revenue on the lease receivable. If an unguaranteed residual value is involved, the
lessor should reduce both the sales revenue and cost of goods sold by the present value of the
unguaranteed residual value. The gross profit, however, will not change.
25. Although not part of the classification tests, the lessor must also determine whether the collectibility of
payments from the lessee is probable, as it has implications for the subsequent accounting of the lease.
Because collection of the lease payments is not probable for Packer Company, it should record the
receipt of the payments as a deposit liability and not derecognize the leased asset.
26. (a) (1) The lessee’s accounting for a lease with an unguaranteed residual value is the same as the
accounting for a lease with no residual value. That is, unguaranteed residual values are not
included in the lessee’s lease payments, either for classification or measurement purposes.
(2) A guaranteed residual value has significance for the lessee in two ways. First, for classification
purposes, the full amount of a guaranteed residual value is used in calculating the present
value of the lease payments in determining whether or not a lease meets the present value
test. In addition, as far as the initial measurement of the lease liability, a guaranteed residual
value may be included, depending on how much a lessee expects to owe under the guarantee.
(b) The value of the lease liability may be made up of two components—the periodic rental payments
and amounts probable to be owed under a guaranteed residual value. That is, if the expected
residual value at the end of the lease term is less than the guaranteed residual value, then the
lessee will expect to pay in cash a certain amount to the lessor at the end of the lease term. As
such, the lessee should include the present value of the difference between the guaranteed
residual and expected residual if the expected residual is less than the guarantee. If the residual
value at the end of the lease term differs in any way from the expected residual at the
commencement of the lease, the lessee recognizes a loss or gain when the final payment of the
guaranteed residual is made.
27. The amount to be recovered by the lessor is the same whether the residual value is guaranteed or
unguaranteed. Therefore, the amount of the periodic rental payments is set the same way by the lessor
whether the residual value is guaranteed or unguaranteed.
28. If a bargain-purchase option exists, the lessee must increase the present value of the lease payments by
the present value of the option price. This is the case for both classification and initial measurement of
the lease liability and right-of-use asset. A bargain purchase option also affects the period over which the
right-of-use asset is amortized, since the lessee amortizes the asset over its economic life rather than
the term of the lease. If the lessee fails to exercise the option, the lessee will recognize a loss to the
extent of the book value of the right-of-use asset in the period that the option expired.
LO: 4, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, Measurement Analysis and Interpretation, AICPA PC:
None
29. Initial direct costs are the incremental costs of a lease that would not have been incurred had the lease not
been executed. For the lessee, some costs that are included in the right-of-use asset are commissions,
legal fees from the execution of the lease, lease documentation preparation costs incurred after the
execution of the lease, and consideration paid for a guarantee of residual value by an unrelated third
party.
For operating leases, the lessor should defer initial direct costs and amortize them as expenses over the
term of the lease. In a sales-type lease transaction, the lessor expenses the initial direct costs at lease
commencement (in the period in which it recognizes the profit on the sale). An exception is when there is
no selling profit or loss on the transaction, in which case the initial direct costs are deferred and
recognized over the lease term.
LO: 4, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
30. A short-term lease is a lease that, at the commencement date, has a lease term of 12 months or less.
Rather than recording a right-of-use asset and lease liability, lessees may elect to expense lease
payments as incurred.
31. Lessees and lessors must provide additional qualitative and quantitative disclosures to help financial
statement users to assess the amount, timing, and uncertainty of future cash flows. Qualitative lease
disclosures include the nature of the leases, how variable lease payments are determined, the existence
and terms and conditions for options to extend or terminate the lease and for residual value guarantees,
and information about significant assumptions and judgments such as discount rates. Quantitative
disclosures include total lease cost, finance lease cost segregated between the amortization of the right-
of-use assets and interest on the lease liabilities, operating and short-term lease cost, weighted-average
remaining lease term and weighted-average discount rate (segregated between finance and operating
leases), and maturity analysis of finance and operating lease liabilities on an annual basis for a minimum
of each of the next five years and the sum of the undiscounted cash flows for all years thereafter.
*32. In a sale-leaseback arrangement, a company (the seller-lessee) transfers an asset to another company
(the buyer-lessor) and then leases that asset back from the buyer-lessor. In order to qualify for sale-
leaseback treatment, the initial transfer of the asset must be such that the seller-lessee gives up control
of the asset to the buyer-lessor. In this way, the transaction is a sale, and gain or loss recognition is
appropriate. In addition, the subsequent leaseback must be classified as an operating lease for the
seller-lessee. This is because if any of the lease classification tests are met, the seller-lessee never
actually gave up control of the asset, and thus a sale is deemed to never have happened. As long as the
initial owner of the asset continues to control the asset, it should not record a sale nor recognize a gain
or loss. Instead, the transaction is treated as borrowing money from the ‘buyer-lessor’ in a financing
arrangement, often labeled a “failed sale.”
LO: 5, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*33. The sale and subsequent lease will receive sale-leaseback accounting treatment. The initial transfer of
the asset was a sale, and the seller-lessee gave control of the asset to the buyer-lessor. In addition, the
subsequent leaseback is classified as an operating lease, and thus Sanchez never takes control of the
asset back from Harper. Had the leaseback been classified as a financing lease, the transaction would
have been considered a ‘failed sale’ and would have simply been accounted for as a borrowing
arrangement. However, because it qualifies for sale-leaseback treatment, Sanchez should recognize
the $4 million gross profit at the commencement of the lease, and record a right-of-use asset and lease
liability at the present value of the lease payments.
*34. Lessors account for a lease as a sales-type lease if the lease transfers control of the underlying asset to
the lessee, based on meeting one of the five lease classification tests. If none of the classification tests
are met, generally the lease will be classified as an operating lease. However, a direct financing lease is
a unique exception to this rule that only occurs in the presence of a third-party residual value guarantee.
If the lessor effectively relinquishes control of the asset to the lessee (substantially all risks/rewards of
ownership), but there is also a third-party residual value guarantee such that the 90% test is met as a
result, the lease is classified as a direct financing lease instead of a sales-type or operating lease.
LO: 6, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*35. In a sales-type lease, the lessor recognizes the gross profit immediately at the commencement of the
lease, and interest revenue each period on the lease receivable. In a direct-financing lease, the lessor
defers its gross profit, and recognizes it over the course of the lease term along with interest revenue. In
an operating lease, the lessor recognizes lease revenue as periodic rental payments are collected and
the performance obligation is satisfied.
*36. Under a direct financing lease, the profit on the lease is deferred and recognized over the life of the
lease (instead of at the lease commencement as would be the case in a sales-type lease). The deferred
gross profit reduces the receivable in the lease, and subsequent accounting for the direct-financing
lease is based on a discount rate that will amortize the net lease receivable over the life of the lease to
zero. That is, in a direct-financing lease the rate used to amortize the lower net lease receivable (lease
receivable less deferred gross profit) will be higher. This results because the rate includes interest
revenue on the lease receivable and revenue from amortizing deferred gross profit.
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 21.1
The lease does not meet the transfer of ownership test, the bargain purchase test,
the economic life test [(5 years ÷ 8 years) < 75%], or the specialized asset test.
However, it does pass the present value test. The present value of the lease
payments [($31,000 X 4.46511*] + [$15,500 X .74726**] = $150,000) is greater than
90% of the FV of the asset (90% X $150,000 = $135,000). Therefore, Callaway
should classify the lease as a finance lease.
*Present value of an annuity due of 1 for 5 periods at 6%.

**Present value of 1 for 5 periods at 6%.
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
BRIEF EXERCISE 21.2
The lease does not meet the transfer of ownership test, the bargain purchase test,
or the specialized asset test. While the initial five year lease term and rental
payments would result in the lease failing the economic life test and the present
value test, Jelly must also take the renewal option into account when computing
the lease term and present value of the lease payments, as the exercise of the
renewal option is reasonably certain. When accounting for the bargain renewal
option, the lease will in fact meet both the economic life test and the present
value test (as shown below). Thus, the lease should be classified as a finance
lease for Jelly Co.
Economic Life Test

6 years (5 years initial + 1 year for renewal option) ÷ 7 years = 85.7% > 75%
Present Value Test

PV of initial rental payments (4.54595* X $15,000): $68,189
PV of bargain renewal option (.78353** X $10,000): 7,835
PV of lease payments: $76,024
Fair value of the equipment: ÷ $76,024
PV of lease payments as a percent of fair value 100%

BRIEF EXERCISE 21.3
The lease payments in the lease arrangement will include both the annual fixed
payments of $800,000 each year, plus the $11,000,000 bargain purchase option
at the end of the lease term (as it is reasonably certain to be exercised). Thus,
the lease payments for the lease agreement total ($800,000 x 6) + $11,000,000 =
$15,800,000.
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
BRIEF EXERCISE 21.4
The lease payments for years 1 and 2 will be $1,700 ($2,000 annual rental minus
$300 lease incentive). In year 3, Fieger will receive no lease incentive, and will
have a full lease payment of $2,000. Thus, in total over the first 3 years, the lease
payments will be $5,400 ($1,700 + $1,700 + $2,000).
LO: 2, 4 Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
BRIEF EXERCISE 21.5
Variable payments in a lease are not considered in determining the initial value
of the lease liability and right-of-use asset. Because the lease payments are
based on 4% of net sales, these payments are considered variable, as they are
not based on an index or rate, the future level of which in not known at lease
commencement. It does not matter that it is highly certain that Sanders will
achieve a minimum of $1,000,000 in net sales each year. Thus, these variable
lease payments are not included in the initial valuation of the lease liability and
right-of-use asset. Since they are the only payments being made in the lease
agreement, Sanders would record the right-of-use asset at zero and record lease
expense when payments are made.
BRIEF EXERCISE 21.6
12/31/19
Right-of-Use Asset ($41,933 X 3.57710*) ...................... 150,000**
Lease Liability ........................................................ 150,000
Lease Liability ................................................................ 41,933

Cash ........................................................................ 41,933

**Rounded by $1.
BRIEF EXERCISE 21.6 (Continued)
12/31/20
Interest Expense [($150,001 – $41,933) X .08] .............. 8,645
Lease Liability ................................................................ 33,288
Cash ........................................................................ 41,933
Amortization Expense ................................................... 37,500

Right-of-Use Asset
($150,001 ÷ 4) .................................................... 37,500
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 21.7
12/31/20
Interest Expense [($300,000 – $48,337) X .08] .............. 20,133
Lease Liability ................................................................ 28,204
Cash ........................................................................ 48,337

Right-of-Use Asset
($300,000 ÷ 8) .................................................... 37,500
BRIEF EXERCISE 21.8
Fair value of leased asset $70,000

Less: Present value of guaranteed residual value
($5,000 X .50025*) 2,501
Amount to be recovered through lease payments $67,499
Amount of equal annual lease payments ($67,499 ÷ 6.74664**) $10,005
*Present value of 1 for 9 periods at 8%.

**Present value of an annuity due of 1 for 9 periods at 8%.
LO: 2, 4 Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 21.9
Fair value of leased asset $47,000

Less: Present value of lessor’s expected residual value*
($30,000 X .79209**) 23,763
Amount of equal annual lease payments ($23,237 ÷ 3.46511***) $6,706
*The expectation of the residual value of the lessee would not matter in this
case. The lessor uses its own expectation of the residual value in determining
the annual lease payments. The lessor probably would not even be aware of the
lessee’s expectations.
***Present value of an ordinary annuity for 4 periods at 6%.
LO: 1, 4, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 21.10
Lease Receivable (4.99271* X $30,044) ........................ 150,001

Cost of Goods Sold ....................................................... 120,000
Sales Revenue ........................................................ 150,001
Inventory ................................................................. 120,000
Cash ................................................................................ 30,044

Lease Receivable ................................................... 30,044

Cash ................................................................................ 30,044

Lease Revenue [($150,001 – $30,044) X .08] ......... 9,597
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Lease Receivable ($40,800 X 4.31213*) ........................ 175,935

Sales Revenue ........................................................ 175,935
Inventory ................................................................. 120,000
Cash ................................................................................ 40,800


Cash ................................................................................ 40,800

Deposit Liability* .................................................... 40,800
*When collectibility of lease payments is not probable, the lessor does not
derecognize the asset or recognize selling profit on the lease. Instead, Geiberger
would recognize any cash receipts as a deposit liability.
Lease Receivable ........................................................... 57

Interest Revenue .................................................... 57
Inventory......................................................................... 1,000
Note to Instructor: The above two entries can be combined into one entry at the
end of the year, as shown below:
Inventory......................................................................... 1,000
Interest Revenue .................................................... 57
Lease Receivable ................................................... 943
1/1/20
Right-of-Use Asset (2.83339* X $23,000) ...................... 65,168

Lease Liability ........................................................ 65,168
Lease Liability ................................................................ 23,000

Cash ........................................................................ 23,000
Schedule A
LEBRON JAMES CORPORATION
Lease Amortization Schedule
Annuity-Due Basis
Reduction
Annual Interest (6%) on of Lease
Date Payment Liability Liability Lease Liability
1/1/20 $65,168
1/1/20 $23,000 $ 0 $23,000 42,168
1/1/21 23,000 2,530 20,470 21,698
1/1/22 23,000 1,302 21,698 0
Schedule B
Lease Expense Schedule
(C)
(A) (B) Amortization
Lease Expense Interest (6%) on of ROU Asset Carrying Value
Date (Straight-Line) Lease Liability (A-B) of ROU Asset
1/1/20 $65,168
12/31/20 $23,000 $2,530 $20,470 44,698
12/31/21 23,000 1,302 21,698 23,000
12/31/22 23,000 0 23,000 0
12/31/20
Lease Expense ............................................................... 23,000
Lease Liability (Schedule A) .................................. 2,530*
Right-of-Use Asset (Schedule B) .......................... 20,470
*The accrual of the lease liability is a result of the accrual of interest related to the
lease liability, as shown in schedule A. Note that this is expensed along with the
amortization of the right-of-use asset at the end of 2020.
1/1/20

Lease Liability ........................................................ 99,169
Lease Liability ................................................................ 35,000

Cash ........................................................................ 35,000
Schedule A
KINGSTON CORPORATION
Annuity-Due Basis
Reduction
Interest (6%) of Lease
Date Annual Payment on Liability Liability Lease Liability
1/1/20 $99,169
1/1/20 $35,000 $ 0 $35,000 64,169
1/1/21 35,000 3,850 31,150 33,019
1/1/22 35,000 1,981 33,019 0
Schedule B
(C)
1/1/20 $99,169
12/31/20 $35,000 $3,850 $31,150 68,019
12/31/21 35,000 1,981 33,019 35,000
12/31/22 35,000 0 35,000 0
12/31/20
Lease Expense ............................................................... 35,000
1/1/20
Cash ................................................................................ 35,000
Unearned Lease Revenue ...................................... 35,000
12/31/20
Unearned Lease Revenue ............................................. 35,000
Lease Revenue ....................................................... 35,000
Depreciation Expense ................................................... 25,000

Accumulated Depreciation –
Leased Equipment ($200,000 ÷ 8) ...................... 25,000
1/1/20

Lease Liability ........................................................ 33,399
Lease Liability ................................................................ 12,000

Cash ........................................................................ 12,000
Schedule A
RODGERS CORPORATION
Annuity-Due Basis
Reduction
1/1/20 $33,399
1/1/20 $12,000 $ 0 $12,000 21,399
1/1/21 12,000 1,712 10,288 11,111
1/1/22 12,000 889 11,111 0
Schedule B
(C)
(A) (B) Amortization of Carrying
Lease Expense Interest (8%) on ROU Asset Value of
Date (Straight-Line) Lease Liability (A-B) ROU Asset
1/1/20 $33,399
12/31/20 $12,000 $1,712 $10,288 23,111
12/31/21 12,000 889 11,111 12,000
12/31/22 12,000 0 12,000 0
12/31/20
Lease Expense ............................................................... 12,000

1/1/20
Cash ................................................................................ 12,000
12/31/20
Unearned Lease Revenue ............................................. 12,000
Lease Revenue ....................................................... 12,000

Accumulated Depreciation–
Leased Equipment [$60,000 ÷ 10] ......................... 6,000
$17,000 X 2.83339* = $48,168
Because the residual value is unguaranteed, Escapee Company does not include
it in its computation of the annual lease payments. If the residual value was
guaranteed, the lessee may or may not be required to include the residual in the
calculation of the lease payments, depending on whether the expected residual
value was higher, equal to, or lower than the guaranteed residual value.
(a) The value of the lease liability would remain the same if the only fact changed
from BE 21.20 was the guarantee of the expected residual value. Residual
values should only be included in the lease liability when the expected
residual value is less than the guaranteed residual value (i.e. when the lessee
expects to make an additional payment at the end of the lease term to the
lessor).
(b) Following from the above reasoning, if the expected residual value drops to
$5,000 and Escapee guarantees a residual of $9,000, Escapee will need to
account for the difference between the expected and guaranteed residual
value in calculating the initial lease liability as follows:
PV of lease payments ($17,000 X 2.83339*) $48,168

PV of residual value [($9,000 – $5,000) X 0.83962**] 3,358
Lease liability $51,526

Note to Instructor: While the measurement of the lease liability/right-of-use

asset only uses the amount probable to be owed under a residual value
guarantee, this contrasts with the classification test related to the present
value test. That is, the full amount of the guaranteed residual value would be
used in performing the present value test for the lessee to determine
whether the finance or operating method of accounting for the lease is
followed.
12/31/2019
Right-of-Use Asset......................................................... 215,544*

Lease Liability ........................................................ 215,544
*PV of rentals ($40,000 X 5.21236*) $208,494

PV of guaranteed
residual value ($20,000 – $10,000***) X 0.70496** 7,050
Lease liability $215,544
Lease Liability ................................................................ 40,000

Cash ........................................................................ 40,000

***The lessee need only include in the initial lease liability the amount of the
residual value that it expects to pay at the end of the lease term. Thus, in this
case, only the residual value in excess of the expected residual value (up to the
guaranteed residual) should be discounted to present value and included in the
computation of the lease liability.
12/31/19
Lease Receivable ........................................................... 222,593*
Sales Revenue ........................................................ 222,593
Inventory ................................................................. 180,000
*([$40,000 X 5.21236] + [$20,000 X .70496])
Cash ................................................................................ 40,000

12/31/20
Cash ................................................................................ 40,000
Interest Revenue [($222,593 – $40,000) X .06] ...... 10,956
Lease Liability
In calculating the lease liability, Forrest must determine which of the executory
costs are considered a component of the lease (to be considered in the
measurement of the lease liability).
• The real estate taxes in this case are variable payments and therefore are not
considered in the measurement of the lease liability and related right-of-use
asset.
• The fixed $500 insurance payments are included in the measurement of the
lease liability because the insurance costs are part of the rental payments.
The lease liability is computed as follows:
PV of rental payments (4.31213* X $4,638): $20,000

PV of insurance payments (4.31213* X $500): 2,156
Initial lease liability: $22,156
*Present value of an annuity due of 1 for 5 periods at 8%
Right-of-Use Asset
The right-of-use asset is initially measured the same as the lease liability, though it
is also adjusted for any initial direct costs, prepaid rent, and lease incentives
associated with the lease. The legal fees resulting from the execution of the lease
are considered initial direct costs, and must be included in the calculation of the
right-of-use asset:
Lease liability: $22,156

Legal fees: 1,000
Right-of-use asset: $23,156
Thus, the journal entry to record the initial lease liability and right-of-use asset is
as follows:

Cash (Legal Fees)................................................... 1,000
Lease Liability ........................................................ 22,156
Answer: $78,998

Cash incentive received from Badger (lessor): (5,000)
Lease document preparation costs: 500
Measurement of right-of-use asset at 1/1/20: $78,998
Employee salaries are specifically excluded as initial direct costs, and would not
be included in the calculation of the right-of-use asset.
Note to Instructor: The lease liability would not include any adjustments for cash
incentive received, or any included initial direct costs. The lease liability would
only reflect the present value of future lease payments.
Answer: $46,551

Cash incentive received from Highlander (lessor): (2,000)
Commissions for selling agents: 900
Legal fees resulting from the execution of the lease: 3,000
Measurement of right-of-use asset at 1/1/20: $46,551
Internal engineering costs are specifically excluded as initial direct costs, and
would not be included in the calculation of the right-of-use asset.
Note to Instructor: The lease liability would not include any adjustments for cash
incentive received, or any included initial direct costs. The lease liability would
only reflect the present value of future lease payments.
1/1/20
Lease Liability ........................................................ 33,974
*PV of rentals ($5,300 X 6.20637*) $32,894

PV bargain purchase option ($2,000 X 0.54027)** 1,080
$33,974
Lease Liability ................................................................ 5,300

Cash ........................................................................ 5,300
12/31/20
Interest Expense [($33,974 – $5,300) X .08] .................. 2,294
Lease Liability ........................................................ 2,294

Right-of-Use Asset
($33,974 ÷ 10*)...................................................... 3,397
*The right-of-use asset is amortized over the economic life of the asset instead
of the lease term because of the bargain-purchase option included in the lease
contract, given that the lessee plans to take ownership of the asset.
Lease Expense ............................................................... 15,000

Cash ........................................................................ 15,000
*Because the lease term is only 1 year, the lessee treats the lease as a short term
lease, does not capitalize the asset on its books, and records lease payments as
expenses when paid.
*BRIEF EXERCISE 21.29
The transaction between Irwin and Peete will qualify as a sale-leaseback, as Irwin
has transferred control of the asset to Peete. That is, the terms of the leaseback
do not meet any of the tests to be classified as a finance lease, and thus does
not transfer control back to Irwin. Irwin will recognize a gain on the sale of the
asset, and record a right-of-use asset and corresponding lease liability for the
operating lease entered into with Peete. Subsequent accounting treatment will
follow the normal accounting for an operating lease.
1/1/20
Cash ................................................................................ 35,000
Trucks ..................................................................... 28,000
Gain on Disposal of Plant Assets ......................... 7,000
Right-of-Use Asset......................................................... 23,245

