Leases should be classified by the lessee as either operating leases or capital leases.
Which of the following statements best characterizes operating leases?
Answer (D) is correct.
Operating leases are transactions whereby lessees rent the right to use
lessor assets without acquiring a substantial portion of the benefits and
risks of ownership of those assets.
Peg Co. leased equipment from Howe Corp. on July 1, year
1 for an eight-year period expiring June 30, year 9. Equal payments
under the lease are $600,000 and are due on July 1 of each
year. The first payment was made on July 1, year 1. The rate of
interest contemplated by Peg and Howe is 10%. The cash selling
price of the equipment is $3,520,000, and the cost of the equipment
on Howe’s accounting records is $2,800,000. The lease is
appropriately recorded as a sales-type lease. What is the amount
of profit on the sale and interest revenue that Howe should record
for the year ended December 31, year 1?
Profit on sale Interest revenue
(b) This is a sales-type lease, so at the inception of the
lease, the lessor would recognize sales of $3,520,000 and cost of
goods sold of $2,800,000, resulting in a profit on sale of
$720,000. In addition, interest revenue is recognized for the
period July 1, year 1, to December 31, year 1. The initial net lease
payments receivable on 7/1/Y1 is $3,520,000. The first rental
payment received on 7/1/Y1 consists entirely of principal, reducing
the net receivable to $2,920,000 ($3,520,000 –
$600,000). Therefore, year 1 interest revenue for the six
months from 7/1/Y1 to 12/31/Y1 is $146,000 ($2,920,000 ×
10% × 6/12).
Howe Co. leased equipment to Kew Corp. on January 2,
year 1, for an eight-year period expiring December 31, year 8.
Equal payments under the lease are $600,000 and are due on
January 2 of each year. The first payment was made on January 2,
year 1. The list selling price of the equipment is $3,520,000 and
its carrying cost on Howe’s books is $2,800,000. The lease is
appropriately accounted for as a sales-type lease. The present
value of the lease payments is $3,300,000. What amount of profit
on the sale should Howe report for the year ended December 31,
(b) This is a sales-type lease, so at the inception of the
lease, the lessor would recognize sales of $3,300,000 (the PV of
the lease payments), and cost of goods sold of $2,800,000, resulting
in profit on the sale of $500,000 ($3,300,000 –
$2,800,000). Note that the list selling price of an asset
($3,520,000 in this case) is not always representative of its FV.
An asset can often be purchased for less than its list price.
The excess of the fair value of leased property at the inception
of the lease over its cost or carrying amount should be classified
by the lessor as
(c) The excess of the fair value of leased property at the
inception of the lease over the lessor’s cost is defined as the manufacturer’s
or dealer’s profit. Answer (a) is incorrect because the
unearned income from a sales-type lease is defined as the difference
between the gross investment in the lease and the sum of
the present values of the components of the gross investment.
Answer (b) is incorrect because the unearned income from a
direct-financing lease is defined as the excess of the gross investment
over the cost (also the PV of lease payments) of the leased
property. Answer (d) is incorrect because a sales-type lease involves a manufacturer’s or dealer’s profit while a direct financing
lease does not
In a lease that is recorded as a sales-type lease by the lessor,
(c) Revenue is to be recognized for a sales-type lease
over the lease term so as to produce a constant rate of return on
the net investment in the lease. This requires the use of the interest
method. Interest revenue does arise in a sales-type lease.
Answer (a) is incorrect because the interest is to be earned over
the life of the lease, not in full at the lease’s inception.
Lease M does not contain a bargain purchase option, but the
lease term is equal to 90% of the estimated economic life of the
leased property. Lease P does not transfer ownership of the
property to the lessee at the end of the lease term, but the lease
term is equal to 75% of the estimated economic life of the leased
property. How should the lessee classify these leases?
Lease M Lease P
(b) If any of the criteria for classification as a capital
lease are met, the lease is classified as such. One of the capital
lease criterion is that the lease term is equal to 75% or more of the
estimated economic life of the leased property. Thus, both leases
M and P should be classified as capital leases.
