Question 1:

PVE-0037
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The lessees balance sheet liability for a capital lease would be periodically reduced
by the total
Minimum lease payment plus the amortization of the related asset.
Minimum lease payment less the amortization of the related asset.
Minimum lease payment less the portion of the minimum lease payment
allocable to interest.
Minimum lease payment.
This answer is correct. During the lease term, each minimum lease payment
consists of both interest and reduction of the lease obligation. Lease amortization
produces a constant periodic rate of interest on the remaining balance of the
obligation, known as the "effective interest" method.
Question 2:
PVE-0007
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The Morn Company leased equipment to the Lizard Company on May 1, year 1. At
that time the collectibility of the minimum lease payments was not reasonably
predictable. The lease expires on May 1, year 3. Lizard could have bought the
equipment from Morn for $900,000 instead of leasing it. Morns accounting records
showed a book value for the equipment on May 1, year 1, of $800,000. Morns
depreciation on the equipment in year 1 was $200,000. During year 1 Lizard paid
$240,000 in rentals to Morn. Morn incurred maintenance and other related costs
under the terms of the lease of $18,000 in year 1. After the lease with Lizard
expires, Morn will lease the equipment to the Cold Company for another 2 years.
The income before income taxes derived by Morn from this lease for the year ended
December 31, year 1, should be
$
22,000
$100,00
0
$122,00
0
$240,00
0
This answer is correct. The lease shall be accounted for as an operating lease
because none of the four requirements applicable to both lessees and lessors is
met. Even if one or more was met, the lease would still be classified as an
operating lease as the payments are not reasonably predictable (ASC Topic 840).
The calculation for lease income for year 1 would be as follows:
Rental income
Less: year 1
depreciation

$
240,000
(200,00
0)

Maintenance costs

(18,000
)
Income from lease for $
year 1
22,000
Question 3:
PVE-0029
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What is the cost basis of an asset acquired by a lease which is accounted for as a
capital lease?
The net realizable value of the asset determined at the date of the lease agreement
plus the sum of the future minimum lease payments under the lease.
The sum of the future minimum lease payments under the lease.
The present value of the minimum lease payments under the lease (exclusive of
executory costs and any profit thereon) discounted at an appropriate rate.
The present value of the market price of the asset discounted at an appropriate rate
as an amount to be received at the end of the lease.
This answer is correct. When a lease is accounted for as a capital lease, lessees
record the lease by debiting the asset and crediting a liability for the present value
of the future minimum lease payments (ASC Topic 840).
Question 4:
PVE-0051
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Conn Company purchased a new machine for $480,000 on January 1, year 1, and
leased it to East the same day. The machine has an estimated 12-year life, and will
be depreciated $40,000 per year. The lease is for a 3-year period expiring January 1,
year 4, at an annual rental of $85,000. Additionally, East paid $30,000 to Conn as a
lease bonus to obtain the 3-year lease. For year 1 Conn incurred insurance expense
of $8,000 for the leased machine. What is Conns year 1 operating profit on this
leased asset?
$67,00
0
$55,00
0
$47,00
0
$37,00
0
This answer is correct. This lease is an operating lease because it does not meet
any of the four criteria to be a capital lease as described in ASC Topic 840. The
lessor (Conn) should recognize as revenue the year 1 rental payment ($85,000) plus
a proportionate fraction of the lease bonus ($30,000/ 3-year lease term = $10,000
per year). Therefore, total revenue for year 1 is $95,000 ($85,000 + $10,000). Year
1 expenses total $48,000 (depreciation of $40,000 and insurance of $8,000). Thus,
operating profit on the leased asset is $47,000 ($95,000 revenues less $48,000
expenses).

Question 5:
PVE-0034
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The lessee should amortize the capitalizable cost of the leased asset in a manner
consistent with the lessees normal depreciation policy for owned assets for leases
that
Transfer
ownership of the
property to the
lessee by
the end of the
lease term
No
No
No
Yes
Yes
Yes
Yes
No
This answer is correct. A lease that transfers ownership of the property to the lessee
by the end of the lease term and a lease that contains a bargain purchase option
are properly classified as capital leases. Per ASC Topic 840, if the lease meets either
of the above criteria, the asset should be amortized in a manner consistent with the
lessees normal depreciation policy for owned assets because the asset will be used
by the lessee for its entire life.
Contain a
bargain
purchase
option

Question 6:
PVE-0048
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In a sale-leaseback transaction, the seller-lessee retains the right to substantially all
of the remaining use of the equipment sold. The profit on the sale should be
deferred and subsequently amortized by the lessee when the lease is classified as
a(n)
Capital Operating
lease
lease
No
Yes
No
No
Yes
No
Yes
Yes
This answer is correct. Per ASC Topic 840, any profit related to a sale-leaseback
transaction in which the seller-lessee retains the right to substantially all of the
remaining use of the equipment sold shall be deferred and amortized in proportion
to the amortization of the leased asset if the transaction is classified as a capital
lease. If the transaction is classified as an operating lease (e.g., if the lease begins
in the last 25% of the assets economic life), the profit shall be deferred and
amortized in proportion to the related gross rental charged to expense over the