Lease Liability ($8,696 X 2.67301*) ........................ 23,245
*Present value of an ordinary annuity for 3 periods at 6%.
IRWIN ANIMATION
Ordinary-Annuity Basis
Reduction
1/1/20 $23,245
1/1/21 $8,696 $ 1,395 $7,301 15,944
1/1/22 8,696 957 7,739 8,205
1/1/23 8,696 491* 8,205 0
*Rounded $1
*BRIEF EXERCISE 21.29 (Continued)
(A) (B) (C)

Lease Expense Interest (6%) on Amortization of Carrying Value
Date (Straight-Line) Lease Liability ROU Asset (A-B) of ROU Asset
1/1/20 $23,245
12/31/20 $8,696 $ 1,395 $7,301 15,944
12/31/21 8,696 957 7,739 8,205
12/31/22 8,696 491 8,205 0
12/31/20
Lease Expense ............................................................... 8,696
Right-of-Use Asset ................................................. 7,301
Lease Liability ........................................................ 1,395
Note to Instructor: The lease payment on 1/1/21 would be as follows:
Lease Liability ................................................................ 8,696

Cash ........................................................................ 8,696
With the change of facts, the leaseback meets the lease term and present value
classification tests (5/5 = 100% of asset’s economic life; $8,309 x 4.21236 =
$35,000 = 100% of asset’s fair value). As a result, the lease is a finance lease for
Irwin. Consequently, Irwin has control of the asset from the lease arrangement,
and has never given up control of the asset (i.e., a failed sale). Therefore, Irwin
will not recognize any gain on the sale of the asset, but instead record a note
payable to demonstrate the financing-nature of the transaction as shown in the
following entry on January 1, 2020.
1/1/20
Cash ................................................................................ 35,000
Notes Payable [$8,309 X 4.21236*] ........................ 35,000
* Present value of an ordinary annuity for 5 periods at 6%.
At December 31, 2020, it makes the following entry to record interest on the note
payable.
12/31/20
Interest Expense ............................................................ 2,100
Interest Payable [$35,000 X .06] ............................ 2,100
This sale-leaseback arrangement is a financing transaction and is often

referred to as a failed sale.
The above lease will be classified as a direct financing lease for Bulls. None of
the lease classification criteria are met for a sales-type lease. That is, ownership
does not transfer at the end of the lease, there is no bargain purchase option, the
asset is not specialized, and the lease term is less than 75% of the useful life of
the asset (5 ÷ 8 = 62.5%). In addition, the present value of the lease payments is
less than 90% of the fair value of the asset, as shown below:
Annual rental payments ................................................ $4,523

Present value of an ordinary annuity
for 5 periods at 4% ..................................................... X 4.45182
Present value of lease payments .................................. $20,136
Fair value of the equipment .......................................... ÷ 30,000
Present value of lease payments
as a percentage of fair value ..................................... 67.12%
The guaranteed residual value is not included in the sales-type lease

classification test, as it is not guaranteed by the lessee, but rather an
independent 3rd party. However, this 3rd party residual value guarantee is taken
into account when determining whether or not the lease is classified as a direct
financing lease. The 90% test will be met when the 3rd party guarantee is taken
into account (as the following calculation shows), and thus the lease is classified
as a direct financing lease:

for 5 periods at 4% ..................................................... x 4.45182
3rd party residual value guarantee ................................ $12,000

Present value of 1 for 5 periods at 4%.......................... x .82193
Present value of residual value guarantee ................... $9,863

Present value of lease payments plus
3rd party residual value guarantee ............................ $29,999
Present value as a percentage of fair value ................. 100%
Because the lease qualifies as a direct financing lease, the gross profit from the
lease is deferred and recognized over the course of the lease. The initial entry at
the commencement of the lease would be as follows:
Lease Receivable ........................................................... 29,999

Deferred Gross Profit ............................................. 2,999
Leased Asset .......................................................... 27,000

In a normal sale-type lease, Bulls would receive lease payments over the life of
the lease which, on a present value basis, equals the lease receivable of $30,000
(using a 4% return). This is demonstrated in the amortization schedule on the
next page:
BULLS, INCORPORATED (Lessor)

Sales-Type Lease
Interest (4%) Recovery

Annual Lease on Lease of Lease Lease
Date Payment Receivable Receivable Receivable
1/1/20 $30,000
12/31/20 $4,523 $1,200 $3,323 26,677
12/31/21 4,523 1,067 3,456 23,221
12/31/22 4,523 929 3,594 19,627
12/31/23 4,523 785 3,738 15,889
12/31/24 4,523 634* 3,889 12,000
12/31/24 12,000 _____ 12,000 -0-
34,615 $4,615 30,000
*Rounded $2
In a direct financing arrangement, Bulls will receive the same lease payments,
but will recognize lease revenue based on the rate of return that will amortize the
net lease receivable to zero (7.11% for Bulls). The following shows the direct
financing lease amortization schedule for Bulls:
BULLS, INCORPORATED (Lessor)

Direct Financing Lease
Interest Reduction of
Annual Lease (7.11%) on Net Lease Net Lease
1/1/20 $27,000
12/31/20 $4,523 $1,920 $2,603 24,397
12/31/21 4,523 1,735 2,788 21,609
12/31/22 4,523 1,536 2,987 18,622
12/31/23 4,523 1,324 3,199 15,423
12/31/24 4,523 1,100* 3,423 12,000
12/31/24 12,000 _____ 12,000 -0-
34,615 $7,615 27,000
*Rounded by $3.
The difference between the interest under a sales-type lease ($1,200) and the
overall revenue recognized for a direct financing lease ($1,920) is the amount of
deferred gross profit that is amortized in the current period ($720).
Cash .......................................................................... 4,523

Deferred Gross Profit** .................................................. 720
Lease Revenue* ...................................................... 1,920
*Lease Revenue = Net Lease Receivable X Rate of Return

= ($30,000 – $3,000) X .0711 = $1,920
**Deferred Gross Profit = Lease Revenue – Sales-Type Interest

= $1,920 – $1,200 = $720
SOLUTIONS TO EXERCISES
EXERCISE 21.1 (15–20 minutes)
Note to Instructor: This is a finance lease, as the lease term is 100% of the
asset’s economic life, and the present value of the rental payments are 100% of
the asset’s fair value, as shown below:
Present value of first payment

($5,552.82 X .92593) ................................. $ 5,141.52
Present value of second payment
($5,830.46 X .85734) ................................. 4,998.69
Present value of third payment
($6,121.98 X .79383) ................................. 4,859.81
Present value of the rental payments ....... $15,000.02*
*Two cents rounding error.
12/31/19
Right-of-Use Asset ......................................... 15,000
Lease Liability ...................................... 15,000
12/31/20
Interest Expense ($15,000 X 8%) ................... 1,200.00
Lease Liability ................................................ 4,352.82
Cash...................................................... 5,552.82
Amortization Expense ($15,000 ÷ 3) ............. 5,000.00

Right-of-Use Asset .............................. 5,000.00
12/31/21
Interest Expense
[($15,000 - $4,352.82) X 8%] ........................ 851.77
Lease Liability ................................................ 4,978.69
Cash...................................................... 5,830.46
Amortization Expense ($15,000 ÷ 3) ............. 5,000.00

Right-of-Use Asset .............................. 5,000.00
EXERCISE 21.1 (Continued)
(b) The initial valuation of the lease liability and related right-of-use asset should
not include any unknown increases or decreases in lease payments due to
increases or decreases in the CPI. Rather, for the initial measurement of the
lease liability, the lessee assumes that all payments will be made as if the CPI
level at the commencement date of the lease does not change. Thus, DU
Journeys should discount the annual lease payments using the ordinary annuity
factor applied to the first lease payment.
LO: 1, 4, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
(a) This is a finance lease to Burke since the lease term (5 years) is greater than
75% of the economic life (6 years) of the leased asset. The lease term is
831/3% (5 ÷ 6) of the asset’s economic life.
(b) Computation of present value of lease payments:

$8,668 X 4.54595* = $39,404
(c)
12/31/19
Right-of-Use Asset .................................................... 39,404

Lease Liability..................................................... 39,404
Lease Liability ......................................................... 8,668

Cash .................................................................... 8,668
12/31/20
Amortization Expense ............................................... 7,881

Right-of-Use Asset ............................................. 7,881
($39,404 ÷ 5)
Lease Liability ......................................................... 7,131

Interest Expense
[($39,404 – $8,668) X .05].................................... 1,537
Cash ........................................................ 8,668
LO: 2, 4 Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
(a) To Delaney, the lessee, this lease is a finance lease because the terms
satisfy the following tests:
1. The lease term is greater than 75% of the economic life of the leased
asset; that is, the lease term is 831/3 % (50/60) of the economic life.
2. The present value of the lease payments for purposes of classifying the
lease is greater than 90% of the fair value of the leased asset; that is, the
present value of $9,793 (see below) is 98% of the fair value ($10,000) of
the leased asset:
PV of monthly payment of $200 for 50 months

[$200 X 44.36350*].............................................. $8,873
PV of residual value of $1,180
[$1,180 X .77929**] ............................................. 920
Present value of lease payments ...................... $9,793
*Present value of an annuity due of 1 for 50 periods at 0.5%

**Present value of 1 for 50 periods at 0.5%
Note to the Instructor: The lease payments used in the calculation of the
present value for classification purposes for the lessee include the full
amount of any guaranteed residual value by the lessee. This contrasts
with the calculation of the present value of lease payments to determine
the lease liability, as seen in (b).
(b) The present value of lease payments, for purposes of determining the lease
liability for the lessee, are different than the present value of lease payments
in determining the classification of the lease when a residual value is
guaranteed by the lessee. That is, to determine the lease liability, the lessee
should only include the present value of any guaranteed residual value
probable to be owed under the lease agreement (i.e. the amount of
guaranteed residual value over the expected residual value). Because the
expected residual value is the same as the guaranteed residual value, no
amounts are probable to be owed under the lease agreement, and the
present value of lease payments to determine the lease liability therefore is:

[$200 X 44.36350*].............................................. $8,873
*Present value of an annuity due of 1 for 50 periods at 0.5%.
(c) Right-of-Use Asset .................................................... 8,873

Lease Liability..................................................... 8,873
(d) Lease Liability ........................................................... 200

Cash .................................................................... 200
(e) Lease Liability ........................................................... 157

Interest Expense (0.5% X [$8,873 – $200]) ............... 43
Cash .................................................................... 200
(f) Amortization Expense ............................................... 177

Right-of-Use Asset ............................................. 177
($8,873 ÷ 50 months)
(g) As explained in part (b), the lessee should include the present value of any
guaranteed residual value probable to be owed under the lease agreement.
Because the expected residual value ($500) is less than the guaranteed residual
value ($1,180), Delaney should include the present value of the difference in the
initial measurement of the lease liability. Thus, the present value of the lease
payments is calculated as follows:

[$200 X 44.36350*] $8,873
PV of guaranteed residual value probable to be owed
[($1,180 - $500) X .77929**] 530
PV of lease payments $9,403
*Present value of an annuity due of 1 for 50 periods at 0.5%.

(a) The lease will be treated as a finance lease for Kimberly-Clark because the
lease meets both the economic life test and the present value test. That is,
1. the present value test in that the present value of the payment is $525,176
[($71,830 x 7.24689*) + ($10,000 x .46319**)] which is equal to the fair value
of the storage building.
2. the lease term test in that the lease term is 83% (10/12) which satisfies the
75% test.

**Present value of $1 for 10 periods at 8%.
Note that for purposes of calculating the initial lease liability, however, the
present value of the lease payments will only include the amount of a residual
value guarantee probable to be owed at the end of the lease term. Thus, the
initial lease liability and right-of-use asset to be recorded on the books of
Kimberly-Clark is calculated as follows:
$ 71,830 Annual rental payment

X 7.24689 PV of annuity due of 1 for n = 10, i = 8%
$ 520,544 PV of periodic rental payments
$ 3,000 Amount probable to be owed under

residual value guarantee ($10,000 - $7,000)
X .46319 PV of 1 for n = 10, i = 8%
$ 1,390 PV of amount probable to be owed
on residual value guarantee

+ 1,390 PV of the residual value
$ 521,934 Lease liability
12/31/19
Right-of-Use Asset ............................... 521,934

Lease Liability ........................... 521,934
Lease Liability....................................... 71,830

Cash........................................... 71,830
12/31/20
Amortization Expense .......................... 52,193

Right-of-Use Asset ................... 52,193
($521,934 ÷ 10)
Lease Liability....................................... 35,822

Interest Expense
(See Schedule 1) ................................. 36,008
Cash........................................... 71,830
12/31/21
Amortization Expense...................... 52,193

Lease Liability .................................. 38,687

Interest Expense
(See Schedule 1) ............................ 33,143
Cash........................................... 71,830
Schedule 1 KIMBERLY-CLARK CORP.

Lease Amortization Schedule (partial)
(Lessee)
Reduction
Annual Lease Interest (8%) on of Lease
12/31/19 $521,934
12/31/19 $71,830 $ 0 $71,830 450,104
12/31/20 71,830 36,008 35,822 414,282
12/31/21 71,830 33,143 38,687 375,595
(b) Initial direct costs and lease incentives do not affect the initial measurement
of the lease liability. Instead, they only affect the measurement of the right-of-use
asset. Initial direct costs incurred by the lessee increase the right-of-use asset,
whereas a lease incentive decreases the value of the right-of-use asset. The
calculation of the right-of-use asset is as follows:

- 1,000 Lease incentive
+ 5,000 Legal fees
$ 525,934 Right-of-use asset
(c) The annual insurance payments of $5,000 are considered part of the annual
payments to the lessor similar to the rental payments, as they do not transfer a
separate good or service to the lessee, but rather are part of the payment to use
the leased asset and are attributable to the lease component. Therefore, the
present value of the $5,000 annual payments should be included in the initial
measurement of the lease liability, and thus the right-of-use asset as well. The
calculation is as follows:
$71,830 Annual rental payment

$520,544 PV of periodic rental payments
$5,000 Annual insurance payment

$36,234 PV of periodic insurance payments
$ 3,000 Amount probable to be owed under

residual value guarantee ($10,000 - $7,000)
X .46319 PV of 1 for n = 10, i = 8%
$ 1,390 PV of amount probable to be owed
of residual value guarantee

+ 36,234 PV of periodic insurance payments
+ 1,390 PV of the residual value
Note how the inclusion of the executory costs leads to an inflated lease liability
and related right-of-use asset. Additionally, note that had the insurance
payments been variable, they would not have been included at all in the
measurement of the lease liability, which would have led to a very different initial
measurement of the liability and asset.
(d) Because Kimberly-Clark expected the residual value of the asset at the end of
the lease to be $7,000, it expected to owe Sheffield an additional $3,000 in
addition to returning the asset under the residual value guarantee. Thus,
Kimberly-Clark has a lease liability of $3,000 remaining on the books. However,
the value of the asset covers the entire guarantee, and thus no additional cash
payment is required by Kimberly-Clark. As a result, they will book a gain, as
shown below:
Lease Liability ..................................................... 3,000

Gain on Lease .............................................. 3,000

(a) Fair value of leased asset to lessor $245,000
Less: Present value of unguaranteed
residual value $24,335 X .63017
(present value of 1 at 8% for 6 periods) 15,335
Six periodic lease payments $229,665 ÷ 4.99271* $46,000**
**Rounded to the nearest dollar.
(b) MORGAN LEASING COMPANY (Lessor)

Annual
Lease Interest (8%) on Recovery
Payment Lease of Lease Lease
Date Plus URV Receivable Receivable Receivable
1/1/20 $245,000
1/1/20 $ 46,000 $ –0– $ 46,000 199,000
1/1/21 46,000 15,920 30,080 168,920
1/1/22 46,000 13,514 32,486 136,434
1/1/23 46,000 10,915 35,085 101,349
1/1/24 46,000 8,108 37,892 63,457
1/1/25 46,000 5,077 40,923 22,534
12/31/25 24,335 1,801* 22,534 0
$300,335 $55,335 $245,000
*Rounded by $2.
(c)
1/1/20
Lease Receivable ....................................................... 245,000*
Cost of Goods Sold 229,665**
Sales Revenue ....................................................... 229,665***
Inventory ................................................................. 245,000
*The lease receivable will include both the present value of the
rental payments ($46,000 X 4.99271) plus the present value of the
residual value ($24,335 X .63017), as the lessor believes it will
receive both of these amounts over the life of the lease.
**While cost of goods sold normally mirrors the value of the
inventory being sold, in this case it is reduced by the present
value of the residual value [$245,000 – ($24,335 X .63017)], as the
lessor will receive the inventory again at the amount of the
residual value.
***Sales revenue represents the present value of the rental
payments ($46,000 X 4.99271), but it does not include the present
value of the residual value. That is, the lessor will get the residual
value back at the end of the lease, and thus has not “sold” that
portion of the asset.
1/1/20
Cash ................................................................................ 46,000
Lease Receivable .................................................... 46,000
12/31/20
Interest Revenue ..................................................... 15,920
1/1/21
Cash ................................................................................ 46,000
Lease Receivable .................................................... 46,000
12/31/21
Computation of annual payments

Fair value of leased asset to lessor $160,000
Less: Present value of residual value
($16,000 X .90703*) 14,512
Two periodic lease payments ($145,488 ÷ 1.85941**) $78,244
*Present value of 1 at 5% for 2 periods

**Present value of an ordinary annuity of 1 for 2 periods at 5%
Castle will classify the lease as a sales-type lease, because the agreement meets
both the present value test ($145,488/$160,000 = 91% which is greater than 90%)
and the lease term test (2/2 = 100%) which is greater than 75%. The $16,000
option to purchase does not count as a bargain purchase, the expected residual
value at the end of the lease term is also $16,000.
CASTLE LEASING COMPANY (Lessor)


1/1/20 $160,000
12/31/20 $78,244 $8,000 $70,244 89,756
12/31/21 78,244 4,488 73,756 16,000
12/31/21 16,000 0 16,000 0
(a)
1/1/20
Lease Receivable ........................................... 160,000*

Cost of Goods Sold ........................................ 105,488**
Sales Revenue ............................................ 145,488***
Inventory...................................................... 120,000
*($78,244 X 1.85941) + ($16,000 X .90703), rounded

**$120,000 – ($16,000 X .90703), rounded
***$160,000 – (16,000 x .90703), rounded
12/31/20
Cash ................................................................ 78,244

Lease Receivable ........................................ 70,244
Interest Revenue ......................................... 8,000
12/31/21
Cash ................................................................ 78,244

Interest Revenue ......................................... 4,488
(b)
12/31/21
Cash ................................................................ 16,000

(a) Because title to the asset passes to the lessee, the lease term is longer than
75% of the economic life of the asset (3/3 = 100%), and the present value of
the lease payments is more than 90% of the fair value of the asset
($95,000/$95,000 = 100%), it is a financing lease to the lessee. Assuming
collectibility of the rents is probable, the lease is accounted for as a sales-
type lease to the lessor.
The lessee should account for the lease as a finance lease and record the
right-of-use asset and lease liability at the present value of the lease
payments using the incremental borrowing rate if it is impracticable to
determine the interest rate implicit in the lease. The lessee’s amortization
depends on whether ownership transfers to the lessee or if there is a
bargain purchase option. If one of these conditions is fulfilled, amortization
would be over the economic life of the asset. Otherwise, it would be
amortized over the lease term. Because both the economic life of the asset and
the lease term are three years, the leased asset should be depreciated over
this period.
The lessor should account for the lease as a sales-type lease. The lessor
should record a lease receivable and sales revenue equal to the present
value of the lease payments of $95,000. In addition, the lessor should
remove the asset (inventory) from its books at $70,000, and the related cost
of goods sold $70,000. Interest is recognized annually at a constant rate
relative to the unrecovered lease receivable (See lease amortization
schedule).
Fair value of leased asset

(Amount to be recovered by lessor through lease
payments) ............................................................................ $95,000
Three annual lease payments: $95,000 ÷ 2.57710*............... $36,863
*Present value of an ordinary annuity of 1 for 3 periods at 8%.
(b) Amortization Schedule
Interest (8%)
Rent Receipt/ Revenue/ Reduction of Receivable/
Payment Expense Principal Liability
1/1/20 — — — $95,000
12/31/20 $36,863 $7,600* $29,263 65,737
12/31/21 36,863 5,259 31,604 34,133
12/31/22 36,863 2,730** 34,133 0
*$95,000 X .08 = $7,600

** Rounded by $1
(c) 1/1/20
Lease Receivable ......................................... 95,000

Cost of Goods Sold...................................... 70,000
Sales Revenue ...................................... 95,000
Inventory ............................................... 70,000
(d) 1/1/20
Right-of-Use Asset ....................................... 95,000

Lease Liability ...................................... 95,000
(e) 1/1/20
Right-of-Use Asset ....................................... 103,311

Cash ...................................................... 10,000
Lease Liability
($36,863 X 2.53130*) ........................... 93,311
*Present value of an ordinary annuity of 1 for 3 periods at 9%.

LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, Measurement, AICPA PC:
Communication
(a) $35,004 X 6.58238* = $230,410

(b) Because the lease term test is met (8/10 = 80% > 75%), the lease is classified
as a sales-type lease.
1/1/20
Lease Receivable ......................................................... 230,410

Cost of Goods Sold ..................................................... 160,000
Sales Revenue ....................................................... 230,410
Inventory ................................................................ 160,000
Cash .............................................................................. 35,004

Lease Receivable .................................................. 35,004
12/31/20
Lease Receivable ......................................................... 11,724

[($230,410 – $35,004) X .06]
(c) If the collectibility of lease payments is not probable for the lessor, the
lessor does not derecognize the asset or recognize selling profit on the lease.
Instead, Crosley would recognize any cash receipts as a deposit liability.
1/1/20
Cash ................................................................................ 35,004
Deposit Liability...................................................... 35,004
A lessor does not derecognize the asset and recognize selling profit until
collectibility becomes probable.
(d) Inventory ................................................................. 1,000

Gain on Lease (Residual Value) ..................... 1,000
EXERCISE 21.9 (20-25 minutes)
(a) Lease Liability = $35,004 x 6.20637* = $217,248

Right-of-Use Asset = $217,248 + $15,000** = $232,248

**The right-of-use asset is initially valued at the same amount as the lease
liability, plus the initial direct costs, minus any lease incentives received.
(b) The lease is classified as a finance lease, since the lease term is 80% of the
economic life of the asset (8/10), which is more than 75% of the economic life.
1/1/20
Right-of-Use Asset.............................................. 232,248
Cash ............................................................. 15,000
Lease Liability ............................................. 217,248
Lease Liability ..................................................... 35,004

Cash ............................................................. 35,004
12/31/20
Interest Expense .......................................................... 14,580
Lease Liability ...................................................... 14,580
[($217,248 – $35,004) X .08]
Amortization Expense
($232,248 ÷ 8)............................................................. 29,031
Right-of-Use Asset ............................................... 29,031
(a) The lease agreement has a bargain-purchase option and thus meets the
criteria to be classified as a finance lease from the viewpoint of the lessee.
Also, the present value of the rental payments plus the bargain purchase
option exceeds 90% of the fair value of the assets.
(b) The lease agreement has a bargain-purchase option. The collectibility of the
lease payments is probable. The lease, therefore, qualifies as a sales-type
lease from the view-point of the lessor.
(c) Computation of lease liability:
$20,471.94 Annual rental payment
$88,277.67 PV of periodic rental payments
$ 4,000.00 Bargain purchase option
X .68058 PV of 1 for n = 5, i = 8%
$ 2,722.32 PV of bargain-purchase option
+ 2,722.32 PV of bargain-purchase option
$91,000.00 Lease liability (rounded)
RODE COMPANY (Lessee)
Annual Lease Interest Reduction

Payment Plus (8%) on of Lease Lease
Date BPO Liability Liability Liability
5/1/20 $91,000.00
5/1/20 $ 20,471.94 $20,471.94 70,528.06
5/1/21 20,471.94 $ 5,642.24 14,829.70 55,698.36
5/1/22 20,471.94 4,455.87 16,016.07 39,682.29
5/1/23 20,471.94 3,174.58 17,297.36 22,384.93
5/1/24 20,471.94 1,790.79 18,681.15 3,703.78
4/30/25 4,000.00 296.22* 3,703.78 0
$106,359.70 $15,359.70 $91,000.00
*Rounding error is 8 cents.
(d) 5/1/20
Right-of-Use Asset................................................ 91,000.00
Lease Liability .............................................. 91,000.00
Lease Liability ....................................................... 20,471.94
Cash .............................................................. 20,471.94
12/31/20
Interest Expense ................................................... 3,761.49
Lease Liability .............................................. 3,761.49
($5,642.24 X 8/12 = $3,761.49)
12/31/20
Amortization Expense .......................................... 6,066.67
Right-of-Use Asset ......................................... 6,066.67
($91,000.00 ÷ 10 =
($9,100.00; $9,100.00 X
(8/12 = $6,066.67)
1/1/21
Lease Liability ....................................................... 3,761.49
Interest Expense ............................................ 3,761.49
5/1/21
Lease Liability ....................................................... 14,829.70
Cash ................................................................ 20,471.94
12/31/21
Lease Liability ................................................ 2,970.58
($4,455.87 X 8/12)
12/31/21
($91,000.00 ÷ 10 years =
($9,100.00)
(Note to instructor: Because a bargain-purchase option was involved, the
leased asset is depreciated over its economic life rather than over the lease
term).
Also, if reversing entries were not made on 1/1/21, the entry on 5/1/21 is as
follows.
Interest Expense ($5,624.24 − $3,761.49) ............ 1,881.75

Lease Liability ($20,471.94 − $3,761.49) .............. 18,591.49
Cash ................................................................ 20,471.94
Note: The lease agreement has a bargain-purchase option. The collectibility of
the lease payments by Mooney is probable. The lease, therefore, qualifies as a
sales-type lease from the viewpoint of the lessor.
The lease payments associated with this lease are the periodic annual rents plus
the bargain purchase option. There is no residual value relevant to the lessor’s
accounting in this lease.
(a) The lease receivable is computed as follows:

X 4.31213 PV of an annuity due of 1 for n = 5, i = 8%
$ 4,000.00 Bargain purchase option

X .68058 PV of 1 for n = 5, i = 8%
$ 2,722.32 PV of bargain-purchase option

+ 2,722.32 PV of bargain-purchase option
$91,000.00 Lease receivable at commencement (rounded)
(b) MOONEY LEASING COMPANY (Lessor)

Annual Lease Interest (8%) Recovery

Payment Plus on Lease of Lease Lease
Date BPO Receivable Receivable Receivable
5/1/20 $91,000.00
5/1/20 $ 20,471.94 $20,471.94 70,528.06
5/1/21 20,471.94 $ 5,642.24 14,829.70 55,698.36
5/1/22 20,471.94 4,455.87 16,016.07 39,682.29
5/1/23 20,471.94 3,174.58 17,297.36 22,384.93
5/1/24 20,471.94 1,790.79 18,681.15 3,703.78
4/30/25 4,000.00 296.22* 3,703.78 0
$106,359.70 $15,359.70 $91,000.00
(c)
5/1/20
Lease Receivable ................................................ 91,000.00

Cost of Goods Sold ............................................ 65,000.00
Sales Revenue ............................................. 91,000.00
Inventory ...................................................... 65,000.00
Cash ..................................................................... 20,471.94

Lease Receivable ........................................ 20,471.94
12/31/20
Lease Receivable ............................................ 3,761.49

Interest Revenue ......................................... 3,761.49
($5,642.24 X 8/12 =
$3,761.49)
5/1/21
Cash ..................................................................... 20,471.94

Lease Receivable ........................................ 18,591.19
($5,642.24 – $3,761.49)
12/31/21
Lease Receivable ................................................ 2,970.58

($4,455.87 X 8/12 =
($2,970.58)
(d) If the collectibility of lease payments is not probable for the lessor, the
Instead, Mooney would recognize any cash receipts as a deposit liability.
5/1/20
Cash ................................................................................ 20,471.94
Deposit Liability...................................................... 20,471.94

(a) This is a finance lease to Flynn since the lease term is 75% (6 ÷ 8) of the
asset’s economic life. In addition, although the lease payments are not
provided in the problem facts, the lease will also meet the present value
test, as shown in part (b). Last, there is a bargain-purchase option in the
lease, as Flynn has the option to purchase the asset at the end of the lease
term for a price $4,000 below the expected residual value of the asset, and
thus exercisability of the option is reasonably certain.
This is a sales-type lease to Bensen since collectibility of the lease payments is
probable, the lease term is 75% of the asset’s economic life, the present
value test will be met, and there is a bargain purchase option.
(b) Computation of annual rental payment (by the lessor):
Fair value of leased asset............................................................... $150,000

Less: Present value of bargain-purchase option
($1,000 X .74622*) ............................................................. 746
PV of lease payments ..................................................................... $149,254
Six annual lease payments: $149,254 ÷ 5.32948** ....................... $28,005
*Present value of $1 at 5% for 6 periods.

**Present value of an annuity due at 5% for 6 periods.
1/1/20
(c) Lease Receivable ............................ 150,000*

Cost of Goods Sold ........................ 120,000
Sales Revenue ......................... 150,000**
Inventory.................................. 120,000
*($28,005 X 5.32948) + ($1,000 X .74622), rounded

**Sales revenue would also include both the present values of
the rental payments and the bargain-purchase option.
Cash................................................. 28,005
Lease Receivable .................... 28,005
12/31/20
Lease Receivable ............................ 6,100

Interest Revenue ..................... 6,100
[($150,000 – $28,005) X .05]
(d) If the collectibility of lease payments is not probable for the lessor, the
Instead, Bensen would recognize any cash receipts as a deposit liability.
1/1/20
Cash ................................................................................ 28,005
Deposit Liability...................................................... 28,005
(e)
1/1/20
Lease Liability .......................................................... 146,677
[($28,005 X 5.21236*) + ($1,000 X .70496**)]
Lease Liability ................................................................ 28,005
Cash .......................................................................... 28,005
*Present value of an annuity due at 6% for 6 periods.
**Present value of $1 at 6% for 6 periods.
12/31/20
Right-of-Use Asset ................................................... 18,335
($146,677 ÷ 8* years)
*The lessee uses the economic life of an asset instead of the lease term for
amortization purposes when ownership transfers or there is a bargain purchase
option.

Lease Liability .......................................................... 7,120
($146,677 – $28,005) X .06
(f) The value of the lease liability for the lessee is unaffected by any initial
direct costs incurred. However, the initial measurement of the right-of-use
asset must be adjusted for initial direct costs incurred. Thus, the initial
right-of-use asset should be measured at $148,677 ($146,677 + $2,000)

Cash........................................... 2,000
Lease Liability ........................... 146,677
(a) The lease will be classified as a sales-type lease for Phelps and a finance
lease for Walsh. While ownership does not transfer at the end of the lease, there
is no bargain purchase option, the asset is not specialized, and the present value
test is not met (see calculation of lease liability for PV of lease payments), the
lease term is greater than 75% of the useful life of the asset (5 ÷ 6 = 83%).
The calculation of the lease receivable for Phelps is done as follows:

Present value of an annuity due
for 5 periods at 8% ..................................................... x 4.31213
Present value of rental payments (rounded)................ $20,280*
*This value should be used in performing the present value test. The lease fails
the present value test because $20,280 ÷ $23,000 = 88.2%, which is less than
90%.
Expected residual value $4,000

Present value of $1 for 5 periods at 8% x .68058
Present value of residual value (rounded) $2,722
Present value of expected residual value $2,722

Present value of annual rental payments 20,280
Lease Receivable $23,000*
*Rounded by $2.
The initial lease liability and right-of-use asset, from Walsh’s (lessee’s) point of
view is the present value of the rental payments ($20,280), and excludes the
residual value. This is because Walsh does not guarantee any part of the
residual value.
(b)
Phelps’ Journal Entries

1/1/20
Lease Receivable ................................................ 23,000*
Cost of Goods Sold ........................................... 13,280**
Sales Revenue ............................................... 20,280***
Inventory ........................................................ 16,000
*($4,703 X 4.31213) + ($4,000 X .68058), rounded

**$16,000 – ($4,000 X .68058), rounded
***$4,703 X 4.31213, rounded
Cash ........................................................................... 4,703

Lease Receivable ................................................ 4,703
12/31/20
Lease Receivable ...................................................... 1,464
Interest Revenue
[(23,000 – $4,703) x .08] .................................... 1,464
Walsh’s Journal Entries

1/1/20
Right-of-Use Asset.................................................... 20,280
Lease Liability ..................................................... 20,280
Lease Liability ........................................................... 4,703

Cash ..................................................................... 4,703
12/31/20
Interest Expense ....................................................... 1,246
Lease Liability
[($20,280 – $4,703) x .08] ................................... 1,246
Amortization Expense .............................................. 4,056

Right-of-Use Asset ($20,280 ÷ 5) ….. ................ 4,056
(c) If the residual value is guaranteed, Walsh must consider this guarantee in
determining whether the present value test for classification purposes, is met.
However, the lease term test was already met, so this will not change the
classification of the lease from either party’s perspective.
With respect to the initial measurement of the lease receivable, the lessor always
includes the residual value in the lease receivable, whether it is guaranteed or
not. Therefore, Phelps’ measurement of the lease receivable ($23,000) does not
change as a result of the guarantee.
For the lessee, only the amount that is probable to be owed under the guaranteed
residual value should be included in the initial measurement of the lease liability
and right-of-use asset. In this case, because Walsh expects the residual value to
be equal to the residual value guarantee, Walsh will not include any amount of the
residual value in the calculation of the lease liability and right-of-use asset, and
the initial measurements will remain $20,280. In order for the answer to change,
the expected residual value would have to be lower than the guarantee.
(d) Walsh would need to include the present value of the amount probable to be
owed under the residual value guarantee in its initial measurement of the lease
liability. Because the expected residual value is less than the guaranteed
residual value, Walsh must include the present value of the difference, or the
amount it expects to pay Phelps at the end of the lease term. Thus, the initial
measurement of the lease liability and right-of-use asset would instead be:
Present value of rental payments (rounded)................ $20,280

Present value of amount probable to be owed
[($4,000 – $3,000) X .68058* ..................................... 681
Lease liability ................................................................. $20,961
*Present value of $1 for 5 periods at 8%.

If the lessee is unaware of the rate implicit in the lease, it should use its
incremental borrowing rate to calculate the present value the lease payments
and initially measure the lease liability and right-of-use asset. Thus, the
calculation of the present value of the lease payments and therefore the lease
liability and right-of-use asset would be:

Present value of an annuity due
for 5 periods at 9% ..................................................... 4.23972
Lease Liability/Right-of-Use Asset ............................... $19,939
The lessor is not impacted in any way if the lessee does not know the rate
implicit in the lease.
Note: This lease is a finance lease to the lessee because the present value
of the minimum lease payments exceeds 90% of the fair value of the asset
($73,094.98 ÷ $80,000 = 91.37%)
$73,094.98 PV of minimum lease payments
(a) PLOTE COMPANY (Lessee)

Reduction
Annual Lease Interest (5%) on of Lease Lease
Date Payment Liability Liability Liability
1/1/20 $73,094.98
1/1/20 $25,562.96 $ –0– $25,562.96 47,532.02
1/1/21 25,562.96 2,376.60 23,186.36 24,345.66
1/1/22 25,562.96 1,217.30* 24,345.66 –0–
$76,688.88 $3,593.90 $73,094.98
(b)
1/1/20
Right-of-Use Asset................................................. 73,094.98

Lease Liability .................................................. 73,094.98
1/1/20
Lease Liability ........................................................ 25,562.96

Cash .................................................................. 25,562.96
12/31/20
Interest Expense .................................................... 2,376.60

Lease Liability .................................................. 2,376.60
Amortization Expense ........................................... 24,364.99

Right-of-Use Asset ........................................... 24,364.99
($73,094.98 ÷ 3)
1/1/21
Lease Liability ($23,186.36 + $2,376.60) ............... 25,562.96

Cash .................................................................. 25,562.96
12/31/21
Interest Expense .................................................... 1,217.30

Lease Liability .................................................. 1,217.30
Amortization Expense ........................................... 24,364.99

Right-of-Use Asset ........................................... 24,364.99
Note to instructor:
The lessor sets the annual rental payment as follows:
Fair value of leased asset to lessor $80,000.00
(present value of 1 at 4% for 3 periods) 6,223.00
Amount to be recovered through lease payments $73,777.00
Five periodic lease payments
$73,777.00 ÷ 2.88609* $25,562.96
*Present value of annuity due of 1 for 3 periods at 4%.
This lease is an operating lease to the lessee because none of the transfer of
control tests are met. The present value of the minimum lease payments is less
than 90% of the fair value of the asset ($70,452.63 ÷ $80,000 = 88%).
$70,452.63 PV of minimum lease payments
PLOTE COMPANY
Annuity-Due Basis
Reduction
1/1/20 $70,452.63
1/1/20 $24,638.87 $ 0 $24,638.87 45,813.76
1/1/21 24,638.87 2,290.69 22,348.18 23,465.58
1/1/22 24,638.87 1,173.29* 23,465.58 0
*Rounding error is 1 cent.
(A) (C)
Lease (B) Amortization of
Expense Interest (5%) on ROU Asset Carrying Value
1/1/20 $70,452.63
12/31/20 $24,638.87 $2,290.69 $22,348.18 48,104.45
12//31/21 24,638.87 1,173.29 23,465.58 24,638.87
12/31/22 24,638.87 0 24,638.87 0
Entries in 2020 are:

1/1/20
Right-of-Use Asset................................................. 70,452.63

Lease Liability .................................................. 70,452.63
Lease Liability ........................................................ 24,638.87

Cash .................................................................. 24,638.87
12/31/20
Lease Expense ....................................................... 24,638.87

Lease Liability ................................................ 2,290.69*
lease liability, as shown in the first schedule. Note that this is expensed along with
amortization of the right-of-use asset at the end of 2020, not in accordance with
payment on the first day of 2021.
Note to instructor:
The lessor sets the annual rental payment as follows:
Fair value of leased asset to lessor $80,000
Five periodic lease payments
$71,110.00 ÷ 2.88609* $24,638.87
(a) The lease will be classified as an operating lease for Nelson, as it does not
meet any of the classification tests to be a sales-type lease.
Entries for Nelson are as follows:
1/1/20
Buildings .................................................................. 4,000,000

Cash .................................................................. 4,000,000
Cash .......................................................................... 275,000

Unearned Lease Revenue ................................ 275,000
12/31/20
Unearned Lease Revenue ....................................... 275,000

Lease Revenue ................................................. 275,000
Depreciation Expense ............................................. 80,000

Accumulated Depreciation—
Leased Buildings .......................................... 80,000
($4,000,000 ÷ 50)
(b) Entries for Wise are as follows:
1/1/20
Right-of-Use Asset................................................... 1,992,895

Lease Liability
($275,000 X 7.24689*) ..................................... 1,992,895
Lease Liability .......................................................... 275,000

Cash .................................................................. 275,000
*Present value of an annuity due for 10 periods at 8%.
WISE INC.
Annuity-Due Basis
Reduction
1/1/20 $1,992,895
1/1/20 $275,000 $ 0 $275,000 1,717,895
1/1/21 275,000 137,432 137,568 1,580,327
1/1/22 275,000 126,426 148,574 1,431,753
1/1/23 275,000 114,540 160,460 1,271,293
Lease Expense Schedule (partial)
(A) (C)
Lease (B) Amortization of Carrying
Expense Interest (8%) on ROU Asset Value of ROU
Date (Straight-Line) Lease Liability (A-B) Asset
1/1/20 $1,992,895
12/31/20 $275,000 $137,432 $137,568 1,855,327
12/31/21 275,000 126,426 148,574 1,706,753
12/31/22 275,000 114,540 160,460 1,546,293
12/31/20
Lease Expense ................................. 275,000
Lease Liability............................................ 137,432*
Right-of-Use Asset .................................... 137,568
(c) The real estate broker’s fee should be capitalized as part of the right-of-use
asset and amortized over the 10-year period. As a result, the initial
measurement of the right-of-use asset would be $2,022,895 ($1,992,895 +
$30,000).
LO: 3, 4, Bloom: AP, Difficulty: Simple, Time: 10-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
(a) Overall from the leased asset, Young Co. will report $38,455 ($150,955 –
$112,500 [$900,000 / 8]) for 2020 when netting the lease revenue with
depreciation expense.
Lessor Entries for 2020:

1/1/20
Machine ...................................................... 900,000
Cash................................................ 900,000
Cash ........................................................... 150,955

Unearned Revenue ........................ 150,955
12/31/20
Unearned Revenue .................................................. 150,955
Lease Revenue ................................................. 150,955

Leased Asset ($900,000 ÷ 8) ....................... 112,500
(b) Lessee Entries for 2020:

1/1/20
Right-of-Use Asset................................................... 427,714*
Lease Liability .................................................. 427,714
Lease Liability .......................................................... 150,955

Cash .................................................................. 150,955
*$150,955 X 2.83339FVF-OA(3,6%)
ST. LEGER INC.

