EXAMPLE TEST QUESTIONS

Chapter 13

1. Under the capital method of accounting for leases the excess of aggregate rentals over the cost of leased property should be recognized as revenue of the lessora. In increasing amounts during the term of the leaseb. In constant amounts during the term of the leasec. In decreasing amounts during the term of the leased. After the cost of leased property has been fully recovered through rentals

Answer c

2. When measuring the present value of future rentals to be capitalized as part of the purchase price in a lease that is be accounted for as a purchase, identifiable payments to cover taxes, insurance, and maintenance should be a. Included in the future rentals to be capitalizedb. Excluded from future rentals to be capitalizedc. Capitalized but at a different discount rate and recorded in a different account than future

rental paymentsd. Capitalized but at a different discount rate and for a relevant period that tends to be different

than that for future rental payments

Answer b

3. Equal monthly rental payments for a particular lease should be charged to rental expense by the lessee for which of the following?

Capital lease Operating leasea. Yes Nob. Yes Yesc. No Nod. No Yes

Answer d

4. In a lease that is recorded as a sales-type lease by the lessor, the difference between the gross investment in the lease and sum of the present values of the components of the gross investment should be recognized as incomea. In full at the lease’s expirationb. In full at the lease’s inception

c. Over the period of the lease using the interest method of amortizationd. Over the period of the lease using the straight-line method of amortization

Answer b

5. For a six-year capital lease, the portion of the minimum lease payment in the third year applicable to the reduction of the obligation should bea. Less than in the second yearb. More than in the second yearc. The same as in the fourth yeard. More than in the fourth year

Answer b

6. Based solely upon the following sets of circumstances, indicate below which set gives rise to a sales type or direct financing lease of a lessor:

Transfers Contains Ownership bargain By end of purchase

Lease? Provision?a. No Yesb. Yes Noc. Yes Yesd. No No

Answer c

7. Generally accepted accounting principles require that certain lease agreements be accounted for as purchases. The theoretical basis for this treatment is that a lease of this typea. Effectively conveys all of the benefits and risks incident to the ownership of propertyb. Is an example of form over substancec. Provides the use of the leased asset to the lessee for a limited period of timed. Must be recorded in accordance with the concept of cause and effect

Answer a

8. The appropriate valuation of an operating lease on the statement of financial position of a lessee isa. Zerob. The absolute sum of the lease paymentsc. The present value of the sum of the lease payments discounted at an appropriate rated. The market value of the asset at the date of the inception of the lease

Answer a

9. A six-year-capital lease entered into on December 31, 2008, specified equal minimum annual lease payments due on December 31, 2010. Minimum payment applicable to which of the following increased over the corresponding December 31, 2010, minimum payment?

Reduction ofInterest Expense Liability

a. Yes Yesb. Yes Noc. No Yesd. No No

Answer c

10. Office equipment recorded under a capital lease containing a bargain purchase option should be amortized a. Over the period of the lease using the interest method of amortizationb. Over the period of the lease using the straight-line method of amortizationc. In a manner consistent with the lessee’s normal depreciation policy for owned assetsd. In a manner consistent with the lessee’s normal depreciation policy for owned assets except

that the period of amortization should be the lease term

Answer c

11. What is the primary accounting issue for lessees?a. Recording interest expense on the lease obligation.b. Determining whether the lease meets the 90% of fair value test.c. Off-balance sheet financing.d. The measurement of the leased asset under a capital lease.

Answer c

12. What is the primary accounting issue for lessors?a. Off-balance sheet financing.b. Revenue recognition and expense allocation over the lease term.c. Treating the lease in the same manner as the lessee does.d. Determining whether the lease is a sales-type lease or a direct financing lease.

Answer b

13. For the lessor to recognize a lease as a sales-type lease, the following must occur.

a. At least one of the capital lease criteria is met, at least one of the certainty criteria is met, and there is a manufacturer or dealer’s profit.

b. At least one of the capital lease criteria is met, both certainty criteria are met, and there is a manufacturer or dealer’s profit.

c. More than one of the capital lease criteria are met, both certainty criteria are met, and there is a manufacturer or dealer’s profit.

d. Only one of the capital lease criteria is met, both certainty criteria are met, and there is a manufacturer or dealer’s profit.

Answer b

14. A net operating loss carryover that occurs in a company’s second year of operationsa. May cause a company to report a tax benefit in the current period income statement.b. Has no effect on income tax expense of the current period because no taxes are paid.c. Causes a company to report a deferred income tax liability for taxes that are not paid

currently.d. Results in future taxable amounts.

Answer a

15. For a sales-type lease, the net investment is equal toa. The present value of the minimum lease payments plus executor costs.b. The net investment minus unearned income.c. Sales minus the gross profit recognized on the sale.d. The present value of the gross investment.

