Chapter 11

Leases

True / False Questions

1. Under IFRS 16, a lessee's debt to equity ratio and rate of return on assets are both affected by
a lease on its commencement.

True False

2. Under IFRS 16, finance leases are agreements that are formulated outwardly as leases for
lessors, but are installment purchases in substance.

True False

3. The use of proportion of the lease term over the remaining economic life to classify a lease as
a finance lease for a lessor is consistent with the basic premise that most of the risks and
rewards of ownership occur during the first say 75% of an asset's life.

True False

4. In accounting for leases under IFRS 16, usually it is either the lessee or the lessor (but not
both) who will recognize amortization on the leased asset.

True False

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5. If the underlying 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, then it must be considered to be an operating
lease.

True False

6. A bargain purchase option is defined as the option of purchasing leased property at a price
that is equal to the expected fair value of a leased asset.

True False

7. When the lessee guarantees an estimated residual value of $75,000, the amount the lessee
records as a right-of-use asset and as a lease liability is increased by $75,000.

True False

8. If the lessee is expected to take ownership of a leased asset at the end of the lease term, the
lessor must use an estimated residual value when calculating the lease payments necessary to
achieve a desired rate of return.

True False

9. On a transaction that qualifies for sale-leaseback accounting, any gain on the "sale" portion of
the transaction is recognized immediately.

True False

10. At the inception of a lease, if it is reasonably certain that the lessee will exercise an option to
renew a lease, the lease term is the noncancelable period plus the renewal period for both the
lessee and the lessor.

True False

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Matching Questions

11. Listed below are five terms followed by a list of phrases that describe or characterize five of
the terms. Match each phrase with the most correct term by placing the letter designating
that term in the space provided.

1. Present value of
outstanding lease Accounting for these by lessors is
payments based on substance over form. ____
The amount capitalized by the
2. Capital leases lessee. ____
3. Bargain purchase option Lease expense. ____
Reduces the lessor's lease
4. Executory costs payment calculation. ____
5. Depreciable assets Leasehold improvements. ____

12. Listed below are five terms followed by a list of phrases that describe or characterize five of
the terms. Match each phrase with the most correct term by placing the letter designating
that term in the space provided.

Rent payments plus lessee-guaranteed

1. Sale-leaseback and third-party-guaranteed residual
payments value. ____
2. Short-term lease Residual value. ____
3. Sales-type lease Leases of twelve months or less. ____
4. Lessee's The amount paid to retain use of the
guarantee asset after sale. ____
5. Lessor's minimum
lease receipts Marketing tool for lessor. ____

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13. Listed below are five terms followed by a list of phrases that describe or characterize five of
the terms. Match each phrase with the most correct term by placing the letter designating
that term in the space provided.

Deducted in lessor's computation of rental

1. Net method payments. ____
Periodic rent payments plus amount
2. Lessor's net expected to be payable under lessee-
investment guaranteed residual value. ____
PV of minimum lease payments plus PV of
3. Gross method unguaranteed residual value. ____
4. Lessee's lease Lease payable equals PV of minimum lease
liability payments. ____
5. PV of BPO Lease receivable equals sum of minimum
price lease payments. ____

14. Listed below are five terms followed by a list of phrases that describe or characterize five of
the terms. Match each phrase with the most correct term by placing the letter designating
that term in the space provided.

Typically used by lessor but not

1. Requires disclosure only lessee ____
2. Bargain purchase option Contingent rentals. ____
3. Depreciation period over
useful life Title transfers to lessee. ____
4. Additional conditions for
lessor in nonoperating Consistent with the realization
leases principle. ____
Purchase price sufficiently less
than the expected fair value when
5. Gross method exercised. ____

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15. Listed below are five terms followed by a list of phrases that describe or characterize five of
the terms. Match each phrase with the correct term by placing the letter designating the best
term in the space provided by the phrase.

Identified as either the implicit

1. Additional loan in a sale- rate or lessee's incremental
leaseback transaction borrowing rate. ____
Accounted for essentially as
2. Interest expense operating leases by lessees. ____
3. Upfront lease payment in
a sale-leaseback Fair value is lower than selling
transaction price. ____
Calculated as effective rate
4. Low-value leases times balance. ____
Fair value is higher than selling
5. Discount rate price. ____

Multiple Choice Questions

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16. The costs that (a) are associated directly with consummating a lease, (b) are essential to
acquire the lease, and (c) would not have been incurred had the lease agreement not
occurred, are referred to as initial direct costs. Initial direct costs incurred by the lessee are
______.

A. added to the right-of-use asset and expensed over an amortization period

B. recorded as an expense at the beginning of the lease

C. deferred in a lease until the asset is returned to the lessor

D. a reduction to the lease liability at the beginning of the lease

17. N Corp. entered into a nine-year finance lease on a warehouse on December 31, 2018. Lease
payments of $26,000, which includes maintenance services of $1,000, are due annually,
beginning on December 31, 2019, and every December 31 thereafter. N does not know the
interest rate implicit in the lease; N's incremental borrowing rate is 9%. The rounded present
value of an ordinary annuity for nine years at 9% is 6.0. What amount should N report as
recorded lease liability on December 31, 2018?

A. $150,000

B. $156,000

C. $225,000

D. $234,000

18. If the lessee and lessor use different interest rates to account for a finance/sales-type lease,
then ______.

A. the lessee is unaware of the lessor's implicit rate

B. total expenses for the lessee will equal the lessor's total revenues

C. IFRS has been violated by at least one party

D. the lessee will report more net income for the year

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19. M Corp. recorded a lease in February of Year 1 using an annuity due present value table. The
company's statement of cash flows for the year ending December 31, Year 1 using the direct
method will report ______.

A. a cash inflow from investing activities

B. a cash outflow from financing activities

C. a cash outflow from investing activities

D. a cash inflow from operating activities

20. J Corp. is a lessee that entered into a lease in February of Year 1. How will the principal portion
of J Corp.'s lease payment show up in the company's statement of cash flows for the year
ending December 31, Year 1?

A. a cash outflow from investing activities

B. a cash outflow from financing activities

C. a cash outflow from operating activities

D. no cash outflow

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21. On December 31, 2018, B Corp. sold a machine to Royal and simultaneously leased it back for
one year. The sale meets the requirements of IFRS 15. Pertinent information at this date
follows:

Sales price $800,000

Fair value 720,000

Book value 660,000

Present value of lease rentals ($6,000 for twelve months at 12%) 68,200

Estimated remaining useful life Twelve years

In B's December 31, 2018 balance sheet, the recognized gain from the sale of this machine
should be ______.

A. $0

B. $54,317

C. $60,000

D. $140,000

22. In an eight-year finance lease, the portion of the annual lease payment that represents
interest in the lease's third year payment is ______.

A. the same as in the fourth year

B. the same as in the first year

C. less than in the second year

D. more than in the second year

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23. Damon is the lessee in connection with a finance lease. Damon will not record ______.

A. depreciation expense

B. amortization expense

C. interest expense

D. a right-of-use asset

24. Red Co. recorded a right-of-use asset of $100,000 in a ten-year finance lease. Payments of
$16,275 are made annually at the end of each year. The interest rate charged by the lessor
was 10%. The balance in the lease payable after two years will be ______.

A. $80,000

B. $86,823

C. $116,309

D. $121,000

25. We classify a lease as a finance lease if ______.

A. the present value of lease payments is less than the asset's book value

B. the present value of lease payments is less than the asset's fair value

C. the lessee obtains control of the use of the asset

D. the usual risks and rewards are retained by the lessor

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26. Karla Salons leased equipment from Smith Co. on July 1, 2018 in a finance lease. The present
value of the lease payments discounted at 10% was $80,000. Ten annual lease payments of
$12,000 are due each year beginning July 1, 2018. Smith Co. had constructed the equipment
recently for $66,000, and its retail fair value was $80,000.

What amount did Smith Co. record in its income statement for the reporting year ending
December 31, 2018, in connection with the lease? (ignore taxes.)

A. $3,400

B. $14,000

C. $17,400

D. $20,800

27. Cady Salons leased equipment from Smith Co. on January 1, 2018 in a lease. The present value
of the lease payments discounted at 10% was $80,000. Ten annual lease payments of $12,000
are due at each January 1 beginning January 1, 2018. Cady Salons was required to return the
equipment to Smith Co. at the end of the lease. The amortization of the right-of-use asset for
the reporting year ending December 31, 2018 would be ______.

A. $5,200

B. $6,800

C. $8,000

D. $12,000

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28. Which of the following statements regarding a lessee-guaranteed residual value is true?