Annuity-Due Basis
Reduction
1/1/20 $427,714
1/1/20 $150,955 $ 0 150,955 276,759
1/1/21 150,955 16,606 134,349 142,410
1/1/22 150,955 8,545 142,410 0

(C)
(A) (B) Amortization Carrying
Lease Expense Interest (6%) on of ROU Asset Value of
Date (Straight-Line) Lease Liability (A-B) ROU Asset
1/1/20 $427,714
12/31/20 $150,955 16,606 134,349 293,365
12/31/21 150,955 8,545 142,410 150,955
12/31/22 150,955 0 150,955 0
12/31/20
Lease Expense ......................................................... 150,955
Lease Liability .................................................. 16,606*
Right-of-Use Asset ........................................... 134,349
the lease expense at the end of 2020.
(c) Under the short-term lease election, St. Leger will not need to record the
right-of-use asset or lease liability on its books. Instead, the company can
expense lease payments as incurred.
1/1/20
Lease Expense ......................................................... 150,955
Cash .................................................................. 150,955
(a) The lease is an operating lease to both Moeller and Kaluzniak, as none of the
classification tests are met. The lease term is only 43% (3 ÷ 7) of the economic life of
the asset, there is no bargain purchase, ownership does not transfer, and the asset
is not specialized. The calculation for the 90% test shows the present value of lease
payments is below 90% ($3,222 ÷ $7,000 = approximately 46%) and ($3,165 ÷ $7,000 =
approximately 45%):
Kaluzniak Corporation
Moeller, Inc.
(b) 1/1/20
Lease Liability ............................................. 3,165
Lease Liability ..................................................... 1,137

Cash ............................................................. 1,137
MOELLER COMPANY
Annuity-Due Basis
Reduction
1/1/20 $3,165
1/1/20 $1,137 $ 0 $1,137 2,028
1/1/21 1,137 162 975 1,053
1/1/22 1,137 84 1,053 0

(C)
Lease Expense Interest (8%) on ROU Asset Value of ROU
1/1/20 $3,165
12/31/20 $1,137 $ 162 $975 2,190
12/31/21 1,137 84 1,053 1,137
12/31/22 1,137 0 1,137 0
12/31/20
Lease Expense .................................................... 1,137
Lease Liability* ............................................ 162
Right-of-Use Asset ...................................... 975
*The lease liability is accrued for the interest that is incurred to date at the end of
the year. The interest, as well as a portion of the original lease liability ($975) will
be paid on the first day of 2021.
(c) As always, the first step will be determining the initial value of the lease
liability. In this case, initial direct costs and prepayments do not affect the value
of the lease liability (though they will affect the value of the right-of-use asset).
With respect to executory costs, only those considered to be part of fixed
payments to the lessor should be included in the initial measurement of the
lease liability. As a result, only the insurance costs should be included in the
present value test. The following calculation shows the calculation of the lease
liability for Moeller:
$3,165 PV of annual rental payment

(see calculation in part a)
557 PV of insurance payments ($200 X 2.78326*)
$3,722 Lease liability
The initial measurement of the right-of-use asset will be increased for any initial
direct costs (i.e. commissions) and any prepayments. As a result, the calculation
of the right-of-use asset is as follows:
$3,722 Initial measurement of lease liability

(calculated above)
500 Commissions paid
750 Prepaid rent
$4,972 Right-of-use asset
(d) This lease qualifies for the short-term lease election for Moeller, as it is one
year or less. Assuming that Moeller elects to use the short-term lease option, the
company records lease expense when payments are made to the lessor. Thus,
Moeller accounts for the lease as follows:
1/1/20
Lease Expense .................................................... 1,137
Cash ............................................................. 1,137

Three periodic lease payments
$3,222 ÷ 2.83339* $1,137
(b) Because this is an operating lease to Kaluzniak, the asset is not

derecognized, but rather kept on the books and depreciated as normal. Lease
payments are simply recognized as revenue when they are paid and earned.
Thus, Kaluzniak will make the following journal entries:
1/1/20
Cash ..................................................................... 1,137
Unearned Lease Revenue ........................... 1,137
12/31/20
Unearned Lease Revenue .................................. 1,137
Lease Revenue ............................................ 1,137
Depreciation Expense ........................................ 714

Equipment ($5,000 ÷ 7)............................ 714
(c) For a lessor, initial direct costs (in this case, legal fees) incurred in
accordance with an operating lease should be amortized and expensed over the
term of the lease. However, internal costs in this case, (advertising) occur
whether a lease was executed or not, and as a result should be expensed as
incurred. Thus, for 2020, the following entries are made:
1/1/20
Prepaid Legal Fees ............................................. 700
Cash ............................................................. 700
(Over the course of the year)

Advertising Expense .......................................... 500
Cash ............................................................ 500
12/31/20
Legal Expense ................................................... 233
Prepaid Legal Fees ($700 ÷ 3)..................... 233
(a) The lease is an operating lease for both Rauch and Donahue, as none of the
classification tests are met. The lease term is only 67% (4 ÷ 6) of the economic life of
the asset, there is no bargain purchase, ownership does not transfer, and the asset
is not specialized. The calculation for the 90% test shows the present value of lease
payments is below 90% ($18,214 ÷ $25,000 = 73%):

(b)
DONAHUE CORPORATION
Annuity-Due Basis
Reduction
1/1/20 $18,214
1/1/20 $4,892 $ 0 $4,892 13,322
1/1/21 4,892 666 4,226 9,096
1/1/22 4,892 455 4,437 4,659
1/1/23 4,892 233 4,659 -0-
(A) (C)
Lease (B) Amortization of
Expense Interest (5%) on ROU Asset Carrying Value
1/1/20 $18,214
12/31/20 $4,892 $ 666 $4,226 13,988
12/31/21 4,892 455 4,437 9,551
12/31/22 4,892 233 4,659 4,892
12/31/23 4,892 -0- 4,892 -0-
(c) 1/1/20

Lease Liability ............................................. 18,214
Lease Liability ..................................................... 4,892

Cash ............................................................. 4,892
12/31/20
Lease Expense .................................................... 4,892
Lease Liability ............................................. 666*
Right-of-Use Asset ...................................... 4,226
1/1/21
Lease Liability ..................................................... 4,892
Cash ...................................................... 4,892
12/31/21
Lease Expense .................................................... 4,892
Lease Liability....................................... 455
(d) Initial direct costs do not affect the value of the lease liability, but they do
change the value of the right-of-use asset. The initial measurement of the right-
of-use asset will be increased for any initial direct costs. As a result, the
calculation of the right-of-use asset is as follows:
$18,214 Initial measurement of lease liability
(Calculated in part a)
+ 750 Initial direct costs
$18,964 Right-of-use asset
To demonstrate how this impacts the amortization of the right-of-use asset,
below are the tables associated with the lease in this situation:
DONAHUE CORPORATION
Annuity-Due Basis
Reduction
1/1/20 $18,214
1/1/20 $4,892 $ 0 $4,892 13,322
1/1/21 4,892 666 4,226 9,096
1/1/22 4,892 455 4,437 4,659
1/1/23 4,892 233 4,659 -0-

(C)
1/1/20 $18,964
12/31/20 $5,080* $ 666 $4,414 14,550
12/31/21 5,080 455 4,625 9,925
12/31/22 5,080 233 4,847 5,078
12/31/23 5,078 -0- 5,078 -0-
*Total payments divided by the lease term, or $20,318 [($4,892 X 4) + $750]
divided by 4 years (rounded).
1/1/20

Cash........................................... 750
Lease Liability ........................... 18,214
Lease Liability....................................... 4,892

Cash........................................... 4,892
12/31/20
Lease Expense ..................................... 5,080
Lease Liability ........................... 666
(e) A fully guaranteed residual value by Donahue would lead to a finance lease
for the company, and thus the subsequent treatment of the right-of-use asset
and lease liability would be different. Instead of reporting a single lease expense,
Donahue recognizes both amortization expense on the right-of-use asset (which
would be calculated the same way as depreciation on similar assets) and interest
expense (same amounts as operating lease). Note, however, that the initial
measurement of the right-of-use asset and lease liability would not change, as
the company expects the residual value to be equal to the guaranteed residual
value. Therefore, no amount is probable to be owed under the guarantee, and no
amount needs to be accounted for in the initial lease liability by Donahue.
(f) A bargain renewal option would cause Donahue to take the additional year
(and payment) into account when determining how to classify the lease and the
initial measurement of the lease liability and right-of-use asset. However, for
purposes of the classification, Donahue need not know the value of the bargain
renewal option, as the additional year of lease term causes the lease term to be 5
years, which is greater than 75% of the useful life of the asset. (5 ÷ 6 = 83%).
Thus, Donahue classifies the lease as a finance lease and accounts for it in the
same way as described in part (e). The only difference is the present value of the
bargain renewal option must be included in the initial measurement of the lease
liability, as it is probable that it will be paid.

(Present value of 1 at 5% for 4 periods) 6,787
Four periodic lease payments
$18,213 ÷ 3.72325* $4,892
(b) 1/1/20
Cash ...................................................... 4,892
Unearned Lease Revenue ........ 4,892
12/31/20
Unearned Lease Revenue .................... 4,892
Lease Revenue ......................... 4,892
Depreciation Expense .......................... 3,333

Equipment ($20,000 ÷ 6) ....... 3,333
(c) Even though the expected residual value declined, the fact that Donahue
has guaranteed a residual value of $8,250 leads Rauch to calculate rental
payments based on the same amount as if a residual value of $8,250 were
unguaranteed. That is, Rauch will look to recover through the lease payments
whatever portion of the fair value of the asset it does not recover through the
receipt of a residual value at the end of the lease term. Thus, all else being equal,
Rauch would demand the same amount in lease payments from Donahue as he
would under the original facts of the question.
Note to Instructor: The explanation above assumes all else being equal.
However, because Donahue guarantees the residual value, it is possible that
Rauch would compensate this reduction in risk with a lower interest rate used in
computing the payments, and the payments would therefore be lower in value.
In addition, the guarantee of the entire residual value of the asset would make
the lease a finance lease for Donahue and a sales-type lease for Rauch.
(d) A fully guaranteed residual value by Donahue would cause the lease to be
classified as a sales-type lease by Rauch. As a result, Rauch would recognize
sales revenue and a lease receivable at the commencement of the lease for the
entire fair value of the asset, as well as derecognize the asset and recognize cost
of goods sold. Rauch would then recognize lease revenue for any interest
accrued on the lease receivable over the lease term, and amortize the lease
receivable over the term as well. Upon receipt of the asset again at the end of the
lease term, Rauch would wipe off the remaining lease receivable, and record the
asset as inventory at its fair value, along with any cash payment required to be
collected if the fair value is less than the guaranteed residual value.
(e) A bargain renewal option also would cause the lease to be classified as a
sales-type lease by Rauch, as it would cause the lease term to be 83% (5 ÷ 6 =
83%) of the economic life of the asset. Thus, the accounting for the lease by
Rauch would be essentially the same as explained in part (d). However, as sales
revenue, Rauch would only recognize the present value of the lease payments
and bargain renewal option. That is, he would need to find the amount of
residual value expected at the end of the lease term, and reduce both sales
revenue and cost of goods sold by the present value of the residual value. In
addition, at the end of the lease term, Rauch could potentially recognize a gain
or loss on the lease, as the value of the residual value it receives could
potentially be higher or lower than the lease receivable it needs to remove upon
the return of the asset.
*EXERCISE 21.23 (20–30 minutes)

Elmer’s Restaurants (Seller-Lessee)*
1/1/20
Cash ....................................................................... 680,000

Equipment...................................................... 600,000
Gain on Sale of Equipment ........................... 80,000
Right-of-Use Asset................................................ 322,775
Lease Liability ............................................... 322,775
($115,970 X 2.78326)**
Lease Liability ....................................................... 115,970

Cash ............................................................... 115,970
ELMER’S RESTAURANTS
Annuity-Due Basis
Reduction
1/1/20 $322,775
1/1/20 $115,970 $0 115,970 206,805
1/1/21 115,970 16,544 99,426 107,379
1/1/22 115,970 8,591* 107,379 0
*Rounded by $1.

(C)
(A) (B) Amortization Carrying
Lease Expense Interest (8%) on of ROU Asset Value of ROU
1/1/20 $322,775
12/31/20 $115,970 $16,544 99,426 223,349
12/31/21 115,970 8,591 107,379 115,970
12/31/22 115,970 0 115,970 0
12/31/20
Lease Expense ...................................................... 115,970
Lease Liability ............................................... 16,544
Right-of-Use Asset ........................................ 99,426
*Lease should be treated as an operating lease because none of the finance
lease classification tests are met.
**Present value of an annuity due for 3 periods at 8%.
Liquidity Finance Co. (Buyer-Lessor)*
1/1/20
Equipment .......................................................... 680,000
Cash ............................................................. 680,000
Cash .................................................................... 115,970

Unearned Lease Revenue .......................... 115,970
12/31/20
Unearned Lease Revenue ................................. 115,970
Lease Revenue ........................................... 115,970
Depreciation Expense ........................................ 68,000

Equipment ($680,000 ÷ 10) ...................... 68,000
*Lease should be treated as an operating lease because the lease does not
meet any of the sales-type classification tests.
*EXERCISE 21.24 (20–30 minutes)

(a) The situation described is a simple sale of equipment. Only one entry for
the sale of the equipment is required:
1/1/20
Cash ..................................................... 520,000
Equipment ................................. 400,000
Gain on Disposal of Equipment 120,000
(b) The situation described is known as a failed sale. That is, the terms of the
lease meet the criteria to be classified as a finance lease to the lessee
(lease term > 75% of economic life, present value of lease payments > 90%
of fair value of the asset). Under a finance lease, the lessee is deemed to
have taken control of the asset. However, since the sale and the lease
occur on the same day, the seller/lessee is deemed to never have given up
control in the first place, and the lease is viewed simply as a financing
arrangement. The present value of the lease payments is $520,000
[$67,342.42 x 7.72173*], which is 100% of the fair value of the asset.
*Present value of an ordinary annuity for 10 years at 5%.
*EXERCISE 21.24 (Continued)
1/1/20
Cash .................................................................... 520,000
Note Payable ........................................... 520,000
12/31/20
Interest Expense ($520,000 X 5%) ..................... 26,000.00
Note Payable ............................................... 41,342.42
Cash ............................................................ 67,342.42
(c) The situation described is considered a sale-leaseback agreement for

financial reporting purposes. That is, the terms of the lease meet the criteria
to be classified as an operating lease to the lessee (lease term < 75% of
economic life, present value of lease payments < 90% of fair value of the
asset). Under an operating lease, the lessee is not deemed to take control of
the asset. However, upon the sale of the asset, the seller-lessee does
relinquish control of the asset, and thus can recognize any gain on the sale.
The lease is accounted for as a normal operating lease.
1/1/20
Cash .................................................................... 520,000
Equipment................................................... 400,000
Gain on Disposal of Equipment ................ 120,000
Right-of-Use Asset............................................. 192,559.59

Lease Liability
($67,342.42 X 2.85941*) ............................ 192,559.59
Lease Liability .................................................... 67,342.42

Cash ............................................................ 67,342.42
ZARLE INC.
Annuity-Due Basis
Reduction
1/1/20 $192,559.59
1/1/20 $67,342.42 $0 67,342.42 125,217.17
1/1/21 67,342.42 6,260.86 61,081.56 64,135.61
1/1/22 67,342.42 3,206.81* 64,135.61 0
*Rounded $.03

(C)
1/1/20 $192,559.59
12/31/20 $67,342.42 $6,260.86 61,081.56 131,478.03
12/31/21 67,342.42 3,206.81 64,135.61 67,342.42
12/31/22 67,342.42 0 67,342.42 0
12/31/20
Lease Expense ................................................... 67,342.42
Lease Liability ............................................ 6,260.86
Right-of-Use Asset ..................................... 61,081.56
*EXERCISE 21.25 (20-25 minutes)
(a) The lease will be classified as an operating lease for Jabari, but will meet the
classification tests of a direct financing lease for Giannis. None of the lease
classification tests are met for a finance/sales-type lease. That is, ownership
does not transfer at the end of the lease, there is no bargain purchase option, the
asset is not specialized, and the lease term is less than 75% of the useful life of
the asset (10 ÷ 15 = 67%). In addition, the present value of the lease payments is
less than 90% of the fair value of the asset, as shown below:
for 10 periods at 5% ................................................... x 7.72173
Present value of lease payments (rounded) ................ $26,632
Fair value of the building............................................... ÷ 34,000
as a percentage of fair value ..................................... 78.33%
The guaranteed residual value is not included in the finance/sales-type lease
classification test, as it is not guaranteed by the lessee, but rather an independent
3rd party. Therefore, Jabari classifies the lease as an operating lease.
However, the 3rd party residual value guarantee is taken into account when
determining whether or not the lease is classified as a direct financing lease for
the lessor. The 90% test will be met when the 3rd party guarantee is taken into
account (as the following calculation shows), and thus the lease is classified as
a direct financing lease for Giannis:
for 10 periods at 5% ................................................... 7.72173
Present value of lease payments (rounded) ................ $26,632
3rd party residual value guarantee ................................ $12,000
Present value of 1 for 10 periods at 5%........................ x .61391
Present value of lease payments plus
3rd party residual value guarantee (rounded) ........... $34,000
Present value as a percentage of fair value ................. 100%
Because the lease qualifies as a direct financing lease, the gross profit from the
lease is deferred and recognized over the course of the lease.
(b)
GIANNIS CORPORATION (Lessor)
Sales-Type Lease

1/1/20 $34,000
12/31/20 $3,449 $1,700 $1,749 32,251
12/31/21 3,449 1,613 1,836 30,415
12/31/22 3,449 1,521 1,928 28,486
12/31/23 3,449 1,424 2,025 26,462
12/31/24 3,449 1,323 2,126 24,336
12/31/25 3,449 1,217 2,232 22,104
12/31/26 3,449 1,105 2,344 19,760
12/31/27 3,449 988 2,461 17,299
12/31/28 3,449 865 2,584 14,715
12/31/29 3,449 734* 2,715 12,000
12/31/30 12,000 _______ 12,000 -0-
$46,490 $12,490 $34,000
*Rounded $2
GIANNIS CORPORATION (Lessor)

Direct Financing Lease
Interest Reduction of
Annual Lease (13.24%) on Net Lease Net Lease
1/1/20 $22,000
12/31/20 $3,449 $2,913 $536 21,464
12/31/21 3,449 2,842 607 20,857
12/31/22 3,449 2,761 688 20,169
12/31/23 3,449 2,670 779 19,390
12/31/24 3,449 2,567 882 18,508
12/31/25 3,449 2,450 999 17,509
12/31/26 3,449 2,318 1,131 16,378
12/31/27 3,449 2,168 1,281 15,097
12/31/28 3,449 1,999 1,450 13,647
12/31/29 3,449 1,802* 1,647 12,000
12/31/29 12,000 _______ 12,000 -0-
$46,490 $24,490 $22,000
*Rounded $5
The difference between the interest under a sales-type lease (ex. in first year,
$1,700) and the overall revenue recognized for a direct financing lease ($2,913) is
the amount of deferred gross profit that is amortized in the current period
($1,213).
(c)
1/1/20
Deferred Gross Profit ............................................. 12,000
Leased Asset .......................................................... 22,000
12/31/20
Cash ................................................................................ 3,449
Deferred Gross Profit** .................................................. 1,213
Lease Revenue* ...................................................... 2,913
*Interest Revenue = Net Lease Receivable X Rate of Return

= ($34,000 – $12,000) X .1324 = $2,913 (rounded)
**Deferred Gross Profit = Interest Revenue – Sales-Type Interest
= $2,913 – $1,700 = $1,213
12/31/21
Cash ................................................................................ 3,449
Deferred Gross Profit** .................................................. 1,229
Lease Revenue* ...................................................... 2,842
*Interest Revenue = Net Lease Receivable X Rate of Return

= ($34,000 – $12,000 + $1,212 – $1,749) X .1324
= ($34,000 – $12,000 – $537) X .1324 = $2,842 (rounded)
**Deferred Gross Profit = Interest Revenue – Sales-Type Interest
= $2,842 – $1,613 = $1,229
(d)
1/1/20

Lease Liability
($3,449 X 7.72173*) ................................... 26,632
*Present value of an ordinary annuity for 10 periods at 5%.
JABARI, INC.
Annuity-Due Basis
Reduction
1/1/20 $26,632
12/31/20 $3,449 $1,332 $2,117 24,515
12/31/21 3,449 1,226 2,223 22,292
12/31/22 3,449 1,115 2,334 19,958
12/31/23 3,449 998 2,451 17,507

(C)
1/1/20 $26,632
12/31/20 $3,449 $1,332 $2,117 24,515
12/31/21 3,449 1,226 2,223 22,292
12/31/22 3,449 1,115 2,334 19,958
12/31/23 3,449 998 2,451 17,507
12/31/20
Lease Expense ..................................... 3,449
Lease Liability....................................... 2,117
Cash........................................... 3,449
12/31/21
Lease Expense ..................................... 3,449
Lease Liability....................................... 2,223
Cash........................................... 3,449
(e) The rate of return required to amortize the net lease receivable to zero would
increase greatly. Recall the rate’s purpose is to create a rate to multiply by the
net lease receivable in order to amortize a portion of the deferred gross profit in
addition to recognizing interest revenue for the period. Given the way the facts
changed, the deferred gross profit total does not change. That is, the fair value
of the building minus the book value ($34,000 – $22,000 = $12,000) does not
change. However, it will be amortized over a shorter period of time than when
considering the original facts. Therefore, a greater portion of the deferred gross
profit (and thus revenue in general) will need to be recognized each period of the
lease, as there are fewer total periods. To do this, a higher rate must be used to
recognize revenue each period, as the lease term was cut in half while the
deferred gross profit remained the same.
(f) Had Jabari guaranteed the residual value of the building itself, it would be
required to classify the lease as a finance lease because it would then include
the present value of the residual value guarantee in the calculation of the present
value of the lease payments when determining the present value test. When this
is done, as shown in part (a), the present value of the lease payments are 100%
of the fair value of the building, and thus the lease meets the 90% test. Under a
finance lease instead of an operating lease, Jabari would recognize amortization
expense and interest expense separately on the income statement, as opposed
to reporting a single straight-line lease expense.
The present value classification test is the same for meeting the sales-type lease
tests for a lessor. Thus, the test is satisfied, and Giannis would classify the lease
as a sales-type lease. With respect to revenue recognition, Giannis would book
sales revenue (along with the related cost of goods sold) immediately upon the
commencement of the lease, and simply recognize subsequent interest on the
lease receivable as lease revenue as it is earned. This contrasts with its revenue
recognition under a direct finance lease from part (a), in that the gross profit
from the lease agreement is deferred over the lease term under a direct finance
lease. Thus, by having Jabari guarantee the residual value instead of a 3rd party,
Giannis would be able to book all gross profit up front instead of amortizing it
over the lease term.
TIME AND PURPOSE OF PROBLEMS
Problem 21.1 (Time 25–35 minutes)

Purpose—to provide an understanding of the journal entries to be recorded for a finance lease by the lessee
given a guaranteed residual value. Journal entries for two periods are required.

Purpose—to develop an understanding of the accounting by the lessee for a finance lease. The student is
required to explain the relationship between the capitalized amount of leased equipment and the leasing
arrangement. The student is asked to prepare the lessee’s journal entries at the date of commencement, for
amortization of the leased asset, and for the first lease payment, as well as to indicate the amounts that should
be reported on the lessee’s balance sheet.

Purpose—to develop an understanding of the accounting for a finance lease by the lessee in an annuity due
arrangement. The student is required to prepare the lease amortization schedule for the entire term of the
lease and all the necessary journal entries for the lease through the first two lease payments. The student is
also asked to indicate the amounts that would be reported on the lessee’s balance sheet.

Purpose—to develop an understanding of the accounting for a finance lease by a lessee in an annuity-due
arrangement. The student is required to prepare all the journal entries, with supportive computations, which the
lessee would have made to record the lease for the first period of the lease.

Purpose—to develop an understanding of the accounting principles used in a finance lease with a bargain
purchase option for the lessee. The student is required to discuss the nature of the lease and make journal
entries for the lessee.

Purpose—to develop an understanding of the accounting principles used in a sales-type lease for both the
lessee and the lessor. The student is required to discuss the nature of the lease and make journal entries for
both the lessee and the lessor.

Purpose—to develop an understanding of a sales-type lease with a guaranteed residual value. The student
discusses the classification of the lease and computes the lease receivable at commencement of lease, sales
price, and cost of goods sold. The student prepares a 10-year amortization schedule and all of the lessor’s
journal entries for the first year.

