Chapter 12
Financial Reporting for Leases
True-False
1. Under ASC 840, when accounting for an operating lease, a liability is recognized when the lease
is signed by the lessee.
2. Under ASC 842, when accounting for a long-term operating lease, a liability is recognized when
the lease is signed by the lessee.
3. Under ASC 840, operating leases are financial statement examples of off –balance sheet financing.
4. Loan covenants are one reason lessees prefer operating lease treatment.
5. The lessee of a finance lease (ASC 842) and of a capital lease (ASC 840) must depreciate a leased
asset over the lease term assuming that any one of the lease criteria applicable to the lessee are met.
6. The annual interest expense associated with a capital lease (ASC 840) decreases over the term of
the lease.
7. A lessee’s minimum lease payments includes the present value of a residual value guarantee.
9. Managers in lessee companies prefer that leases be treated as capital leases.
10. For a lessor using the operating lease method of recording a lease under ASC 840, the net effect
on income is recognized evenly throughout the term of the lease, if the lessor uses straight-line de-
preciation.
11. The lessor’s Net investment in leased asset balance is the same at the end of the lease term
whether the residual value is guaranteed or unguaranteed.
12. The lessor does not have any asset recorded in its financial statements for a lease classified as a
sales-type lease.
13. Under ASC 842 for sale and leaseback transactions, if the seller-lessee does not relinquish con-
trol of the asset, then the seller-lessee would record the cash received as a loan payable rather than
as revenue.
14. Under international standards for lease accounting, operating lease treatment could be required
by the lessee if the leased asset is so specialized that significant modifications would be needed for
another party to use it.
15. Under ASC 842 and IFRS 16, the standards are converged in that there are five criteria to deter-
mine whether a lease qualifies as a finance lease for the lessee.
16. Under ASC 842, long-term operating leases are reported on the lessee’s balance sheet, and de-
preciation expense will be recorded for the right-of-use asset. .
17. Constructive capitalization provides a preview of how ASU 2016-02 will affect lessee financial
statements that use the ASC 840 standards until the effective date of ASC 842.
Multiple-Choice Questions
Select the best answer from those provided.
18. A lease is legally a/an ___________ contract.
a. mutually performed
b. executed
c. executory
d. unilateral
19. When accounting for an operating lease under ASC 840, which one of the following accounts
are charged with the expense on the lessee’s income statement?
a. Depreciation Expense
b. Amortization Expense
c. Rent Expense
d. Lease Operating Expense
20. When accounting for a long-term operating lease under ASC 842, which one of the following
accounts are charged with the expense on the lessee’s income statement?
a. Depreciation Expense
b. Amortization Expense
c. Rent Expense
d. Lease Expense
21. Under ASC 840, the lessor of a building with an operating lease will present on its balance sheet
an asset equal to
a. zero.
b. the present value of future lease receipts.
c. the depreciated historical cost of the asset.
d. the fair value of the leased asset.
22. Under ASC 840, operating leases require note disclosure of minimum lease payments for the
a. amount of annual rental payments for the next five years.
b. discounted present value of future lease payments for the total of the next five years and the
aggregate thereafter.
c. undiscounted present value of total future lease payments.
d. future cash outflows for each of the next five years and the aggregate thereafter.
23. Compared to a firm with a capital lease, operating leases under ASC 840 help the lessee firm
earn
a. a higher asset turnover ratio.
b. a lower return on assets.
c. a higher debt-to-equity ratio.
d. a lower NOPAT.
24. If a corporation signs a ten-year lease for a building and the present value of the lease payments
is $250,000, the lease is a capital lease under ASC 840 if the
a. fair value of the building is $1,000,000.
b. remaining useful life of the building is 20 years.
c. lessor can purchase the building for $5,000 at the end of the lease when the fair value is esti-
mated to be $25,000.
d. building reverts back to the lessor at the end of the lease.
25. If a corporation signs a ten-year lease for a building and the present value of the lease payments
is $250,000, the lease is a finance lease under ASC 842 if the
a. fair value of the building is $1,000,000.
b. remaining useful life of the building is 20 years.
c. lessor can purchase the building for $5,000 at the end of the lease when the fair value is esti-
mated to be $25,000.
d. building reverts back to the lessor at the end of the lease.
26. GAAP establishes specific criteria for the treatment of leases under ASC 840 and ASC 842. If
any of the criteria are met, the lessee
a. must treat the lease as an operating lease under ASC 840.
b. must treat the lease as a capital lease under ASC 840 or a finance lease under ASC 842.
c. may choose the treatment if two or less criteria are met.
d. may elect to treat the lease as an operating lease under ASC 840 and ASC 842 if only one criterion is
met.
27. GAAP establishes specific criteria for the treatment of leases under ASC 840. Which of the fol-
lowing does not accurately describe the criteria applicable to a lessee?