A. The lessor's lease receivable should be increased by the amount of the residual value.

B. The lessor's lease receivable should be increased by the amount of the residual value to the
extent that guaranteed residual value is expected to exceed estimated residual value.

C. The lessee's right-of-use asset and lease payable at the beginning of the lease should be
increased by the present value of the residual value.

D. The lessee's right-of-use asset and lease payable at the beginning of the lease should be
decreased by the present value of the residual value to the extent that guaranteed residual
value is expected to exceed estimated residual value.

29. The costs that (a) are associated directly with consummating a lease, (b) are essential to
acquire the lease, and (c) would not have been incurred had the lease agreement not
occurred, are referred to as ______.

A. initial direct costs

B. consummating expenses

C. lease acquisition expenses

D. nonlease components.

30. Initial direct costs are expensed at the beginning of the lease in ______.

A. a sales-type lease

B. a sale-leaseback

C. an operating lease

D. none of these

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31. Star Corp. has a rate of return on assets of 10% and a debt/equity ratio of 2 to 1 before
entering into a lease. Not including any indirect effects on earnings, when Star Corp. records
the lease, the immediate impact on these ratios is a(an) ______.

Return on Assets Debt/Equity

a. Increase Increase

b. Decrease Decrease

c. Increase Decrease

d. Decrease Increase

A. Option A

B. Option B

C. Option C

D. Option D

32. Jacobs Eatery leased restaurant equipment from Gamma Leasing. Gamma earns interest
under such arrangements at a 6% annual rate. The lease term is eight months with monthly
payments of $20,000 due at the end of each month. Jacobs Eatery elected the short-term
lease option. What is the effect of the lease on Jacobs Eatery's earnings during the eight-
month term (ignore taxes)?

A. an initial expense of $160,000

B. an expense of $20,000 initially and $20,000 at the end of seven months

C. an expense of $20,000 at the end of each of the eight months

D. no expense within the eight-month period

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33. Omega leased a machine for a ten-year noncancelable term. At the end of the ten-year term,
Omega has five consecutive one-year renewal options. A replacement machine can be
acquired at the end of the term for the leased machine, but due to an expensive installation
process and Omega's lease term for its store, Omega expects to lease the machine for twelve
years. What is the lease term?

A. ten years

B. eleven years

C. twelve years

D. fifteen years

34. On January 1, Porter Moving and Storage leased a truck for a four-year period, at which time
possession of the truck will revert back to the lessor. Annual lease payments are $30,000 due
on December 31 of each year, calculated by the lessor using a 5% discount rate. If Porter's
revenues exceed a specified amount during the lease term, Porter will pay an additional
$12,000 lease payment at the end of the lease. Porter estimates a 60% probability of meeting
the target revenue amount. What amount, if any, should be added to the right-of-use asset
and lease payable under the contingent rent agreement?

A. No additional amount should be added.

B. An additional $6,000 should be added.

C. An additional $7,200 should be added.

D. An additional $12,000 should be added.

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35. Gamma Leasing acquires equipment and leases it to customers under long-term sales-type
leases. Gamma earns interest under these arrangements at a 6% annual rate. Gamma
purchased a machine and then leased it for $300,000 under an arrangement that specified
annual payments to be received for five years, beginning at the commencement of the lease.
The lessee had the option to purchase the machine at the end of the lease term for $50,000
when it was expected to have a residual value of $80,000. Calculate the amount of the annual
lease payments. (Round your answer to the nearest whole dollar amount.)

The present value of $1: n = 5, i = 6% is 0.74726.

The present value of an ordinary annuity of $1: n = 5, i = 6% is 4.21236.
The present value of an annuity due of $1: n = 5, i = 6% is 4.46511.

A. $62,349

B. $58,820

C. $67,188

D. $78,385

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36. On January 1, Smith Industries leased equipment to a customer for a four-year period, at
which time possession of the leased asset will revert back to Smith. The equipment cost Smith
$350,000 and has an expected useful life of six years. Its normal sales price is $350,000. The
residual value after four years is $50,000. Lease payments are due on December 31 of each
year, beginning with the first payment at the end of the first year. The interest rate is 5%.
Calculate the amount of the annual lease payments. (Round your answer to the nearest whole
dollar amount.)

The present value of $1: n = 4, i = 5% is 0.82270.

The present value of an ordinary annuity of $1: n = 4, i = 5% is 3.54595.
The present value of an annuity due of $1: n = 4, i = 5% is 3.72325.

A. $87,104

B. $82,955

C. $98,704

D. $77,337

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37. On January 1, Ramirez Supply leased a car for a four-year period, at which time possession of
the car will revert back to the lessor. Annual lease payments are $20,000 due on December 31
of each year, calculated by the lessor using a 5% discount rate. Negotiations led to Ramirez
guaranteeing the lessor a $72,000 residual value at the end of the lease term although
Ramirez estimates that the residual value after four years will be $70,000. What is the amount
to be added to the right-of-use asset and lease payable under the residual value guarantee?
(Round your answer to the nearest whole dollar amount.)

The present value of $1: n = 4, i = 5% is 0.82270.

The present value of an ordinary annuity of $1: n = 4, i = 5% is 3.54595.
The present value of an annuity due of $1: n = 4, i = 5% is 3.72325.

A. $823

B. $1,216

C. $1,645

D. $2,061

38. Bird leased equipment that had a retail cash selling price of $1,200,000 and a useful life of five
years with no residual value. The lessor paid $1,060,000 to acquire the equipment and used
an implicit rate of 8% when calculating annual lease payments of $278,284 beginning January
1, at the beginning of the lease. Incremental costs of negotiating and consummating the
completed lease transaction incurred by the lessor were $30,000. What is the effect of the
lease on the lessor's earnings during the first year (ignore taxes)? (Round your answer to the
nearest whole dollar amount.)

A. $164,839

B. $171,242

C. $178,625

D. $183,737

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39. On January 1, 2018, Gemini Corporation leased equipment under a finance lease designed to
earn the lessor a 12% rate of return for providing long-term financing. The lease agreement
specified ten annual payments of $225,000 beginning January 1, and each December 31
thereafter through 2026. A ten-year service agreement was scheduled to provide
maintenance of the equipment as required for a fee of $15,000 per year. Insurance premiums
of $12,000 annually are related to the equipment. Both amounts were to be paid by the lessor
and the lease payments reflect both expenditures. At what amount will Gemini record a right-
of-use asset? (Round your answer to the nearest whole dollar amount.)

A. $1,139,085

B. $1,234,009

C. $1,328,932

D. $1,423,856

40. A lessee will reassess variable lease payments that depend on an index or a rate ______.

A. only when the lessee remeasures the right-of-use asset and lease liability for other reasons

B. only when the lessor also reassesses the variable lease payments

C. whenever there is a change in the cash flows resulting from a change in the reference index
or rate

D. never

Short Answer Questions

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41. Use this information to answer the following questions:

On January 1, 2018, Robertson Construction leased several items of equipment under a two-
year operating lease agreement from Jamison Leasing, which routinely finances equipment
for other firms at an annual interest rate of 4%. The contract calls for four rent payments of
$40,000 each, payable semiannually on June 30 and December 31 each year. The equipment
was acquired by Jamison Leasing at a cost of $360,000 and was expected to have a useful life
of five years with no residual value. Both firms record amortization and depreciation
semiannually.

Required:
Prepare the appropriate journal entries for the lessee from the beginning of the lease through
the end of 2018. Round your answers to the nearest whole dollar amounts.

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42. Use this information to answer the following questions:

On January 1, 2018, Robertson Construction leased several items of equipment under a two-
year operating lease agreement from Jamison Leasing, which routinely finances equipment
for other firms at an annual interest rate of 4%. The contract calls for four rent payments of
$40,000 each, payable semiannually on June 30 and December 31 each year. The equipment
was acquired by Jamison Leasing at a cost of $360,000 and was expected to have a useful life
of five years with no residual value. Both firms record amortization and depreciation
semiannually.

Required:

Prepare the appropriate journal entries for the lessor (Jamison Leasing) from the beginning of
the lease through the end of 2018. Round your answers to the nearest whole dollar amounts.

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43. Maker Corp. manufactures imaging equipment. Easy Leasing purchased an MRI machine from
Maker for $1,000,000 and leased it to Imaging Group, Inc. on January 1, 2018.