Purpose—to develop an understanding of a finance lease with a guaranteed residual value. The student
explains why it is a finance lease and computes the amount of the initial liability and right-of-use asset (with
initial direct costs). The student prepares a 10-year amortization schedule and all of the lessee’s journal entries
for the first year.
Purpose—to develop an understanding of the accounting treatment accorded a sales-type lease involving an
unguaranteed residual value. The student is required to discuss the nature of the lease with regard to the
lessor and to compute the lease receivable, the sales price, and the cost of goods sold. The student is also
required to construct a 10-year lease amortization schedule for the leasing arrangement, and to prepare the
lessor’s journal entries for the first year of the lease contract.

Purpose—to develop an understanding of lessee accounting for a finance lease with an unguaranteed residual
value. The student explains why it is a finance lease and computes the amount of the initial liability. The
student prepares a 10-year amortization schedule and all of the lessee’s journal entries for the first year.

Purpose—to develop an understanding of how residual values affect the accounting for the lessee and the
lessor. The student must understand both the accounting for a guaranteed and unguaranteed residual value and
possible classification by the lessor as a direct financing lease.

Purpose—to develop an understanding of the accounting procedures involved in a finance/sales-type leasing
arrangement. The student is required to discuss the nature of this lease transaction from the viewpoint of both
the lessee and lessor. The student is also requested to prepare the journal entries to record the lease for both
the lessee (including initial direct costs) and lessor plus illustrate the items and amounts that would be reported
on the balance sheet at the end of the first year for the lessee and the lessor.

Purpose—to provide an understanding of how lease information is reported on the balance sheet and income
statement for three different years in regard to the lessee. In addition, the year-end month is changed in order
to help provide an understanding of the complications involved with partial periods.

Purpose—to provide an understanding of how lease information is reported on the balance sheet and income
statement for three different years in regard to the lessor. In addition, the year-end month is changed in order
to help provide an understanding of the complications involved with partial periods.

Purpose—to develop an understanding of the accounting treatment for operating leases. The student is
required to identify the type of lease involved, explain the respective reasons for their classification, and
discuss the accounting treatment that should be applied for both the lessee and lessor. The student is also
asked to prepare the journal entries to reflect the first year of this lease contract for both the lessee and lessor
and consider the effect of an unguaranteed residual value for the lessor.

Purpose—to develop an understanding of the accounting treatment for an operating lease. The student is
asked to prepare the journal entries to reflect the first year of this lease contract for both the lessee and lessor.

Purpose—to develop an understanding of the accounting treatment for operating leases. The student is
asked to prepare the journal entries to reflect the first year of this lease contract for both the lessee and lessor
and to discuss the disclosures required of the lessee and lessor.
SOLUTIONS TO PROBLEMS
PROBLEM 21.1
Note: This lease is a finance lease to the lessee because the lease term
(six years) exceeds 75% of the remaining economic life of the asset (six years). Also,
the present value of the lease payments exceeds 90% of the fair value of the
asset.

X 4.99271 PV of an annuity-due of 1 for n = 6, i = 8%
$ 50,000 Guaranteed residual value

X .63017 PV of 1 for n = 6, i = 8%
$ 31,509 PV of guaranteed residual value

+ 31,509 PV of guaranteed residual value
$ 599,999 PV of lease payments
However, for purposes of measuring the initial lease liability, only amounts
expected to be owed under the residual value guarantee should be included.
That is, only the present value of the difference between the residual value
guarantee and the expected residual value at the end of the lease term should be
included.

$ 5,000 Amount expected to be owed under residual value guarantee

($50,000 – $45,000)
X .63017 PV of 1 for n = 6, i = 8%
$ 3,151 PV of guaranteed residual value

+ 3,151 PV of guaranteed residual value
$ 571,641 PV of lease payments
PROBLEM 21.1 (Continued)
(a) VANCE COMPANY (Lessee)

Annual
Lease Reduction
Payment Interest (8%) of Lease Lease
Date Plus GRV on Liability Liability Liability
1/1/20 $571,641
1/1/20 $113,864 $ –0– $113,864 457,777
1/1/21 113,864 36,622 77,242 380,535
1/1/22 113,864 30,443 83,421 297,114
1/1/23 113,864 23,769 90,095 207,019
1/1/24 113,864 16,562 97,302 109,717
1/1/25 113,864 8,777 105,087 4,630
12/31/25 5,000 370 4,630 0
$688,184 $116,543 $571,641
(b) January 1, 2020

Lease Liability ........................................................ 571,641
Lease Liability ................................................................ 113,864

Cash ........................................................................ 113,864
December 31, 2020

Lease Liability ........................................................ 36,622

Right-of-Use Asset ($571,641 ÷ 6) ......................... 95,274
January 1, 2021
Lease Liability ($36,622 + $77,242) ............................... 113,864
Cash ........................................................................ 113,864
December 31, 2021

Lease Liability ........................................................ 30,443

Note to instructor: The guaranteed residual value is not subtracted from the
right-of-use asset for purposes of determining the amortizable base. This
reflects the intangible nature of the right-of-use asset. The lessee records as
a right-of-use asset only the amount of the fair value of the asset it intends
to use up throughout the course of the lease term. The return of the asset to
the lessor is not considered a benefit to the lessee, and thus should not be
included in the right-of-use asset. The right-of-use asset should be amortized to
zero, as all of its benefit is realized through the asset’s use.
(c) A lease incentive does not impact the measurement of the lease liability.
However, a reduction in the right-of-use asset must be made. Thus, the right-of-
use asset would be measured at $566,641 ($571,641 – $5,000).
The prepayment of rent by the lessee should be recorded as an asset in the form
of an increased right-of-use asset. Therefore, the right-of-use asset would
initially be measured at $576,641 ($571,641 + $5,000).
PROBLEM 21.2
(a) The $550,000 is the present value of the five annual lease payments of
$120,987 to be made at the beginning of each year discounted at 5% since
the lessee knows the implicit rate.
(b) Right-of-Use Asset ................................................. 550,000

Lease Liability.................................................. 550,000
($120,987 X Present value of annuity due
factor for 5 years at 5%: $120,987 X
4.54595 = $550,000*)
*Rounded.
Lease Liability ........................................................ 120,987

Cash ................................................................. 120,987
(c) Amortization Expense ............................................ 220,000

Right-of-Use Asset .......................................... 220,000
($550,000 X 40% = $220,000)
Interest Expense..................................................... 21,451

Lease Liability.................................................. 21,451
(See amortization schedule)
(d) Lease Liability ........................................................ 120,987

Cash ................................................................. 120,987
CAGE COMPANY (Lessee)

Annual Reduction
Lease Interest (5%) of Lease Lease
Date Payment on Liability Liability Liability
1/1/20 $550,000
1/1/20 $120,987 $ –0– $120,987 429,013
1/1/21 120,987 21,451 99,536 329,477
1/1/22 120,987 16,474 104,513 224,964
(e) CAGE COMPANY

Balance Sheet (Partial)
December 31, 2020
Assets Liabilities
Non-current assets: Current:
Right-of-use Asset $330,000 Lease liability $120,987*
Noncurrent:
Lease liability $329,477**
*The current portion of the lease liability will contain a component for the accrued interest
expense to be paid on the lease liability ($429,013 X 5% = $21,451) plus a component for the
reduction of the original lease liability ($120,987 – $21,451 = $99,536).
**See amortization schedule from part (d).
(f) Insurance payments are an executory cost. Assuming a gross lease, the
insurance payments must be included in the present value of the lease payments
when initially valuing the lease liability. Therefore, the initial liability would be
measured as follows:
Present value of rental payments (see part b) ..... $550,000

Present value of insurance payments
($2,000 X 4.54595*) .............................................. 9,092
Lease Liability ........................................................ $559,092
* PV of an annuity due of $1 for 5 periods.
PROBLEM 21.3
(a) December 31, 2020

Lease Liability ........................................................ 175,888*
(To record leased asset and related
liability at the present value of
5 future annual payments of $40,000
plus a bargain-purchase option of
$5,000 discounted at 8%)
*($40,000 X 4.31213**) + ($5,000 X .68058***) = $175,888

**Present value of an annuity due of 1 for 5 periods at 8%.
***Present value of 1 for 5 periods at 8%.
December 31, 2020

Lease Liability ........................................................ 40,000
Cash ................................................................. 40,000
(To record the first rental payment)
(b) LUDWICK STEEL COMPANY (Lessee)

(Annuity Due Basis)
Annual Reduction
Lease Interest (8%) of Lease Lease
Date Payment on Liability Liability Liability
12/31/20 — — — $175,888
12/31/20 $40,000 $ 0 $40,000 135,888
12/31/21 40,000 10,871 29,129 106,759
12/31/22 40,000 8,541 31,459 75,300
12/31/23 40,000 6,024 33,976 41,324
12/31/24 40,000 3,306 36,694 4,630
12/31/25 5,000 370 4,630 0
December 31, 2021

Amortization Expense ............................................ 25,127
(To record amortization of the right-of-use
asset based on a cost to Ludwick of
$175,888 and a life of 7 years)
December 31, 2021

Lease Liability ........................................................ 29,129
Cash ................................................................. 40,000
(To record annual payment on lease
liability of which $10,871 represents
interest at 8% on the unpaid principal
of $135,888)
(c) December 31, 2022

Amortization Expense ............................................... 25,127
Right-of-Use Asset ............................................. 25,127
(To record annual amortization on leased
assets)
Interest Expense........................................................ 8,541

Lease Liability ........................................................... 31,459
Cash .................................................................... 40,000
(To record annual payment on lease
liability of which $8,541 represents
interest at 8% on the unpaid principal
of $106,759)
Note: Because a bargain purchase option is used, the right-of-the-asset should

be amortized over seven years.
(d) LUDWICK STEEL COMPANY

December 31, 2022
Non-current assets: Current liabilities:
Right-of-Use asset $125,634* Lease liability $33,976**
Long-term liabilities:
Lease liability $41,324***
*$175,888 – ($25,127 X 2)
**Reduction of lease liability in 2023 (see schedule in part (b)).
***Lease liability as of 12/31/22 less the reduction of lease liability in 2023
($75,300 – $33,976)
PROBLEM 21.4
Entries on August 1, 2020:
(1) Right-of-Use Asset ............................................. 4,119,480

Lease Liability.............................................. 4,119,480
Explanation and computation: This is a finance lease because the lease

term exceeds 75% of the asset’s useful life. That is, the lease term is 80%
(12 ÷ 15) of the asset’s useful life.
The leased computer and the related liability are recorded at the present
value of the lease payments as follows: $40,000 X 102.987 = $4,119,480.
(2) Lease Liability .................................................. 40,000

Cash ........................................................... 40,000
Explanation: This entry is to record the August 1, 2020, first payment under
the lease agreement. No interest is recognized on August 1 because the
agreement began on that date, and no time as elapsed.
Entries on August 31, 2020:
(1) Interest Expense............................................... 20,397

Lease Liability............................................ 20,397
Explanation and computation: Interest accrued on the unpaid balance of the

lease liability from August 1 to August 31, 2020, is computed as follows:
($4,119,480 – $40,000) X .005 = $20,397.
(2) Amortization Expense ...................................... 28,608

Explanation and computation: Amortization is recorded for one month of the

use of computer using the lease term: ($4,119,480 ÷ 12) X 1/12 = $28,608.
PROBLEM 21.5
(a) GRISHELL TRUCKING COMPANY

Schedule to Compute the Discounted Present Value
of Terminal Facilities and the Related Obligation
January 1, 2020
Present value of first 10 payments:

Immediate payment ....................................... $ 800,000
Present value of an ordinary annuity for
9 years at 6% ($800,000 X 6.801692) ........ 5,441,354 $6,241,354*
Present value of last 10 payments:

First payment of $320,000............................. 320,000
Present value of an ordinary annuity for
9 years at 6% ($320,000 X 6.801692) ........ 2,176,541
Present value of last 10 payments at
January 1, 2028.......................................... 2,496,541
Discount to January 1, 2020
($2,496,541 X .558395) ............................... 1,394,056
Discounted present value of terminal

facilities and related obligation ................ $7,635,410
(Note to instructor: The student can compute the $6,241,354 by using the
present value of an annuity due for 10 periods at 6%.
*The calculation could also be done as a pure annuity due of 1 for 10

periods as follows ($2 rounding difference):
First 10 annual payments ............................ $800,000

Present value of an annuity due of 1 for
10 years at 6% ........................................... X 7.80169 $6,241,352
For the last ten periods, the present value of an annuity due for 20 periods
less the present value of an annuity due for 10 periods can be used as
follows: (12.15812 – 7.80169) X $320,000 = $1,394,058 ($2 difference due to
rounding). The $1 bargain purchase option is not included in this
computation because it is immaterial.
(b) GRISHELL TRUCKING COMPANY

Journal Entries
(1) 1/1/22
Lease Liability ($386,732 + $413,268)................ 800,000

Cash ............................................................. 800,000
Partial Amortization Schedule

(Annuity-Due Basis)
Interest (6%)
on Lease Reduction of
Lease Liability Lease Lease
Date Payment Liability Liability
1/1/20 $7,635,410
1/1/20 $800,000 $ 0 $800,000 6,835,410
1/1/21 800,000 410,125 389,875 6,445,535
1/1/22 800,000 386,732 413,268 6,032,267
1/1/23 800,000 361,936 438,064 5,594,203
(2) 12/31/22

(To record annual amortization expense
on leased assets) ($7,635,410 ÷ 40)
Note: The leased asset is depreciated over its economic life because a
bargain-purchase option is available at the end of the lease term.
(3) 12/31/22

Lease Liability.................................................. 361,936
(To record interest accrual at 6% on
outstanding lease liability of $6,032,267)
PROBLEM 21.6
(a) This is a finance lease for Jensen since the lease term is greater than 75% of
the economic life of the leased asset. The lease term is 78% (7 ÷ 9) of the
asset’s economic life. In addition, the present value of the lease payments is
greater than 90% of the asset’s fair value, as shown in part (c).
This is a sales-type lease for Glaus (lessor), for the same reasons as for the
lessee.
(b) Calculation of annual rental payment
$700,000 – ($50,000 X .71068*)

= $109,365
6.07569**
*Present value of $1 at 5% for 7 periods.

**Present value of an annuity due at 5% for 7 periods.
(c) Computation of lease liability, or present value of lease payments:
PV of annual payments: $109,365 X 5.91732* = $647,148
Because the guaranteed residual value is equal to the expected residual

value, the lessee would not include any amount of the guaranteed residual value
in its calculation of the initial lease liability. Note that Jensen used its
incremental borrowing rate because Jensen does not know the implicit rate.
Note to the Instructor: The lease liability only includes the amount expected
to be owed under a residual value guarantee. This contrasts with the
classification test, which includes the full value of a guaranteed residual.
The classification test would be performed as done below:
PV of annual payments: $109,365 X 5.91732* = $647,148

PV of guaranteed residual value: $50,000 X .66506** = 33,253
$680,401
**Present value of $1 at 6% for 7 periods.
$680,401 ÷ $700,000 = 97%, which is greater than 90%, and thus the lease is
a finance lease to the lessee.
1/1/20
(d)

Lease Liability ........................................................ 647,148
Lease Liability ................................................................ 109,365

Cash ........................................................................ 109,365
12/31/20

Right-of-Use Asset
($647,148 ÷ 7) ...................................................... 92,450

Lease Liability
($647,148 – $109,365) X .06 ................................ 32,267
1/1/21
Lease Liability ................................................................ 109,365*

Cash ........................................................................ 109,365
*The reduction in the liability is composed of two components.

One component is the payment of the accrued interest expense
from the prior period ($32,267) and the other component is the
reduction of the initial lease liability recorded ($77,098).
12/31/21


Lease Liability ........................................................ 27,641
[($647,148 – $109,365 –
$77,098) X .06]
1/1/20
(e)

Sales Revenue ........................................................ 700,000
Inventory ................................................................. 525,000
Cash ................................................................................ 109,365

12/31/20

Interest Revenue
[($700,000 – $109,365) X .05].............................. 29,532
1/1/21
Cash ................................................................................ 109,365

12/31/21

Interest Revenue
($700,000 – $109,365 –
$79,833) X .05 ............................................................. 25,540
(f) PV of annual payments

($109,365 X 5.91732*) $647,148
PV of amount probable to be owed
[($50,000 – $40,000) X .66506**] $6,651
Lease Liability $653,799

**Present value of $1 for 7 periods at 6%.
In this case, the guaranteed residual value is greater than the expected residual
value. Therefore, the lessee must include the present value of the amount
probable to be owed under the guaranteed residual value in its calculation of the
initial lease liability.
PROBLEM 21.7
(a) The noncancelable lease is a sales-type lease because: (1) the lease term is
for 83% (10 ÷ 12) of the economic life of the leased asset, and
(2) the present value of the lease payments exceeds 90% of the fair value of
the leased property (see calculation below).
1. Lease Receivable:
Present value of annual payments of $60,000
made at the beginning of each period for 10 years,
$60,000 X 8.10782 (PV of an annuity due at 5%) ........... $486,469
Present value of guaranteed residual value,
$15,000 X .61391 (PV of $1 at 5% for 10 years) ............. 9,209
Present value of lease payments ............................... $495,678
2. Sales price is the same as the present value of

lease payments ............................................................... $495,678
3. Cost of sales is the cost of manufacturing the

x-ray machine ................................................................. $300,000
(b) AMIRANTE INC. (Lessor)

(Annuity due basis, guaranteed residual value)
Annual Lease Interest (5%) on Recovery

Beginning Payment Plus Lease of Lease Lease
of Year Residual Value Receivable Receivable Receivable
(a) (b) (c) (d)
Initial PV — — — $495,678
1 $ 60,000 — $ 60,000 435,678
2 60,000 $ 21,784 38,216 397,462
3 60,000 19,873 40,127 357,335
4 60,000 17,867 42,133 315,202
5 60,000 15,760 44,240 270,962
6 60,000 13,548 46,452 224,510
7 60,000 11,226 48,774 175,736
8 60,000 8,787 51,213 124,523
9 60,000 6,226 53,774 70,749
10 60,000 3,537 56,463 14,286
End of 10 15,000 714 14,286 0
$615,000 $119,322 $495,678
(a) Annual lease payments and guaranteed residual value.

(b) Preceding balance of (d) X 5%, except beginning of first year of lease term.
(c) (a) minus (b).
(d) Preceding balance minus (c).
(c) Lessor’s journal entries:

Beginning of the Year
Cost of Goods Sold ................................................ 300,000
Sales Revenue ................................................. 495,678
Inventory .......................................................... 300,000
(To record lease receivable and sale)
Selling Expenses .................................................... 14,000
Accounts Payable/Cash .................................. 14,000
(To record the incurrence of initial direct
costs relating to the lease)
Cash ........................................................................... 60,000

Lease Receivable................................................ 60,000
(To record receipt of the first lease
payment)
End of the Year

Interest Revenue................................................. 21,784
(To record interest during the first
year of the lease)
LO: 2, 4, Bloom: AP, Difficulty: Complex, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
PROBLEM 21.8
(a) The noncancelable lease is a finance lease because: (1) the lease term is for
83% (10 ÷ 12) of the economic life of the leased asset and (2) the present
value of the lease payments exceeds 90% of the fair value of the leased
asset, as shown below:
PV of Lease Payments:
PV of rental payments, $60,000 X 8.10782 ....................... $486,469
PV of guaranteed residual value, $15,000 X .61391......... 9,209
PV of lease payments ........................................................ $495,678
Fair value of the asset ....................................................... ÷ 495,678
Percentage of fair value of the leased asset.................... 100%
However, for purposes of measuring the initial lease liability, only probable
amounts expected to be owed under the residual value guarantee should be
included. That is, only the present value of the difference between
the residual value guarantee and the expected residual value at the end of
the lease term should be included. The calculation of the initial value of the
lease liability is as follows:
PV of Lease Liability:
PV of rental payments, $60,000 X 8.10782 ....................... $486,469
PV of guaranteed residual expected to be owed
[($15,000 – $10,000) X .61391] ....................................... 3,070
Initial lease liability ............................................................ $489,539
(b) CHAMBERS MEDICAL (Lessee)

(Annuity-Due Basis, GRV)
Annual Lease Interest (5%) Reduction
Beginning Payment Plus on Unpaid of Lease Lease
of Year GRV Liability Liability Liability
(a) (b) (c) (d)
Initial PV $489,539
1 $ 60,000 $ 0 $ 60,000 429,539
2 60,000 21,477 38,523 391,016
3 60,000 19,551 40,449 350,567
4 60,000 17,528 42,472 308,095
5 60,000 15,405 44,595 263,500
6 60,000 13,175 46,825 216,675
7 60,000 10,834 49,166 167,509
8 60,000 8,375 51,625 115,884
9 60,000 5,794 54,206 61,678
10 60,000 3,084 56,916 4,762
End of 10 5,000 238 4,762 0
$605,000 $115,461 $489,539
(a) Annual lease payments and amount expected to be owed under residual value
guarantee.
(c) (a) minus (b).
(c) Lessee’s journal entries:

Lease Liability.................................................. 489,539
(To record the lease of x-ray equipment
using finance lease method)
Lease Liability ........................................................ 60,000

Cash ................................................................. 60,000
(To record payment of annual lease
obligation)
End of the Year

Lease Liability.................................................. 21,477
(To record accrual of annual interest on
lease obligation)

(To record amortization expense for
year 1 using straight-line method
[$489,539 ÷ 10 years])
Note to instructor: The guaranteed residual value is not subtracted from the
right-of-use asset for purposes of determining the amortizable base. This
reflects the intangible nature of the right-of-use asset. The lessee records as
a right-of-use asset only the amount of the fair value of the asset it intends
to use up throughout the course of the lease term. The return of the asset to
the lessor is not considered a benefit to the lessee, and thus should not be
included in the right-of-use asset. The right-of-use asset should be amortized to
zero, as all of its benefit is realized through the asset’s use.
(d) The document preparation costs are considered initial direct costs. As such,
they will impact the initial measurement of the right-of-use asset, but will not
affect the lease liability. The right-of-use asset must be increased as a result of
any initial direct costs incurred. Therefore, under the new circumstances, the
initial measurement of the right-of-use asset would be $496,539 ($489,539 +
$7,000).
PROBLEM 21.9
(a) The lease is a sales-type lease because: (1) the lease term exceeds 75% of
the asset’s estimated economic life (10/12 = 83%), and (2) the present value of
the lease payments is greater than 90% of the fair value of the asset, as
calculated below:


÷ 299,140 Fair value of check-in kiosk
96.90% Rental payments percentage of fair value
1. Present value of an annuity due of $1 for

10 periods discounted at 8% ..................................... 7.24689
Annual lease payment .................................................... X $ 40,000
Present value of the 10 rental payments ...................... $289,876
Add: Present value of estimated residual
value of $20,000 in 10 years at 8%
($20,000 X .46319) ................................................. 9,264
Lease receivable at commencement ............................. $299,140
2. Sales revenue is $289,876 (the present value of the 10 annual lease

payments) or, the lease receivable of $299,140 minus the PV of the un-
guaranteed residual value of $9,264.
3. Cost of goods sold is $170,736 (the $180,000 cost of the asset less the
present value of the unguaranteed residual value of $9,264). The $4,000
in sales commissions are not included in the cost of goods sold, though
they would be expensed separately by the lessor.
(b) GEORGE COMPANY (Lessor)

Annuity Due Basis, Unguaranteed Residual Value
Annual Lease Interest (8%) Lease

Beginning Payment Plus on Lease Receivable Lease
of Year Residual Value Receivable Recovery Receivable
(a) (b) (c) (d)
Initial PV $299,140
1 $ 40,000 $ 0 $ 40,000 259,140
2 40,000 20,731 19,269 239,871
3 40,000 19,190 20,810 219,061
4 40,000 17,525 22,475 196,586
5 40,000 15,727 24,273 172,313
6 40,000 13,785 26,215 146,098
7 40,000 11,688 28,312 117,786
8 40,000 9,423 30,577 87,209
9 40,000 6,977 33,023 54,186
10 40,000 4,335 35,665 18,521
End of 10 20,000 1,479* 18,521 0
$420,000 $120,860 $299,140
*Rounding error is $3.