On December 31, year 1, Day Co. leased a new machine
from Parr with the following pertinent information:
Lease term 6 years
Annual rental payable at beginning of each year $50,000
Useful life of machine 8 years
Day’s incremental borrowing rate 15%
Implicit interest rate in lease (known by Day) 12%
Present value of annuity of 1 in advance for 6 periods at
The lease is not renewable, and the machine reverts to Parr at the
termination of the lease. The cost of the machine on Parr’s accounting
records is $375,500. At the beginning of the lease term,
Day should record a lease liability of
(b) This is a capital lease for the lessee because the lease
term is 75% of the useful life of the machine [6 years = (75% × 8
years)]. For a capital lease, the lessee records as a leased asset
and a lease obligation the lower of the PV of the minimum lease
payments or the FV of the leased asset (not given in this problem).
The PV of the minimum lease payments is computed using
the lower of the lessee’s incremental borrowing rate (15%) or the
implicit rate used by the lessor if known by the lessee (12%).
Since the implicit rate is lower, and known by the lessee, it is used
to compute the PV ($50,000 × 4.61 = $230,500). The cost of the
asset on the lessor’s books ($375,500) is irrelevant.
On January 1, year 1, Day Corp. entered into a ten-year
lease agreement with Ward, Inc. for industrial equipment. Annual
lease payments of $10,000 are payable at the end of each
year. Day knows that the lessor expects a 10% return on the
lease. Day has a 12% incremental borrowing rate. The equipment
is expected to have an estimated useful life of ten years. In
addition, a third party has guaranteed to pay Ward a residual
value of $5,000 at the end of the lease.
The present value of an ordinary annuity of $1 at
12% for ten years is 5.6502
10% for ten years is 6.1446
The present value of $1 at
12% for ten years is .3220
10% for ten years is .3855
In Day’s October 31, year 1 balance sheet, the principal amount
of the lease obligation was
(b) This is a capital lease since the lease term (ten years)
is the same as the useful life of the leased asset. In a capital lease,
the lessee records an asset and a liability based on the PV of the
minimum lease payments. The minimum lease payments includes
rentals and a guaranteed residual value, if guaranteed by
the lessee. In this case the minimum lease payments include
only the rentals, since the residual value is guaranteed by a third
party. The minimum lease payments are discounted using the
lower of the lessee’s incremental borrowing rate or the implicit
rate used by the lessor, if known. In this case, the lessee knows
the implicit rate is 10%, which is lower than the incremental borrowing
rate of 12%. Thus, the present value or principal amount
of the lease obligation is $61,446 ($10,000 × 6.1446) through the
first year. Although accrued interest would be recognized at
10/31/Y1, the principal amount does not change until 1/1/Y2.
Robbins, Inc. leased a machine from Ready Leasing Co.
The lease qualifies as a capital lease and requires ten annual payments
of $10,000 beginning immediately. The lease specifies an
interest rate of 12% and a purchase option of $10,000 at the end
of the tenth year, even though the machine’s estimated value on
that date is $20,000. Robbins’ incremental borrowing rate is
The present value of an annuity due of one at
12% for ten years is 6.328
14% for ten years is 5.946
The present value of one at
12% for ten years is .322
14% for ten years is .270
What amount should Robbins record as lease liability at the beginning
of the lease term?
(c) The lessee records a capital lease at the present value
of the minimum lease payments. The minimum lease payments
includes rental payments and bargain purchase options (among
other items). The $10,000 purchase option is a bargain purchase
option because it allows the lessor to purchase the leased
asset at an amount less than its expected fair value. The lessee
computes the present value using its incremental borrowing rate
(14%), unless the lessor’s implicit rate (12%) is lower and is
known by the lessee. This question indicates that the implicit
rate is stated in the lease; therefore it would be known to the
lessee. At the beginning of the lease term, Robbins should record
a leased asset and lease liability at $66,500.
PV of rentals ($10,000 × 6.328) = $63,280
PV of BPO ($10,000 × .322) = 3,220
PV at 12% $66,500
Neal Corp. entered into a nine-year capital lease on a warehouse
on December 31, year 1. Lease payments of $52,000,
which includes real estate taxes of $2,000, are due annually, beginning
on December 31, year 2, and every December 31 thereafter.
Neal does not know the interest rate implicit in the lease;
Neal’s incremental borrowing rate is 9%. The rounded present
value of an ordinary annuity for nine years at 9% is 5.6. What
amount should Neal report as capitalized lease liability at December
31, year 1?
(a) The annual executory costs (real estate taxes of
$2,000) are not an expense or liability until incurred; therefore
they are excluded from the minimum lease payments and are not
reflected in the initial lease liability. The 12/31/Y1 capital lease
liability is recorded at the PV of the minimum lease payments
[5.6 × ($52,000 – $2,000) = $280,000].