New Revenue Recognition Accounting Standards Homework Problems

Leases

(Instructors: Note: Please do not distribute actual solutions attached to students, as it would potentially hurt relationship with Ernst & Young, which has been kind enough to allow us to use these problems in our course).

Initiation

Year 1

Year 2

Year 3

Year 4

Year 5

Cash lease payments

$25,000

$26,000

$27,000

$28,000

$29,000

Income statement:

Periodic lease expense (straight-line)

27,000

Prepaid (accrued) rent for period

$25,000

($27,000)

($1,000)



$1,000

$2,000

Balance sheet at end of year:

Lease liability

($124,645)

($103,630)

($80,735)

($55,885)

($29,000)

$ 

ROU asset:

Lease liability

$124,645

$103,630

$80,735

$55,885

$29,000

$ 

Adjust:

Prepaid (accrued) rent — cumulative

25,000

(2,000)

(3,000)

(2,000)

Unamortized direct initial costs

5,000

4,000

3,000

2,000

1,000

ROU asset

$154,645

$105,630

$80,735

$54,885

$28,000

At lease commencement

ROU asset

$154,645

Lease liability

$124,645

Cash

30,000

To recognize initial ROU asset and lease liability and to reflect payment of first lease payment and initial direct costs.

Year 1 journal entries

Lease expense

$28,000

ROU asset

$28,000

Lease liability

$21,015

ROU asset

$21,015

To record lease expense (including amortization of initial direct costs) and adjust the ROU asset for the difference between the cash paid and straight-line lease expense and to adjust the lease liability to the PV of the remaining lease payments with an offset to the ROU asset (the adjustment of $21,015 is calculated as the initially recognized lease liability ($124,645) less the PV of the remaining lease payments ($103,630) at the end of year 1).

Initial

Year 1

Year 2

Year 3

Year 4

Cash lease payments

$50,000

$53,000

$56,000

$60,000

Income statement:

Lease expense recognized:

Interest expense

$ 6,956

$ 4,884

$ 2,583

Amortization expense

51,144

$51,145

Total periodic expense

$58,100

$56,028

$53,727

$51,145

Balance sheet:

ROU asset

$204,577

$153,433

$102,289

$51,145

Lease liability

($154,577)

($161,533)

($113,417)

($60,000)

At lease commencement

ROU asset

$204,577

Lease liability

$50,000

Cash

154,577

This recognizes the initial ROU asset and lease liability and reflects the first payment of $50,000.

Year 1 journal entries

Interest expense

$6,956

Lease liability

$6,956

This records interest expense and accretes the lease liability using the interest method ($154,577 x 4.5%).

Amortization expense

$23,000

Right-to-use asset

$23,000

This records amortization expense on the right-to-use asset ($204,577/4).

3. Lessor classifies the lease as a sales-type lease because the lease term is a major part of the remaining economic life of the asset. While there is no bright-line test under ASC 842, 77% is more than the 75% threshold that Lessor uses in the lease classification test.

Lease commencement

First, we determine the implicit rate using the PV of an annuity due as follows:

I/Y

Cash receipt

Given

$160,000

$25,000

$75,000

Solve for the implicit rate

12.3434%

The lease amortization table is as follows:

Year

Cash receipt

Interest

Principal

Balance

Initial net investment*

$135,000

$16,664

($16,664)

151,664

$25,000

15,635

9,365

142,299

25,000

14,479

10,521

131,778

25,000

13,180

11,820

119,958

25,000

11,721

13,279

106,679

25,000

10,081

14,919

91,760

25,000

8,240

16,760

75,000

*The initial net investment of $135,000 is calculated as the initial fair value of $160,000 less the initial cash receipt of $25,000.

At lease commencement

To record the net investment in the sales-type lease and derecognize the underlying asset and record the payment of initial direct costs and the receipt of lease payments for the first year:

Net investment in the lease (a)

$135,000

Cash

25,000

Cost of goods sold (b)

132,290

Broker’s commission expense (c)

3,000

Revenue (d)

$142,290

Property held for lease (e)

150,000

Cash (f)

3,000

(a) The net investment in the lease consists of (1) the present value of the 7 annual lease payments of $25,000, less the first lease payment of $25,000 paid at lease commencement, plus the present value of the guaranteed residual value of $35,000, both discounted at the rate implicit in the lease, which equals $117,290 (i.e., the lease receivable) and (2) the present value of unguaranteed residual asset of $40,000, which equals $17,710. Note that the net investment in the lease is subject to the same considerations as other assets when classifying its components as current or noncurrent assets in a classified balance sheet.

(b) Cost of goods sold is the carrying amount of the equipment of $150,000 less the present value of the unguaranteed residual asset of $17,710.

(d) Revenue is the lower of the lease receivable ($142,290) and fair value ($160,000).

(e) $150,000 is the carrying amount of the underlying asset.

(f) Assumes Lessor is paying cash for the initial direct costs on the lease commencement date.

At lease commencement, Lessor recognizes selling profit of $10,000, which is calculated as the lease receivable of $142,290 less the carrying amount of the asset of $150,000, net of any unguaranteed residual asset of $17,710.

Year 1 journal entry for the sales-type lease (based on amortization table):

Net investment in the lease

$16,664

Interest revenue

16,664

This records the first year of interest revenue.

Year 2 journal entry for the sales-type lease (based on amortization table):

Cash

$25,000

Net investment in the lease

$ 9,365

Interest revenue

15,635

This records the lease payment and interest revenue.

4. Lessor classifies the lease as an operating lease because none of the criterion for a sales-type lease are met and the PV of the sum of the lease payments by Lessee (there is no RVG from either the Lessee or another third party) does not exceed substantially all of the fair value of the underlying asset, so it does not qualify as a direct financing lease. The implicit rate on the lease is 10.7775% and the PV of lease payments totals $93,517 equaling 55% of the FV.

Lessor accounts for the operating lease by recognizing the lease payment of $30,000 per year on a straight-line basis after determining that another systematic and rational basis does not better represent the pattern in which benefit is expected to be derived from the use of the underlying asset. Lessor defers the initial direct costs (the broker’s commission) at lease commencement and amortizes them over the lease term on the same basis as lease income (straight-line basis over the four-year lease term).

Lease commencement

Deferred IDC

$2,000

Cash

$2,000

Year 1

Cash

$30,000

Lease revenue

$30,000

Expense

$500

Deferred IDC

500

Year 2

Cash

$30,000

Lease revenue

$30,000

Expense

$500

Deferred IDC

$500

Leases, ASC 842 – homework problem solutions 7

SCORE No. 02328-161US