(a) Annual lease payment (and return of expected residual value at end of the lease).
(c) (a) minus (b).
(c) Beginning of the Year

Sales Revenue ........................................................ 289,876
Inventory ................................................................. 180,000
(To record the sale and the cost of goods
sold in the lease transaction)
Selling Expenses ........................................................... 4,000

Cash ........................................................................ 4,000
(To record payment of the initial direct
costs relating to the lease)
Cash ................................................................................... 40,000

(To record receipt of the first lease
payment)
End of the Year

Lease Receivable .............................................................. 20,731
Interest Revenue ....................................................... 20,731
(To record interest during the
first year of the lease)
PROBLEM 21.10
(a) The lease is a finance lease because: (1) the lease term exceeds 75% of the
asset’s economic life (10/12 = 83%) and (2) the present value of the lease
payments exceeds 90% of the fair value of the leased asset.
Initial Lease Liability:

Lease payments ($40,000) X PV of an
annuity due for 10 periods at 8% (7.24689).................. $289,876
(b) NATIONAL AIRLINES (Lessee)

(Annuity-due basis and URV)
Interest (8%) Reduction

Beginning Annual Lease on Lease of Lease Lease
of Year Payment Liability Liability Liability
(a) (b) (c) (d)
Initial PV — — — $289,876
1 $ 40,000 — $ 40,000 249,876
2 40,000 $ 19,990 20,010 229,866
3 40,000 18,389 21,611 208,255
4 40,000 16,660 23,340 184,915
5 40,000 14,793 25,207 159,708
6 40,000 12,777 27,223 132,485
7 40,000 10,599 29,401 103,084
8 40,000 8,247 31,753 71,331
9 40,000 5,706 34,294 37,037
10 40,000 2,963 37,037 0
$400,000 $110,124 $289,876
(a) Annual lease payment required by lease contract.

(c) (a) minus (b).
(c) Lessee’s journal entries:

Lease Liability ........................................................ 289,876
(To record the lease of computer
equipment using finance lease method)
Lease Liability ................................................................ 40,000

Cash ........................................................................ 40,000
(To record the first rental payment)
End of the Year

Lease Liability ........................................................ 19,990
(To record accrual of annual interest on
lease liability)

(To record amortization expense for
first year [$289,876 ÷ 10])
PROBLEM 21.11
(a) The lease agreement satisfies the 90% of fair value requirement (calculation
below).
PV of rental payments, $30,300 X 7.24689* ...................... $219,581
PV of guaranteed residual value, $50,000 X .46319** ...... 23,160
PV of Lease Payments ...................................................... $242,741
Percentage of fair value of the leased asset.................... 100%
For the lessee, it is a finance lease, and for the lessor, it is a sales-type
lease.
Note to Instructor: While the present value classification test includes the
full amount of the residual value guarantee, for purposes of measuring the
initial lease liability, only amounts expected to be owed under the residual
value guarantee should be included. That is, only the present value of the
difference between the residual value guarantee and the expected residual
value at the end of the lease term should be included. The calculation of the
initial value of the lease liability is as follows:
PV of guaranteed residual expected to be owed
[($50,000 – $45,000) X .46319**] .................................... 2,316

(b) January 1, 2020

Lessee:
Lease Liability.................................................. 221,897
Lease Liability ........................................................ 30,300

Cash ................................................................. 30,300
January 1, 2020
Lessor:
Cost of Goods Sold ................................................ 180,000
Sales Revenue ................................................. 242,741
Inventory .......................................................... 180,000
Cash ........................................................................ 30,300

Lease Receivable............................................. 30,300
December 31, 2020

Lessee:
Lease Liability
[($221,897– $30,300) X .08] .......................... 15,328

Right-of-Use Asset
($221,897 ÷ 10) ............................................. 22,190
December 31, 2020

Lessor:
Lease Revenue
[($242,741 – $30,300) X .08] ............................. 16,995
(c) In both (1) and (2), the lessee is no longer obligated or expected to make any
payment at the end of the lease. As a result, there should be no amount of
the residual value included in the lessee’s initial measurement of the lease
liability or right-of-use asset. Thus, in both (1) and (2), the amount of the
initial lease liability is $219,581, or the present value of the annual rental
payments (see part a for calculation).
(d) (1) When a residual value is guaranteed by a 3rd party, it creates a unique
situation for a lessor. In this case, King expects to receive 100% of the fair
value of the asset through the rental payments of the lessee and the
payment of the residual value guarantee (either the return of equipment by
the lessee and/or cash from the 3rd party). While King relinquishes control of
the equipment to Goring, Goring does not take control of the asset, as the
present value of the lease payments for Goring is less than 90% of the fair
value of the asset, and no other classification test is met. As a result, the
existence of a 3rd party guarantee leads the asset to be classified as a direct
financing lease to the lessor, as the present value of the rental payments
plus any guaranteed residual (whether guaranteed by the lessee or an
unrelated 3rd party) exceeds 90% of the fair value of the equipment, and
collectibility of the payments is probable. While the classification of the
lease changes, the initial measurement of the lease receivable for the lessor
does not; that is, the lease receivable is still equal to the present value of
the rental payments plus the residual value, or $242,741 (see calculation in
part a).
Note to Instructor: while the lease receivable does not change, the net
investment in the lease does. Net investment in the lease is defined as the
lease receivable plus any unguaranteed residual value minus deferred gross
profit. Thus, as a result of the profit of the transaction being deferred
instead of recognized up front, the net investment would be $242,741 –
[$242,741 – $180,000] = $180,000.
(2) While the lessor still includes even an unguaranteed residual value in the
calculation of a lease receivable under a sales-type or direct-finance lease,
the lack of a residual value guarantee in this case could lead the lease to be
classified as an operating lease, as present value of the lease payments may
be less than 90% of the fair value of the asset. As a result, the lessor might
not remove the asset from its books at all, but rather continue to depreciate
the asset as normal and book lease revenue as it receives and earns rental
payments. In this situation ($219,581 ÷ $242,741 = 90.5%) the present value
test is still met and the lease is classified as a sales-type lease.
PROBLEM 21.12
(a) The lease should be treated as a finance lease by Winston Industries

requiring the lessee to capitalize the leased asset. The lease qualifies for
finance lease accounting by the lessee because: (1) title to the engines
transfers to the lessee, (2) the lease term is equal to the estimated life of the
asset, and (3) the present value of the minimum lease payments exceeds
90% of the fair value of the leased engines. In addition, the engines are
specially built.
For Ewing Inc. the transaction is a sales-type lease because the same
classification tests are met as were met for Winston. This lease arrangement
also represents the manufacturer’s financing the transaction over a period of
10 years.
Present Value of Lease Payments

$384,532 X 7.80169* .................................................. $3,000,000
*Present value of an annuity due at 6% for 10 years, rounded by $1.
Dealer Profit
Sales (present value of lease payments) .................... $3,000,000
Less: Cost of engines .................................................. 2,600,000
Profit on sale................................................................. $ 400,000
(b) Right-of-Use Asset ........................................... 3,000,000

Lease Liability............................................ 3,000,000
(c) Lease Receivable ............................................. 3,000,000

Cost of Goods Sold .......................................... 2,600,000
Sales Revenue ........................................... 3,000,000
Inventory .................................................... 2,600,000
(d) Lessee (January 1, 2020)

Lease Liability .................................................. 384,532
Cash ........................................................... 384,532
Lessor (January 1, 2020)

Cash .................................................................. 384,532
Lease Receivable....................................... 384,532
(e) WINSTON INDUSTRIES/EWING INCORPORATED
Annual
Lease Interest on Reduction in Lease
Receipt/ Receivable/ Receivable/ Receivable/
Date Payment Liability at 6% Liability Liability
1/1/20 $3,000,000
1/1/20 $384,532 $ –0– $384,532 2,615,468
1/1/21 384,532 156,928 227,604 2,387,864
1/1/22 384,532 143,272 241,260 2,146,604
Lessee December 31, 2020
Interest Expense............................................... 156,928
Lease Liability............................................ 156,928
Amortization Expense ...................................... 300,000

Right-of-Use Asset (3,000,000 ÷ 10) ......... 300,000
Lessor December 31, 2020
Lease Receivable ............................................. 156,928
Interest Revenue........................................ 156,928
(f) WINSTON INDUSTRIES

December 31, 2020
Non-current assets: Current liabilities:

Right-of-Use $2,700,000* Lease liability $384,532**
asset
Lease liability $2,387,864***
(See amortization
schedule in part (e))
*$3,000,000 – ($3,000,000 ÷ 10)

**Lease payments in 2021 (on January 1) will be the following:
Lease Liability .................................................. 384,532
Cash ........................................................... 384,532
Part of the reduction in the lease liability will be attributable to the

previously accrued interest expense, and part will be a reduction of the
initial lease liability recorded. Nonetheless, the full payment will be a
reduction in lease liability in the following year, and should be classified as
current.
***$3,000,000 – $384,532 + $156,928 – $384,532
EWING INC.
December 31, 2020
Assets
Current assets:
Lease receivable ......................................................... $ 384,532*
Noncurrent assets:
Lease receivable ......................................................... $2,387,864**
Note: The title Net Investment in leases is sometimes shown instead of

Lease receivable.
*Lease receivable is composed of accrued interest revenue ($156,928) as

well as the planned reduction of the initial lease receivable ($227,604).
**$2,615,468 – $227,604
(g) Legal fees incurred in connection with a lease are considered initial direct
costs of the lease, and should be capitalized as part of the right-of-use asset. In
contrast, lease incentives reduce the initial value of the right-of-use asset.
However, neither initial direct costs nor lease incentives affect the value of the
lease liability. Thus, the entry to initially record the lease is as follows:
Right-of-Use Asset................................................... 2,980,000

Cash ($50,000 – $30,000) ................................. 20,000
Lease Liability .................................................. 3,000,000
PROBLEM 21.13
(a) 1. $ 20,027 Interest expense (See amortization schedule)

$ 52,174 Amortization expense ($313,043 ÷ 6 = $52,174)
2. Current liabilities:
Non-current assets:
$260,869 Right-of-Use asset ($313,043 – $52,174)
3. $ 16,614 Interest expense (See amortization schedule)

Non-current Assets:
$208,695 Right-of-Use Asset
(b) 1. $ 5,007 Interest expense ($20,027 X 3/12 = $5,007)

$ 13,044 Amortization expense
($313,043 ÷ 6 = $52,174;
($52,174 X 3/12 = $13,044)
$ 47,680 Lease liability ($42,673 + $5,007)
$207,670 Lease liability ($250,343 + $5,007 – $47,680)
Non-current Assets:
$299,999 Right-of-Use Asset ($313,043 – $13,044)
3. $ 19,174 Interest expense

[($20,027 – $5,007) + ($16,614 X 3/12) =
[$15,020 + $4,154 = $19,174]
($46,086 + [$16,614 X 3/12] =
[$46,086 + $4,154 = $50,240)
$161,584 Lease liability ($207,670 + $4,154 – $50,240)
Property, plant, and equipment:

$247,825 Right-of-Use Asset ($313,043 – $13,044 – $52,174)
PROBLEM 21.14
(a) 1. $313,043 Sales revenue

$280,000 Cost of goods sold
$ 20,027 Lease revenue
2. Current assets:
$ 62,700 Lease receivable ($42,673 + $20,027)
Noncurrent assets:
$207,670 Lease receivable (net investment)
3. $ 16,614 Lease revenue
4. Current assets:
Noncurrent assets:
$161,584 Lease receivable (net investment)
(b) 1. $313,043 Sales revenue

$280,000 Cost of goods sold
$ 5,007 Lease revenue ($20,027 X 3/12 = $5,007)
2. Current assets:
Noncurrent assets:
$207,670 Lease receivable
3. $ 19,174 Lease revenue

[($20,027 – $5,007) + ($16,614 X 3/12) =
[$15,020 + $4,154 = $19,174]
4. Current assets:
Noncurrent assets:
$161,584 Lease receivable
PROBLEM 21.15
(a) The lease agreement satisfies the 90% of fair value requirement (calculation
below).
PV of guaranteed residual value, $17,500 X .82270** ...... 14,397
PV of lease payments ........................................................ $60,830
Percentage of fair value of the leased asset.................... 90.79%

For the lessee, it is a finance lease, and for the lessor, it is a sales-type
lease.
Note to Instructor: While the present value classification test includes the
full amount of the residual value guarantee, for purposes of measuring the
initial lease liability, only amounts expected to be owed under the residual
value guarantee should be included. That is, only the present value of the
difference between the residual value guarantee and the expected residual
value at the end of the lease term should be included. The calculation of the
initial value of the lease liability is as follows:
PV of guaranteed residual expected to be owed ............. -0-
(b) January 1, 2020

Lease Liability ........................................................ 46,433
Lease Liability ................................................................ 12,471

Cash ........................................................................ 12,471
December 31, 2020

Lease Liability
[($46,433 – $12,471) X .05] ................................. 1,698

Right-of-Use Asset
($46,433 ÷ 4) ........................................................ 11,608
(c)
January 1, 2020
Cost of Goods Sold ($50,000 – $14,397)....................... 35,603
Sales Revenue ($67,000 – $14,397) ....................... 52,603
Inventory ................................................................. 50,000
Cash ................................................................................ 12,471

December 31, 2020

Lease Receivable .............................................................. 2,726
Lease Revenue
[($67,000 – $12,471) X .05] ..................................... 2,726
(d) Without the residual value guarantee, the lease agreement fails to satisfy the
90% of fair value requirement (calculation below).
For both the lessee and the lessor, it is classified as an operating lease.
Irving Company (Lessee) Entries

January 1, 2020
Lease Liability ........................................................ 46,433
Lease Liability ................................................................ 12,471

Cash ........................................................................ 12,471
IRVING COMPANY
Annuity-Due Basis
Reduction
1/1/20 $46,433
1/1/20 $12,471 $ 0 $12,471 33,962
1/1/21 12,471 1,698 10,773 23,189
1/1/22 12,471 1,159 11,312 11,877
1/1/23 12,471 594 11,877 0

(C)
1/1/20 $46,433
12/31/20 $12,471 $1,698 $10,773 35,660
12/31/21 12,471 1,159 11,312 24,348
12/31/22 12,471 594 11,877 12,471
12/31/23 12,471 0 12,471 0
December 31, 2020

Lease Expense ............................................................... 12,471
Lease Liability ........................................................ 1,698*
Anthony Incorporated (Lessor) Entries

January 1, 2020
Cash ................................................................................ 12,471
December 31, 2020

Unearned Lease Revenue ................................................ 12,471
Lease Revenue .......................................................... 12,471
Depreciation Expense ...................................................... 5,000

Leased Machinery ($50,000 ÷ 10) ......................... 5,000
PROBLEM 21.16
(a) The lease will be classified as an operating lease for both the lessee and the
lessor. The lease does not transfer ownership at the end of the lease term,
does not have a bargain purchase option, and the asset is not specialized.
In addition, neither the 75% test (3 ÷ 8 = 37.5%) nor the 90% test (calculation
below) are met.
(b)
DAWKINS COMPANY
Annuity-Due Basis
Reduction
1/1/20 $29,810
1/1/20 $10,521 $ 0 $10,521 19,289
1/1/21 10,521 1,157 9,364 9,925
1/1/22 10,521 596* 9,925 0

(C)
1/1/20 $29,810
12/31/20 $10,521 $1,157 $9,364 20,446
12/31/21 10,521 596 9,925 10,521
12/31/22 10,521 0 10,521 0
(c)
January 1, 2020
Lease Liability ........................................................ 29,810
Lease Liability ................................................................ 10,521

Cash ........................................................................ 10,521
December 31, 2020

Lease Expense ............................................................... 10,521
Lease Liability ........................................................ 1,157*
lease liability, as shown in the lease amortization schedule. Note that this is
expensed along with the amortization of the right-of-use asset at the end of 2020.
(d)
January 1, 2020
Cash ................................................................................ 10,521
December 31, 2020

Lease Revenue .......................................................... 10,521

Leased Machinery ($40,000 ÷ 8) ........................... 5,000
(e) When a lessee elects to use the short-term lease option, the company need
not recognize a lease liability or right-of-use asset on its books. Instead, the lessee
expenses payments as they are made.
As a result, if the lease were only 1 year, Dawkins’ only entry for the lease would
be the following:
January 1, 2020
Lease Expense ............................................................... 10,521
Cash ........................................................................ 10,521
PROBLEM 21.17
(a) The lease is an operating lease to the lessee and lessor because:
1. it does not transfer ownership,

2. it does not contain a bargain purchase option,
3. it does not cover at least 75% of the estimated economic life (5/7 = 71%)
of the crane, and
4. the present value of the lease payments is not at least 90% of the fair
value of the leased crane.
$48,555 annual lease payments X PV of an annuity-due at 8% for 5 years

$48,555 X 4.31213 = $209,375, which is less than $216,000 (90% X
$240,000).
5. it does not meet the specialized asset test.
At least one of the five tests would have had to be satisfied for the lease to
be classified as other than an operating lease.
(b) Lessee’s Entries

1/1/20
Right-of-Use Asset............................................................ 209,375
Lease Liability ........................................................... 209,375
Lease Liability ................................................................... 48,555

Cash ........................................................................... 48,555
ABRIENDO CONSTRUCTION
Annuity-Due Basis
Reduction
1/1/20 $209,375
1/1/20 $48,555 $ 0 48,555 160,820
12/31/20 48,555 12,866 35,689 125,131
12/31/21 48,555 10,010 38,545 86,586
12/31/22 48,555 6,927 41,628 44,958

(C)
1/1/20 $209,375
12/31/20 $48,555 $12,866 $35,689 173,686
12/31/21 48,555 10,010 38,545 135,141
12/31/22 48,555 6,927 41,628 93,513
12/31/20
Lease Expense .................................................................. 48,555
Right-of-Use Asset ................................................... 35,689
Lease Liability ........................................................... 12,866
Lessor’s Entries
1/1/20
Cash ................................................................................... 48,555
Unearned Lease Revenue ......................................... 48,555
12/31/20
Accumulated Depreciation—Leased Equipment
[($240,000 – $15,000) ÷ 7] ..................................... 32,143

Lease Revenue .......................................................... 48,555
(c) Abriendo as lessee must record both a lease liability, as well as a right-of-use
asset. The first cash payment is a total reduction of the lease liability (as no
time has passed, and thus no interest has accrued). At the end of the year,
Abriendo must make an accrual for the annual lease expense. In this case,
since the payment does not occur until the first day of the following year,
Abriendo must accrue a lease liability equal to the amount of interest for
2020. In addition, Abriendo amortizes the asset whatever amount gives the
company a straight-line lease expense. In the balance sheet, Abriendo will
present a right-of-use asset of $173,686 ($209,375 – $35,689) and a lease
liability of $173,686 ($209,375 – $48,555 + $12,866). In the income statement,
Abriendo will show a single lease expense for $48,555.
Cleveland as lessor must disclose in the balance sheet or in the notes the cost
of the leased crane ($240,000) and the accumulated depreciation of $32,143
separately from assets not leased. Additionally, Cleveland must disclose in
the notes the minimum future rentals as a total of $194,220, and for each of
the succeeding four years: 2021—$48,555; 2022—$48,555; 2023—$48,555;
2024—$48,555.
The income statement for the lessor reports lease revenue of $48,555. While
this amount was initially unearned, Cleveland earned that revenue through the
passing of time that the crane was leased. As a result, at the end of the year,
Cleveland makes an adjusting entry to recognize that revenue.
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS
CA 21.1 (Time 15–25 minutes)

Purpose—to provide the student with an understanding of the theoretical reasons for requiring certain leases to
be capitalized by the lessee and how a finance lease is recorded at its commencement and how the amount to
be recorded is determined. The student explains how to determine the lessee’s expenses during the first year
and how the lessee will report the lease on the balance sheet at the end of the year.