lease term. It is important to note that losses are recognized immediately for either
a capital or operating lease.
Question 7:
PVE-0008
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Rent received in advance by the lessor for an operating lease should be recognized
as revenue
When received.
At the leases inception.
In the period specified by
the lease.
At the leases expiration.
This answer is correct. Under an operating lease rental revenue is to be recognized
in each accounting period on a straight-line basis unless another systematic and
rational basis is more representative of the decline in the assets service potential.
Question 8:
PVE-0001
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The present value of the minimum lease payments should be used by the lessee in
the determination of a (n)
Capital lease Operating lease
liability
liability
Yes
No
Yes
Yes
No
Yes
No
No
This answer is correct. Per ASC Topic 840, the present value of the minimum lease
payments should be used to determine the liability under a capital lease. Under an
operating lease, a liability arises when rent expense is recorded but has not been
paid. Furthermore, it is recorded at the actual amount of cash to be paid, not its
present value.
Question 9:
PVE-0057
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Koby Co. entered into a capital lease with a vendor for equipment on January 2 for
seven years. The equipment has no guaranteed residual value. The lease required
Koby to pay $500,000 annually on January 2, beginning with the current year. The
present value of an annuity due for seven years was 5.35 at the inception of the
lease. What amount should Koby capitalize as leased equipment?
$
500,000
$

825,000
$2,675,0
00
$3,500,0
00
This answer is correct. The requirement is to determine the amount of the
capitalized value of the leased equipment. The equipment should be capitalized as
the present value of the minimum lease payments. The present value of the
minimum lease payments at January 2 is calculated as the present value of the
annuity due factor times the payment, or $2,675,000 (5.35 x $500,000).
Question 10:
PVE-0044
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On January 1, year 1, Vick Company as lessee signed a 10-year noncancelable lease
for a machine stipulating annual payments of $20,000. The first payment was made
on January 1, year 1. Vick appropriately treated this transaction as a capital lease.
The 10 lease payments have a present value of $135,000 at January 1, year 1,
based on implicit interest of 10%. For the year ended December 31, year 1, Vick
should record interest expense of
$0
$
6,500
$11,50
0
$13,50
0
This answer is correct. At the inception of the lease on 1/1/Y1, the capitalized lease
liability was $135,000. The first payment, also on 1/1/Y1, consisted entirely of
principal and reduced the liability to $115,000 ($135,000 $20,000). Therefore,
year 1 interest expense is $11,500 ($115,000 x 10%).
Question 11:
PVE-0013
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When should a lessor recognize in income a nonrefundable lease bonus paid by a
lessee on signing an operating lease?
When received.
At the inception of the
lease.
At the expiration of the
lease.
Over the life of the
lease.
This answer is correct. ASC Topic 840 specifies that, in an operating lease, the lesser
should recognize rental revenues on a straight-line basis. This means that a lease

bonus should be recorded as unearned revenue and recognized as rental revenue

over the life of the lease.
Question 12:
PVE-0032
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For a capital lease, the amount recorded initially by the lessee as a liability should
Exceed the present value at the beginning of the lease term of minimum lease
payments during the lease term.
Exceed the total of the minimum lease payments during the lease term.
Not exceed the fair value of the leased property at the inception of the lease.
Equal the total of the minimum lease payments during the lease term.
This answer is correct. Per ASC Topic 840, the lessee shall record a capital lease as a
debit to an asset account and a credit to a liability account for an amount equal to
the present value of the total of the minimum lease payments as of the beginning of
the lease term. However, if the amount so determined exceeds the fair value of the
leased property at the inception of the lease, the amount recorded as the asset and
obligation shall be the fair value of the leased property.
Question 13:
PVE-0010
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Howard Company sublet a portion of its warehouse for 5 years at an annual rental of
$18,000, beginning on May 1, year 1. The tenant paid 1 years rent in advance,
which Howard recorded as a credit to unearned rental income. Howard reports on a
calendar-year basis. The adjustment on December 31, year 1, should be
Dr.
Cr.
No entry
Unearned rental
$
income
$
6,000
Rental income
6,000
Rental income
$
Unearned rental
$
6,000
income
6,000
Unearned rental
$
income
$
12,000
Rental income
12,000
This answer is correct. The solutions approach is to determine how much of the
annual rental payment is earned income and how much should be deferred to the
next period. The amount earned this period is calculated by multiplying the annual
payments by that portion of the year that has expired since May 1, year 1 ($18,000
x 8/12 = $12,000). The adjusting entry is
Unearned rental
12,00
income
0
Rental income
12,00

