Vol.

2, Chapter 5 – Lease Accounting

Problem 1: Solution

Option 1:
Year 1 Year 2 Year 3
January $ 5,000 $ 5,200 $ 5,400
February $ 5,000 $ 5,200 $ 5,400
March $ 5,000 $ 5,200 $ 5,400
April $ 5,000 $ 5,200 $ 5,400
May $ 5,000 $ 5,200 $ 5,400
June $ 5,000 $ 5,200 $ 5,400
July $ 5,000 $ 5,200 $ 5,400
August $ 5,000 $ 5,200 $ 5,400
September $ 5,000 $ 5,200 $ 5,400
October $ 5,000 $ 5,200 $ 5,400
November $ 5,000 $ 5,200 $ 5,400
December $ 5,000 $ 5,200 $ 5,400
Total $60,000 $62,400 $64,800

Total rent for 3 years = $187,200

Option 2:
Year 1 Year 2 Year 3
January $ 5,000 $ 5,200 $ 5,400
February $ 5,000 $ 5,200 $ 5,400
March $ 5,000 $ 5,200 $ 5,400
April $ 5,000 $ 5,200 $ 5,400
May $ 5,000 $ 5,200 $ 5,400
June $ 5,000 $ 5,200 $ 5,400
July $ 5,000 $ 5,200 $ 5,400
August $ 5,000 $ 5,200 $ 5,400
September $ 5,000 $ 5,200 $ 5,400
October $ 5,000 $ 5,200 $ 5,400
November $ 5,000 $ 5,200 $ 5,400
December $ 5,000 $ 5,200 $ 5,400
Total $60,000 $62,400 $64,800

Rent = $4,000 + 1% of monthly sales

Year Monthly sales
1 $100,000
2 120,000
3 140,000
Total rent for 3 years = $187,200

Lease Accounting  1 
Problem 2: Solution

1. Rent expense 1,000

Prepaid rent 2,000
Cash 3,000

To record the payment of rent for April-June.

2. Rent expense 1,000
Prepaid expense 1,000

To recognize rent for May.

Problem 3: Solution

1. Indifference point:
= $4,200 / .05 × 12
= $1,008,000
2. Should Paula agree to new terms?
In 20X6 her lease payment will be $3,958 per month.
In 20X7 her lease payment will be $4,433 per month.

Paula should stay with her current arrangement because she

will save only $9 after the first two years, and will begin to
lose money after that.

3. Cost of error over 5 years

In 20X6 her lease payment will be $3,958 per month.
In 20X7 her lease payment will be $4,433 per month.
In 20X8 her lease payment will be $4,965 per month.
In 20X9 her lease payment will be $5,561 per month.
In 20X0 her lease payment will be $6,229 per month.

Total lease payment made over 5 years with error

= $301,760.25

Total lease payment made over 5 years without error

= $252,000

Difference = $49,760.25
Taxes at 25% = $12,440.06
Error net of tax = $37,320.19

Lease Accounting  2 
Problem 4: Solution

1. Rent expense 3,000.00

Cash 3,000.00

To record the payment of rent for one month.

2. Security deposit 5,000.00

Cash 5,000.00

To record payment of security deposit.

3. Amortization 1,666.67
Leasehold Improvement 1,666.67

To amortize leasehold improvement and recognize expense for

one month. Calculation of amortization:
Leasehold improvement × 1/60 = 100,000 × 1/60 = $1,666.67
Problem 5: Solution

Part 1
7/1/X1 Prepaid Computer Lease $2,000
Deferred Computer Expense 2,000
Cash $4,000

To record initial lease payment.

Part 2
7/31/X1 Computer Lease Expense $2,000
Prepaid Computer Lease $2,000

To record computer lease expense for July 20X1.

Part 3
8/1/X1 Prepaid Computer Lease $2,000
Cash $2,000

To record computer lease payment for August 20X1.