Lease description:

Quarterly rental payments $65,258: beginning of each period

Lease term Five years (20 quarters)

No residual value; no bargain purchase option

Economic life of MRI machine Five years

Implicit interest rate and lessee's incremental borrowing 12%

rate

Fair value of asset $1,000,000

Present value of an annuity due of $1: n = 20, i = 3% 15.3238

Required:
Round your answers to the nearest whole dollar amounts.
1. How should this lease be classified by Imaging Group and by Easy Leasing?
2. Prepare appropriate entries for both Imaging Group and Easy Leasing from the beginning
of the lease through the second rental payment on April 1, 2018. Depreciation and
amortization are recorded at the end of each fiscal year (December 31).
3. Assume Imaging Group leased the machine directly from the manufacturer, Maker Corp.,
which produced the machine at a cost of $700,000. Prepare appropriate entries for Maker
from the beginning of the lease through the second rental payment on April 1, 2018.

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44. On January 1, 2018, NaviFast leased telecommunications equipment from Rapid Voice, Inc.
Rapid Voice's cash selling price for the equipment is $435,526. The lease agreement specifies
six annual payments of $100,000 beginning December 31, 2018 and at each December 31
thereafter through 2023. The six-year lease is equal to the estimated useful life of the
equipment. The contract specifies that lease payments for each year will increase by the
higher of (a) the increase in the Consumer Price Index for the preceding year and (b) 3
percent. The CPI at the beginning of the lease is 120. Rapid Voice routinely leases equipment
to other firms. The interest rate in these lease arrangements is 10%.

Required: Prepare the appropriate journal entries for NaviFast to record the lease at its
beginning. Round your answers to the nearest whole dollar amounts.

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45. On January 1, 2018, Osiris Inc. leased manufacturing equipment from Giza Leasing for a four-
year period ending December 31, 2018, at which time possession of the leased asset will
revert back to Giza. The equipment cost Giza $206,092 and has an expected economic life of
five years. Giza expects the residual value on December 31, 2018 to be $25,000. Negotiations
led to Osiris guaranteeing a $35,000 residual value.

Equal payments under the lease are $50,000 and are due on December 31 of each year with
the first payment being made on December 31, 2018. Osiris is aware that Giza used a 5%
interest rate when calculating lease payments.

Required:
Round your answers to the nearest whole dollar amounts.
1. Prepare the appropriate journal entry for Osiris on January 1, 2018, to record the lease.
2. Prepare all appropriate journal entries for Osiris on December 31, 2018, related to the
lease.

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46. On January 1, 2018, Patagonia Leasing leased equipment to Pebble Services under a
finance/sales-type lease designed to earn Patagonia a 12% rate of return for providing long-
term financing. The lease agreement specified:

a. Ten annual payments of $110,000 beginning January 1, 2018, the beginning of the lease
and each December 31 thereafter through 2026.
b. The estimated useful life of the leased equipment is ten years with no residual value. Its
cost to Patagonia was $632,824.
c. The lease qualifies as a finance lease/sales-type lease.
d. A ten-year service agreement with Mechanics International was negotiated to provide
maintenance of the equipment as required. Payments of $10,000 per year are specified,
beginning January 1, 2018. Patagonia was to pay this cost as incurred, but lease payments
reflect this expenditure.

Required:
Round your answers to the nearest whole dollar amounts.
Prepare the appropriate journal entries for both the lessee and lessor related to the lease on:

1. January 1, 2018.
2. December 31, 2018.

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47. Discuss the economic advantages of leasing.

48. What amounts are considered to be lease payments when the lessee calculates the right-of-
use asset and lease payable?

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49. Occasionally, a lease agreement includes a guarantee by the lessee that the lessor will recover
a specified residual value when custody of the asset reverts back to the lessor at the end of
the lease term. Under what circumstance can the guaranteed residual value influence the
amounts recorded by the lessee and lessor? In that circumstance, how are the amounts
affected?

50. Compare the way a purchase option that is reasonably certain to be exercised and a lessee-
guaranteed residual value are treated by the lessee and lessor when determining lease
payments.

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 Chapter 11 Leases Answer Key

True / False Questions

1. Under IFRS 16, a lessee's debt to equity ratio and rate of return on assets are both affected
by a lease on its commencement.

FALSE

AACSB: Reflective Thinking

AICPA: BB Critical thinking
AICPA: FN Risk analysis
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Topic: Lease identification

2. Under IFRS 16, finance leases are agreements that are formulated outwardly as leases for
lessors, but are installment purchases in substance.

TRUE

AACSB: Reflective Thinking

AICPA: BB Critical thinking
AICPA: FN Risk analysis
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Topic: Lease identification

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3. The use of proportion of the lease term over the remaining economic life to classify a lease
as a finance lease for a lessor is consistent with the basic premise that most of the risks and
rewards of ownership occur during the first say 75% of an asset's life.

TRUE

AACSB: Reflective Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 11-04 Explain the basis for each of the criteria and conditions used by a lessor to classify leases.
Topic: Lease classification-Criteria

4. In accounting for leases under IFRS 16, usually it is either the lessee or the lessor (but not
both) who will recognize amortization on the leased asset.

FALSE

AACSB: Reflective Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 11-04 Explain the basis for each of the criteria and conditions used by a lessor to classify leases.
Topic: Lessee accounting and Lessor accounting

5. If the underlying 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, then it must be considered to be
an operating lease.

FALSE

AACSB: Reflective Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement

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 Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 11-04 Explain the basis for each of the criteria and conditions used by a lessor to classify leases.
Topic: Lease classification

6. A bargain purchase option is defined as the option of purchasing leased property at a price
that is equal to the expected fair value of a leased asset.

FALSE

AACSB: Reflective Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 11-04 Explain the basis for each of the criteria and conditions used by a lessor to classify leases.
Topic: Lease classification-Criteria

7. When the lessee guarantees an estimated residual value of $75,000, the amount the lessee
records as a right-of-use asset and as a lease liability is increased by $75,000.

FALSE

AACSB: Analytical Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Topic: Lessee accounting

11-28
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8. If the lessee is expected to take ownership of a leased asset at the end of the lease term,
the lessor must use an estimated residual value when calculating the lease payments
necessary to achieve a desired rate of return.

FALSE

AACSB: Reflective Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 11-05 Describe and demonstrate how the lessor accounts for an operating lease and a finance lease.
Topic: Lessor accounting

9. On a transaction that qualifies for sale-leaseback accounting, any gain on the "sale"
portion of the transaction is recognized immediately.

TRUE

AACSB: Reflective Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 2 Medium
Learning Objective: 11-10 Explain sale-leaseback agreements and other special leasing arrangements and their
accounting treatment.
Topic: Sale-leaseback transactions

10. At the inception of a lease, if it is reasonably certain that the lessee will exercise an option
to renew a lease, the lease term is the noncancelable period plus the renewal period for
both the lessee and the lessor.

TRUE

AACSB: Reflective Thinking

AICPA: BB Critical thinking

11-29
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 AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Topic: Lessee accounting

Matching Questions

11. Listed below are five terms followed by a list of phrases that describe or characterize five of
the terms. Match each phrase with the most correct term by placing the letter designating
that term in the space provided.

1. Present value of
outstanding lease Accounting for these by lessors is
payments based on substance over form. 2
The amount capitalized by the
2. Capital leases lessee. 1
3. Bargain purchase option Lease expense. 4
Reduces the lessor's lease
4. Executory costs payment calculation. 3
5. Depreciable assets Leasehold improvements. 5

AACSB: Reflective Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Learning Objective: 11-04 Explain the basis for each of the criteria and conditions used by a lessor to classify leases.
Learning Objective: 11-09 Explain the impact on lease accounting of executory costs, the discount rate, initial direct costs,
and contingent rentals.

11-30
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 Topic: Lease classification
Topic: Lessee accounting
Topic: Lessor accounting
Topic: Other Lease Issues

12. Listed below are five terms followed by a list of phrases that describe or characterize five of
the terms. Match each phrase with the most correct term by placing the letter designating
that term in the space provided.

1. Sale-leaseback Rent payments plus lessee-guaranteed

payments and third-party-guaranteed residual value. 5
2. Short-term lease Residual value. 4
3. Sales-type lease Leases of twelve months or less. 2
4. Lessee's The amount paid to retain use of the
guarantee asset after sale. 1
5. Lessor's minimum
lease receipts Marketing tool for lessor. 3

AACSB: Reflective Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Learning Objective: 11-08 Explain how lease accounting is affected by the residual value of a leased asset.
Learning Objective: 11-09 Explain the impact on lease accounting of executory costs, the discount rate, initial direct costs,
and contingent rentals.
Learning Objective: 11-10 Explain sale-leaseback agreements and other special leasing arrangements and their
accounting treatment.
Topic: Lessor-Sales-type lease
Topic: Other lease issues-Nonlease-Indirect-Improvements
Topic: Sale-leaseback transactions
Topic: Uncertainty-Residual value

11-31
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13. Listed below are five terms followed by a list of phrases that describe or characterize five of
the terms. Match each phrase with the most correct term by placing the letter designating
that term in the space provided.