0
Question 14:
PVE-0045
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On January 1, year 1, Flip Corporation signed a 10-year noncancelable lease for
certain machinery. The terms of the lease called for Flip to make annual payments
of $30,000 for 10 years with title to pass to Flip at the end of this period.
Accordingly, Flip accounted for this lease transaction as a capital lease of the
machinery. The machinery has an estimated useful life of 15 years and no salvage
value. Flip uses the straight-line method of depreciation for all of its fixed assets.
The lease payments were determined to have a present value of $201,302 with an
effective interest rate of 10%. With respect to this capitalized lease, Flip should
record for year 1
Lease expense of $30,000.
Interest expense of $16,580 and depreciation
expense of $13,420.
Interest expense of $20,130 and depreciation
expense of $13,420.
Interest expense of $13,420 and depreciation
expense of $16,580.
This answer is correct. Per ASC Topic 840, a lessees capital lease will incur interest
expense. Interest expense, $20,130, is the carrying value of the lease obligation
multiplied by the effective interest rate ($201,302 x 10%). Additionally, the cost of
the equipment is depreciated over the life of the asset rather than the life of the
lease since title automatically passes to the lessee at the end of 10 years and the
lessee will own the asset. Depreciation expense, $13,420, is the cost of the
equipment depreciated over 15 years ($201,302/15 years). One difficulty with this
question is whether there was a $30,000 payment on January 1, year 1. If so the
interest expense would have been $17,130 [($201,302 $30,000 x 10%)]. There is
no interest expense given in that amount. Therefore we must assume an ordinary
annuity.
Question 15:
PVE-0049
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On December 31, year 1, Bain Corp. sold a machine to Ryan and simultaneously
leased it back for 1 year. Pertinent information at this date follows:
Sales price
Carrying amount
Present value of reasonable rentals ($3,000 for 12
months @ 12%)
Estimated remaining useful life

$360,0
00
330,00
0
34,100
12
years

In Bains December 31, year 1 balance sheet, the deferred revenue from the sale of
this machine should be
$34,10
0
$30,00
0
$
4,100
$0
This answer is correct. ASC Topic 840 generally treats a sale-leaseback as a single
financing transaction in which any profit on the sale is deferred and amortized by
the seller. However, ASC Topic 840 amends this general rule when either only a
minor part of the remaining use of the leased asset is retained (case 1), or when
more than a minor part but less than substantially all of the remaining use of the
leased asset is retained (case 2). Case 1 occurs when the PV of the lease payments
is 10% or less of the FV of the sale-leaseback property. Case 2 occurs when the
leaseback is more than minor but does not meet the criteria of a capital lease. This
is an example of case 1, because the PV of the lease payments ($34,100) is equal to
or less than 10% of the FV of the asset ($360,000). ASC Topic 840 specifies that
under these circumstances, the full gain ($360,000 $330,000 = $30,000) is
recognized, and none is deferred.
Question 16:
PVE-0035
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On January 1 of the current year, Tell Co. leased equipment from Swill Co. under a
nine-year sales-type lease. The equipment had a cost of $400,000, and an
estimated useful life of fifteen years. Semiannual lease payments of $44,000 are
due every January 1 and July 1. The present value of lease payments at 12% was
$505,000, which equals the sales price of the equipment. Using the straight-line
method, what amount should Tell recognize as depreciation expense on the
equipment in the current year?
$26,66
7
$33,66
7
$44,44
4
$56,11
1
This answer is correct. The leased asset should be recorded at the present value of
the future lease payments because it is less than or equal to the fair value of the
leased asset. Since the facts do not indicate that title is transferred to the lessee or
a bargain purchase or lease option exists, the leased asset should be depreciated
over the lesser of the lease term or the assets useful life; $56,111 (= $505,000 9
years).

Question 17:
PVE-0005
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Bain Co. entered into a 10-year lease agreement for a new piece of equipment
worth $500,000. At the end of the lease, Bain will have the option to purchase the
equipment. Which of the following would require the lease to be accounted for as a
capital lease?
The lease includes an option to purchase stock in the
company.
The estimated useful life of the leased asset is 12
years.
The present value of the minimum lease payments is
$400,000.
The purchase option at the end of the lease is at fair
market value.
This answer is correct because the ten-year lease term is greater than or equal to
75% of the life of the leased asset (10/12 = 83%).
Question 18:
PVE-0042
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Steam Co. acquired equipment under a capital lease for six years. Minimum lease
payments were $60,000 payable annually at year-end. The interest rate was 5%
with an annuity factor for six years of 5.0757. The present value of the payments
was equal to the fair market value of the equipment. What amount should Steam
report as interest expense at the end of the first year of the lease?
$0
$3,000
$15,22
7
$18,00
0
This answer is correct. The requirement is to determine the amount of interest
expense that should be reported. This problem requires you to calculate the present
value of the minimum lease payments, which is the present value of the ordinary
annuity of $60,000 at 5% for 6 periods, or $304,542 (5.0757 x $60,000). This is the
correct answer because interest expense for Year 1 is calculated as 5% of the
carrying value of $304,542, or $15,227.
Question 19:
PVE-0043
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On December 30, year 1, Ames Co. leased equipment under a capital lease for 10
years. It contracted to pay $40,000 annual rent on December 31, year 1, and on
December 31 of each of the next 9 years. The capital lease liability was recorded at
$270,000 on December 30, year 1, before the first payment. The equipments useful