Lease Accounting  3 
Problem 6: Solution
1. Alternative #1
Total
Year Rent Other Costs
1 $24,000 $12,000 $36,000
2 24,000 12,600 36,600
3 24,000 13,200 37,200
4 24,000 13,800 37,800
5 24,000 14,400 38,400
6 24,000 15,000 39,000
7 24,000 15,600 39,600
8 24,000 16,200 40,200
9 24,000 16,800 40,800
10 24,000 17,400 41,400
Alternative #2
Year Rent
1 $33,600
2 34,440
3 35,280
4 36,120
5 36,960
6 37,800
7 38,640
8 39,480
9 40,320
10 41,160

2. Alternative #2 is recommended. It is recommended because

total costs are minimized with this alternative over the 10-
year period.
Problem 7: Solution

Part 1
Present value of payments:
Initial payment $10,000
Payments at the end of years 1-5 (10,000 × 3.6048) 36,048
Total $46,048
Part 2
Amortization of Obligation:
Annual Reduction Balance of
Date of Lease Interest in Liability
Payment Payment Expense Liability Account
Total capitalized $46,048
Signing of lease $10,000 - $10,000 36,048
1 year later 10,000 $4,326 5,674 30,374
2 years later 10,000 3,645 6,355 24,019
3 years later 10,000 2,882 7,118 16,901
4 years later 10,000 2,028 7,972 8,929
5 years later 10,000 1,071 8,929 -0-
Total $60,000 $13,952 $46,048

Lease Accounting  4 
Problem 8: Solution
1. Present value of lease payment:

Annual lease payments = $5,000

Less: Amount of maintenance
Contract = $1,000
Net lease payment = $4,000
Present value of an annuity
for 4 payments at 10% = 3.1699
Plus present value for
initial payment at 10% = 1 × initial payment of
$4,000-1,000
= $3,000
Present value = $3,000 + $4,000 × 3.1699
= $15,679.60
2. Should the lease be capitalized?
The lease should be capitalized because it meets criterion #4.
The present value of the payments is 90% or more of the fair
market value.
Problem 9: Solution
1. Present value of lease payments
Present
Payment Value of
Number Payment Payment
1 $2,000 $2,000.00
2 2,000 1,941.75
3 2,000 1,885.19
4 2,000 1,830.28
5 2,000 1,776.97
6 2,000 1,725.22
7 2,000 1,674.97
8 2,000 1,626.18
9 2,000 1,578.82
10 2,000 1,532.83
11 2,000 1,488.19
12 2,000 1,444.84
$20,505.25
2. If the lease is capitalized, no rent is recorded over the
life of the lease.

3. Amount of interest recorded over the life of the lease if

the lease is capitalized:
Amount of payments = $2,000 × 12 = $24,000.00
Present value of lease payments per part 1 above: $20,505.25
Total interest expense: $3,494.75

Lease Accounting  5 
Problem 10: Solution

1. The lease should be capitalized based on the bargain

purchase provision.

2. Present value of the 10 payments of $2,300 is $18,648 based

on a 10% discount rate (annuity due). (8.1078 × $2,300 =
$18,648)
Present value of the $500 future purchase is $310. (500 ×
.6209 = $310)

So the present value of the lease is $18,648 + $310 =

$18,958.

Journal entry:
Leased equipment under capital lease $18,958
Prepaid insurance $ 200

Cash $ 2,500
Obligations under lease $16,658
Problem 11: Solution
Part 1
Value Recovery Provision: Is the present value of lease payments
equal to or greater than $5,400 (90% of $6,000)?
initial payment $1,525.00
payments 2-5: 1,525 × 3.0373 4,631.88
$6,156.88

Since $6,156.88 is greater than $5,400, the lease of the posting

machine should be capitalized at $6,156.88.
Part 2
The renovation of the hotel should be capitalized at $200,000
(100 rooms × $2,000 per room).
Part 3

Annual Amortization:$200,000 = $8,510.64

23.5

Lease Accounting  6 
Problem 12: Solution
Part 1
Value Recovery Provision:
P.V. of lease payments = fair market value × .9

Since 4,604.80* is greater than 4,050**, the owner is wrong in

his belief.

*$1,000 + $1,000(3.6048) = $4,604.80

**($4,500)(.9) = $4,050

Part 2

The present value of the lease payment stream is $4,604.80.