Deducted in lessor's computation of rental

1. Net method payments. 5
Periodic rent payments plus amount
2. Lessor's net expected to be payable under lessee-
investment guaranteed residual value. 4
PV of minimum lease payments plus PV of
3. Gross method unguaranteed residual value. 2
4. Lessee's lease Lease payable equals PV of minimum lease
liability payments. 1
5. PV of BPO Lease receivable equals sum of minimum
price lease payments. 3

AACSB: Reflective Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Learning Objective: 11-05 Describe and demonstrate how the lessor accounts for an operating lease and a finance lease.
Learning Objective: 11-06 Describe and demonstrate how the lessor accounts for a sales-type lease.
Learning Objective: 11-08 Explain how lease accounting is affected by the residual value of a leased asset.
Topic: Lessee accounting
Topic: Lessor accounting
Topic: Lessor-Sales-type lease
Topic: Other Lease Issues

11-32
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14. Listed below are five terms followed by a list of phrases that describe or characterize five of
the terms. Match each phrase with the most correct term by placing the letter designating
that term in the space provided.

Typically used by lessor but not

1. Requires disclosure only lessee 5
2. Bargain purchase option Contingent rentals. 1
3. Depreciation period over
useful life Title transfers to lessee. 3
4. Additional conditions for
lessor in nonoperating Consistent with the realization
leases principle. 4
Purchase price sufficiently less
than the expected fair value when
5. Gross method exercised. 2

AACSB: Reflective Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 11-05 Describe and demonstrate how the lessor accounts for an operating lease and a finance lease.
Learning Objective: 11-09 Explain the impact on lease accounting of executory costs, the discount rate, initial direct costs,
and contingent rentals.
Topic: Lessor accounting
Topic: Other Lease Issues

11-33
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15. Listed below are five terms followed by a list of phrases that describe or characterize five of
the terms. Match each phrase with the correct term by placing the letter designating the
best term in the space provided by the phrase.

Identified as either the implicit

1. Additional loan in a sale- rate or lessee's incremental
leaseback transaction borrowing rate. 5
Accounted for essentially as
2. Interest expense operating leases by lessees. 4
3. Upfront lease payment in Fair value is lower than selling
a sale-leaseback transaction price. 1
Calculated as effective rate times
4. Low-value leases balance. 2
Fair value is higher than selling
5. Discount rate price. 3

AACSB: Reflective Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Learning Objective: 11-09 Explain the impact on lease accounting of executory costs, the discount rate, initial direct costs,
and contingent rentals.
Topic: Lessee accounting
Topic: Lessor-Sales-type lease
Topic: Other Lease Issues

Multiple Choice Questions

11-34
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16. The costs that (a) are associated directly with consummating a lease, (b) are essential to
acquire the lease, and (c) would not have been incurred had the lease agreement not
occurred, are referred to as initial direct costs. Initial direct costs incurred by the lessee are
______.

A. added to the right-of-use asset and expensed over an amortization period

B. recorded as an expense at the beginning of the lease

C. deferred in a lease until the asset is returned to the lessor

D. a reduction to the lease liability at the beginning of the lease

AACSB: Reflective Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 11-09 Explain the impact on lease accounting of executory costs, the discount rate, initial direct costs,
and contingent rentals.
Topic: Other Lease Issues

11-35
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17. N Corp. entered into a nine-year finance lease on a warehouse on December 31, 2018.
Lease payments of $26,000, which includes maintenance services of $1,000, are due
annually, beginning on December 31, 2019, and every December 31 thereafter. N does not
know the interest rate implicit in the lease; N's incremental borrowing rate is 9%. The
rounded present value of an ordinary annuity for nine years at 9% is 6.0. What amount
should N report as recorded lease liability on December 31, 2018?

A. $150,000

B. $156,000

C. $225,000

D. $234,000
The recorded lease liability should be the annual lease payments less the nonlease
component (maintenance), times the present value factor for an ordinary annuity of $1 for
nine years at 9%. The calculation would be: ($26,000 − 1,000) × 6.0 = $150,000. The
maintenance fees are a period cost and should be charged to expense.

AACSB: Knowledge Application

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 11-09 Explain the impact on lease accounting of executory costs, the discount rate, initial direct costs,
and contingent rentals.
Topic: Other Lease Issues

11-36
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18. If the lessee and lessor use different interest rates to account for a finance/sales-type lease,
then ______.

A. the lessee is unaware of the lessor's implicit rate

B. total expenses for the lessee will equal the lessor's total revenues

C. IFRS has been violated by at least one party

D. the lessee will report more net income for the year

AACSB: Analytical Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 11-09 Explain the impact on lease accounting of executory costs, the discount rate, initial direct costs,
and contingent rentals.
Topic: Other Lease Issues

11-37
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19. M Corp. recorded a lease in February of Year 1 using an annuity due present value table.
The company's statement of cash flows for the year ending December 31, Year 1 using the
direct method will report ______.

A. a cash inflow from investing activities

B. a cash outflow from financing activities

C. a cash outflow from investing activities

D. a cash inflow from operating activities

The company would report the right-of-use asset and the lease liability as a significant
noncash investing and financing activity in the disclosure notes to the financial
statements.

The cash lease payments are divided into the interest portion and the principal portion.
The interest portion is reported as a cash outflow from operating activities or financing
activities, consistent with the company's treatment of other finance charges. However,
since an annuity due table was used, there was no interest in the first payment. The
principal portion is reported as a cash outflow from financing activities.

AACSB: Analytical Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 3 Hard
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Topic: Lessee accounting

11-38
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20. J Corp. is a lessee that entered into a lease in February of Year 1. How will the principal
portion of J Corp.'s lease payment show up in the company's statement of cash flows for
the year ending December 31, Year 1?

A. a cash outflow from investing activities

B. a cash outflow from financing activities

C. a cash outflow from operating activities

D. no cash outflow
The principal portions of the lease payments for leases are reported in a statement of cash
flows as financing activities by the lessee.

AACSB: Reflective Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Topic: Lessee accounting

11-39
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21. On December 31, 2018, B Corp. sold a machine to Royal and simultaneously leased it back
for one year. The sale meets the requirements of IFRS 15. Pertinent information at this date
follows:

Sales price $800,000

Fair value 720,000

Book value 660,000

Present value of lease rentals ($6,000 for twelve months at 12%) 68,200

Estimated remaining useful life Twelve years

In B's December 31, 2018 balance sheet, the recognized gain from the sale of this machine
should be ______.

A. $0

B. $54,317

C. $60,000

D. $140,000
As the sale meets the requirements of IFRS 15, the seller-lessee will recognize a gain from
the sale as: ([Fair value − Book value] × [Fair value − Lease liability]/Fair value) = (720,000

− 660,000) × (720,000 − 68,200)/720,000 = 54,317.

AACSB: Knowledge Application

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 11-10 Explain sale-leaseback agreements and other special leasing arrangements and their
accounting treatment.
Topic: Sale-leaseback transactions

11-40
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22. In an eight-year finance lease, the portion of the annual lease payment that represents
interest in the lease's third year payment is ______.

A. the same as in the fourth year

B. the same as in the first year

C. less than in the second year

D. more than in the second year

Since interest is computed on the beginning balance of the liability account, as that
balance is reduced, the interest component of subsequent payments is reduced. The
interest portion of the payment in the third year will therefore be less than the interest
portion of the payment in the second year.

AACSB: Analytical Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Topic: Lessee accounting

23. Damon is the lessee in connection with a finance lease. Damon will not record ______.

A. depreciation expense

B. amortization expense

C. interest expense

D. a right-of-use asset
In a lease, the lessee records amortization expense on its right-of-use asset.

AACSB: Reflective Thinking

11-41
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 AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Topic: Lessee accounting

24. Red Co. recorded a right-of-use asset of $100,000 in a ten-year finance lease. Payments of
$16,275 are made annually at the end of each year. The interest rate charged by the lessor
was 10%. The balance in the lease payable after two years will be ______.