life is 12 years, and the interest rate implicit in the lease is 10%. Ames uses the
straight-line method to depreciate all equipment. In recording the December 31,
year 2, payment, by what amount should Ames reduce the capital lease liability?
$27,00
0
$23,00
0
$22,50
0
$17,00
0
This answer is correct. The initial lease obligation at 12/31/Y1 was $270,000. The
first payment was made the same day, and therefore consisted entirely of principal
reduction. After the payment, the lease obligation was $230,000 ($270,000
$40,000). The next lease payment, on 12/31/Y2, consists of both principal and
interest. The interest portion is $23,000 ($230,000 x 10%), so the reduction in the
lease liability is $17,000 ($40,000 $23,000).
Question 20:
PVE-0031
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A lease contains a bargain purchase option. In determining the lessees capitalizable
cost at the beginning of the lease term, the payment called for by the bargain
purchase option would
Not be capitalized.
Be subtracted at its
present value.
Be added at its exercise
price.
Be added at its present
value.
This answer is correct. Per ASC Topic 840, minimum lease payments include the
rental payments plus the amount of the bargain purchase option if it exists. The
amount to be capitalized is the present value of the minimum lease payments.
Therefore, the present value of the bargain purchase option would be added to the
present value of the rental payments (assumed to be previously calculated) in
determining the lessees capitalizable cost.
Question 21:
PVE-0039
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On December 31, year 1, Neal, Inc. leased machinery with a fair value of $105,000
from Frey Rentals Co. The agreement is a 6-year noncancelable lease requiring
annual payments of $20,000 beginning December 31, year 1. The lease is
appropriately accounted for by Neal as a capital lease. Neals incremental borrowing
rate is 11%. Neal knows the interest rate implicit in the lease payments is 10%.

The present value of an annuity due of 1 for 6 years at 10% is 4.7908.

The present value of an annuity due of 1 for 6 years at 11% is 4.6959.
In its December 31, year 1 balance sheet, Neal should report a lease liability of
$75,81
6
$85,00
0
$93,91
8
$95,81
6
This answer is correct. The initial lease liability at 12/31/Y1, before the 12/31/Y1
payment, is $95,816 ($20,000 x 4.7908). The liability is recorded at the lower of the
FV of the leased asset ($105,000) or the PV of the minimum lease payments
($95,816). The 10% rate is used to compute PV, rather than the 11% rate, because
ASC Topic 840 states that the discount rate is to be the lessees incremental
borrowing rate, unless the lessors implicit rate is known and is less than the
lessees incremental borrowing rate. The 12/31/Y1 payment consists entirely of
principal, reducing the 12/31/Y1 liability to $75,816 (95,816 $20,000).
Question 22:
PVE-0026
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Benedict Company leased equipment to Mark, Inc. on January 1, year 2. The lease is
for an 8-year period expiring December 31, year 9. The first of 8 equal annual
payments of $600,000 was made on January 1, year 2. Benedict had purchased the
equipment on December 29, year 1, for $3,200,000. The lease is appropriately
accounted for as a sales-type lease by Benedict. Assume that the present value at
January 1, year 2, of all rent payments over the lease term discounted at a 10%
interest rate was $3,520,000. What amount of interest income should Benedict
record in year 3 (the second year of the lease period) as a result of the lease?
$261,20
0
$296,00
0
$320,00
0
$327,20
0
This answer is correct. The income recorded would be 10% of the present value of
the lease receivable balance outstanding in year 2 (year 3). The interest can be
computed using an amortization table. Notice that interest is accrued on December
31 of each year, and is paid the following day on January 1.
Cash
Interest
received Income
Dr (Cr)

Interest
receivable

Amount of
payment
applied to

Carrying
value of
the lease

principal
1/1/Y2
1/1/Y2
12/31/Y2 Interest
accrual
1/1/Y3
12/31/Y3 Interest
accrual

$600,000 $
-(292,000)
600,000

-(261,200)

$600,000
-$292,000
(292,000)
261,200

308,000

receivable
$3,520,000
2,920,000
2,920,000
2,612,000
2,612,000

Therefore, interest income in year 3 should be $261,200.

Question 23:
PVE-0024
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In a lease that is recorded as a sales-type lease by the lessor, interest revenue
Does not arise.
Should be recognized over the period of the lease using the
interest method.
Should be recognized over the period of the lease using the
straight-line method.
Should be recognized in full as revenue at the leases inception.
This answer is correct. Per ASC Topic 840, revenue is to be recognized for a salestype lease over the lease term in order to produce a constant rate of return on the
net investment in the lease. This requires the use of the interest method.
Question 24:
PVE-0036
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The lessees net carrying value of an asset arising from the capitalization of a lease
would be periodically reduced by the
Total minimum lease payment.
Portion of minimum lease payment allocable to interest.
Portion of minimum lease payment allocable to reduction
of principal.
Depreciation/amortization of the asset.
This answer is correct. The solutions approach is to prepare the journal entry for the
lease payment
Capital lease obligation
(principal)
Interest expense
Cas
h

xx
x
xx
x
xx
x

and the journal entry for the lease amortization.

Amortization of leased asset
Accumulated
amortization/depreciation

xx
x
xx
x

Therefore, only the amortization of the leased asset results in a reduction of the
carrying value of the asset.
Question 25:
PVE-0050
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On January 1, year 1, Hooks Oil Co. sold equipment with a carrying amount of
$100,000, and a remaining useful life of 10 years, to Maco Drilling for $150,000.
Hooks immediately leased the equipment back under a 10-year capital lease with a
present value of $150,000 and will depreciate the equipment using the straight-line
method. Hooks made the first annual lease payment of $24,412 in December year
1. In Hooks December 31, year 1 balance sheet, the unearned gain on equipment
sale should be
$50,00
0
$45,00
0
$25,58
8
$0
This answer is correct. According to ASC Topic 840, sale-leaseback transactions are
treated as though two transactions were a single financing transaction, if the lease
qualifies as a capital lease. Any gain on the sale is deferred and amortized over the
lease term (if possession reverts to the lessor) or the economic life (if ownership
transfers to the lessee). Since this is a capital lease, the entire gain ($150,000
$100,000 = $50,000) is deferred at 1/1/Y1. At 12/31/Y1 an adjusting entry must be
prepared to amortize 1/10 of the unearned gain (1/10 x $50,000 = $5,000), because
the lease covers 10 years. Therefore, the unearned gain at 12/31/Y1 is $45,000
($50,000 $5,000).
Question 26:
PVE-0041
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Bond Company leased equipment from Howe, Inc. on December 31, year 1, for a 10year period (the useful life of the asset) expiring December 30, year 11. Equal
annual payments under the lease are $100,000 and are due on December 31 of
each year. The first payment was made on December 31, year 1, and the second
payment was made on the due date. The present value at December 31, year 1, of
the minimum lease payments over the lease term discounted at 10% (the implicit
rate computed by Howe and known by Bond) was $676,000. Bonds incremental