CHAPTER 12 Financial Reporting for Leases
a. The lease agreement contains a bargain purchase option.
b. The lease term is equal to or exceeds 75% of the leased asset’s useful life.
c. The lease agreement transfers title of the leased asset to the lessee at the end of the lease term.
d. The present value of the minimum lease payments is equal to or greater than 75% of the leased
asset’s fair value.
28. When a lessee has a capital lease under ASC 840, the amount shown for the asset and the
amount shown for the related liability are equal
a. only at the lease inception.
b. throughout the life of the lease.
c. only at the termination of the lease.
d. throughout the life of the lease, but only when there is an unguaranteed residual value.
29. When a lessee has a finance lease under ASC 842, the amount shown for the asset and the
amount shown for the related liability are equal
a. only at the lease inception.
b. throughout the life of the lease.
c. only at the termination of the lease.
d. throughout the life of the lease, but only when there is an unguaranteed residual value.
30. Under ASC 840, a lessee mistakenly treated an operating lease as a capital lease. How does this
mistake impact the following at the inception of the lease?
Total Assets Total Liabilities
a. Understated Overstated
b. Understated Understated
c. Overstated Overstated
d. Overstated Understated
31. Under ASC 840, a lessee mistakenly treated an operating lease as a capital lease. How does this
mistake impact the following at the inception of the lease?
Current Ratio Asset Turnover Ratio
a. Overstated Understated
b. Understated Understated
c. Overstated Overstated
d. Understated Overstated
32. A lessor mistakenly treated a direct financing lease as an operating lease. How does this mistake
impact the following at the end of the first year of the lease term?
Rent/Lease Revenue Interest Revenue
a. Overstated Understated
b. Understated Understated
c. Overstated Overstated
d. Understated Overstated
33. A lessor mistakenly treated a direct financing lease as an operating lease (the lessor uses
straight-line depreciation). How does this mistake impact the following at the end of the first year of
the lease term?
Net Income Interest Revenue
a. Overstated Understated
b. Understated Understated
c. Overstated Overstated
d. Understated Overstated
34. Under ASC 840, a lessee must use which one of the following discount rates to value a capital
lease?
a. Prime rate
b. Lower of implicit lease rate or prime lending rate
c. Lessee’s incremental borrowing rate
d. Lower of the known implicit lease rate or lessee’s incremental borrowing rate
35. When accounting for a capital lease under ASC 840, depreciation expense is equal to the
a. lease payments.
CHAPTER 12 Financial Reporting for Leases
b. principal portion of the lease payments.
c. normal depreciation computed on the depreciable base of the asset.
d. straight-line depreciation only on the full amount of the leased asset.
36. Executory costs of a lease are treated by the lessee as
a. capitalized costs of the lease.
b. additional interest expense.
c. operating expenses.
d. deferred revenue.
37. If a lease contains a residual value guarantee, the lessee must
a. add the guaranteed amount to the present value of the minimum lease payments.
b. add the present value of the guaranteed amount to the present value of the minimum lease pay-
ments.
c. include the guaranteed amount in the minimum lease payments only if the lessee intends to keep
the asset at the end of the lease.
d. ignore the guaranteed amount if the lessee intends to keep the asset at the end of the lease.
38. All the following statements about residual value guarantees are correct about residual value
guarantees, except that they
a. protect lessors against lessees who abuse leased assets.
b. protect lessees against lessors who abuse leased assets.
c. protects lessors against technological changes.
d. protects lessors against marketplace changes.
Use the following to answer questions 39 – 47:
REFERENCE: Ref. 12_01
Pepper, Inc. agrees to lease equipment from the Blue Corporation for 10 years at $25,000 at the end
of each year. The equipment has a fair value of $175,000 and an estimated useful life of 10 years.
The lease includes a guaranteed residual value of $10,000. In addition to the lease payments, Pepper
will pay $5,000 per year for a maintenance agreement. Pepper can finance this lease with its bank at
a 12% rate. The lessor’s implicit lease rate, known to the lessee, is 10%. The lessor and the lessee
use ASC 840 guidelines for lease accounting.
Present value interest factors are:
10% 12%
PV factor of $1 for 10 periods 0.38554 0.32197
PV factor for ordinary annuity for 10 periods 6.14457 5.65022
[QUESTION]
REFER TO: Ref. 12_01
39. To value the lease asset, Pepper should use a discount rate of
a. 10%.
b. 11%.
c. 12%.
d. prime rate.
40. The Pepper lease is a/an
a. operating lease because the lease value is less than 90% of the fair value of the asset.
b. capital lease because the lease value is 90% of the fair value of the asset.
c. operating lease because the asset reverts to Blue at the end of the lease.
d. capital lease because the lease term is more than 75% of the life of the asset.
41. Upon acquisition, the leased equipment will be valued on Pepper’s balance sheet at (Round all
calculations to the nearest whole dollar amount.)
a. $144,475.
b. $157,469.
c. $175,000.
d. $250,000.