Part 3

Leased equipment under capital lease $4,604.80

Cash $1,000.00
Obligation under capital lease 3,604.80

Part 4

Interest for 20X1: 3,604.80 × .12 = $432.58

Part 5

Lease payments 2-5 $5,000.00

Obligation under capital lease 3,604.80
Total interest (20X1-20X5) $1,395.20

Lease Accounting  7 
Problem 13: Solution
1. Compare the present value of lease payments to 90% of the
fair market value:
Payment Payment PV of
Number Net of Maint. Payment
1 $5,300 $ 5,170.73
2 5,300 5,044.62
3 5,300 4,921.58
4 5,300 4,801.54
5 5,300 4,684.43
6 5,300 4,570.17
7 5,300 4,458.71
8 5,300 4,349.96
9 5,300 4,243.86
10 5,300 4,140.35
11 5,300 4,039.37
12 5,300 3,940.85
13 5,300 3,844.73
14 5,300 3,750.95
15 5,300 3,659.47
16 5,300 3,570.21
17 5,300 3,483.13
18 5,300 3,398.18
19 5,300 3,315.30
20 5,300 3,234.44
RVG 4,000 2,441.08
$85,063.64
The lease should be capitalized since $85,063.64 exceeds
$67,500.
2. Leased equipment $85,063.64
Obligations under capital lease $85,063.64
To record capitalization of leased computer system.
3. Journal entry to record the second payment:
Maintenance expense $ 200.00
Interest expense 2,047.26
Obligations under capital lease 3,252.74
Cash $5,500.00
Determination of interest expense: Interest rate for the
quarter × obligations under capital lease for quarter
Obligation at 1/1/X1 $85,063.64
Reduction at 3/31/X1:
Payment net of maint. $5,300.00
Interest for quarter 2,126.59 3,173.41
Obligation at 3/31/X1 81,890.23
Interest for the quarter: $81,890.23 × .025 = $2,047.26

Lease Accounting  8 
Problem 14: Solution

Part 1

Initial payment $10,000.00

Future payments (4) (10,000 × 3.2397) 32,397.00
Residual value guarantee (5,000 × .6499) 3,249.50

Total $45,646.50

Part 2

Leased equipment $45,646.00

Cash $10,000.00
Obligations under capital lease 35,646.50

Part 3

Obligations under capital lease $6,791.81

Interest expense 3,208.19
Cash $10,000.00

Problem 15: Solution

Part 1
Initial payment $35,000
Less: maintenance costs (5,000)
30,000

Future net lease payments ($30,000 × 3.1699) 95,097

Residual guarantee ($10,000 × .6209) 6,209

Total $131,306
Part 2

$131,306 > 140,000 (.9)

Yes. The present value of lease payments exceeds 90% of the

system's fair market value.

Lease Accounting  9 
Problem 16: Solution

Part 1

Present Value of Lease Payments:

Initial payment (net) $ 47,000

Future payments (net) (47,000 × 3.1699) 148,985

$195,985

Leased equipment $195,985

Prepaid maintenance 10,000
Prepaid insurance 3,000
Cash $60,000
Obligations under capital leases $148,985

Part 2
Obligations under capital leases $32,101.50
Interest expense 14,898.50
Prepaid maintenance 10,000.00
Prepaid insurance 3,000.00
Cash $60,000

Part 3

Total payments net of maintenance

and insurance (47,000 × 5) $235,000
Capitalized leased equipment 195,985

Total interest $ 39,015

Lease Accounting  10 
Problem 17: Solution

Part 1

Initial lease payment (net) $ 9,500

Future net base payments (9,500 × 9.3936) 89,239
Residual value guaranteed (10,000 × .5051) 5,051