borrowing rate was 12% at December 31, year 1. The lease is appropriately
accounted for as a capital lease by Bond. What should be the balance in Bonds
liability under capital lease account at December 31, year 2?
$533,60
0
$545,12
0
$607,96
0
$800,00
0
This answer is correct. The first payment (paid on the date the lease is signed)
contains no interest and is, therefore, all reduction of principal. The second
payment includes interest of $57,600 (10% x $576,000) and principal of $42,400
($100,000 $57,600). Note that because Howes implicit interest rate of 10% is
known by Bond and is lower than Bonds incremental rate, it is used to compute the
interest payment.

Cash
Date payment
12/31/Y
1
12/31/Y $100,000
1

10%
Interest

12/31/Y 100,000
2

$57,600

Reductio
n
of
Lease
principal liability
$676,0
00
576,00
0
$42,400
533,60
0

Therefore, Bond should report a liability under capital lease as of 12/31/Y2 of

$533,600.
Question 27:
PVE-0058
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Erdman Corp. signs a lease to rent equipment for ten years. The lease payments of
$20,000 per year are due on January 2 each year. At the end of the lease term,
Erdman may purchase the equipment for $500. The equipment is estimated to have
a useful life of 10 years. Erdman prepares its financial statements in accordance
with IFRS. Erdman should classify this lease as a(n):
Operating
lease.
Capital lease.
Sales-type
lease.
Finance

lease.
This answer is correct. IFRS requires a lease to be classified as a finance lease if
substantially all the risks or benefits of ownership have been transferred to the
lessee. Because the lease contains a bargain purchase option and the lease is for
the entire life of the asset, all the risks and benefits have been transferred.
Therefore, the lease meets the criteria for a finance lease.
Question 28:
PVE-0014
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Arrow Company purchased a machine on January 1, year 1, for $1,440,000 for the
purpose of leasing it. The machine is expected to have an 8-year life from date of
purchase, no residual value, and be depreciated on the straight-line basis. On
February 1, year 1, the machine was leased to Baxter Company for a 3-year period
ending January 31, year 4, at a monthly rental of $30,000. Additionally, Baxter paid
$72,000 to Arrow on February 1, year 1, as a lease bonus. What is the amount of
income before income taxes that Arrow should report on this leased asset for the
year ended December 31, year 1?
$172,00
0
$187,00
0
$222,00
0
$237,00
0
This answer is correct. Income from the lease is the monthly rental plus a
proportionate fraction of the lease bonus less any depreciation expense.
Rental income

=11 months x
=$
$30,000
330,000
=$72,000 x 11/36 =$ 22,000

Lease bonus
income
Depreciation
=$1,440,000/8
expense
years
Income from leased
asset

=$(180,00
0)
$
172,000

Note that the lease bonus is recognized as income proportionately over the 36month lease period. The leased asset is depreciated for a full year since it has an 8year life from the date of purchase (January 1).
Question 29:
PVE-0002
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Which of the following is a characteristic of a capital lease?
The lease term is substantially less than the estimated economic life of the leased

property.
The lease contains a bargain-purchase option.
The present value of the minimum lease payments at the beginning of the lease
term is 75% or more of the fair value of the property at the inception of the lease.
The future obligation does not appear in the balance sheet of the lessee.
This answer is correct because accounting standards require that a lease which
contains a bargain purchase option be classified as a capital lease.
Question 30:
PVE-0003
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Lease Y contains a bargain purchase option and the lease term is equal to 75% of
the estimated economic life of the leased property. Lease Z contains a bargain
purchase option and the lease term is equal to less than 75% of the estimated
economic life of the leased property. How should the lessee classify these leases?
Lease Y
Lease Z
Operating
Operating
lease
lease
Operating
Capital lease
lease
Capital lease Capital lease
Operating
Capital lease
lease
This answer is correct. ASC Topic 840 states that a lease shall be classified as a
capital lease by the lessee if one or more of the four criteria are met. The four
criteria are as follows:
1 Lease transfers ownership to the lessee during lease term
.
2 Lease contains a bargain purchase option
.
3 Lease term is 75% or more of the economic useful life of the property
.
4 Present value of the minimum lease payment equals 90% or more of FV of
. the leased property
Since both Lease Y and Lease Z meet at least one of the criteria, both are
considered capital leases.
Question 31:
PVE-0056
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Which of the following is a criterion for a lease to be classified as a capital lease in
the books of a lessee?
The lease contains a bargain purchase option.
The lease does not transfer ownership of the property to the lessee.

