On January 1, year 1, Hooks Oil Co. sold equipment with a
carrying amount of $100,000, and a remaining useful life of ten
years, to Maco Drilling for $150,000. Hooks immediately leased
the equipment back under a ten-year capital lease with a present
value of $150,000 and will depreciate the equipment using the
straight-line method. Hooks made the first annual lease payment
of $24,412 in December year 1. In Hooks’ December 31, year 1
balance sheet, the unearned gain on equipment sale should be
(b) Sale-leaseback transactions are treated as though
two transactions were a single financing transaction, if the lease
qualifies as a capital lease. Any gain on the sale is deferred and
amortized over the lease term (if possession reverts to the lessor)
or the economic life (if ownership transfers to the lessee); both
are ten years in this case. Since this is a capital lease, the entire
gain ($150,000 – $100,000 = $50,000) is deferred at 1/1/Y1. At
12/31/Y1, an adjusting entry must be prepared to amortize 1/10
of the unearned gain (1/10 × $50,000 = $5,000), because the
lease covers ten years. Therefore, the unearned gain at 12/31/Y1
is $45,000 ($50,000 – $5,000).
In a sale-leaseback transaction, the seller-lessee has retained
the property. The gain on the sale should be recognized at the
time of the sale-leaseback when the lease is classified as a(n)
Capital lease Operating lease
(b) Any profit related to a sale-leaseback transaction in
which the seller-lessee retains the property leased (i.e., the sellerlessee
retains substantially all of the benefits and risks of the ownership
of the property sold), shall be deferred and amortized in
proportion to the amortization of the leased asset, if a capital
lease. If it is an operating lease, the profit will be deferred in proportion
to the related gross rental charged to expense over the
lease term. It is important to note that losses, however, are
recognized immediately for either a capital or operating lease.
Since the gain on the sale should be deferred in either case, no
gain is recognized at the time of the sale.
NOTE: An example of an operating lease in which
substantially all of the remaining use of the leased asset
is retained by the lessee occurs when the lease term
begins within the last 25% of the asset’s original useful
Able sold its headquarters building at a gain, and simultaneously
leased back the building. The lease was reported as a capital
lease. At the time of sale, the gain should be reported as
(d) In a sale-leaseback transaction, if the leaseback is
recorded as a capital lease and the lessee has retained substantially
all of the rights to use the property, then any gain on the
sale must be deferred and amortized over the life of the property
in proportion to the amortization of the leased asset. This deferred
gain acts as an asset valuation allowance resulting in the
net amount shown for the leased asset being equal to the same
carrying value as if the sale and leaseback transaction had not
On January 1, year 1, Goliath entered into a five-year operating
lease for equipment. In January year 3, Goliath decided that
it no longer needs the equipment and terminates the contract by
paying a penalty of $3,000. How should Goliath account for the
lease termination costs?
(a) A termination of an operating lease requires that the
fair value of the termination costs be recognized as an expense or
loss in calculating income from continuing operations in the year
the lease was terminated.
In January year 1, Hopper Corp. signed a capital lease for
equipment with a term of twenty years. In year 3, Hopper negotiated
a modification to a capital lease that resulted in the lease
being reclassified as an operating lease. Hopper calculated the
company had a gain of $8,000 on the lease modification. Hopper
retains all rights to use the property during the remainder of the
lease term. How should Hopper account for the lease modification?
(b) A modification to a capital lease that changes the
classification of the lease to an operating lease requires the transaction
be accounted for as a sales-leaseback transaction. Since
Hopper retains substantially all rights to use the property (and
the property is not within the last 25% of its useful life), the gain
will be deferred and recognized over the remaining lease term.
56. (c) A loss on a capital lease termination is recognized
immediately as a loss from continuing operations.
On January 1, year 1, Belkor entered into a 10-year capital
lease for equipment. On December 1, year 4, Belkor terminates
the capital lease and incurs a $20,000 loss. How should Belkor
recognize the lease termination on their financial statements?
(c) A loss on a capital lease termination is recognized
immediately as a loss from continuing operations.
Morgan Corp. signs a lease to rent equipment for ten years.
The lease payments of $10,000 per year are due on January 2
each year. At the end of the lease term, Morgan may purchase
the equipment for $50. The equipment is estimated to have a
useful life of 12 years. Morgan prepares its financial statements in
accordance with IFRS. Morgan should classify this lease as a(n)
(c) The requirement is to identify how the lease should
be classified. Answer (c) is correct because IFRS requires a lease
to be classified as a finance lease if substantially all the risks or
benefits of ownership have been transferred to the lessee. Because
the lease contains a bargain purchase option, it meets the
criteria for a finance lease. Answer (a) is incorrect because the
lease does not qualify as an operating lease since the risks and
benefits of ownership have been transferred. Answer (b) is incorrect
because US GAAP uses the term “capital lease,” whereas
IFRS uses the term “finance lease.” Answer (d) is incorrect because
IFRS does not use the term “sales-type lease.”
Santiago Corp. signs an agreement to lease land and a building
for 20 years. At the end of the lease, the property will not
transfer to Santiago. The life of the building is estimated to be 20
years. Santiago prepares its financial statements in accordance
with IFRS. How should Santiago account for the lease?
(c) The requirement is to identify how Santiago should
account for the lease. Answer (c) is correct because IFRS provides
that because land has an indefinite life, if title is not expected
to pass by the end of the lease term, then the substantial
risks and rewards of ownership do not transfer. Thus, the lease
should be separated into two components. The land should be
recorded as an operating lease and the building should be recorded
as a finance lease.
Which of the following is not true regarding lease accounting
(d) The requirement is to identify the incorrect statement
regarding lease accounting under IFRS. Answer (d) is
correct because IFRS does not use the same thresholds as US
GAAP. IFRS standards require more judgment
Under IFRS what is the interest rate used by lessees to capitalize
a finance lease when the implicit rate cannot be determined?
(d) The requirement is to identify the rate used to capitalize
a finance lease when the implicit rate cannot be determined.
Answer (d) is correct because the lessee’s incremental
borrowing rate is used.