LESSON 5
Review material
Review questions
Notes:
In review and assignment questions, you’ll often be given both the lessee’s IBR and the rate implicit in the
lease. Remember to use the rate implicit in the lease for your calculations, unless it is not practicably
determinable.
For all questions relating to lessors, use the gross method to record the lease; that is, recognize both the
gross lease payments receivable and unearned finance revenue at the inception of the lease.
Question 1
KLG PLC signed a lease for equipment with an expected economic life of five years and
a fair value of €300,000. The lessor is the leasing subsidiary of an international bank. The
terms of the lease are as follows:
 The lease term begins on January 2, 20X5, and runs for three years.
 The lease requires payments of €99,000 each December 31, which include €3,700 for
maintenance and insurance costs.
 At the end of the initial lease term, the lease is renewable for another two years at the
option of KLG for €24,900 per year, including €2,900 for maintenance and insurance
costs. The normal rental cost of similar used equipment is in the range of €40,000 per
year.
 At the end of the lease term, the asset reverts to the lessor.
The interest rate implicit in the lease is 10%. KLG uses straight-line depreciation for
similar owned equipment.
Required
1. Explain why this is a finance lease for the lessee.
2. Prepare a lease amortization schedule showing how the lease liability reduces over
the lease term.
3. Show how the lease would be reflected in the balance sheet, income statement, and
cash flow statement for the first two years, assuming the fiscal year ends on
December 31. Assume that KLG distinguishes between its short-term and long-term
debt on the balance sheet. The indirect method is used in the operating activities
section of the cash flow statement.
Financial Accounting: Liabilities & Equities
Review material 5  1
4. How much interest expense would be reported on the income statement in each year
from 20X5 to 20X10 if KLG had a September 30 fiscal year end?
5. Prepare the 20X5 note disclosure for the five-year cash flows related to the lease
liability and list the other note disclosures that would have to be made in relation to
the leased asset and liability.
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2,
Second Edition (Toronto: McGraw-Hill Ryerson, 2003), Question A18-14,
pages 1062–1063. Adapted with permission.
Question 2
Espanarda Purchasing owns the building it uses; it had an original cost of €825,000 and a
net book value of €450,000 as of January 1, 20X5. On this date, the building was sold to
Aliante Leasing for €500,000, and was simultaneously leased back to Espanarda.
The lease has a guaranteed, 10-year term, and required payments on December 31 of
each year. The payments are €94,500, and the lease allows the property to revert to the
lessee at the end of the lease. The rate of interest implicit in the lease is 12%. Aliante
Leasing will pay property taxes of €6,000 per year. These costs are included in the lease
payment. Espanarda will pay maintenance and operating costs. The building is being
depreciated straight-line over its remaining 10-year life.
Required
1. Prepare entries to record the sale and leaseback of the building.
2. Prepare year-end adjusting entries for 20X5.
3. Show how lease-related amounts will be presented on the balance sheet, income
statement, and cash flow statement in 20X5. Assume that Espanarda distinguishes
between its short-term and long-term debt on the balance sheet.
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2,
Second Edition (Toronto: McGraw-Hill Ryerson, 2003), Question A18-25,
pages 1066–1067. Adapted with permission.
Question 3
Belgian Leasing Co. leased a piece of machinery to Serge Concrete Company, with the
following terms:
 The lease is for five years; Serge cannot cancel the lease during this period.
 The lease payment is €79,600. This includes €7,900 in estimated insurance costs.
 At the end of the five-year initial lease term, Serge can elect to renew the lease for one
additional five-year term at a price of €29,500, including €2,500 of estimated insurance
costs. Market rentals are approximately twice as expensive.
 At the end of the first or second lease term, the leased asset reverts back to the lessor.
 Lease payments are due at the beginning of each lease year.
Review material 5  2
Financial Accounting: Liabilities & Equities
Other information
 Serge could borrow money to buy this asset at an interest rate of 10%, which is also
equal to the rate implicit in the lease.