The lease term is equal to 65% or more of the estimated useful life of the leased
property.
The present value of the minimum lease payments is 70% or more of the fair
market value of the leased property.
This answer is correct. The requirement is to identify the criterion for a lease to be
classified as a capital lease. According to ASC Topic 840, this answer is correct
because if the lease contains a bargain purchase option, it must be classified as a
capital lease.
Question 32:
PVE-0023
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On August 1, year 1, Kern Company leased a machine to Day Company for a 6-year
period requiring payments of $10,000 at the beginning of each year. The machine
cost $48,000, which is the fair value at the lease date, and has a useful life of 8
years with no residual value. Kerns implicit interest rate is 10% and present value
factors are as follows:
Present value of an annuity due of $1 at 10%
for 6 periods
Present value of an annuity due of $1 at 10%
for 8 periods

4.79
1
5.86
8

Kern appropriately recorded the lease as a direct financing lease. At the inception
of the lease, the gross lease receivables account balance should be
$60,00
0
$58,68
0
$48,00
0
$47,91
0
This answer is correct. Lease payments receivable is debited for the gross
investment in the lease, which includes the minimum lease payments plus any
unguaranteed residual value. Since there is no residual value in this problem, gross
investment is simply the minimum lease payments (6 rentals at $10,000 each, or
$60,000).
Question 33:
PVE-0006
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On 1/31/Y1, Clay Company leased a new machine from Saxe Corp. The following
data relate to the lease transaction at its inception:
Lease term

10
years

Annual rental payable at beginning of each lease

year
Useful life of machine
Implicit interest rate
Present value of an annuity of 1 in advance for 10
periods at 10%
Present value of annuity of 1 in arrears for 10
periods at 10%
Fair value of the machine

$50,00
0
15
years
10%
6.76
6.15
$400,0
00

The lease has no renewal option, and the possession of the machine reverts to Saxe
when the lease terminates. At the inception of the lease, Clay should record a lease
liability of
$400,00
0
$338,00
0
$307,50
0
$0
This answer is correct. At the inception of a lease, the lessee records a lease liability
if the lease is considered to be a capital lease. To be considered a capital lease, a
lease must satisfy any one of the four criteria specified in ASC Topic 840. This lease
does not satisfy any of the four criteria. The lease has no bargain purchase option
and does not transfer title. The lease term is not 75% or more of the useful life (10
years out of 15 years is 67%) and the PV of the lease payments is not 90% or more
of the FV of the asset [(6.76 x $50,000) / $400,000 = 84.5%]. Therefore, this is an
operating lease, not a capital lease, and no liability is recorded at the leases
inception.
Question 34:
PVE-0030
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Beal, Inc. intends to lease a machine from Paul Corp. Beals incremental borrowing
rate is 14%. The prime rate of interest is 8%. Pauls implicit rate in the lease is 10%,
which is known to Beal. Beal computes the present value of the minimum lease
payments using
8%
10
%
12
%
14
%
This answer is correct. ASC Topic 840 states that the lessee should compute the PV
of the minimum lease payments using the lesser of the lessees incremental

borrowing rate (14% in this case) or the implicit rate used by the lessor if known
(10% in this case). The PV of the minimum lease payments should be computed
using the implicit rate of 10% because it is known by the lessee and is lower than
the incremental rate.
Question 35:
PVE-0012
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Initial direct costs are
Expensed currently for sales-type leases.
Capitalized and amortized to expense over the lease term for
all leases.
Capitalized only if the related lease qualifies as a capital lease.
Presented on the balance sheet as a contra account to
capitalized leased assets.
This answer is correct. Initial direct costs are costs incurred in connection with the
negotiation and consummation of leases, such as legal fees, commissions, etc. For
sales-type leases, profit or loss is recognized upon inception of the lease. In keeping
with the matching principle, the costs of consummating that lease should be taken
into income at the same time as the resulting profit or loss. Therefore, initial direct
costs for sales-type leases are expensed currently.
Question 36:
PVE-0021
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On January 1, year 1, JCK Co. signed a contract for an 8-year lease of its equipment
with a 10-year life. The present value of the 16 equal semiannual payments in
advance equaled 85% of the equipments fair value. The contract had no provision
for JCK, the lessor, to give up legal ownership of the equipment. Should JCK
recognize rent or interest revenue in year 2, and should the revenue recognized in
year 2 be the same or smaller than the revenue recognized in year 1?
Year 2 amount
recognized
compared to year
1
Rent
The same
Rent
Smaller
Interest
The same
Interest
Smaller
This answer is correct. This lease qualifies as a direct financing lease; therefore
interest revenue will be recognized rather than rent revenue. Had the lease qualified
as an operating lease, rent revenue would have been recognized. The lessors
criteria for direct financing classification is as follows:
Year 2 revenues
recognized