A. $80,000

B. $86,823

C. $116,309

D. $121,000

Year 1

Interest expense (10% × $100,000) 10,000

Lease payable 6,275

Cash 16,275

Year 2

Interest expense (10% × [$100,000 − 6,275]) 9,373

Lease payable 6,902

Cash 16,275

Balance: $100,000 − 6,275 − 6,902 = $86,823

AACSB: Knowledge Application

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Apply

11-42
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 Difficulty: 2 Medium
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Topic: Lessee accounting

25. We classify a lease as a finance lease if ______.

A. the present value of lease payments is less than the asset's book value

B. the present value of lease payments is less than the asset's fair value

C. the lessee obtains control of the use of the asset

D. the usual risks and rewards are retained by the lessor

We have a finance lease if the lease transfers substantially all the risks and rewards of
ownership of the underlying asset.

AACSB: Reflective Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 11-04 Explain the basis for each of the criteria and conditions used by a lessor to classify leases.
Topic: Lease classification-Criteria

11-43
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26 Karla Salons leased equipment from Smith Co. on July 1, 2018 in a finance lease. The present
. value of the lease payments discounted at 10% was $80,000. Ten annual lease payments of
$12,000 are due each year beginning July 1, 2018. Smith Co. had constructed the equipment
recently for $66,000, and its retail fair value was $80,000.

What amount did Smith Co. record in its income statement for the reporting year ending
December 31, 2018, in connection with the lease? (ignore taxes.)

A. $3,400

B. $14,000

C. $17,400

D. $20,800

Lease receivable (PV of lease payments [ “ selling price” ] )

Selling profit (difference)

Asset (lessor’s cost: book value)

Interest revenue = (10% × 1/2 year × [$80,000 − 12,000]) = $3,400.

Total revenue with regard to the lease = $14,000 profit + $3,400 interest revenue = $17,400.

AACSB: Knowledge Application

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 11-06 Describe and demonstrate how the lessor accounts for a sales-type lease.
Topic: Lessor-Sales-type lease

11-44
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27. Cady Salons leased equipment from Smith Co. on January 1, 2018 in a lease. The present
value of the lease payments discounted at 10% was $80,000. Ten annual lease payments of
$12,000 are due at each January 1 beginning January 1, 2018. Cady Salons was required to
return the equipment to Smith Co. at the end of the lease. The amortization of the right-of-
use asset for the reporting year ending December 31, 2018 would be ______.

A. $5,200

B. $6,800

C. $8,000

D. $12,000
In a lease, the lessee amortizes its right-of-use asset over the lease term if title does not
transfer to the lessee at the end of the lease.

AACSB: Knowledge Application

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Topic: Lessee accounting

11-45
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28. Which of the following statements regarding a lessee-guaranteed residual value is true?

A. The lessor's lease receivable should be increased by the amount of the residual value.

B. The lessor's lease receivable should be increased by the amount of the residual value to
the extent that guaranteed residual value is expected to exceed estimated residual
value.

C. The lessee's right-of-use asset and lease payable at the beginning of the lease should
be increased by the present value of the residual value.

D. The lessee's right-of-use asset and lease payable at the beginning of the lease should
be decreased by the present value of the residual value to the extent that guaranteed
residual value is expected to exceed estimated residual value.

AACSB: Analytical Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 3 Hard
Learning Objective: 11-08 Explain how lease accounting is affected by the residual value of a leased asset.
Topic: Other Lease Issues

29. The costs that (a) are associated directly with consummating a lease, (b) are essential to
acquire the lease, and (c) would not have been incurred had the lease agreement not
occurred, are referred to as ______.

A. initial direct costs

B. consummating expenses

C. lease acquisition expenses

D. nonlease components.

AACSB: Reflective Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement

11-46
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 Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 11-09 Explain the impact on lease accounting of executory costs, the discount rate, initial direct costs,
and contingent rentals.
Topic: Other Lease Issues

30. Initial direct costs are expensed at the beginning of the lease in ______.

A. a sales-type lease

B. a sale-leaseback

C. an operating lease

D. none of these

AACSB: Reflective Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 11-09 Explain the impact on lease accounting of executory costs, the discount rate, initial direct costs,
and contingent rentals.
Topic: Other Lease Issues

11-47
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31. Star Corp. has a rate of return on assets of 10% and a debt/equity ratio of 2 to 1 before
entering into a lease. Not including any indirect effects on earnings, when Star Corp.
records the lease, the immediate impact on these ratios is a(an) ______.

Return on Assets Debt/Equity

a. Increase Increase

b. Decrease Decrease

c. Increase Decrease

d. Decrease Increase

A. Option A

B. Option B

C. Option C

D. Option D
A lease increases assets (ROU asset) and liabilities (lease liability) the same amount and
thus has no effect on equity, which is A minus L = Equity. Because assets, the denominator,
increase and earnings remain the same, the rate of return decreases. In the debt/equity
ratio, the numerator is increased with no effect on the denominator and the ratio
increases.

AACSB: Analytical Thinking

AICPA: BB Resource management
AICPA: FN Risk analysis
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 11-01 Identify and describe the operational, financial, and tax objectives that motivate leasing.
Topic: Lease identification

11-48
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32. Jacobs Eatery leased restaurant equipment from Gamma Leasing. Gamma earns interest
under such arrangements at a 6% annual rate. The lease term is eight months with
monthly payments of $20,000 due at the end of each month. Jacobs Eatery elected the
short-term lease option. What is the effect of the lease on Jacobs Eatery's earnings during
the eight-month term (ignore taxes)?

A. an initial expense of $160,000

B. an expense of $20,000 initially and $20,000 at the end of seven months

C. an expense of $20,000 at the end of each of the eight months

D. no expense within the eight-month period

AACSB: Knowledge Application

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Topic: Lessee-Short-term lease

11-49
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33. Omega leased a machine for a ten-year noncancelable term. At the end of the ten-year
term, Omega has five consecutive one-year renewal options. A replacement machine can
be acquired at the end of the term for the leased machine, but due to an expensive
installation process and Omega's lease term for its store, Omega expects to lease the
machine for twelve years. What is the lease term?

A. ten years

B. eleven years

C. twelve years

D. fifteen years
The lease term consists of ten years plus two renewal years, or twelve years, because the
expensive installation now means that Omega is reasonably certain to exercise two of its
one-year renewal options.

AACSB: Analytical Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 11-02 Assess whether a contract contains a leas, whether there is more than one lease component or
other non-lease components, and its term if there is a lease.
Topic: Lease term

11-50
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34. On January 1, Porter Moving and Storage leased a truck for a four-year period, at which
time possession of the truck will revert back to the lessor. Annual lease payments are
$30,000 due on December 31 of each year, calculated by the lessor using a 5% discount
rate. If Porter's revenues exceed a specified amount during the lease term, Porter will pay
an additional $12,000 lease payment at the end of the lease. Porter estimates a 60%
probability of meeting the target revenue amount. What amount, if any, should be added
to the right-of-use asset and lease payable under the contingent rent agreement?

A. No additional amount should be added.

B. An additional $6,000 should be added.

C. An additional $7,200 should be added.

D. An additional $12,000 should be added.

If the amounts of future lease payments are uncertain due to contingencies or otherwise,
we don't consider them as part of the lease payments.

AACSB: Reflective Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 11-09 Explain the impact on lease accounting of executory costs, the discount rate, initial direct costs,
and contingent rentals.
Topic: Lessee-accounting-Contingent rent

11-51
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35. Gamma Leasing acquires equipment and leases it to customers under long-term sales-type
leases. Gamma earns interest under these arrangements at a 6% annual rate. Gamma
purchased a machine and then leased it for $300,000 under an arrangement that specified
annual payments to be received for five years, beginning at the commencement of the
lease. The lessee had the option to purchase the machine at the end of the lease term for
$50,000 when it was expected to have a residual value of $80,000. Calculate the amount of
the annual lease payments. (Round your answer to the nearest whole dollar amount.)

The present value of $1: n = 5, i = 6% is 0.74726.

The present value of an ordinary annuity of $1: n = 5, i = 6% is 4.21236.
The present value of an annuity due of $1: n = 5, i = 6% is 4.46511.

A. $62,349

B. $58,820

C. $67,188

D. $78,385
A purchase option is a provision in a lease contract that gives the lessee the option of
purchasing the leased property at a specified exercise price. If that price is sufficiently
lower than the expected fair value of the property when the option becomes exercisable
that the exercise of the option appears "reasonably certain" at the beginning of the lease,
transfer of ownership is expected and the lease would be considered a finance lease.
Also, the exercise price would be part of the lease payments for both the lessee and lessor,
influencing the amount recorded as a right-of-use asset, lease payable, and lease
receivable. Furthermore, the lease term would be considered as ending at the time the
option becomes exercisable.