Purpose—to provide an understanding of the factors underlying the accounting for a leasing arrangement from
the point of view of both the lessee and lessor. The student is required to determine the classification of this
leasing arrangement, the appropriate accounting treatment which should be accorded this lease, and the
financial statement disclosure requirements for both the lessee and lessor.

Purpose—to provide the student with an understanding of the classification of three leases. The student
determines how the lessee should classify each lease, what amount should be recorded as a liability at the
commencement of each lease, and how the lessee should record each lease payment for each lease.

Purpose—to provide the student with an assignment to describe: (a) the accounting for a finance lease both at
commencement and during the first year and (b) the accounting for an operating lease. The student is also
required to compare and contrast a sales-type lease with a direct-financing lease.

Purpose—to provide the student with a lease arrangement with a bargain-purchase option in order to examine
the ethical issues of lease accounting.

Purpose—to develop a memo to your audit supervisor to discuss: (a) why you inspected the lease agreement,
(b) what you determined about the lease, and (c) how you advised your client to account for the lease. As part
of the discussion you are required to make the journal entry necessary to record the lease property.
*CA 21.7 (Time 15–25 minutes)

Purpose— The student is required to discuss the accounting issues related to a sale-leaseback.
CA 21.1
(a) The FASB believes that the reporting of an asset and liability for a lease arrangement is
consistent with the conceptual framework definition of assets and liabilities. That is, assets are
probable future economic benefits obtained or controlled by a particular entity as a result of past
transactions or events. Liabilities are probable future sacrifices of economic benefits arising
from present obligations of a particular entity to transfer assets or provide services to other
entities in the future as a result of past transactions or events.
It follows that if the lease transfers control of the underlying asset to a lessee, then the lease is
classified as a finance lease; all other leases are classified as operating leases. In an operating
lease, a lessee obtains the right to use the underlying asset, but not ownership of the asset
itself. Operating leases are capitalized since the right-to-use is an asset and a liability is incurred.
(b) Evans should account for this lease at its commencement as an asset and an obligation at an
amount equal to the present value at the beginning of the lease term of lease payments during
the lease term. From the information provided, this lease is a finance lease as control of the
asset belongs to Evans.
(c) Evans will incur interest expense equal to the interest rate used to capitalize the lease at its
commencement multiplied by the appropriate net carrying value of the lease liability at the
beginning of the period.
In addition, Evans will incur an expense relating to amortization of the cost of the right-of-use
asset. This amortization should be based on the lease term and amortized in a manner
consistent with Evans’ normal depreciation policy for owned assets.
(d) The right-of-use asset recorded under the finance lease should be classified on Evans’
December 31, 2020, balance sheet as noncurrent and should be separately identified by Evans
in its balance sheet or footnotes thereto. The related obligation recorded under the finance
lease should be reported on Evans’ December 31, 2020, balance sheet appropriately classified
into current and noncurrent liabilities categories and should be separately identified by Evans in
its balance sheet.
LO: 2, 4, Bloom: AN, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
CA 21.2
(a) (1) Because the present value of the lease payments is greater than 90 percent of the fair
value of the asset at commencement of the lease, Sylvan should record this as a finance
lease.
(2) Since the given facts state that Sylvan (lessee) does not have access to information that
would enable determination of Breton Leasing Corporation’s (lessor) implicit rate for this
lease, Sylvan should determine the present value of the lease payments using the
incremental borrowing rate (10 percent). This is the rate that Sylvan would have to pay for
a like amount of debt obtained through normal third party sources (bank or other direct
financing).
(3) The amount recorded as an asset on Sylvan’s books should be shown in the non-current
asset section of the balance sheet as “Right-of-Use Asset or another similar title. At the
same time as the asset is recorded, a corresponding liability (“Lease Liability” or similar
title) is recognized in the same amount. This liability is classified as both current and
noncurrent, with the current portion being that amount that will be paid on the principal
amount during the next year. The cost of the lease is matched with revenue through
amortization taken on the machine over the life of the lease. Since ownership of the
machine is not expressly conveyed to Sylvan in the terms of the lease at its
commencement, the term of the lease is the appropriate life for amortization purposes. The
lease payments represent a payment of principal and interest at each payment date.
Interest expense is computed at the rate at which the lease payments were discounted and
represents a fixed interest rate applied to the declining balance of the debt. Executory
costs (such as insurance, maintenance, or taxes) paid by Sylvan are charged to an
appropriate expense, accrual, or deferral account as incurred or paid.
(4) The lessee should make the following qualitative disclosures:

• Nature of its leases, including general description of those leases.
• How variable lease payments are determined.
• Existence and terms and conditions for options to extend or terminate the lease and
for residual value guarantees.
• Information about significant assumptions and judgments (e.g., discount rates).
In addition, the quantitative information that should be disclosed for the lessee is follows:
• Total lease cost
• Finance lease cost, segregated between the amortization of the right-of-use assets
and interest on the lease liabilities
• Operating and short-term lease cost.
• Weighted-average remaining lease term and weighted-average discount rate

(segregated between finance and operating leases).
• Maturity analysis of finance and operating lease liabilities, on an annual basis for a
minimum of each of the next five years, the sum of the undiscounted cash flows for all
years thereafter.
(b) (1) Based on the given facts, Breton has entered into a sales-type lease. The discounted
present value of the lease payments is in excess of 90 percent of the fair value of the asset
at commencement of the lease arrangement and collectibility of lease payments is
probable.
(2) Breton should record a Lease Receivable for the present value of the lease payments and
the present value of the residual value. It might be noted that since the residual value is
unguaranteed that Breton may choose to record the residual value in a separate account
and not include the residual value in the lease receivable amount. It should also remove
the machine from the books by a credit to the applicable asset account.
(3) During the life of the lease, Breton will record payments received as a reduction in the
receivable. Interest is recognized as interest revenue by applying the implicit interest rate
to the declining balance of the lease receivable. The implicit rate is the rate of interest that
will discount the sum of the payments and unguaranteed residual value to the fair value of
the machine at the date of the lease agreement. This method of income recognition is
termed the effective interest method of amortization. In this case, Breton will use the 9%
implicit rate.
(4) Breton must make the following disclosures with respect to this lease:
 Lease-related income, including profit and loss recognized at lease commencement for
sales-type, and Interest income.
 Income from variable lease payments not included in the lease receivable.
 The components of the net investment in sales-type, including the carrying amount of
the lease receivable, the unguaranteed residual asset.
 A maturity analysis for operating lease payments and a separate maturity analysis for
the lease receivable (sales-type).
Management approaches for risk associated with residual value of leased assets (e.g.,
buyback agreements or third party insurance).
CA 21.3
(a) A lease should be classified as a finance lease when it transfers substantially all of the benefits
and risks inherent to the ownership of property by meeting any one of the five tests for
classifying a lease as a finance lease.
Lease L should be classified as a finance lease because the lease term is equal to 80 percent
of the estimated economic life of the equipment, which exceeds the 75 percent test or more.
Lease M should be classified as a finance lease because the lease contains a bargain purchase
option.
Lease N should be classified as an operating lease because it does not meet any of the five
tests for classifying a lease as a finance lease.
(b) For Lease L, Santiago Company should record as a liability at the commencement of the lease
an amount equal to the present value of the lease payments during the lease term.
For Lease M, Santiago Company should record as a liability at commencement of the lease an
amount determined in the same manner as for Lease L plus the bargain purchase option should
be included in the lease payments at its present value.
For Lease N, Santiago Company should record as a liability at commencement of the lease the
present value of the lease payments.
(c) For Lease L, Santiago Company should allocate each lease payment between a reduction of
the liability and interest expense so as to produce a constant periodic rate of interest on the
remaining balance of the liability. Thus, the interest expense and amortization of the right-of-use
asset will not equal the lease payment.
For Lease M, Santiago Company should allocate each lease payment in the same manner as
for Lease L.
For Lease N, if the lease does not meet any of the lease classification tests for a finance lease, a
lessee should classify such a lease as an operating lease. For leases classified as operating, the
lessee records a right-of-use asset and lease liability at commencement of the lease, similar to the
finance lease approach. However, unlike the finance lease, the lessee records the same amount for
lease expense each period over the lease term (often referred to as the straight-line method for
expense measurement).
To accomplish the goal of achieving a single operating cost that is constant from period to period,
companies continue to use the effective interest method for amortizing the lease liability. However
instead of reporting interest expense, a lessee reports interest on the lease liability as Lease
Expense. In addition, the lessee no longer reports amortization expense related to the right-of-use
asset. Instead it “plugs” in an amount that increases the lease expense amount so that it is the
same amount from period to period. This plugged amount then reduces the right-of-use asset, such
that both the right to use asset and the lease liability are amortized to zero at the end of the lease.
LO: 2, Bloom: AN, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
CA 21.4
Part 1
(a) A lessee would account for a finance (and an operating lease) as an asset and a liability at the
commencement of the lease. For a finance lease, rental payments during the year are allocated
between a reduction in the liability and interest expense. The asset is amortized in a manner
consistent with the lessee’s normal depreciation policy for owned assets, except that in most
circumstances, the period of amortization would be the lease term.
(b) If the lease does not meet any of the lease classification tests for a finance lease, a lessee
should classify such a lease as an operating lease. For leases classified as operating, the
lessee records a right-of-use asset and lease liability at commencement of the lease, similar to
the finance lease approach. However, unlike the finance lease, the lessee records the same
amount for lease expense each period over the lease term (often referred to as the straight-line
method for expense measurement).
To accomplish the goal of achieving a single operating cost that is constant from period to
period, companies continue to use the effective interest method for amortizing the lease liability.
However instead of reporting interest expense, a lessee reports interest on the lease liability as
Lease Expense. In addition, the lessee no longer reports amortization expense related to the
right-of-use asset. Instead it “plugs” in an amount that increases the lease expense amount
so that it is the same amount from period to period. This plugged amount then reduces the
right-of-use asset, such that both the right-of-use asset and the lease liability are amortized to
zero at the end of the lease.
Part 2
(a) A lease receivable is recorded in as sales-type lease by the lessor. The lease receivable is the
present value of the lease payments plus the present value of the unguaranteed residual value
accruing to the benefit of the lessor. Under the operating method, the lessor continues to
recognize the asset on its balance sheet and recognizes equal amounts of lease revenue
(straight-line basis) in each period. In most cases, it also depreciates the leased asset on a
straight-line basis.
(b) For a sales-type lease, interest revenue is recognized over the lease term by use of the
effective interest method to produce a constant periodic rate of return on the lease receivable.
In an operating lease, the lessor recognizes lease revenue for the rent payments and
depreciates the leased asset over its economic life.
(c) In a sales-type lease, the excess of the sales price over the carrying amount of the leased
equipment is considered gross profit and would be included in income in the period when the
sales transaction is recorded. Subsequently, it also recognizes interest revenue over the life of
the lease.
In an operating lease, there is no gross profit. The revenue on the lease transaction is
composed of the rental payments.
CA 21.5
(a) The ethical issues are fairness and integrity of financial reporting versus profits and possibly
misleading financial statements. On one hand, if Buchanan can substantiate her position, it is
possible that the agreement should be considered an operating lease. On the other hand, if
Buchanan cannot or will not provide substantiation, she would appear to be trying to manipulate
the financial statements to reduce the recorded lease liability, to increase net income in the
earlier years of the lease term, and/or get straight-line lease expense reporting.
(b) If Buchanan has no particular expertise in copier technology, she has no rational case for her
suggestion. If she has expertise, then her suggestion may be rational and would not be merely
a means to manipulate the balance sheet to avoid recording a higher liability.
(c) Suffolk must decide whether the situation presents a legitimate difference of opinion where pro-
fessional judgment could take the answer either way or an attempt by Buchanan to mislead.
Suffolk must decide whether he wishes to argue with Buchanan or simply accept Buchanan’s
position. Suffolk should assess the consequences of both alternatives. Suffolk might conduct
further research regarding copier technology before reaching a decision.
LO: 4, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Professional Behavior
*CA 21.6
Memorandum Prepared by: (Your Initials)

Date:
HOCKNEY, INC.
December 31, 2020
Reclassification of Leased Auto
as a Finance Lease
While performing a routine inspection of the client’s garage, I found a used automobile which was not
listed among the company’s assets in the equipment subsidiary ledger. I asked Stacy Reeder, plant
manager, about the vehicle, and she indicated that because it was only being leased, it was not listed
along with other company assets. Having elected to account for this agreement as a short-term lease,
Hockney, Inc. had charged $3,240 to 2020 rent expense.
Examining the noncancelable lease agreement entered into with Crown New and Used Cars on
January 1, 2020, I determined that the automobile should be capitalized as a finance lease because
its lease term (2 years) is greater than 75% of its useful life (2.5 years). In addition, Hockney
guaranteed the estimated residual value at the end of the lease term, meaning the present value of
the lease payments are 100% of the fair value of the automobile.
I advised the client to capitalize this lease at the present value of its rental payments: $5,778 (the present
value of the monthly payments). After inquiring of management about the residual value expected at the
end of the lease agreement, and ensuring management’s significant judgments and assumptions were
reasonable, I determined that the expected residual value of the lease equals the guaranteed residual, and
thus none of the residual value guarantee should be included in the initial measurement of the lease liability
or right-of-use asset (as no amount is expected to be owed under the residual value guarantee). The
following journal entry to record the initial lease liability and related right-of-use asset was suggested
to management:
Right-of-Use Asset ........................................................................... 5,778

Lease Liability .......................................................................... 5,778
To account for the first year’s payments as well as to reverse the original entries, I advised the client
to make the following entry:
Lease Liability .................................................................................. 2,778

Interest Expense (8% X $5,778) ...................................................... 462
Rent Expense .......................................................................... 3,240
Finally, this vehicle must be amortized over its lease term, using the straight-line method. I computed
annual amortization of $2,889 (the initial right-of-use asset, $5,778, divided by the 2-year lease term).
The client was advised to make the following entry to record 2020 amortization:
Amortization Expense ...................................................................... 2,889

Right-of-Use Asset ................................................................... 2,889
LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Professional Behavior
*CA 21.7
(a) The major accounting issue is whether the transaction is a sale or a financing. To determine
whether it is a sale, the revenue recognition guidelines are used. That is, if control has passed
from seller to buyer then a sale has occurred. Conversely, if control has not passed from seller
to buyer the transaction is recorded as a financing (often referred to as a failed sale).
(b) (1) This transaction should be reported as a financing as control of the leased asset has not
passed from the seller to the buyer. In essence, Perriman is borrowing money from the
purchaser-lessor (often referred to as a financing or a failed sale). (2) In a financing (failed
sale), Perriman:
•does not reduce the carrying value of the building;
•continues to depreciate the building as if it was the legal owner; and
•increases cash and records a note payable.
LO: 5, Bloom: AN, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
FINANCIAL REPORTING PROBLEM
Note to instructor: P&G has not yet adopted the new lease standard; its
reporting reflects application of prior GAAP.
(a) In P&G’s Management’s Discussion and Analysis (under Contractual

Commitments), both capital leases and operating leases are disclosed.
(b) P&G reported (note 12) capital leases of $31 million in total, and $13 million
for less than 1 year (see Contractual Commitments under Management’s
Discussion and Analysis). In addition, P&G has a significant amount of
operating leases totaling $1,493 million.
(c) P&G in note 12 disclosed future minimum rental commitments under

noncancelable operating leases in excess of one year as of June 30, 2017,
of:
2018—$261 million
2019—$273 million
2020—$237 million
2021—$194 million
2022—$160 million
2023 and beyond—$368 million
Note: The notes to the financial statements and MD&A are not included in
Appendix B. It can be accessed at P&G’s corporate site.
LO: 2, 4, Bloom: AN, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Measurement Analysis and Interpretation,
Reporting, Research, AICPA PC: Communication
COMPARATIVE ANALYSIS CASE
Note to instructor: Southwest and Delta have not yet adopted the new lease
standard; their reporting reflects application of prior GAAP.
(a) Southwest uses both capital leases and long-term operating leases.
Southwest primarily leases aircraft and some terminal space.
(b) Southwest has some long-term leases that don’t expire until after 2022 and
in many cases the leases can be renewed. Most aircraft leases have
purchase options at or near the end of the lease term at fair market value,
generally limited to a stated percentage of the lessor’s defined cost of the
aircraft.
(c) Future minimum commitments under noncancelable leases are set forth
below (in millions):
Operating
(after
Capital Operating subleases)
2018 .................................................... $107 $ 359 $257
2019 .................................................... 106 331 233
2020 .................................................... 105 364 186
2021 .................................................... 100 155 114
2022 .................................................... 96 85 98
Later years ......................................... 416 177 169
$930 $1,471 1,057
(d) At year-end 2017, the present value of minimum lease payments under
capital leases was $780 million. Imputed interest deducted from the future
minimum annual rental commitments was $150 million.
(e) The details of rental expense are set forth below:
2017 2016 2015

$939 $932 $909
(f) The main difference between Southwest and Delta is that Delta is leasing
more types of assets compared to Southwest. In addition to aircraft and
terminal space, Delta is leasing airport terminals maintenance facilities, ticket
offices, and other property and equipment.
LO: 2, 4, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Measurement Analysis and Interpretation,
Reporting, Research, AICPA PC: Communication
FINANCIAL STATEMENT ANALYSIS CASE
Note to instructor: Wal-Mart has not yet adopted the new lease accounting
standard; its reporting reflects application of prior GAAP.
($ millions)
(a) The total obligations under capital leases at 1/31/2018 for Wal-Mart Company is
$7,447 [Current: $667 + Noncurrent: $6,780] (the present value of the future
lease payments).
(b) The total rental expense for Wal-Mart in fiscal 2017 (ending 1/31/2018) was
$2.9 billion.
(c) The present value of minimum lease payments related to capital lease and
financial obligation is 7.447 million.
LO: 2, 4, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement Analysis and Interpretation, Reporting,
Research, AICPA PC: None
ACCOUNTING, ANALYSIS, AND PRINCIPLES
Accounting
(a) There are five lease capitalization tests. They are (1) transfer of ownership,
(2) bargain-purchase option, (3) the lease term is 75% or more of the economic
life of the leased asset, (4) the present value of the lease payments is 90% or
more of the leased asset’s fair value, and (5) alternative use test.
This lease does not transfer ownership. The option to purchase at the end of
the lease is clearly not a bargain. The lessor has an alternative use for the
computers at the end of the lease. The lease term is (3 ÷ 5) = 0.6 or 60% of the
economic life, so the economic life test is not met. The recovery of investment
test is as follows:
= $3,057.25 X (PVF-AD3,12)
= ($3,057.25 X 2.69005)
= $8,224.16.
Present value of lease payments as % of fair value
= $8,224.16 ÷ $10,000 = 0.8224 or 82.24 percent.
Therefore, the present value test is not met either. Consequently, this lease is
accounted for as an operating lease. Therefore, Salaur makes the following
journal entries at the commencement date.
1/1/20
Right-of-Use Asset ...................... 8,224.16

Lease Liability ...................... 8,224.16
Lease Liability .............................. 3,057.25

Cash ...................................... 3,057.25
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued)
SALAUR COMPANY
Annuity-Due Basis
Reduction
Annual Interest (12%) of Lease
Date Payment on Liability Liability Lease Liability
1/1/20 $8,224.16
1/1/20 $3,057.25 $ 0 $3,057.25 5,166.91
1/1/21 3,057.25 620.03 2,437.22 2,729.69
1/1/22 3,057.25 327.56 2,729.69 0
(B) (C)
(A) Interest (12%) Amortization of Carrying Value
Straight-Line on Lease ROU Asset of ROU Asset
Date Expense Liability (A-B)
1/1/20 $8,224.16
12/31/20 $3,057.25 $ 620.03 $2,437.22 5,786.94
12/31/20 3,057.25 327.56 2,729.69 3,057.25
12/31/21 3,057.25 0 3,057.25 0
The entry to record lease expense in 2020 is as follows.
12/31/20
Lease Expense............................. 3,057.25

Right-of-Use Asset ............... 2,437.22
Lease Liability ...................... 620.03
(b) With the bargain purchase option, the lease is now classified as a finance
lease. Salaur computes the lease liability and right-of-use asset, as follows.

