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# Financial Accounting and Reporting

## Accounting for Leases 27

PROBLEMS AND SOLUTIONS
ACCOUNTING FOR LEASES
1. Company A leases property to Company Z in an operating lease for \$6,000 in the first year,
\$5,000 in the second year, and \$1,000 in the third (and last) year of the lease. Company A
will recognize rental revenue of \$4,000 in the first year whereas Company Z will recognize
rental expense of \$4,000 in the first year. (True or False?)
Answer In operating leases, cash payments are sometimes different from year to year.
However, unless some aspect of the lease or the leased property is different over time,
the same amount of revenue and expense must be recognized in each year. In this lease,
\$12,000 will be paid over a three-year period. Therefore, since there is no indication
that the lease or the leased property is different during these years, a revenue should be
recorded by the lessor and an expense should be recorded by the lessee of \$4,000 per
year (\$12,000 total payment allocated over three years). (True)
2. In accounting for capitalized leases, an interest rate is required. An interest rate is needed to
determine the amount of interest revenue or interest expense to be recognized. For all such
computations, the lessor uses its own incremental borrowing rate as its interest rate. That is
the interest rate that the lessor would get if this additional amount of money was being bor-
rowed. (True or False?)
Answer In all lease computations, the lessor uses the imputed interest rate that is built
into the terms of the contract. This is the profit rate included in the contract because the
money will be paid over a period of time. Conversely, the lessee will use its incremental
borrowing rate for its interest computations unless the lessors imputed interest rate is
known and it is less. (False)
3. Company A leases property to Company Z. It is to be reported as a capitalized lease. Com-
pany Z will pay \$10,000 per year for four years. At the end of that time, the property will
be returned to Company Z. The property has an expected useful life of 5 years. The present
value of the payments is \$32,000. Thus, Company Z reports a capitalized asset of \$32,000.
Assume that the straight-line method of depreciation is being used. At the end of the assets
first year of usage, Company Z should report depreciation expense of \$6,400.
Answer Depreciation should be based on the number of years that the lessor will get use
from the asset. In this case, although the asset should last for 5 years, the lease is for
only four years. Thus, the \$32,000 capitalized value of the property should be depreci-
ated over four years so that annual depreciation is \$8,000 for Company Z. (False)
4. Company A leases property to Company Z. It is a capitalized lease. Company Z will pay
\$10,000 per year for four years. Payments are made at the end of each year. Company Z
has an incremental borrowing rate of 10%. The present value of these payments at that rate
is \$32,000. Thus, Company Z reports a net capitalized liability of \$32,000. At the end of
the first year of usage, Company Z should recognize interest expense of \$3,200. (True or
False?)
Answer Interest is recognized based on the net liability balance for the year. At the be-
ginning of the year, the net liability balance is \$32,000. Since the lease payments are
made at the end of each year, the net liability balance of \$32,000 does not change dur-
ing the year. Interest expense is \$3,200 based on this net liability balance and the 10%
interest rate. (True)