 The equipment has a fair market value of €390,000 at the beginning of the lease term,
and a useful life of approximately 12 years.
 The lease term corresponds to the fiscal year.
 Serge uses straight-line depreciation for all depreciable assets.
Required
1. For this lease, what is the
i)
ii)
iii)
iv)
v)
vi)
vii)
lease term?
guaranteed residual value?
unguaranteed residual value?
bargain purchase option?
bargain renewal terms?
minimum net lease payment?
incremental borrowing rate?
2. Is this lease an operating lease or a finance lease for the lessee? Why?
3. Prepare journal entries for the first year of the lease on Serge’s books.
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2,
Second Edition (Toronto: McGraw-Hill Ryerson, 2003), Question A18-2,
pages 1056–1057. Adapted with permission.
Question 4
Lessor and Lessee agreed to a non-cancellable lease for which the following information
is available:
a) Lessor’s cost of the asset leased is €40,308. The asset is new at the inception of the
lease term.
b) Lease term is three years, starting January 2, 20X5.
c) Annual lease payments will be made each January 2 during the three-year lease term.
Payments will include €1,100 of estimated insurance costs during the three-year term.
d) Estimated useful life of the leased asset is six years.
e) On January 2, 20X5, the lessor estimated that the residual value of the leased asset
would be €6,000 on the renewal option date [see i), below], and zero at the end of its
useful life. The residual value is not guaranteed.
f) The straight-line depreciation method is used for the leased asset.
g) The interest rate implicit in the lease is 8%. Assume that Lessee cannot practicably
determine this rate.
h) Lessee’s incremental borrowing rate is 14%.
Financial Accounting: Liabilities & Equities
Review material 5  3
i) Renewal option, exercisable on January 2, 20X8, is for three years, with an annual
payment of €1,200 each January 2. No insurance costs are included, as these will be
the lessee’s responsibility in the renewal period. This is a bargain renewal option.
j) Title to the leased asset is retained by the lessor.
k) The lessor paid €2,200 in initial direct costs.
Required
1. Calculate the annual payment that would be required for the first three years of the
lease term.
2. Is this an operating lease or a finance lease to the lessee? Explain. What amount (if
any) would the asset be recorded at on the books of the lessee at the inception of the
lease?
3. Is this an operating lease or a finance lease to the lessor? Explain.
4. Prepare an amortization schedule showing how the lessor’s net lease receivable
would reduce over the life of the lease.
5. Show all lease-related accounts as they would appear in the balance sheet and income
statement of the lessee and the lessor at December 31, 20X5, for the year then ended.
Assume the lessor’s balance sheet is unclassified.
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2,
Second Edition (Toronto: McGraw-Hill Ryerson, 2003), Question A19-24, page 1105.
Adapted with permission.
Question 5
On December 31, 20X3, a lessor completed manufacturing a piece of machinery at a cost
of €35,000. The machinery was held for lease. The machine was eventually leased on
January 2, 20X5, for five years in a lease that required annual payments of €14,300 at the
beginning of each year. These payments include an estimated €1,700 of maintenance
costs annually, which the lessor pays each January. At inception of the lease, the sales
value of the leased asset was €55,600; at the end of five years, it is expected to be worth
€10,400. The lessee may renew the lease at the end of the five-year term, for two
additional years, with an annual payment each January of €3,500. The lessee is
responsible for maintenance during the second lease term. The machinery is expected to
be almost worthless at the end of this second lease term. The lessor paid €2,700 in
commissions to the salesperson who closed the deal.
Required
Round amounts to the nearest dollar.
1. What interest rate is implicit in the lease? Assume that the commission relating to the
lease was paid and expensed by the lessor at the beginning of the lease and has no
effect on finance revenue or interest rates.
Review material 5  4
Financial Accounting: Liabilities & Equities
2. Prepare an amortization schedule that shows how the net lease receivable is reduced
over the life of the lease.
3. Give the entries for the lessor in 20X5, 20X6, and 20X7 assuming that the lessor uses
the gross method and has a December 31 year end.