Amount to be recovered (fair value) $300,000

Less: Present value of the exercise price ($50,000 × 0.74726*) (37,363)

Amount to be recovered through periodic lease payments $262,637

Lease payments at the beginning of each of the next five years: ($262,637 ÷ $58,820
4.46511**)

11-52
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 *Present value of $1: n = 5, i = 6%
**Present value of an annuity due of $1: n = 5, i = 6%

AACSB: Knowledge Application

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 11-05 Describe and demonstrate how the lessor accounts for an operating lease and a finance lease.
Topic: Lessor accounting

11-53
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36. On January 1, Smith Industries leased equipment to a customer for a four-year period, at
which time possession of the leased asset will revert back to Smith. The equipment cost
Smith $350,000 and has an expected useful life of six years. Its normal sales price is
$350,000. The residual value after four years is $50,000. Lease payments are due on
December 31 of each year, beginning with the first payment at the end of the first year.
The interest rate is 5%. Calculate the amount of the annual lease payments. (Round your
answer to the nearest whole dollar amount.)

The present value of $1: n = 4, i = 5% is 0.82270.

The present value of an ordinary annuity of $1: n = 4, i = 5% is 3.54595.
The present value of an annuity due of $1: n = 4, i = 5% is 3.72325.

A. $87,104

B. $82,955

C. $98,704

D. $77,337

Amount to be recovered (fair value) $350,000

Less: Present value of the residual value ($50,000 × 0.82270*) (41,135)

Amount to be recovered through periodic lease payments $308,865

Lease payments at the end of each of the next four years: ($308,865 ÷ $87,104
3.54595**)

*Present value of $1: n = 4, i = 5%

**Present value of an ordinary annuity of $1: n = 4, i = 5%

When the lessor gets a lease asset back at the end of the lease term, the value of the asset
itself, which at the beginning of the lease is estimated as the residual value, will provide
another source of recovery of the lessor's investment. That reduces the amount needed
from lessee payments.

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 AACSB: Knowledge Application
AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 11-05 Describe and demonstrate how the lessor accounts for an operating lease and a finance lease.
Topic: Lessor accounting-Annual lease payments

11-55
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37. On January 1, Ramirez Supply leased a car for a four-year period, at which time possession
of the car will revert back to the lessor. Annual lease payments are $20,000 due on
December 31 of each year, calculated by the lessor using a 5% discount rate. Negotiations
led to Ramirez guaranteeing the lessor a $72,000 residual value at the end of the lease
term although Ramirez estimates that the residual value after four years will be $70,000.
What is the amount to be added to the right-of-use asset and lease payable under the
residual value guarantee? (Round your answer to the nearest whole dollar amount.)

The present value of $1: n = 4, i = 5% is 0.82270.

The present value of an ordinary annuity of $1: n = 4, i = 5% is 3.54595.
The present value of an annuity due of $1: n = 4, i = 5% is 3.72325.

A. $823

B. $1,216

C. $1,645

D. $2,061
If a cash payment under a lessee-guaranteed residual value is predicted, the present value
of that payment is added to the present value of the lease payments the lessee records as
both a right-of-use asset and a lease liability. Likewise, it also adds to the amount that the
lessor records as a lease receivable. Ramirez guarantees a cash payment of $2,000 to make
up the difference of the $72,000 total guarantee to the lessor and the guaranteed residual
value estimate of $70,000 for the asset to be returned to the lessor.

Amount to be added to the right-of-use asset and lease liability:

($72,000 − 70,000 = $2,000) × 0.82270** = $1,645

**Present value of $1: n = 4, i = 5%

AACSB: Knowledge Application

AICPA: BB Critical thinking
AICPA: FN Measurement

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 Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 11-08 Explain how lease accounting is affected by the residual value of a leased asset.
Topic: Lessee accounting-Residual value

11-57
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38. Bird leased equipment that had a retail cash selling price of $1,200,000 and a useful life of
five years with no residual value. The lessor paid $1,060,000 to acquire the equipment and
used an implicit rate of 8% when calculating annual lease payments of $278,284 beginning
January 1, at the beginning of the lease. Incremental costs of negotiating and
consummating the completed lease transaction incurred by the lessor were $30,000. What
is the effect of the lease on the lessor's earnings during the first year (ignore taxes)?
(Round your answer to the nearest whole dollar amount.)

A. $164,839

B. $171,242

C. $178,625

D. $183,737
In a sales-type lease that includes selling profit, initial direct costs are expensed in the
period of "sale" —that is, at the beginning of the lease. This assumes that, in a sales-type
lease, the primary reason for incurring these costs is to enable the sale of the leased asset.

The lessor's earnings will be increased by $183,737 as calculated below:

January 1 interest revenue $0

Dec. 31, interest revenue (8% × [$1,200,000*– 278,284]) 73,737

Interest revenue for the year $73,737

Sales revenue 1,200,000

Cost of goods sold (1,060,000)

Selling profit $140,000

Selling expense (initial direct cost). (30,000)

Increase in earnings $183,737

AACSB: Knowledge Application

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Apply

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 Difficulty: 3 Hard
Learning Objective: 11-05 Describe and demonstrate how the lessor accounts for an operating lease and a finance lease.
Topic: Lessor accounting-Nonlease-Indirect-Improvements

11-59
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39. On January 1, 2018, Gemini Corporation leased equipment under a finance lease designed
to earn the lessor a 12% rate of return for providing long-term financing. The lease
agreement specified ten annual payments of $225,000 beginning January 1, and each
December 31 thereafter through 2026. A ten-year service agreement was scheduled to
provide maintenance of the equipment as required for a fee of $15,000 per year. Insurance
premiums of $12,000 annually are related to the equipment. Both amounts were to be
paid by the lessor and the lease payments reflect both expenditures. At what amount will
Gemini record a right-of-use asset? (Round your answer to the nearest whole dollar
amount.)

A. $1,139,085

B. $1,234,009

C. $1,328,932

D. $1,423,856
Gemini is receiving two separate benefits in the lease contract (1) the right to use
equipment and (2) maintenance on that equipment. So, payments specified in the lease
contract contain a separate lease component (use of equipment for $225,000) and a
nonlease component (maintenance of $15,000). The payment for insurance does not
transfer to the lessee a separate good or service. Payments for insurance and property
taxes are specifically identified in the lease standard as part of the lease payments (to be
capitalized) rather than nonlease components (to be expensed separately) if they are fixed
amounts in the lease contract. (If the payments will be billed separately, they are separate
components of the lease and not included in the lease payments.) So, the right-of-use asset
and lease liability (and the lessor's lease receivable) would be measured as the present
value of the $210,000 lease payments rather than $225,000.
At the beginning of the lease, Gemini records a right-of-use asset and lease liability for the
present value of the ten $210,000 lease payments. For the first payment of $225,000,
$15,000 is recorded as maintenance expense and the remaining $210,000 reduces the
lease liability.

January 1

Right-of-use asset ([$225,000 − 15,000] × 6.32825**) 1,328,933

11-60
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 Lease payable (present value of lease payments) 1,328,933

**Present value of an annuity due of $1: n = 10, i = 12%

Lease payable (payment less nonlease component) 210,000

Maintenance expense (2018 fee) 15,000

Cash (annual payment) 225,000

AACSB: Knowledge Application

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 11-02 Assess whether a contract contains a leas, whether there is more than one lease component or
other non-lease components, and its term if there is a lease.
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Topic: Lessee accounting

40. A lessee will reassess variable lease payments that depend on an index or a rate ______.

A. only when the lessee remeasures the right-of-use asset and lease liability for other
reasons

B. only when the lessor also reassesses the variable lease payments

C. whenever there is a change in the cash flows resulting from a change in the reference
index or rate

D. never

AACSB: Reflective Thinking

AICPA: BB Critical thinking
AICPA: FN Measurement

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 Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 2 Medium
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Topic: Lessee accounting

Short Answer Questions

11-62
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41. Use this information to answer the following questions:

On January 1, 2018, Robertson Construction leased several items of equipment under a

two-year operating lease agreement from Jamison Leasing, which routinely finances
equipment for other firms at an annual interest rate of 4%. The contract calls for four rent
payments of $40,000 each, payable semiannually on June 30 and December 31 each year.
The equipment was acquired by Jamison Leasing at a cost of $360,000 and was expected to
have a useful life of five years with no residual value. Both firms record amortization and
depreciation semiannually.