1 The lease transfers ownership to the lessee, at the end of the lease
.

2 The lease contains a bargain purchase option

.
3 The lease term is > 75% of an assets economic life
.
4 The present value of the minimum lease payments is > 90% of the fair value
. of the leased asset.
In addition, collectibility of the minimum lease payments must be predictable and
there may be no important uncertainties concerning costs yet to be incurred by the
lessee. Since the question is silent in this regard, we will assume that the latter
conditions are met. Recall that if one of the first four criteria are met, the lease is
treated as a capital lease. In this case, since the lease term is for 80% of the assets
economic life, test (3) is met, and the lease is properly treated as a capital lease. In
addition, the amount of interest revenue will be smaller in year 2 than the revenue
in year 1. This result occurs because the present value of the minimum lease
payments or carrying value of the obligation decreases each year as lease
payments are received. As this occurs, the amount of interest revenue on the
outstanding amount of the investment will decrease as well. Over the course of
time, the investment reduction portion of each level payment increases and the
amount of interest declines.
Question 37:
PVE-0004
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On January 1, year 1, Frost Co. entered into a two-year lease agreement with Ananz
Co. to lease 10 new computers. The lease term begins on January 1, year 1 and
ends on December 31, year 2. The lease agreement requires Frost to pay Ananz two
annual lease payments of $8,000. The present value of the minimum lease
payments is $13,000. Which of the following circumstances would require Frost to
classify and account for the arrangement as a capital lease?
The economic life of the computers is three years.
The fair value of the computers on January 1, year 1, is $14,000.
Frost Co. does not have the option of purchasing the computers at the end of the
lease term.
Ownership of the computers remains with Ananz Co. throughout the lease term and
after the lease ends.
This answer is correct because the present value of the minimum lease payments
($13,000) is greater than 90% of the fair value of the leased asset.
Question 38:
PVE-0033
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What are the three types of period costs that a lessee experiences with capital
leases?
Lease expense, interest expense,
amortization expense.
Interest expense, amortization expense,

executory costs.
Amortization expense, executory costs, lease
expense.
Executory costs, interest expense, lease
expense.
This answer is correct. The three costs incurred by a lessee with respect to capital
leases are interest expense, amortization expense, and executory costs. Each
payment consists of principal reduction and interest expense. The amount
capitalized must be amortized over the useful life of the asset. Executory costs,
such as insurance, maintenance, etc., are borne by the lessee. The basic premise in
capital leases is the risks and responsibilities of ownership are transferred from
lessor to lessee.
Question 39:
PVE-0020
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In a lease that is recorded as a direct financing lease by the lessor, the difference
between the gross investment in the lease and the sum of the present values of the
components of the gross investment should be recognized as income
In full at the leases expiration.
In full at the leases inception.
Over the period of the lease using the interest method of
amortization.
Over the period of the lease using the straight-line method of
amortization.
This answer is correct. For a direct financing lease, the difference between the gross
investment in the lease and the sum of the present values of the components of the
gross investment is, by definition, unearned interest income. Per ASC Topic 840, the
unearned interest income is recognized as income over the lease term so as to
produce a constant rate of return on the net investment using the effective interest
method of amortization. Other methods of amortization are allowed by ASC Topic
840 provided the results are not materially different from those obtained by
applying the prescribed method. Because no information is given concerning such
materiality, this answer is the best answer.
Question 40:
PVE-0027
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Melville Company leased equipment from Rice Corporation on July 1, year 1, for an
8-year period expiring June 30, year 9. Equal payments under the lease are
$600,000 and are due on July 1 of each year. The first payment was made on July 1,
year 1. The rate of interest contemplated by Melville and Rice is 10%. The cash
selling price of the equipment is $3,520,000 and the cost of the equipment on
Rices accounting records is $2,800,000. Assuming that the lease is appropriately
recorded as a sales-type lease, what is the amount of profit on the sale and interest
income that Rice should record for the year ended December 31, year 1?
$0 and $0.

$0 and $146,000.
$720,000 and
$146,000.
$720,000 and
$160,000.
This answer is correct. Melvilles gross profit is the difference between the present
value of the lease payments, $3,520,000 (which is also the cash selling price of the
equipment), and the cost of goods sold ($2,800,000), or $720,000. Interest income
is found by multiplying the book value of the receivable from the lessee (total lease
payments receivable minus unearned interest) outstanding during year 1
($3,520,000 initial balance less $600,000 payment made on 7/1/Y1) times the
implicit interest rate (10%) for 1/2 of a year. Therefore, interest income is $146,000
($2,920,000 x 10% x 1/2).
Question 41:
PVE-0025
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Farm Co. leased equipment to Union Co. on July 1, year 1, and properly recorded the
sales-type lease at $135,000, the present value of the lease payments discounted
at 10%. The first of eight annual lease payments of $20,000 due at the beginning of
each year was received and recorded on July 3, year 1. Farm had purchased the
equipment for $110,000. What amount of interest revenue from the lease should
Farm report in its year 1 income statement?
$0
$5,50
0
$5,75
0
$6,75
0
This answer is correct. In this sales-type lease, the lessor would recognize a gross
profit on the sale on 7/1/Y1 of $25,000 ($135,000 present value less $110,000 cost).
In addition, interest revenue is recognized in year 1 for the period 7/1 through
12/31. The initial net lease payments receivable on 7/1/Y1 is $135,000. The first
rental payment received on 7/3/Y1 consists entirely of principal, reducing the net
receivable to $115,000 ($135,000 - $20,000). Therefore, year 1 interest revenue for
the 6-month period is $5,750 ($115,000 x 10% x 6/12).
Question 42:
PVE-0046
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Hines Company leased a new machine from Ashwood Company on December 31,
year 1, under a lease with the following pertinent information:
Lease term
Annual rental payable at the beginning of

