Solutions

CHAPTER 21

Accounting for Leases

ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)

Topics / Questions / Brief
Exercises / Exercises /
Problems / Concepts for Analysis
1. Rationale for leasing. / 1, 2, 3
2. Concepts, classification, and measurement
of leases. / 4, 5, 6, 7, 8, 10, 11, 12, 13, 14, 17, 19, 20 / 5, 9 / 1 / 1
3. Finance / Sales – Type Leases. / 16, 18, 19, 22, 23, 24, 25 / 1, 2, 3, 4, 6, 7, 8, 10, 11, 12, 13, 14 / 2, 3, 4, 5,6,7,8,9,10, 11, 12, 13, 14, 15 / 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14 / 2, 4, 5
4. Operating leases. / 15, 21, 22 / 15, 16, 17, 18, 19 / 16, 17, 18, 19, 20, 21, 22 / 15, 16, 17 / 2, 4
5. Special Issues
Residual values; bargain-purchase options; Other lease costs; initial direct costs, presentation and disclosure. / 9, 10, 12, 17, 26, 27, 28, 30, 31 / 4, 8, 9, 20, 21, 22, 23, 24, 25, 26, 27, 28 / 1, 2, 3, 4,5, 6,7,8, 9, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19, 20,21, 22 / 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14 / 1, 2, 3, 4, 5, 6
*6. Sale-leaseback. / 32, 33 / 29, 30 / 23, 24 / 7
*7. Direct financing lease. / 34, 35, 36 / 31, 32 / 25

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


ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)

Learning Objectives /
Questions /
Brief Exercises / Exercises / Problems / Concepts for Analysis
1. Understand the environment related to leasing transactions. / 1, 2, 3, 4, 5, 6, 7, 8, 10, 11, 12, 14, 17, 19, 20 / 5, 9 / 1 / 1
2. Explain the accounting for finance/sales-type leases. / 16, 18, 19, 22, 23, 24, 25 / 1, 2, 3, 4, 6, 7, 8, 10, 11, 12, 13, 14 / 2, 3, 4, 5, 6,7,8,9, 10, 11, 12, 13, 14, 15 / 1, 2, 3, 5, 6, 7, 8, 10, 11, 12, 13, 14, 15 / 2, 4, 7, 5
3. Explain the accounting for operating leases. / 15, 21, 22 / 15, 16, 17, 18, 19 / 16, 17, 18, 19, 20, 21, 22 / 9, 15, 16, 17 / 2, 4
4. Discuss the accounting and reporting for special features of lease arrangements. / 9, 10, 12, 13, 17, 26, 27, 28, 29, 30, 31 / 4, 8, 9, 20, 21, 22, 23, 24, 25, 26, 27, 28 / 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19, 20, 21, 22 / 1, 2, 3, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14 / 1, 2, 3, 4, 5, 7
*5. Describe the lessee’s accounting for sale-leaseback transactions. / 32, 33 / 29, 30 / 23, 24 / 7
*6 Describe the lessor’s accounting for a direct financing lease. / 34, 35, 36 / 31, 32 / 25