4. Prepare the balance sheet and income statement disclosure related to the lease in
20X5. Assume that the lessor has an unclassified balance sheet — in other words,
does not distinguish between current and non-current amounts.
5. How much income related to the lease would the lessor recognize in 20X5 if their
year end was August 31?
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2,
Second Edition (Toronto: McGraw-Hill Ryerson, 2003), Question A19-22,
pages 1103–1104. Adapted with permission.
Financial Accounting: Liabilities & Equities
Review material 5  5
Review solutions
Question 1
Requirement 1
This is a finance lease for the lessee because the lease term, including the bargain
renewal, covers all (5/5) of the economic life of the equipment. The PV of the MLPs
represents 89% (€265,683/€300,000) of the fair value, which may or may not be
considered substantially all of the fair value of the asset.
a) (€99,000 – €3,700) (PVA, 10%, 3) (2.48685) .............................
b) (€24,900 – €2,900) (PVA, 10%, 2) (PV, 10%, 3)
(1.73554) (0.75131) .....................................................................
€236,997
28,686
€ 265,683
Requirement 2
Lease Amortization Schedule — End-of-Year Payments
Lease
Year
Outstanding
Balance
20X5
20X6
20X7
20X8
20X9
€ 265,683
196,951
121,346
38,181
19,999
Interest
at 10%
€ 26,568
19,695
12,135
3,818
2,000
€ 64,216
End of Period
Cash Flow
€ 95,300
95,300
95,300
22,000
22,000
Inc/(Dec)
in Balance
€ (68,732)
(75,605)
(83,165)
(18,182)
(20,000)
Ending
Balance
€ 196,951
121,346
38,181
19,999
(1)*
* due to rounding
Requirement 3
20X6
Income Statement
Interest expense
Depreciation expense
Maintenance and insurance expense
Balance sheet
Plant and equipment
Assets under capital lease
Accumulated depreciation
Current liabilities
Current portion of lease liability*
Long-term debt
Lease liability
Less: current portion
Review material 5  6
€
19,695
53,137
3,700
€ 265,683
(106,274)
€ 159,409
83,165
€ 121,346
(83,165)
€ 38,181
20X5
€
26,568
53,137
3,700
€ 265,683
(53,137)
€ 212,546
75,605
€ 196,951
(75,605)
€ 121,346
Financial Accounting: Liabilities & Equities
CFS
Operations
Addback: depreciation
Financing
Repayment of lease liability
€
€
53,137
(75,605)
53,137
(68,732)
* Principal portion of next lease payment; see amortization schedule.
When the lease payment is at the beginning of the year, the payment amount is the
current portion. If the lease payment is at the end of the year, the current portion is only
the principal portion of the next payment.
The change in short-term and long-term portions could be reported on the CFS, but this is
less likely.
Requirement 4
Allocation of Interest to Fiscal Years
Lease Payment
December 31 Interest
20X5
€ 26,568
20X6
19,695
20X7
12,135
20X8
3,818
20X9
2,000
Totals
€ 64,216
1
Allocation
(9/12: 3/12)
€ 19,926
6,642
14,771
4,924
9,101
3,034
2,864
954
1,500
500
€ 64,216
Expense
€ 19,926
Year
Sept. 30, 20X5
21,413 1
Sept. 30, 20X6
14,025
Sept. 30, 20X7
5,898
Sept. 30, 20X8
2,454
500
€ 64,216
Sept. 30, 20X9
Sept. 30, 20X10
€6,642 + €14,771 and so on.
Requirement 5
Cash flow note:
The company has the following cash commitments under finance leases:
Due for payment
Total
Total minimum lease payments
Interest
Maintenance and insurance
Total cash commitments
Less: Current portion
Long-term lease liability
€
€
€
Financial Accounting: Liabilities & Equities
247,800
37,648
13,200
196,952
75,605
121,347
Within 1 year
€
€
99,000
19,695
3,700
75,605
1 to 5 years
Later than 5
years
€
€
-
€
-
€
148,800
17,953
9,500
121,347
Review material 5  7
Interest for 1 to 5 years = 12,135 + 3,818 + 2,000, from amortization table.