Answer d

16. When a lease contract does not transfer title to the lessee, there is no bargain purchase option, and the lease term is not at least 75 percent of the estimated useful life of the leased asset.

a. The lessee must classify the lease as an operating lease.b. The amount of unguaranteed salvage value, if any, determines whether the lease is a capital

lease or an operating lease.c. The interest rate used to determine the present value of the minimum lease payments also

determines whether the lease is a capital lease or an operating lease.d. The lessee must use the greater of the lessor’s rate of return or the lessee’s incremental

borrowing rate to determine whether the lease is a capital lease or an operating lease.

Answer b

17. When does the lessee report executory costs as an expense?a. When they are spelled out in the lease agreement.b. Only when they are incurred by the lessee and the lease is classified as a capital lease.c. When they are incurred by the lessee.

d. Only when they are incurred by the lessee and the lease is classified as an operating lease.

Answer c

18. If the lessor incurs initial direct cost to bring about the lease, when are those costs expensed in total during the first year of the lease term.

a. When the lease is classified as a sales-type lease.b. When the lease is classified as a direct financing lease.c. When the lease is classified as an operating lease.d. Initial direct costs are always expensed during the first year of the lease term.

Answer b

19. When a sale and leaseback occursa. A gain or loss on the sale of the leased asset is deferred and amortized over the lease term .b. A gain on sale of the leased asset is deferred and amortized over the lease term.c. Whether a gain or loss on sale of the leased asset is deferred and amortized over the lease

term depends on whether the lease is classified as a capital lease or an operating lease.d. Both gains and losses are recognized in earnings when the asset is sold.

Answer b

20. Which of the following would indicate that the lessee should not classify a lease as a capital lease?

a. The fair value of the leased asset is $100,000 and the present value of the minimum lease payments is $95,000.

b. The lease provides for no unguaranteed salvage value.c. The lessee has the option to purchase the leased asset in 4 years for $2 when the asset’s

salvage value is expected to be $20,000.d. The asset’s useful life is 20 years, a 4 year lease occurs when the asset is 26 years old.

Answer d

Essay

1. List four advantages of leasing over the purchase of property for use by a business.

1. It offers 100 percent financing.2. It offers protection against obsolescence.3. It is frequently less costly than other forms of financing the cost of the acquisition of fixed

assets.4. If the lease qualifies as an operating lease, it does not add debt to the balance sheet.

2. Define the following:a. Capital lease

A capital lease, is based on the view that the lease constitutes an agreement through which the lessor finances the acquisition of assets by the lessee. Consequently, capital leases are in-substance installment purchases of assets.

b. Operating lease

An operating lease and is based on the view that the lease constitutes a rental agreement between the lessor and lessee.

3. List the four criteria for recording a lease transaction as a capital lease.

If at its inception the lease meets any one of the following four criteria, the lessee will classify the lease as a capital lease; otherwise, it is classified as an operating lease:

1. The lease transfers ownership of the property to the lessee by the end of the lease term. This includes the fixed noncancelable term of the lease plus various specified renewal options and periods.

2. The lease contains a bargain purchase option. This means that when the lessee has the option to purchase the leased asset, at the inception of the lease the stated purchase price is sufficiently lower than the fair market value of the property expected at the date the option will become exercisable such that it appears to be at a bargain price. In this case, exercise of the option appears to be reasonably assured.

3. The lease term is equal to 75 percent or more of the estimated remaining economic life of the leased property, unless the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property.

4. At the beginning of the lease term, the present value of the minimum lease payments (the amounts of the payments the lessee is required to make excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessee) equals or exceeds 90 percent of the fair value of the leased property less any related investment tax credit retained by the lessor. (This criterion is also ignored when the lease term falls within the last 25 percent of the total estimated economic life of the leased property).

4. How is the recorded amount of a lessee capital lease determined?

The provisions of SFAS No. 13 require a lessee entering into a capital lease agreement to record both an asset and a liability at the lower of the following:

1. The sum of the present value of the minimum lease payments at the inception of the lease (see the following discussion).

2. The fair value of the leased property at the inception of the lease.

5. What is the difference between a sales-type and a direct financing type of capital lease?

The lessor should report a lease as a sales-type lease when at least one of the capital lease criteria is met, both lessor certainty criteria are met and there is a manufacturer’s or dealer’s profit (or loss). This implies that the leased asset is an item of inventory and that the seller is earning a gross profit on the sale. Sales-type leases arise when manufacturers or dealers use leasing as a means of marketing their products

When at least one of the capital lease criteria and both lessor certainty criteria are met, but the lessor has no manufacturer’s or dealer’s profit (or loss), lessor’s account for the lease as a direct financing lease. Under the direct financing method, the lessor is essentially viewed as a lending institution for revenue recognition purposes.

6. What is a leveraged lease? How do lessees and lessors record leveraged leases?

A leveraged lease is a special leasing arrangement involving three different parties: (1) the equity holder—the lessor; (2) the asset user—the lessee; and (3) the debtholder—a long-term financer. The lessee records the lease as a capital lease. The lessor records the lease as a direct financing lease.