42. The lease liability will be valued on Pepper’s balance sheet at (Round all calculations to the
nearest whole dollar amount.)
a. $144,475.
b. $157,469.
c. $175,000.
d. $250,000.
43. The entry to record this lease on Pepper’s books is (Round all calculations to the nearest whole
dollar amount.)
a. DR Leased equipment—Capital lease 144,475
CR Obligation under capital lease 144,475
b. DR Leased equipment—Capital lease 157,469
CR Obligation under capital lease 157,469
c. DR Leased equipment—Capital lease 157,469
DR Discount on lease obligation 92,531
CR Obligation under capital lease 250,000
d. DR Leased equipment—Capital lease 167,469
DR Discount on lease obligation 82,531
CR Obligation under capital lease 250,000
44. At the end of Year 1, Pepper will make a payment of $30,000. Which one of the following entries
will properly record this payment? (Round all calculations to the nearest whole dollar amount.)
a. DR Obligation under capital lease 30,000
CR Cash 30,000
b. DR Obligation under capital lease 14,253
DR Interest expense 15,747
CR Cash 30,000
c. DR Obligation under capital lease 9,253
DR Maintenance expense 5,000
DR Interest expense 15,747
CR Cash 30,000
d. DR Obligation under capital lease 25,000
DR Maintenance expense 5,000
CR Cash 30,000
45. How much straight-line depreciation expense will Pepper record for Year 1? (Round all calcula-
tions to the nearest whole dollar amount.)
a. $14,747
b. $15,362
c. $15,747
d. $17,500
46. If the equipment is worth $12,500 at the end of the lease, Pepper will make which one of the
following journal entries?
a. DR Obligation under capital lease 12,500
CR Leased equipment—Capital lease 12,500
b. DR Obligation under capital lease 10,000
CR Leased equipment—Capital lease 10,000
c. DR Obligation under capital lease 10,000
CR Accumulated depreciation 10,000
d. No entry required.
47. If the equipment is worth $7,500 at the end of the lease, Pepper will make which one of the fol-
lowing journal entries?
a. DR Obligation under capital lease 7,500
CR Leased equipment—Capital lease 7,500
b. DR Obligation under capital lease 12,500
CR Leased equipment—Capital lease 10,000
CR Cash 2,500
c. DR Obligation under capital lease 10,000
DR Loss on residual value guarantee 2,500
CR Leased equipment—Capital lease 10,000
CR Cash 2,500
d. No entry required.
48. Under ASC 840, over the life of a lease, the amount charged to expense is
a. greater for an operating lease.
b. greater for a capital lease.
c. the same for a capital or operating lease.
d. less for a capital lease.
49. Under ASC 840, the difference between the expense charged with a capital lease and an operat-
ing lease is
a. the amount of total expense, with a capital lease higher than an operating lease.
b. the amount of total expense, with an operating lease higher than a capital lease.
c. the number of years that recognize expense.
d. the timing of the expense recognition.
50. To adjust for distortions that arise from off-balance sheet leases when comparing among firms,
analysts rely on
a. the balance sheet.
b. the income statement.
c. the statement of stockholders’ equity.
d. required note disclosures.
51. Which one of the following ratios deteriorates with the lessee’s capitalization of a lease under ASC
840?
a. Current ratio
b. Return on equity
c. Inventory turnover
d. Common earnings leverage
52. Which of the following does not describe a difference between ASC 842 and IFRS16?
a. IFRS allows some right-of-use assets to be carried at fair value.
b. IFRS does not provide for operating leases.
c. IFRS permits early adoption only if firms have adopted IFRS 15, the new revenue recognition
standard.
d. ASC 842 limits the recognized gain to that of the residual interest retained by the buyer-lessor.
53. If a car dealership leases cars for four years with guaranteed purchase options, guaranteed resid-
ual values, and insured financing agreements, these leases are treated under ASC 840 as
a. operating leases.
b. capital leases.
c. sales-type leases.
d. direct-financing leases.
CHAPTER 12 Financial Reporting for Leases
Use the following to answer questions 54 – 56:
REFERENCE: Ref. 12_02
Blue Manufacturing produces lathes at an inventory cost of $25,000 each that sell for $32,000 each.
For credit-approved customers, Blue leases the lathes for $8,500 per year for five years. The lathes
are guaranteed to last four years and generally have a six-year life. Collection is predictable and
reasonably assured. Additionally, the lessor is aware of all costs to be incurred under the lease that
will not be reimbursed by the lessor.
[QUESTION]
REFER TO: Ref. 12_02
54. Blue Manufacturing treats a lathe lease as a/an
a. operating lease.
b. ordinary capital lease.
c. sales-type lease.
d. direct-financing lease.
55. What is the manufacturing profit of Blue Manufacturing on a leased lathe?
a. $7,000
b. $8,500
c. $10,500
d. $17,500