8 years
$

each lease year

Useful life of the machine
Present value of the 8 lease payments at
12/31/Y1

50,000
10
years
$258,0
00

The machine reverts to Ashwood at lease expiration date and has a fair value of
$280,000 at the inception of the lease. Hines uses the straight-line method of
depreciation. For the year ended December 31, year 2, how much depreciation
(amortization) should Hines record for the capitalized leased machine?
$35,00
0
$32,25
0
$28,00
0
$25,80
0
This answer is correct. Per ASC Topic 840, the lessee records the asset at the lower
of (1) the present value of the minimum lease payments or (2) the fair market value
of the leased asset. In this case, the present value ($258,000) is less than the fair
market value ($280,000); therefore, $258,000 is capitalized. Since the machine
reverts to the lessor at the end of the lease, the lessee should depreciate it over the
lease term (8 years) even though it is less than the useful life (10 years).
Depreciation expense is $32,250 ($258,000/8 years).
Question 43:
PVE-0022
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Beth Co. leased equipment to Wolf, Inc. on April 1, year 1. The lease is appropriately
recorded as a direct financing lease by Beth. The lease is for an 8-year period
expiring March 31, year 9. The first equal annual payment of $500,000 was made
on April 1, year 1. Beth had purchased the equipment on January 1, year 1, for
$2,800,000. The equipment has an estimated useful life of 8 years with no residual
value expected. Beth uses straight-line depreciation and takes a full years
depreciation in the year of purchase. The cash selling price of the equipment is
$2,934,000. Assuming an interest rate of 10%, what amount of interest income
should Beth record in year 1 as a result of the lease?
$0
$182,55
0
$243,40
0
$280,00
0
This answer is correct. The present value of the eight $500,000 lease payments is
given to be $2,934,000 (cash selling price of the equipment). Since $500,000 is paid
at the inception of the lease, the book value of the lease payments receivable (total

minimum lease payments minus unearned interest income) outstanding for the last
9 months is $2,434,000. The 10% interest thereon is $243,400, but only 3/4 (9
months/12 months) of this amount, or $182,550, is associated with the period
ending December 31, year 1.
Question 44:
PVE-0015
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On January 1, year 1, Glen Co. leased a building to Dix Corp. for a 10-year term at
an annual rental of $50,000. At inception of the lease, Glen received the first 2
years rent of $100,000 and a security deposit of $100,000. This deposit will not be
returned to Dix upon expiration of the lease but will be applied to payment of rent
for the last 2 years of the lease. What portion of the $200,000 should be shown as a
current and long-term liability, respectively, in Glens December 31, year 1 balance
sheet?
Current
Long-term
Liability
liability
$0
$ 200,000
$ 50,000
$ 100,000
$ 100,000
$ 100,000
$ 100,000
$ 50,000
This answer is correct. At 1/1/Y1, Glen would record as a current liability unearned
rent of $50,000, and as a long-term liability unearned rent of $150,000. During year
1, the current portion of unearned rent was earned and would be recognized as
revenue. At 12/31/Y1, the portion of the long-term liability representing the second
years rent ($50,000) would be reclassified as current, leaving as a long-term
liability, the $100,000 representing the last 2 years rent.
Question 45:
PVE-0038
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Barker Company leased a new machine from Bell Company on July 1, year 1, under
a lease with the following pertinent information:
Lease term

10
years
Annual rental payable at the beginning of each lease $30,0
year
00
Useful life of the machine
12
years
Implicit interest rate
14%
Present value of an annuity of $1 in advance for 10
periods at 14%
Present value of $1 for 10 periods at 14%

5.95
0.27

Barker has the option to purchase the machine on July 1, year 11, by paying
$40,000, which approximates the expected fair value of the machine on the option
exercise date. The cost of the machine on Bells accounting records is $150,000.
On July 1, year 1, Barker should record a capitalized leased asset of
$150,00
0
$178,50
0
$189,30
0
$190,00
0
This answer is correct. In a capital lease, the lessee records as an asset the lower of
(1) the present value (PV) of the minimum lease payments, or (2) the FV of the
leased asset. Since the FV is not given, we must assume that the asset is to be
recorded at the PV of the minimum lease payments. The minimum lease payments
must include any bargain purchase options (BPO). However, the $40,000 purchase
option in this problem is not a BPO, since $40,000 approximates the expected fair
value of the machine on the option exercise date. Therefore, the PV of the minimum
lease payments is $178,500 (5.95 x $30,000). Note that the cost of the asset to the
lessor ($150,000) is not relevant to the lessee.
Question 46:
PVE-0047
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In a sale-leaseback transaction, a gain resulting from the sale should be deferred at
the time of the sale-leaseback and subsequently amortized when
I. The seller-lessee has transferred substantially all the risks of ownership.
II. The seller-lessee retains the right to substantially all of the remaining
use of the property.
I only.
II only.
Both I and II.
Neither I nor II.
This answer is correct. Per ASC Topic 840, in a sale-leaseback where the sellerlessee retains the right to substantially all of the remaining use of the property, a
gain resulting from the sale should be deferred and subsequently amortized. On the
other hand, when the seller-lessee has transferred substantially all the risks of
ownership, any gain or loss on sale is recognized immediately.