= $3,057.25 X (PVF-AD3,12)
= ($3,057.25 X 2.69005)
= $8,224.16
Present value of bargain purchase option
= $100 X (PV3,12)
= ($100 X .7118) = 71.18
$8,295.34
Salaur makes the following entries at lease commencement.
1/1/20
Right-of-Use Asset................................................ 8,295.34

Lease Liability ............................................... 8,295.34
Lease Liability ....................................................... 3,057.25

Cash ............................................................... 3,057.25
SALAUR COMPANY
Annual Lease Interest Reduction

Payment Plus (12%) on of Lease Lease
Date BPO Liability Liability Liability
1/1/20 $8,295.34
1/1/20 $ 3,057.25 $ 0 $ 3,057.25 5,238.09
1/1/21 3,057.25 628.57 2,428.68 2,809.41
1/1/22 3,057.25 337.13 2,720.12 89.29
1/1//23 100.00 10.71 89.29 0
$9,271.75 $976.41 $8,295.34
12/31/20
Interest Expense ................................................... 628.57

Lease Liability ............................................... 628.57

Right-of-Use Asset
($8,295.34 ÷ 5) ............................................ 1,659.07
Note that the right-of-use asset is amortized over the economic life (5 years) of
the asset, as Salaur is expected to purchase the computers at the end of the
lease.
Analysis
While all leases with terms longer than one year are capitalized (recorded on the
balance sheet), the amounts differ depending on whether the lease is classified
as a finance or operating lease. As indicated in the entries above, the right-of-
use asset increases and the denominator of the return on assets ratio (ROA =
Net income ÷ Average assets) will increase, but by different amounts (generally
by more with a finance lease, and by higher amounts in the early years of a
finance lease). The classification tests are designed such that leases that
represent an in-substance purchase, will increase the denominator more, which
is more representative of the transaction. Similarly, the debt to assets ratio (Total
debt ÷ Total assets) will reflect the obligations, according the non-cancellable
payments required in the lease.
This reporting is in contrast to prior GAAP, under which many operating leases
were not capitalized, which gave the impression that companies with operating
leases looked more profitable and more solvent than is really the case. If
companies capitalize differing percentages of their leases, it will be difficult to
compare the companies based on ROAs and debt to total asset ratios.
Principles
The fundamental quality is faithful representation. The lease criteria are

designed to report leases according to their economic substance. Thus, if
through a lease arrangement a company has control of the leased asset (whether
classified as finance or operating), it meets the definition of an asset and should
be recognized on the balance sheet. Similarly, the associated liability should be
recognized if it represents an unavoidable obligation and thereby meets the
definition of a liability. That is, the financial statements faithfully represent
(completeness) if they report all assets and liabilities of the company.
Note to instructor: Under prior GAAP, companies could structure a lease to avoid
capitalization, which detracts from representational faithful reporting of the lease
arrangement, which may not be neutral.
LO: 2, 4, Bloom: SYN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
CODIFICATION EXERCISES
CE21.1
Master Glossary
(a) Commencement date of the lease (commencement date) is the date on which a lessor
makes an underlying asset available for use by a lessee.
(b) The incremental borrowing rate is the rate of interest that a lessee would have to pay to
borrow on a collateralized basis over a similar term an amount equal to the lease payments in a
similar economic environment.
(c) Unguaranteed residual asset is amount that a lessor expects to derive from the underlying
asset following the end of the lease term that is not guaranteed by the lessee or any other third
party unrelated to the lessor, measured on a discounted basis.
(d) Variable lease payments are payments made by a lessee to a lessor for the right to use an
underlying asset that vary because of changes in facts or circumstances occurring after the
commencement date, other than the passage of time.
LO: 2, 4, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, Research, Technology and Tools, AICPA PC:
Communication
CE21.2
According to FASB ASC 842-10-30-5 to 6: Initial Measurement of the Lease Payments
At the commencement date, the lease payments shall consist of the following payments relating to the
use of the underlying asset during the lease term:
• Fixed payments, including in substance fixed payments, less any lease incentives paid or payable to
the lessee (see paragraphs 842-10-55-30 through 55-31).
• Variable lease payments that depend on an index or a rate (such as the Consumer Price Index or a
market interest rate), initially measured using the index or rate at the commencement date.
• The exercise price of an option to purchase the underlying asset if the lessee is reasonably certain
to exercise that option (assessed considering the factors in paragraph 842-10-55-26).
• Payments for penalties for terminating the lease if the lease term (as determined in accordance
with paragraph 842-10-30-1) reflects the lessee exercising an option to terminate the lease.
• Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction.
However, such fees shall not be included in the fair value of the underlying asset for purposes of
applying paragraph 842-10-25-2(d).
• For a lessee only, amounts probable of being owed by the lessee under residual value guarantees
(see paragraphs 842-10-55-34 through 55- 36).
Lease payments do not include any of the following:
• Variable lease payments other than those in paragraph 842-10-30-5(b)
• Any guarantee by the lessee of the lessor’s debt
• Amounts allocated to nonlease components in accordance with paragraphs 842-10-15-33
through 15-42.
Communication
CODIFICATION EXERCISES (Continued)
CE21.3
According to 842-20-50-3 (Disclosure):
A lessee shall disclose all of the following:

a. Information about the nature of its leases, including:
1. A general description of those leases.
2. The basis and terms and conditions on which variable lease payments are determined.
3. The existence and terms and conditions of options to extend or terminate the lease. A lessee should
provide narrative disclosure about the options that are recognized as part of its right-of-use assets
and lease liabilities and those that are not.
4. The existence and terms and conditions of residual value guarantees provided by the lessee.
5. The restrictions or covenants imposed by leases, for example, those relating to dividends or incurring
additional financial obligations. A lessee should identify the information relating to subleases included
in the disclosures provided in (1) through (5), as applicable.
b. Information about leases that have not yet commenced but that create significant rights and obligations for
the lessee, including the nature of any involvement with the construction or design of the underlying asset.
c. Information about significant assumptions and judgments made in applying the requirements of this Topic,
which may include the following:
1. The determination of whether a contract contains a lease (as described in paragraphs 842-10-15-2
through 15-27)
2. The allocation of the consideration in a contract between lease and nonlease components (as
described in paragraphs 842-10-15-28 through 15-32).
3. The determination of the discount rate for the lease.
842-20-50-4 For each period presented in the financial statements, a lessee shall disclose the following
amounts relating to a lessee’s total lease cost, which includes both amounts recognized in profit or loss during
the period and any amounts capitalized as part of the cost of another asset in accordance with other
Topics, and the cash flows arising from lease transactions:
a. Finance lease cost, segregated between the amortization of the right-of-use assets and interest on
the lease liabilities.
b. Operating lease cost determined in accordance with paragraphs 842-20-25-6(a) and 842-20-25-7.
c. Short-term lease cost, excluding expenses relating to leases with a lease term of one month or
less, determined in accordance with paragraph 842-20-25-2.
d. Variable lease cost determined in accordance with paragraphs 842-20-25-5(b) and 842-20-25-6(b).
e. Sublease income, disclosed on a gross basis, separate from the finance or operating lease expense.
f. Net gain or loss recognized from sale and leaseback transactions in accordance with paragraph 842-
40-25-4.
g. Amounts segregated between those for finance and operating leases for the following items:
1. Cash paid for amounts included in the measurement of lease liabilities, segregated between
operating and financing cash flows
2. Supplemental noncash information on lease liabilities arising from obtaining right-of-use
assets
3. Weighted-average remaining lease term
4. Weighted-average discount rate.
Communication
CE21.4
According to FASB ASC 842-30-35-1 > Sales-Type and Direct Financing Leases
After the commencement date, a lessor shall measure the net investment in the lease by doing
both of the following:
a. Increasing the carrying amount to reflect the interest income on the net investment in the
lease. A lessor shall determine the interest income on the net investment in the lease in each
period during the lease term as the amount that produces a constant periodic discount rate on
the remaining balance of the net investment in the lease.
b. Reducing the carrying amount to reflect the lease payments collected during the period.
842-30-35-2 After the commencement date, a lessor shall not remeasure the net investment in the
lease unless the lease is modified and that modification is not accounted for as a separate contract
in accordance with paragraph 842-10-25-8.
Communication
CODIFICATION RESEARCH CASE
(a) According to FASB ASC 842-20-30-1 (Initial Measurement – General):
1. At the commencement date, a lessee shall measure the lease liability at

the present value of the lease payments not yet paid, discounted using
the discount rate for the lease at lease commencement (as described
in paragraphs 842-20-30-2 through 30-4).
2. According to 842-20-30-5 (Initial Measurement of the Right-of-Use
Asset), at the commencement date, the cost of the right-of-use asset
shall consist of all of the following:
a. The amount of the initial measurement of the lease liability
b. Any lease payments made to the lessor at or before the
commencement date, minus any lease incentives received
c. Any initial direct costs incurred by the lessee (as described in
paragraphs 842-10-30-9 through 30-10).
(b) According to the FASB ASC 842-10-30-1 to 3 (Lease Term and Purchase
Options), an entity shall determine the lease term as the noncancellable
period of the lease, together with all of the following:
a. Periods covered by an option to extend the lease if the lessee is
reasonably certain to exercise that option
b. Periods covered by an option to terminate the lease if the lessee is
reasonably certain not to exercise that option
c. Periods covered by an option to extend (or not to terminate) the lease in
which exercise of the option is controlled by the lessor.
842-10-30-2 At the commencement date, an entity shall include the periods

described in paragraph 842-10-30-1 in the lease term having considered all
relevant factors that create an economic incentive for the lessee (that is,
contract-based, asset-based, entity-based, and market-based factors).
Those factors shall be considered together, and the existence of any one
factor does not necessarily signify that a lessee is reasonably certain to
exercise or not to exercise an option.
842-10-30-3 At the commencement date, an entity shall assess an option to

purchase the underlying asset on the same basis as an option to extend or
not to terminate a lease, as described in paragraph 842-10-30-2.
CODIFICATION RESEARCH CASE (Continued)
(c) According to FASB ASC 842-10-25-8 (Lease Modifications), An entity shall

account for a modification to a contract as a separate contract (that is,
separate from the original contract) when both of the following conditions
are present:
a. The modification grants the lessee an additional right of use not included
in the original lease (for example, the right to use an additional asset).
b. The lease payments increase commensurate with the standalone price
for the additional right of use, adjusted for the circumstances of the
particular contract.
For example, the standalone price for the lease of one floor of an office
building in which the lessee already leases other floors in that building may
be different from the standalone price of a similar floor in a different office
building, because it was not necessary for a lessor to incur costs that it
would have incurred for a new lessee.
LO: 1, 2, 4, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, Research, Technology and
Tools, AICPA PC: Communication
IFRS CONCEPTS AND APPLICATION
IFRS21.1
The IFRS leasing standard is IFRS 16, issued in January, 2016.

LO: 8, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Global, Communication, AICPA BB: Global and Industry Perspectives, AICPA FC: Reporting, AICPA PC:
Communication
IFRS21.2
The following are similarities and differences between lease accounting under
IFRS and U.S. GAAP.
Similarities
• Both GAAP and IFRS share the same objective of recording leases by
lessees and lessors according to their economic substance—that is,
according to the definitions of assets and liabilities.
• Much of the terminology for lease accounting in IFRS and GAAP is the same.
• Both GAAP and IFRS require lessees to recognize a right-of-use asset and
related lease liability for leases with terms longer than one year.
• Under both IFRS and GAAP, lessors use the same general lease
classification criteria to determine if there is transfer of control of the
underlying asset and if lessors classify leases as sales-type or operating.
• GAAP and IFRS use the same lessor accounting model for leases classified
as sales-type or operating.
• GAAP and IFRS have similar qualitative and quantitative disclosure
requirements for lessees and lessors.
Differences
• There is no classification test for lessees under IFRS 16. Thus, lessees
account for all leases using the finance lease method; that is, leases
classified as operating leases under GAAP will be accounted for differently
compared to IFRS.
• IFRS allows alternative measurement bases for the right-of-use asset (e.g.,
the revaluation model, in accordance with IAS 16, Property, Plant and
Equipment).
IFRS21.2 (Continued)
• In addition to the short term lease exception, IFRS has an additional lessee
recognition and measurement exemption for leases of assets of low value
(e.g., personal computers, small office furniture).
• IFRS does not include any explicit guidance on collectibility of the lease
payments by lessors and amounts necessary to satisfy a residual value
guarantee.
• IFRS does not distinguish between sales-type and direct financing leases for
lessors. Therefore, IFRS 16 permits recognition of selling profit on direct
financing leases at lease commencement.
• IFRS applies to leases of any asset, whether its tangible plant property or
intangible assets. GAAP applies only to tangible plant property
• IFRS uses the same model for leases for both lessees and lessors, whereas
GAAP uses a different model for lessees and lessors.
LO: 8, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Global, Communication, AICPA BB: Global and Industry Perspectives, AICPA FC: Reporting, AICPA PC:
Communication
IFRS21.3
Under the finance lease method, the lessee treats the right-of-use asset as if the
asset were being purchased on an installment basis: a financial transaction in
which an asset is acquired and an obligation is created. The asset and the
obligation are stated in the lessee’s balance sheet at the present value of the
lease payments during the lease term, using the lessor’s implicit rate unless the
implicit rate cannot be determined (then use the incremental borrowing rate). The
effective-interest method is used to allocate each lease payment between a
reduction of the lease obligation and interest expense. The right-of-use asset is
depreciated in a manner consistent with the lessee’s normal depreciation policy
on assets owned.
LO: 8, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Global, Communication, AICPA BB: Global and Industry Perspectives, AICPA FC: Measurement Analysis
and Interpretation, Reporting, AICPA PC: Communication
IFRS21.4
12/31/20
Interest Expense [($300,000 – $48,337) X 8%].............. 20,133

Lease Liability ........................................................ 20,133

Accumulated Depreciation—Right-of-Use Asset
($300,000 ÷ 8) .................................................... 37,500
IFRS21.5
1/1/21
Lease Liability ($20,133 + $28,204) ............................... 48,337

Cash ....................................................................... 48,337
IFRS21.6
(a) The present value of the lease payments for purposes of classifying the
lease is computed as follows:
PV of Monthly payment of $200 for 50 months

[$200 X 44.36350*].............................................. $8,873
*Present value of an annuity due of 1 for 50 periods at 0.5%
(b) Right-of-Use Asset .................................................... 8,873

Lease Liability..................................................... 8,873
(c) Lease Liability ........................................................... 200

Cash .................................................................... 200
(d) Lease Liability ........................................................... 157

Interest Expense (0.5% X [$8,873 – $200]) ............... 43
Cash .................................................................... 200
(e) Depreciation Expense ............................................... 177

Accumulated Depreciation—Right-of-Use
Asset ($8,873 ÷ 50 months) ............................ 177
LO: 8, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
IFRS21.7
The present value of the lease payments (right-of-use asset) is computed as

follows.
$150,955 X 2.83339* = $427,714
* Present value of an annuity due of 1 for 3 periods at 6%
(a) Lessee Entries for 2020:

1/1/20
Lease Liability ................................ 427,714
Lease Liability............................................ 150,955

Cash................................................ 150,955
St. Ledger prepares the following amortization schedule.
ST. LEDGER INCORPORATED

Annuity-Due Basis
Reduction
1/1/20 $427,714
1/1/20 $150,955 $ 0 150,955 276,759
12/31/20 150,955 16,606 134,349 142,410
12/31/21 150,955 8,545 142,410 0
12/31/20
Interest Expense ...................................................... 16,606
Lease Liability .................................................. 16,606

Accumulated Depreciation—
Right-of-Use Asset ($427,714 ÷ 3) ............... 142,571
(b) Under the short-term lease election, St. Ledger will not need to record the
right-of-use asset or lease liability on its books. Instead, the company can simply
expense lease payments as they are paid. If the lease payment occurred at the
commencement of the lease, St. Ledger would record the payment as a lease
expense.
1/1/20
Lease Expense ......................................................... 150,955
Cash .................................................................. 150,955
(c) Lessor Entries for 2020:
1/1/20
Machine .................................................................... 900,000
Cash .................................................................. 900,000
Cash .......................................................................... 150,955

Unearned Lease Revenue ................................ 150,955
12/31/20
Unearned Lease Revenue ....................................... 150,955
Lease Revenue ................................................. 150,955

Accumulated Depreciation -
Leased Asset ($900,000 ÷ 8) ....................... 112,500
Overall from the leased asset, Young Co. will report $38,455 ($150,955 –
$112,500) for 2020 when netting the lease revenue with depreciation expense.
IFRS21.8
(a) (1) According to IFRS 16, (paragraphs 26-28), a lessee shall measure the
lease liability at the present value of the lease payments that are not paid at
that date. The lease payments shall be discounted using the interest rate
implicit in the lease, if that rate can be readily determined. If that rate cannot
be readily determined, the lessee shall use the lessee’s incremental
borrowing rate.
The lease payments included in the measurement of the lease liability

comprise the following payments for the right to use the underlying asset
during the lease term that are not paid at the commencement date:
(a) fixed payments less any lease incentives receivable;
(b) variable lease payments that depend on an index or a rate, initially
measured using the index or rate as at the commencement date;
(c) amounts expected to be payable by the lessee under residual value
guarantees;
(d) the exercise price of a purchase option if the lessee is reasonably
certain to exercise that option; and
(e) payments of penalties for terminating the lease, if the lease term
reflects the lessee exercising an option to terminate the lease.
Variable lease payments that depend on an index or a rate described in

paragraph 27(b) include, for example, payments linked to a consumer price
index, payments linked to a benchmark interest rate (such as LIBOR) or
payments that vary to reflect changes in market rental rates.
(2) (paragraphs 23-24) Initial measurement of the right-of-use asset shall

comprise:
(a) the amount of the initial measurement of the lease liability;
(b) any lease payments made at or before the commencement date, less
any lease incentives received;
(c) any initial direct costs incurred by the lessee; and
(d) an estimate of costs to be incurred by the lessee in dismantling and
removing the underlying asset, restoring the site on which it is located
or restoring the underlying asset to the condition required by the terms
and conditions of the lease, unless those costs are incurred to produce
inventories. The lessee incurs the obligation for those costs either at
the commencement date or as a consequence of having used the
underlying asset during a particular period.
(b) According to IFRS 16 (paragraphs 18-19), an entity shall determine the lease
term as the non-cancellable period of a lease, together with both:
1. periods covered by an option to extend the lease if the lessee is reasonably

certain to exercise that option; and
2. periods covered by an option to terminate the lease if the lessee is
reasonably certain not to exercise that option.
In assessing whether a lessee is reasonably certain to exercise an option to

extend a lease, or not to exercise an option to terminate a lease, an entity shall
consider all relevant facts and circumstances that create an economic incentive
for the lessee to exercise the option to extend the lease, or not to exercise the
option to terminate the lease.
(c) IFRS 16 (paragraph 44) indicates that a lessee shall account for a lease
modification as a separate lease if both:
(a) the modification increases the scope of the lease by adding the right to
use one or more underlying assets; and
(b) the consideration for the lease increases by an amount commensurate
with the stand-alone price for the increase in scope and any appropriate
adjustments to that stand-alone price to reflect the circumstances of the
particular contract.
LO: 8, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Analytic, Global, Communication, AICPA BB: Global and Industry Perspectives, AICPA FC: Reporting,
Research, Technology, AICPA PC: Communication
IFRS21.9
(a) M&S uses both finance leases and operating leases.
(b) M&S reported finance leases of £48.6 million in total, and £.4 million for less
than 1 year, £1.6 million for more than 1 year and less than 5 years, and
£46.7 million for more than 5 years.
(c) M&S disclosed future minimum rentals (in millions) under non-cancelable
operating lease agreements as of 1 April 2017, of:
Within one year ................................................................. £ 342.0

Later than one year and not later than five years ........... 1,115.9
Later than five years and not later than ten years .......... 964.1
Later than ten years and not later than 15 years ............ 421.9
Later than 15 years and not later than 20 years .............. 285.3
Later than 20 years and not later than 25 years .............. 166.8
Later than 125 years .......................................................... 1,069.5
Total ................................................................................... £4,365.5
LO: 8, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, Global, Communication, AICPA BB: Global and Industry Perspectives, AICPA FC: Reporting,
Research, Technology and Tools, AICPA PC: Communication

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CHAPTER 21

Accounting for Leases

ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)

1. Rationale for leasing. 1, 2, 3

3. Finance / Sales – 16, 18, 19, 1, 2, 3, 4, 2, 3, 4, 1, 2, 3, 4, 2, 4, 5

5. Special Issues 9, 10, 12, 4, 8, 9, 20, 1, 2, 3, 4,5, 1, 2, 3, 4, 1, 2, 3, 4,

*6. Sale-leaseback. 32, 33 29, 30 23, 24 7

*7. Direct financing 34, 35, 36 31, 32 25

*This material is dealt with in an Appendix to the chapter.

2. Explain the accounting 16, 18, 19, 1, 2, 3, 4, 6, 2, 3, 4, 5, 1, 2, 3, 5, 2, 4, 7, 5

4. Discuss the accounting 9, 10, 12, 4, 8, 9, 20, 1, 2, 3, 4, 1, 2, 3, 5, 1, 2, 3, 4,

*5. Describe the lessee’s 32, 33 29, 30 23, 24 7

*6 Describe the lessor’s 34, 35, 36 31, 32 25

*This material is dealt with in an Appendix to the chapter.

2. (a) Possible advantages of leasing for the lessee:

3. Possible advantages of leasing for a lessor:

5. The five classification tests are the following:

BRIEF EXERCISE 21.1

*Present value of an annuity due of 1 for 5 periods at 6%.

BRIEF EXERCISE 21.2

Economic Life Test

Present Value Test

*Present value of an annuity due of 1 for 5 periods at 5%.

BRIEF EXERCISE 21.4

BRIEF EXERCISE 21.5

BRIEF EXERCISE 21.6

Lease Liability ................................................................ 41,933

*Present value of an annuity due of 1 for 4 periods at 8%.

Amortization Expense ................................................... 37,500

BRIEF EXERCISE 21.7

Amortization Expense ................................................... 37,500

BRIEF EXERCISE 21.8

Fair value of leased asset $70,000

Amount of equal annual lease payments ($67,499 ÷ 6.74664**) $10,005

*Present value of 1 for 9 periods at 8%.

Fair value of leased asset $47,000

Amount of equal annual lease payments ($23,237 ÷ 3.46511***) $6,706

BRIEF EXERCISE 21.10

Lease Receivable (4.99271* X $30,044) ........................ 150,001

Cash ................................................................................ 30,044

*Present value of an annuity due of 1 for 6 periods at 8%.

BRIEF EXERCISE 21.11

Cash ................................................................................ 30,044

Lease Receivable ($40,800 X 4.31213*) ........................ 175,935

Cash ................................................................................ 40,800

*Present value of an annuity due of 1 for 5 periods at 8%.

BRIEF EXERCISE 21.13

Cash ................................................................................ 40,800

BRIEF EXERCISE 21.14

Lease Receivable ........................................................... 57

Right-of-Use Asset (2.83339* X $23,000) ...................... 65,168

*Present value of an annuity due of 1 for 3 periods at 6%.

Lease Liability ................................................................ 23,000

BRIEF EXERCISE 21.16

Right-of-Use Asset (2.83339* X $35,000) ...................... 99,169

Lease Liability ................................................................ 35,000

*Present value of an annuity due of 1 for 3 periods at 6%.

BRIEF EXERCISE 21.17

Depreciation Expense ................................................... 25,000

Right-of-Use Asset (2.78326* X $12,000) ...................... 33,399

*Present value of an annuity due of 1 for 3 periods at 8%.

Lease Liability ................................................................ 12,000

BRIEF EXERCISE 21.19

Depreciation Expense ................................................... 6,000

PV of rentals ($40,000 X 5.21236) $208,494

PV of rentals ($5,300 X 6.20637) $32,894