Maintenance and insurance for 1 to 5 years = 3,700 + 2,900 + 2,900
€12,135 + €3,818 + €2,000 + €1
Other notes:
The company must disclose depreciation period and method for the leased asset.
Other disclosures required by the lessee include the net carrying amount for each class of
asset, contingent rents recognized in income during the period, the expected future
minimum sublease payments under non-cancellable subleases, and a description of the
significant leasing arrangements.
Question 2
Requirement 1
Cash .......................................................................................
Accumulated depreciation, building ......................................
Building ...........................................................................
Deferred gain on sale and leaseback of building .............
* (€825,000 – €450,000)
500,000
375,000*
Building under finance lease .................................................
Lease liability...................................................................
500,000
825,000
50,000
500,000
Fair value of the building = €500,000
(€94,500 – €6,000) (PVA, 12%, 10) (5.65022) = €500,044; therefore PV of MLPs
represents fair value.
This is a finance lease as it covers all the remaining useful life.
Requirement 2
Interest expense .....................................................................
Lease liability (€500,000  0.12).....................................
60,000
Lease liability.........................................................................
Property tax expense ..............................................................
Cash .................................................................................
88,500
6,000
Depreciation expense, leased building (€500,000/10) ...........
Accumulated depreciation, leased building .....................
50,000
Deferred gain on sale and leaseback (€50,000/10) ................
Depreciation expense, leased building ............................
5,000
Review material 5  8
60,000
94,500
50,000
5,000
Financial Accounting: Liabilities & Equities
Requirement 3
Balance Sheet
Depreciable assets
Building under finance lease
Accumulated depreciation
Deferred credits (long-term)
Deferred gain on sale and leaseback
Short-term liabilities
Current portion of long-term lease liability*
Long-term liabilities
Lease liability (€500,000 + €60,000 – €88,500)
Less: current portion
* Current portion:
Interest, 20X3: €471,500  0.12
Payment, 20X3:
Principal portion
€ 500,000
(50,000)
€ 450,000 dr
45,000 cr
31,920 cr
€ 471,500
(31,920)*
439,580 cr
€56,580
88,500
€31,920
Income Statement
Depreciation expense
Property tax expense
Interest expense
€45,000
6,000
60,000
CFS
(Indirect) Operating: Add back depreciation
€
45,000
(Direct) Operating: No depreciation listed
Cash outflow for interest
(60,000)
Investing: Cash from sale and leaseback
500,000
Financing: Reduction of lease liability
(20X5 payment, €88,500 – 60,000)
(28,500)
Question 3
Requirement 1
i)
The lease term is 10 years. The second 5-year lease term is a bargain renewal
option, based on the information regarding market rental rates, so it is reasonably
certain that the lessee will exercise this option.
ii)
Guaranteed residual, none.
iii)
Unguaranteed residual exists as the value of the asset to the lessor at the end of the
lease term. Because the fair market value, cash flows, and implicit rate are known,
this can be calculated as €54,000 (see spreadsheet excerpt below).
Financial Accounting: Liabilities & Equities
Review material 5  9
iv)
Bargain purchase option, none.
v)
Bargain renewal terms, €29,500 per year for the second 5-year lease term (€27,000
net of insurance costs).
vi)
Minimum net lease payment
a) (€79,600 – €7,900)  5 years
b) (€29,500 – €2,500)  5 years
€358,500
135,000
€493,500
vii) Incremental borrowing rate, 10%
CALCULATION OF IRR
Lease
Cash
Year
Flows
IRR
20X1
(€ 318,300)
10.0%
20X2
71,700
20X3
71,700
20X4
71,700
20X5
71,700
20X6
27,000
20X7
27,000
20X8
27,000
20X9
27,000
20X10
27,000
Unguaranted
residual
54,000
Requirement 2
To be a finance lease, the lease would have to meet one of five criteria, applied
judgementally:
1. Transfer of title
2. BPO
3. Economic life vs lease term
4. PV of MLP vs fair value
5. Specialized nature of leased assets
No
No
Likely; 10/12 represents major part of economic
life
Likely; €368,887* = 95% of €390,000;
substantially all of the fair value.