Required:
Prepare the appropriate journal entries for the lessee from the beginning of the lease
through the end of 2018. Round your answers to the nearest whole dollar amounts.

Robertson Services, Inc.

January 1, 2018

Right-of-use asset 152,309

Lease payable ($40,000 × 152,309

3.80773*)

*Present value of an ordinary annuity of $1: n = 4, i = 2%

June 30, 2018

Interest expense (2% × 3,046

$152,309)

Lease payable (difference) 36,954

Cash 40,000

Amortization expense ($152,309 38,077

÷ 4)

Right-of-use asset 38,077

11-63
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 In a lease, the lessee records interest using the effective interest rate and amortizes the
right-of-use asset amortization over its lease term (< its useful life).

December 31, 2018

Interest expense (2% × [152,309 2,307

− 36,954])

Lease payable (difference) 37,693

Cash (lease payment) 40,000

Amortization expense ($152,309 38,077

÷ 4)

Right-of-use asset 38,077

AACSB: Knowledge Application

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Learning Objective: 11-05 Describe and demonstrate how the lessor accounts for an operating lease and a finance lease.
Topic: Lessee or Lessor accounting

11-64
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42. Use this information to answer the following questions:

On January 1, 2018, Robertson Construction leased several items of equipment under a

two-year operating lease agreement from Jamison Leasing, which routinely finances
equipment for other firms at an annual interest rate of 4%. The contract calls for four rent
payments of $40,000 each, payable semiannually on June 30 and December 31 each year.
The equipment was acquired by Jamison Leasing at a cost of $360,000 and was expected to
have a useful life of five years with no residual value. Both firms record amortization and
depreciation semiannually.

Required:

Prepare the appropriate journal entries for the lessor (Jamison Leasing) from the
beginning of the lease through the end of 2018. Round your answers to the nearest whole
dollar amounts.

Jamison Leasing

June 30, 2018

Cash 40,000

Lease revenue 40,000

Depreciation expense 36,000

($360,000/10 semiannual
periods)

Accumulated depreciation 36,000

December 31, 2018

Cash 40,000

Lease revenue 40,000

Depreciation expense 36,000

($360,000/10 semiannual
periods)

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 Accumulated depreciation 36,000

AACSB: Knowledge Application

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Learning Objective: 11-05 Describe and demonstrate how the lessor accounts for an operating lease and a finance lease.
Topic: Lessee or Lessor accounting

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43 Maker Corp. manufactures imaging equipment. Easy Leasing purchased an MRI machine from
. Maker for $1,000,000 and leased it to Imaging Group, Inc. on January 1, 2018.

Lease description:

Quarterly rental payments $65,258: beginning of each period

Lease term Five years (20 quarters)

No residual value; no bargain purchase option

Economic life of MRI machine Five years

Implicit interest rate and lessee's incremental borrowing rate 12%

Fair value of asset $1,000,000

Present value of an annuity due of $1: n = 20, i = 3% 15.3238

Required:
Round your answers to the nearest whole dollar amounts.
1. How should this lease be classified by Imaging Group and by Easy Leasing?
2. Prepare appropriate entries for both Imaging Group and Easy Leasing from the beginning of
the lease through the second rental payment on April 1, 2018. Depreciation and amortization
are recorded at the end of each fiscal year (December 31).
3. Assume Imaging Group leased the machine directly from the manufacturer, Maker Corp.,
which produced the machine at a cost of $700,000. Prepare appropriate entries for Maker from
the beginning of the lease through the second rental payment on April 1, 2018.

1. Finance lease to lessee; sales-type lease to lessor since the lease term is for the major part
(100%) of the economic life of the asset. Although only one of five classification criteria is
necessary, the present value of the lease payments equals the fair value of the asset and this
also satisfies the finance/sales-type lease classification. For the lessor, there is no selling profit
because the fair value equals the lessor's cost.

Calculation of the Present Value of Lease Payments

Present value of periodic lease payments

11-67
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$65,258 × 15.3238** = $1,000,000
(rounded)

**Present value of an annuity due of $1: n = 20, i = 3%

2. Neither depreciation nor amortization are required to be recorded since the entries are only
required through April.

Imaging Group (Lessee)

January 1, 2018

Right-of-use asset (calculated 1,000,000

above)

Lease payable (calculated above) 1,000,000

Lease payable 65,258

Cash (lease payment) 65,258

April 1, 2018

Interest expense (3% × [$1 28,042

million − 65,258])

Lease payable (difference) 37,216

Cash (lease payment) 65,258

Easy Leasing (Lessor)

January 1, 2018

Lease receivable (present value 1,000,000

calculated above)

Inventory of equipment (lessor's 1,000,000

cost)

Cash (lease payment) 65,258

Lease receivable 65,258

April 1, 2018

Cash (lease payment) 65,258

Lease receivable (difference) 37,216

Interest revenue (3% × [$1 28,042

million − 65,258])

11-68
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3. For the lessor, there is a selling profit because the fair value is more than the manufacturing
cost.

Maker (Lessor)

January 1, 2018

Lease receivable (present value 1,000,000

calculated above)

Cost of goods sold (lessor's cost) 700,000

Sales revenue (present value

calculated above)

Inventory of equipment (lessor's cost)

Cash (lease payment) 65,258

Lease receivable

April 1, 2018

Cash (lease payment) 65,258

Lease receivable (difference)

Interest revenue (3% × [$1 million −

65,258])

AACSB: Knowledge Application

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 11-04 Explain the basis for each of the criteria and conditions used by a lessor to classify leases.
Learning Objective: 11-05 Describe and demonstrate how the lessor accounts for an operating lease and a finance lease.
Learning Objective: 11-06 Describe and demonstrate how the lessor accounts for a sales-type lease.
Topic: Lease classification-Finance-Sales-type-Operating
Topic: Lessor accounting

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44. On January 1, 2018, NaviFast leased telecommunications equipment from Rapid Voice, Inc.
Rapid Voice's cash selling price for the equipment is $435,526. The lease agreement
specifies six annual payments of $100,000 beginning December 31, 2018 and at each
December 31 thereafter through 2023. The six-year lease is equal to the estimated useful
life of the equipment. The contract specifies that lease payments for each year will increase
by the higher of (a) the increase in the Consumer Price Index for the preceding year and (b)
3 percent. The CPI at the beginning of the lease is 120. Rapid Voice routinely leases
equipment to other firms. The interest rate in these lease arrangements is 10%.

Required: Prepare the appropriate journal entries for NaviFast to record the lease at its
beginning. Round your answers to the nearest whole dollar amounts.

When apparent "variable" payments actually are in-substance fixed payments, we include
these fixed payments in disguise as part of the lessee's lease payments. Because NaviFast,
the lessee, is required to make payments each year that are at least 3 percent more than
the previous year, regardless of changes in the CPI, those payments are considered in-
substance fixed payments. At the beginning of the lease, then, NaviFast measures the
right-of-use asset and lease payable at $1,397,091, the present value of those payments:

Year In-Substance Fixed Present Value Factor* Present Value

Payments

1 $100,000 × 0.90909 = $90,909

2 103,000 × 0.82645 = 85,124

3 106,090 × 0.75131 = 79,706

4 109,273 × 0.68301 = 74,634

5 112,551 × 0.62092 = 69,885

6 115,927 × 0.56447 = 65,438

$465,697

*Present value of $1: n = 1, 2, 3, 4, 5, 6, i = 10%.

Beginning of the Lease (January 1, 2018)

Right-of-use asset (present value of lease payments) 465,697

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 Lease payable (present value of lease payments) 465,697

AACSB: Knowledge Application

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Learning Objective: 11-09 Explain the impact on lease accounting of executory costs, the discount rate, initial direct costs,
and contingent rentals.
Topic: Contingent rents
Topic: Lessee accounting

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45. On January 1, 2018, Osiris Inc. leased manufacturing equipment from Giza Leasing for a
four-year period ending December 31, 2018, at which time possession of the leased asset
will revert back to Giza. The equipment cost Giza $206,092 and has an expected economic
life of five years. Giza expects the residual value on December 31, 2018 to be $25,000.
Negotiations led to Osiris guaranteeing a $35,000 residual value.

Equal payments under the lease are $50,000 and are due on December 31 of each year with
the first payment being made on December 31, 2018. Osiris is aware that Giza used a 5%
interest rate when calculating lease payments.