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


ASSIGNMENT CHARACTERISTICS TABLE

Item / Description / Level of
Difficulty / Time
(minutes)
E21-1 / Lessee Entries; Finance Lease with No Residual Value / Moderate / 15–20
E21-2 / Lessee Entries; Finance Lease with Unguaranteed Residual Value / Moderate / 15–20
E21-3 / Lessee Computations and Entries; Finance Lease with Guaranteed Residual Value / Moderate / 20–25
E21-4 / Lessee Entries; Finance Lease and Unguaranteed Residual Value / Moderate / 20–30
E21-5 / Computation of Rental; Journal Entries for Lessor / Simple / 15–25
E21-6 / Lessor Entries; Sales-Type Lease with Option to Purchase / Moderate / 20-25
E21-7 / Type of Lease; Amortization Schedule / Moderate / 15-20
E21-8 / Lessor Entries; Sales-Type Lease / Moderate / 15-20
E21-9 / Lessee Entries; Initial Direct Costs / Moderate / 20–25
E21-10 / Lessee Entries with Bargain-Purchase Option / Moderate / 20-30
E21-11 / Lessor Entries with Bargain-Purchase Option / Moderate / 20–30
E21-12 / Lessee-Lessor Entries; Sales-Type Lease with a Bargain Purchase Option / Moderate / 20-25
E21-13 / Lessee-Lessor Entries; Sales-Type Lease; Guaranteed Residual Value / Moderate / 20-25
E21-14 / Lessee Entries; Initial Direct Costs / Simple / 20-25
E21-15 / Amortization Schedule and Journal Entries for Lessee. / Moderate / 20–30
E21-16 / Amortization Schedule and Journal Entries for Lessee. / Moderate / 20–30
E21-17 / Accounting for an Operating Lease / Moderate / 10-20
E21-18 / Accounting for an Operating Lease / Simple / 15–20
E21-19 / Accounting for an Operating Lease / Moderate / 20-25
E21-20 / Accounting for an Operating Lease / Moderate / 20–25
E21-21 / Accounting for an Operating Lease / Moderate / 20–25
E21-22 / Accounting for an Operating Lease / Moderate / 25-30
*E21-23 / Sale-Leaseback / Moderate / 20-30
*E21-24 / Lessee-Lessor, Sale-Leaseback / Moderate / 20–30
*E21-25 / Direct Financing Lease / Moderate / 20-25
P21-1 / Lessee Entries, Finance Lease. / Simple / 20–25
P21-2 / Lessee Entries and Balance Sheet Presentation, Finance Lease. / Simple / 20–30
P21-3 / Lessee Entries and Balance Sheet Presentation, Finance Lease. / Moderate / 35–45
P21-4 / Lessee Entries, Finance Lease with Monthly Payments. / Moderate / 30–40
P21-5 / Basic Lessee Accounting with Difficult PV Calculation / Moderate / 40-50
P21-6 / Lessee-Lessor Entries, Finance Lease with a Guaranteed Residual Value. / Simple / 25–35
P21-7 / Lessor Computations and Entries, Sales-Type Lease with Guaranteed Residual Value. / Complex / 30-40
P21-8 / Lessee Computations and Entries, Finance Lease with Guaranteed Residual Value. / Complex / 30–40
P21-9 / Lessor Computations and Entries, Sales-Type Lease with Unguaranteed Residual Value. / Complex / 30-40
P21-10 / Lessee Computations and Entries, Finance Lease with Unguaranteed Residual Value. / Complex / 30–40
P21-11 / Lessee-Lessor Accounting for Residual Values. / Complex / 30–40
P21-12 / Lessee-Lessor Entries, Balance Sheet Presentation, Finance and Sales-Type Lease. / Moderate / 35-45
P21-13 / Balance Sheet and Income Statement Disclosure—Lessee. / Moderate / 35–45
P21-14 / Balance Sheet and Income Statement Disclosure—Lessor. / Moderate / 40-50
P21-15 / Finance and Operating Lease. / Moderate / 30–40
P21-16 / Operating lease. / Moderate / 30–40
P21-17 / Lessee-Lessor Entries, Operating Lease with an Unguaranteed Residual Value. / Moderate / 30–40
Item / Description / Level of
Difficulty / Time
(minutes)
CA21-1 / Lessee accounting and reporting. / Moderate / 15–25
CA21-2 / Lessor and lessee accounting and disclosure. / Moderate / 25–35
CA21-3 / Lessee capitalization tests. / Moderate / 20–30
CA21-4 / Comparison of different types of accounting by lessee
and lessor. / Moderate / 15–25
CA21-5 / Lease capitalization, bargain-purchase option. / Moderate / 20–25
CA21-6 / Short-Term lease vs. finance lease. / Moderate / 20–30
*CA21-7 / Sale-Leaseback. / Moderate / 15–25


ANSWERS TO QUESTIONS

1. The major lessor groups in the United States are banks, captives, and independents. Banks are the largest players in the leasing business. Captives are subsidiaries whose primary business is to perform leasing operations for the parent company. They have the point of sale advantage in finding leasing customers for as soon as a parent receives a possible order, a lease financing arrangement can be developed by its leasing subsidiary. Furthermore, the captive (lessor) has the product knowledge which gives it an advantage when financing the parents’ product. The current trend is for captives to focus on the company’s products rather than to do general lease financings. Last, independents are often good at developing innovative contracts for lessees.

LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None

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

1. Leasing may be more flexible in that the lease agreement may contain less restrictive provisions than the bond indenture.

2. Leasing permits 100% financing of assets, as the lease is often signed without requiring any money down from the lessee.

3. Leasing may permit more rapid changes in equipment, reduce the risk of obsolescence, and pass the risk in residual value to the lessor or a third party.