No indication of this
* PV of MLP
a) (€79,600 – €7,900) (PVAD, 10%, 5) (4.16987)
b) (€29,500 – €2,500) (PVAD, 10%, 5) (PV, 10%, 5)
(4.16987) (.62092)
Review material 5  10
€298,980
69,907
€368,887
Financial Accounting: Liabilities & Equities
Requirement 3
Beginning of fiscal year and lease term
Asset under finance lease (PV of MLPs < fair value) .......................
Lease liability...............................................................................
368,887
Insurance expense ..............................................................................
Lease liability.....................................................................................
Cash .............................................................................................
7,900
71,700
368,887
79,600
End of fiscal year
Interest expense .................................................................................
Lease liability...............................................................................
(€368,887 – €71,700)  .10
29,719
Depreciation expense .........................................................................
Accumulated depreciation ...........................................................
€368,887/10
36,889
29,719
36,889
Question 4
Requirement 1
Lease payment
= (–€2,200)  (PVAD, 8%, 3) + [€1,200 (PVAD, 8%, 3)
(PV, 8%, 3)]
€40,308
= (–€2,200)  (2.78326) + [€1,200 (2.78326) (0.79383)]
= €14,320
Lease payment = €14,320 + €1,100
= €15,420
€40,308
Requirement 2
For the lessee, this is a finance lease, as the lease term, including the bargain renewal, is
100% of the economic life. The renewal is a bargain because it is so much less than the
cost of the first term.
Capitalizable value (the lessee’s IBR (14%) is used because the lessee does not know the
interest rate implicit in the lease).
= [(€15,420 – €1,100) (PVAD, 14%, 3)] + [€1,200 (PVAD, 14%, 3) (PV, 14%, 3)]
= €14,320 (2.64666) + €1,200 (2.64666)(0.67497)
= €40,044
Requirement 3
For the lessor, this is also a finance lease due to economic life vs. term.
Financial Accounting: Liabilities & Equities
Review material 5  11
Requirement 4
Lessor Amortization Table
Year
Beginning
Balance
20X5
20X6
20X7
20X8
20X9
20X10
€ 40,308
28,188
16,123
3,093
2,140
1,111
€
Interest
@ 8%
Decrease
Payment
Ending
in Balance
0
2,255
1,290
247
171
89
€ 12,120*
14,320
14,320
1,200
1,200
1,200
€ 12,120
12,065
13,030
953
1,029
1,111
Balance
€ 28,188
16,123
3,093
2,140
1,111
0
* €14,320 – €2,200 initial indirect costs. No interest is allocated to the first payment, as it
takes place on January 2, 20X5.
Requirement 5
Lessee’s Balance Sheet
Plant and equipment
Leased asset
Less: depreciation (1/6)
€ 40,044
(6,674)
€ 33,370
Current liabilities
Current portion of lease liability (€15,420 – €1,100)
Long-term liabilities
Lease liability
Less: current portion
€ 14,320
€ 29,325*
(14,320)
€ 15,005
* €40,044 – €14,320 + [0.14 (€40,044 – €14,320)]
Lessee’s Income Statement
€
€
€
Depreciation expense
Insurance expense
Interest expense [0.14 (€40,044 – €14,320)]
6,674
1,100
3,601
Lessor’s Balance Sheet
Lease receivable, net
(€28,188 + €2,255); see amortization table for calculations
€ 30,443
Lessor’s Income Statement
Finance income
Review material 5  12
€
2,255
Financial Accounting: Liabilities & Equities
Question 5
Requirement 1
The second renewal period is considered a bargain and is included in the lease term. Even
the gross, undiscounted annual rent in the second lease term (€3,500 per year for two
years) is less than the estimated residual value at the beginning of this lease term
(€10,400).