Required:
Round your answers to the nearest whole dollar amounts.
1. Prepare the appropriate journal entry for Osiris on January 1, 2018, to record the lease.
2. Prepare all appropriate journal entries for Osiris on December 31, 2018, related to the
lease.

1.

Lessee's Calculation of the Right-of-Use Asset and Lease Liability:

Present value of periodic lease payments $177,298

($50,000 × 3.54595*)

Plus: Present value of an estimated cash payment

under a

residual value guarantee ($10,000† × .82270**) 8,227

Present value of expected lease payments $185,525

*
Present value of $1: n = 4, i = 5%

**
Present value of an ordinary annuity of $1: n = 4,

i = 5%

†$35,000 guaranteed residual value minus

$25,000 expected residual value

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 If a cash payment under a lessee-guaranteed residual value is predicted, the present value
of that payment is added to the present value of the lease payments that the lessee
records as both a right-of-use asset and a lease liability and, if a sales-type lease, that the
lessor records as a lease receivable.

Beginning of the Lease (January 1, 2018)

Lessee

Right-of-use asset 185,525

Lease payable (calculated above) 185,525

2.
December 31, 2018

Amortization expense ($185,525 46,381

÷ 4 years)

Right-of-use asset 46,381

Interest expense (5% × 185,525) 9,276

Lease payable (difference: from 40,724

schedule)

Cash (annual payment) 50,000

AACSB: Knowledge Application

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Learning Objective: 11-08 Explain how lease accounting is affected by the residual value of a leased asset.
Topic: Lessee accounting
Topic: Residual value

11-73
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46. On January 1, 2018, Patagonia Leasing leased equipment to Pebble Services under a
finance/sales-type lease designed to earn Patagonia a 12% rate of return for providing
long-term financing. The lease agreement specified:

a. Ten annual payments of $110,000 beginning January 1, 2018, the beginning of the lease
and each December 31 thereafter through 2026.
b. The estimated useful life of the leased equipment is ten years with no residual value. Its
cost to Patagonia was $632,824.
c. The lease qualifies as a finance lease/sales-type lease.
d. A ten-year service agreement with Mechanics International was negotiated to provide
maintenance of the equipment as required. Payments of $10,000 per year are specified,
beginning January 1, 2018. Patagonia was to pay this cost as incurred, but lease payments
reflect this expenditure.

Required:
Round your answers to the nearest whole dollar amounts.
Prepare the appropriate journal entries for both the lessee and lessor related to the lease
on:

1. January 1, 2018.
2. December 31, 2018.

A partial amortization schedule, appropriate for both the lessee and lessor, follows:

Payments Effective Interest Decrease in Balance Outstanding Balance

(12% × outstanding
balance)

632,825

January 1/2018 100,000 100,000 532,825

December 31, 2018 .12 (532,825) = 63,939 36,061 496,764

100,000

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 December 31, 2019 .12 (496,764) = 59,612 40,388 456,376
100,000

1.
Pebble Services (Lessee)

Right-of-use asset ([$110,000 − 632,825

10,000] × 6.32825**)

Lease payable (present value of 632,825

lease payments)
*
Present value of $1: n = 10, i =

12%
**
Present value of an annuity due of

$1: n = 10, i = 12%

Lease payable (payment less 100,000

maintenance costs)

Maintenance expense (2018 fee) 10,000

Cash (annual payment) 110,000

Patagonia (Lessor)

Lease receivable ([$110,000 − 632,825

10,000] × 6.32825**)

Equipment (lessor's cost) 632,825

Cash (annual payment) 110,000

Maintenance fee payable (or cash) 10,000

Lease receivable 100,000

2.
December 31, 2018

Pebble Services (Lessee)

Interest expense (12% × 63,939

[$632,825 − 100,000])

Lease payable (difference) 36,061

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 Prepaid maintenance (2019 fee) 10,000

Cash (lease payment) 110,000

Amortization expense ($632,825 63,283

÷ 10 years)

Right-of-use asset 63,283

Patagonia (Lessor)

Cash (lease payment) 110,000

Lease receivable (difference) 36,061

Maintenance fee payable (or 10,000

cash)

Interest revenue (12% × 63,939

[$632,825 − 100,000])

AACSB: Knowledge Application

AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 11-02 Assess whether a contract contains a leas, whether there is more than one lease component or
other non-lease components, and its term if there is a lease.
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Learning Objective: 11-05 Describe and demonstrate how the lessor accounts for an operating lease and a finance lease.
Topic: Lessee or Lessor accounting
Topic: Non-lease component

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47. Discuss the economic advantages of leasing.

The lessor may find some benefits to leasing an asset rather than selling it. One advantage
is that the residual value is retained if title never passes to the lessee. When the lease term
is complete, the lessor still owns the asset. The lessor may lease it again or sell the property
for an immediate gain. Another advantage to the lessor is the ongoing business
relationship with the lessee. Often, the lessee will lease or buy more assets from the same
dealer/lessor. Another advantage is increased sales. Leasing is a way to offer special
financing to increase sales.

The lessee may also find advantages in leasing. An important advantage for firms with
little finance is avoiding down payment requirements. Lessors frequently finance 100% of
the value of an asset. This permits the lessee to use funds for other purposes. A second
advantage to the lessee is reduced risk. The risks of ownership include obsolescence,
physical deterioration of the asset, or casualty loss. The risks of ownership can be
completely or partially avoided through leasing.

AACSB: Communication
AICPA: BB Resource management
AICPA: FN Risk analysis
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 11-01 Identify and describe the operational, financial, and tax objectives that motivate leasing.
Topic: Lease identification

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48. What amounts are considered to be lease payments when the lessee calculates the right-
of-use asset and lease payable?

Lease payments include fixed payments plus the exercise price for a purchase option if
exercise is "reasonably certain" plus any termination penalty for a termination option if
exercise is "reasonably certain" plus variable lease payments only if (a) deemed in-
substance fixed payments or (b) based on an index or rate (with any changes in payments
included only if and when the lessee remeasures the lease liability for another reason) plus
any excess of guaranteed residual value over expected residual value.

AACSB: Communication
AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 2 Medium
Learning Objective: 11-02 Assess whether a contract contains a leas, whether there is more than one lease component or
other non-lease components, and its term if there is a lease.
Learning Objective: 11-03 Describe and demonstrate how the lessee accounts for a lease.
Topic: Lessee accounting

11-78
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McGraw-Hill Education.
49. Occasionally, a lease agreement includes a guarantee by the lessee that the lessor will
recover a specified residual value when custody of the asset reverts back to the lessor at
the end of the lease term. Under what circumstance can the guaranteed residual value
influence the amounts recorded by the lessee and lessor? In that circumstance, how are the
amounts affected?

A lessee-guaranteed residual value is considered if the lessee-guaranteed residual value

exceeds the estimate of the actual residual value. If a cash payment under a lessee-
guaranteed residual value is predicted, the present value of that payment is added to the
present value of the lease payments the lessee records as both a right-of-use asset and a
lease liability. Similarly, its present value (residual asset) also adds to the amount that the
lessor records as a lease receivable (as part of its net investment in the lease).

AACSB: Communication
AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 11-08 Explain how lease accounting is affected by the residual value of a leased asset.
Topic: Lessee or lessor accounting-Residual value

11-79
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50. Compare the way a purchase option that is reasonably certain to be exercised and a lessee-
guaranteed residual value are treated by the lessee and lessor when determining lease
payments.

If a purchase option is reasonably certain to be exercised, the exercise price is included in

determining lease payments. A lessee-guaranteed residual value is not included in
determining lease payments unless the amount guaranteed exceeds the estimated fair
value at the end of the lease. In that case, though, the excess lessee-guaranteed residual
value is treated precisely the same way that the reasonably certain exercise price is
treated. The expectation that the option price will be paid effectively adds an additional
cash flow to the lease. The same is true for the expectation that a cash payment will be
made due to a lessee-guaranteed residual value. Those additional payments are included
as components of lease payments. They therefore are included in the computation of the
amount to be capitalized (as an asset and liability) by the lessee and a lease receivable by
the lessor. But, a residual value not guaranteed by the lessee is ignored by the lessee, but
still is expected to be received by the lessor, thus influencing the size of the lease
payments and becoming part of the lease receivable (as a residual asset).

AACSB: Communication
AICPA: BB Critical thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Evaluate
Difficulty: 3 Hard
Learning Objective: 11-07 Describe the way a bargain purchase option affects lease accounting.
Learning Objective: 11-08 Explain how lease accounting is affected by the residual value of a leased asset.
Topic: Lessee or lessor accounting-Residual value-Purchase option

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