Total $103,790

Prepaid expense $ 500

Leased equipment 103,790
Cash $10,000
Obligation under capital leases $94,290

Part 2

Annual Reduction Balance of

Date of Lease Interest in Liability
Payment Payment Expense Liability Account

Capitalization of lease $103,790

1/1/X3 $ 9,500 $ 0 $ 9,500 94,290
7/1/X3 9,500 4,715 4,785 89,505
1/1/X4 9,500 4,475 5,025 84,480
7/1/X4 9,500 4,224 5,276 79,204
1/1/X5 9,500 3,960 5,540 73,664
7/1/X5 9,500 3,683 5,817 67,847
1/1/X6 9,500 3,392 6,108 61,739
7/1/X6 9,500 3,087 6,413 55,326
1/1/X7 9,500 2,766 6,734 48,593
7/1/X7 9,500 2,430 7,070 41,522
1/1/X8 9,500 2,076 7,424 34,098
7/1/X8 9,500 1,705 7,795 26,303
1/1/X9 9,500 1,315 8,185 18,119
7/1/X9 9,500 906 8,594 9,525
12/31/9 10,000* 476 9,525** 0

$143,000 $ 39,211 $103,790

*Assumes residual guarantee of $10,000 will be paid.

**Minor difference of $1 due to rounding.

Lease Accounting  11 
Problem 18: Solution

Part 1

Net Income
1. Return on Fixed Assets =
Average Fixed Assets

$550,000 = 9.32%
Return on Fixed Assets =
$5,900,000

Net Income
2. Return on Total Assets =
Average Total Assets

$550,000 = 8.30%
Return on Total Assets =
$6,625,000

EBIT
3. Number of Times Interest Earned =
Interest Expense

Number of Times Interest Earned = $1,595,000 = 2.55 times

$625,000

Part 2

$550,000 = 8.70%
Return on Fixed Assets =
$6,325,000

$550,000 = 7.80%
Return on Total Assets =
$7,050,000

Number of Times Interest Earned = 1,695,000 = 2.34 times

725,000

Part 3

Based on the above calculations, the noncapitalization results in

higher ratios than if the lease had been capitalized. Therefore,
this would generally be considered to be a wise decision,
everything else being the same.

Lease Accounting  12 
Problem 19: Solution

1. East Coast's balance sheet after acquisition:

Total Assets $8,000,000

Debt $5,500,000
Equity $2,500,000
Total Claims $8,000,000

2. West Bank's balance sheet (operating lease):

Total Assets $5,000,000

Debt $2,500,000
Equity $2,500,000
Total Claims $5,000,000

3. West Bank's balance sheet (capitalized lease):

Total Assets $8,000,000

Debt $5,500,000
Equity $2,500,000
Total Claims $8,000,000

4. Debt-equity ratio:

East Coast's debt-equity ratio = $5,500,000 / $2,500,000 = 2.20

West Bank's debt-equity ratio:
operating lease = $2,500,000 / $2,500,000 = 1.00
capital lease = $5,500,000 / $2,500,000 = 2.20

5. Return on assets and return on equity:

Return on Assets Return on Equity

East Coast 10% 32%

West Bank(OL) 16% 32%
West Bank (CL) 10% 32%

Lease Accounting  13 
Problem 20: Solution
1. Present value of leasing:
Years 0 1 2 3 4 5
Lease $9,000 $9,000 $9,000 $9,000 $9,000 $ 0
Less: Lease tax shield* 2,700 2,700 2,700 2,700 2,700
Annual cash flows 9,000 6,300 6,300 6,300 6,300 -2,700
PV factors 1 0.9259 0.8573 0.7938 0.735 0.6806
PV of cash flows $9,000 $5,833 $5,401 $5,001 $4,631 ($1,838)
Total present value of cash flows = $28,028
* Tax shield = $9,000 * 30% = $2,700
2. Present value of owning:
Years 0 1 2 3 4 5
Purchase price $35,000
Maintenance $2,000 $2,000 $2,000 $2,000 $2,000
Salvage value -5,000
Less: Depreciation tax shield -2,400 -2,400 -2,400 -2,400 -2,400
Net purchase cost
Annual cash flows $35,000 (400) (400) (400) (400) (5,400)
Discount factors 1 0.9259 0.8573 0.7938 0.735 0.6806
PV of cash flows $35,000 ($370) ($343) ($318) ($294)($3,675)
Total present value of cash flows = $32,396
1.) Depreciation tax shield = depreciation expense * tax rate
=((($35,000 - 5,000) / 5) + 2,000) * 30% = $2,400

3. Recommendation:
Recommend that RR lease the fairway mower, since the present values of cash
flows is significantly lower with leasing compared to owning

Lease Accounting  14