4. Leasing may have favorable tax advantages.

(b) Assuming that funds are readily available through debt financing, there may not be great advantages (in addition to the above-mentioned) to signing a noncancelable, long-term lease. One additional advantage of leasing is its availability when other debt financing is unavailable.

(c) Given the new reporting standard on leasing the financial statement effects of a long-term noncancelable lease versus the purchase of the asset are somewhat similar. That is assets under a long term lease are capitalized at the present value of the future lease payments and this value is probably equivalent to the purchase price of the assets. On the liability side, the bond payable amount would be equivalent to the present value of the future lease payments. In summary, the amounts presented in the balance sheet would be quite comparable. The description of the leased asset (right-of-use asset) and related liability would however be different than under a bond financing as would the general classifications; the specific labels (leased assets and lease liability) would be different.

LO: 1, Bloom: C, Difficulty: Moderate, Time: 5-10, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None

3. Possible advantages of leasing for a lessor:

1. It often provides profitable interest margins.

2. It can stimulate sales of a lessor’s product whether it be from a dealer (lessor) or a manufacturer (lessor).

3. It often provides tax benefits which enhances the return for the lessor and other parties to the lease.

4. It can provide a high residual value to the lessor upon the return of the property at the end of the lease term, which can potentially provide very large profits.

LO: 1, Bloom: C, Difficulty: Moderate, Time: 5-10, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None

4. Lessees generally have two possible lease accounting methods: (a) the finance method and (b) the operating method. Under both methods, the lessee records a right-of-use asset and a related lease liability. However, the subsequent treatment of the right-of-use asset and lease liability differs under each method. For a finance lease, the lessee recognizes interest expense on the lease liability over the life of the lease using the effective interest method and records amortization expense on the right-of-use asset generally on a straight line basis. A lessee therefore reports both interest expense and amortization of the right to use asset on the income statement. In an operating lease the lessee also measures interest expense using the effective interest method. However the lessee amortizes the right-of-use asset, such that the total lease expense is the same from period to period. In other words for operating leases, only a single lease expense (comprised of interest on the liability and amortization of the right-of-use asset) is recognized on the income statement typically on a straight-line basis.

To determine which method to apply, a lessee should classify a lease based on whether the arrangement is effectively a purchase of the underlying asset (i.e. if control transfers to the lessee). If the lease meets one of five classification tests to determine whether the arrangement is effectively a purchase of the underlying asset, the lease is treated as a finance lease. Otherwise, if none of the tests are met, the lessee is deemed to only obtain the right to use the asset (not ownership of the asset itself), and accounts for the lease as an operating lease.

LO: 1, Bloom: C, Difficulty: Moderate, Time: 5-10, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None

5. The five classification tests are the following:

1. Transfer of Ownership Test: if the lease transfers ownership of the asset to the lessee at the end of the lease term, it is a finance lease.

2. Lease Purchase Option Test: if it is reasonably certain that the lessee will exercise the option (i.e. it is a bargain purchase option), it is a finance lease.

3. Lease Term Test: when the lease term is a major part of the remaining economic life of the leased asset (often indicated by a guideline of 75% or more of the economic life of the asset), then the lease is a finance lease.

4. Present Value Test: if the present value of the lease payments (fixed payments + residual value guarantee + bargain-purchase option) is reasonably close to the fair value of the asset (often indicated by a guideline of 90% or more of the fair value of the asset), then the lease is a finance lease.

5. Alternative Use Test: if at the end of the lease term, the lessor does not have an alternative use for the asset, the lease is a finance lease.

LO: 1, Bloom: C, Difficulty: Moderate, Time: 5-10, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None

6. The discount rate used by the lessee in the present value test and for valuing the lease liability is the implicit interest rate used by the lessor. This rate is defined as the discount rate that, at the commencement of the lease, causes the aggregate present value of the lease payments and unguaranteed residual value to be equal to the fair value of the leased asset. However, if it is impracticable for the lessee to determine the implicit rate of the lessor, the lessee should use its incremental borrowing rate. The incremental borrowing rate is the rate of interest the lessee would have to pay on a similar lease or incur to borrow over a similar term the funds necessary to purchase the asset.

LO: 1, Bloom: C, Difficulty: Moderate, Time: 5-10, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None

7. (a) If a lease is for a major part of the economic life of the lease, the lease is classified as a finance lease. In practice, 75% of the economic life of the asset is generally used to meet this classification test. That is, if the lease term is 75% or greater of the economic life of the asset, the lease is classified as a finance lease.