The interest rate implicit in the lease is 11.0380%. That is
€55,600 = (€14,300 – €1,700) (PVAD, x%, 5) + (€3,500)(PVAD, x%, 2) (PV, x%, 5)
x = 11.0380 (solved by spreadsheet)
Trial and error comes close at 11%:
€55,600 = (€14,300 – €1,700) (PVAD, 11%, 5) + (€3,500)(PVAD, 11%, 2) (PV, 11%, 5)
€55,600 = (€14,300 – €1,700) (4.10245) + (€3,500)(1.90090) (0.59345)
€55,600 = €55,639
Requirement 2
Lessor Amortization Table
Year
Beginning
Balance
Interest at
11.038%
Annual
Payment
Decrease
in Balance
Ending
Balance
20X5
20X6
20X7
20X8
20X9
20X10
20X11
€ 55,600
43,000
35,146
26,425
16,742
5,990
3,151
€
€ 12,600
12,600
12,600
12,600
12,600
3,500
3,500
€ 12,600
7,854
8,721
9,683
10,752
2,839
3,151
€ 43,000
35,146
26,425
16,742
5,990
3,151
0
0
4,746
3,879
2,917
1,848
661
349
€ 14,400
Requirement 3
January 2, 20X5
Selling expense ................................................................
Cash ...........................................................................
Lease payments receivable ..............................................
Unearned finance income ..........................................
Sales ...........................................................................
1
[(€14,300 – €1,700)  5] + (€3,500  2)
Cost of sales .....................................................................
Inventory ....................................................................
Cash .................................................................................
Maintenance expense .................................................
Lease payment receivable ..........................................
Maintenance expense .......................................................
Cash ...........................................................................
Financial Accounting: Liabilities & Equities
2,700
2,700
70,000
1
14,400
55,600
35,000
35,000
14,300
1,700
12,600
1,700
1,700
Review material 5  13
December 31, 20X5
Unearned finance income ................................................
Finance income ..........................................................
January 2, 20X6
Cash .................................................................................
Maintenance expense .................................................
Lease payments receivable ........................................
Maintenance expense .......................................................
Cash ...........................................................................
December 31, 20X6
Unearned finance income ................................................
Finance income ..........................................................
January 2, 20X7
Cash .................................................................................
Maintenance expense .................................................
Lease payments receivable ........................................
Maintenance expense .......................................................
Cash ...........................................................................
December 31, 20X7
Unearned finance income ................................................
Finance income ..........................................................
4,746
4,746
14,300
1,700
12,600
1,700
1,700
3,879
3,879
14,300
1,700
12,600
1,700
1,700
2,917
2,917
Requirement 4
20X5 financial statements
Income Statement
Sales
Cost of sales
Selling expense
Finance income
€ 55,600
35,000
2,700
4,746
cr
dr
dr
cr
Balance Sheet
Lease payments receivable, net
€ 47,746
1
1
(€70,000 – €12,600) – (€14,400 – €4,746)
The company has the following investments in finance leases outstanding:
Review material 5  14
Financial Accounting: Liabilities & Equities
To be received
Total
Gross investment in finance leases
Unearned finance income
PV of minimum lease payments
€
€
57,400
9,654
47,746
W ithin 1 year 1 to 5 years
€
€
12,600
12,600
€
41,300
9,306
31,994
€
Later than 5
years
€
€
3,500
348
3,152
(see amortization schedule for calculations)
The lessor would also disclose the significant leasing arrangements.
Requirement 5
The lessor would report the following in the August 31, 20X5, income statement:
Revenues
Sales
Finance income (€4,746  8/12)
€ 55,600
3,164
Expenses
Cost of sales
Selling expenses
Net change to profits
(35,000)
(2,700)
€ 21,064
Financial Accounting: Liabilities & Equities
Review material 5  15